Lewis Model And Its Value In Understanding Growth In A Labor Surplus Economy

Labor supply and economic growth

The following essay focuses on the dual sector model. It is more famously known as the Lewis model and the relevance of this model in a labor surplus economy like China. This model explains the impact of labor migration between two major sectors. The model consists of capitalist and subsistence sector. Capitalist sector refers to the urban manufacturing sector, and subsistence sector refers to the traditional agricultural sector. In this report, the Lewis model is applied on the economic transition of China, which is a labor surplus economy and consists of the capitalist and subsistence sectors, and the relevance of it has been discussed.

The subsistence sector, i.e. sector D has unlimited labor supply. Thus, the rate of wage is comparatively lower in sector D than in sector C. The urban manufacturing sector absorbs this extra labor from the traditional sector and develops. In the traditional agricultural sector, the marginal products of labor become zero after a certain point due to fixed supply of land. Hence, employing labor after that point leads to a fall in the total output. Therefore, there is existence of surplus labor in the traditional sector, and transfer of one unit of labor to the capitalist sector does not decrease the output of the traditional sector. On the other hand, in the capitalist or industrial sector, the scarcity of labor supply keeps the wage at a higher level. The trade unions also bargain to push the wage higher and maintain that (Hunt 1989). However, Lewis said that the wages in urban manufacturing sector stays same, while the surplus is earned by the capitalists. The surplus labor from the agricultural sector migrates to the capitalist or industrial sector to look for jobs. The labor, disguisedly unemployed in the traditional sector, gets employment in the urban sector. Hence, production in the industrial sector increases and surplus is generated. These surpluses are reinvested further in the economy. As the modern sector has both the forward and backward linkages, the growth in output in one sector results in the increase in demand in the related sectors. According to Gollin (2014), the speed of the expansion is dependent on the investment rate and formation of the capital in the sector as well as in the economy. In the urban region, the wage is steady and even but more than that in the rural region. The higher wage attracts the agricultural workers to move to the urban areas for jobs. Thus, the modern industrial sector is expanded with a rise in the employment for restoring the economic growth. Higher employment indicates higher aggregate demand, rise in the national output and further economic growth.

Figure 1: Traditional sector production function

(Source: Author)

Figure 1 depicts the production function in the traditional agricultural sector. It shows that the traditional agricultural sector employs labor more than the highest point of the total production curve. At the highest point on the TP_L curve, the marginal product of labor is zero, as shown in figure 1(a) and 1(b), i.e. point L₁. An increase in the employment beyond this point would lead to a fall in the output due to lack of resources and inefficiency of labor. Therefore, beyond L1, the migration of any worker from the traditional to the industrial sector would lead to improvement in the productivity of remaining labor in the traditional sector and the employment of that worker in the industrial sector increases productivity in this sector (Temin 2015). The migration of worker results in the autonomous expansion of demand, increase in government purchases and expansion in the different sectors in the economy.

Discussion on the dual sectors of the model

The two sectors in this Lewis model are the Capitalist sector (C) and Subsistence sector (D). The modern capitalist sector is characterized by short supply of labor, and hence, higher wage of the labor. Lewis assumed that the wage is fixed at a level. The other important feature is competitive and free market. The demand is higher for the specialized or skilled labor. This modern sector expands by absorbing the surplus labor of the traditional sector, i.e. sector D. This sector is usually comprised of MNCs and large scale industries. Surplus is generated in this sector, which is reinvested for further capital formation and expansion of this sector. Labor gets employment at a point where real wage is equal to marginal product of labor (Diao and McMillan 2017).

The traditional or subsistence sector (D) is characterized by unlimited supply of labor, low wage and coexistence of small scale industries and agriculture. Disguised unemployment or the presence of surplus labor is a very important feature of this sector. The market only serves the needs of the local community and lack of product differentiation makes the market less competitive. The other important feature of this sector is that the marginal productivity of labor (MP_L) is less than the subsistence level of wage (Wang and Piesse 2013).

The developing countries in the world are traditionally agriculture based economies. According to Naudé (2013), in a developing economy, migration of labor can lead to three stages of labor productivity.

In stage I, the marginal productivity of labor is less than the subsistence level of wage, that is, MP_L = 0 < W_S (Hodson 2014). There is disguised unemployment at this stage in the agricultural sector in the absolute terms.

In the stage II, when the capitalist sector wants to the absorb the surplus labor from the traditional sector, then the wage rate in this sector starts rising. In this stage, W_S > MP_L > 0, this means that subsistence wage level is higher than the marginal product of labor, which is again higher than zero. At this level, the surplus labor starts to shrink (Lewis 1997).

In stage III, as the labor migration to the modern sector rises, labor supply rises in this sector, while that falls in the traditional agricultural sector below the point L1. The higher ages in the modern sector attracts the surplus labor from the agricultural sector. Hence, marginal productivity of labor increases more than the subsistence level of wage and therefore, the rate of wage in the traditional sector starts rising (Fergusson 2013). As the rate of wage increases in sector D, the standard of living of the labor also increases. This leads to a rise in the aggregate demand in the economy for consumer and other industrial goods. This rising demand for the industrial goods leads to an expansion of the industrial sector C. The deficit in the labor supply in the C sector is therefore filled by the surplus labor of sector D, who migrates to sector C due to higher wages.

Impact of the migration of labor

At the same time, as the congestion of workers increases in the urban areas, the demand for food and other agricultural and industrial products increase. The workers buy the products at the market price. The demand for the agricultural products initially comes from the local communities. From the turning point in stage II, the demand for these products rises from the urban areas also. The demand also increases from the exports to the international market. The Lewis turning point occurs in stage III, and in this stage, the commercialization of agricultural labor happens. Therefore, the traditional agricultural sector also expands along with the modern capitalist sector. However, there exists a wage gap between the skilled and unskilled labor in the urban areas. The demand for the skilled workers is higher, leading to higher wage compared to that of the unskilled workers (Rodrik 2014).

According to Yu et al. (2013), the labor and capital are each other’s complementary; the low level of capital and surplus labor reduce the investment in the traditional agricultural sector. The economic benefits in an economy is realized when the level of employment increases, investment rises and different sectors of the economy expand. Rise in employment increases the level of output in a sector as the more labor are employed for the production process. However, the additional labor is only productive when the marginal productivity is increasing complemented by the level of capital. In a labor surplus economy like China, migration of labor leads to flexibility of labor market. The younger workers are more educated and skilled relative to the older workers. Hence, any sector can utilize the human capital in a more efficient way if it employs more of the young workers. Lewis (1993) stated that, the contribution of the young workers is more in terms of production, taxes and social events as compared to the benefits that they receive from the government. These young workers are easily motivated and can be encouraged to innovate and improve in terms of production. Innovation leads to enhancement of the marginal productivity of labor as well as of capital.

The above discussion on the dual sector of Lewis model can be illustrated with an example from the economy of China. Chinese economy witnessed massive growth during 1965-2009. This can be attributed to the growth of the non-agricultural sector, i.e. the industrial sector. It was driven by capital formation and rapid labor migration. The dualistic economic development of the Lewis model was present in the Chinese economy during this period (Rodrik 2014). It was an agrarian economy initially. There was surplus labor with low productivity. Rural liberalization in 1978 led to release of surplus labor from the rural economy. As the labor supply increased in the industrial sector, economic activities also increased. It also made the labor market competitive and raised the wage level. Due to existence of surplus labor, the workers wanted to get employment at the minimum wage, the firms also induced to employ more labor at lower wages. Hence, the non agricultural sector witnessed a rapid development. The increase in the total factor productivity led to a rapid growth in the Chinese economy since 1990. As the productivity of one sector increases, its capacity to meet the demands of both the domestic and international market increases. Hence, export sector expands and export is increased. The economy thus goes through a structural change. China’s economic reform policies facilitated the economic transition. GDP increased due to rising economies of scale. The increase in employment reduced the level of poverty of the developing country (Lewis 2013).

As mentioned earlier, the third turning point in this model results in the commercialization of the traditional agricultural sector. Commercialization results in expansion of demand for foods in urban regions. However, the too much supply of labor leads to unemployment in this sector due to the gap in skills, but, the real wage of the existing workers rises (Temin 2015).

Conclusion

The essay describes the impact of the migration of labor on a dual sector economy. The labor migration leads to rise in the trade of goods and services of the non agricultural sectors of an economy. An economy goes through a transition when the labor starts to migrate from traditional agricultural sector to the modern industrial sector. The modern sector expands with the absorption of the migrated surplus labor of the traditional sector. The surplus labor moves to the modern sector to get employment at a higher wage. However, as the labor supply increases, the wage in the modern sector falls. Commercialization leads to rise in wage in the agricultural sector. Hence, both the sectors get developed due to absorption of the surplus labor. Although, there exists a wage gap in the modern sector due to a gap in skills of the workers. Therefore, the transition of the labor from one sector to the other leads to structural changes in the economy.

References

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