STRUCTURAL-CHANGE GROWTH MODELS

• The focus of these theories is on the way economies are transformed over
time, from traditional to modern/industrial economies.

• The Basic Model is the Lewis theory of Structural Economic Growth and
Development.

• Arthur Lewis put forward a development model of a dualistic economy,

consisting of rural agricultural and urban manufacturing sectors.

• The Model explains the “structural transformation” of a

subsistence/agricultural economy to a modern/Industrial economy.

The Lewis Model

The Lewis model is a model of STRUCTURAL CHANGE since it outlines the
development from a traditional economy to an industrialized one.

Key Assumptions and Implications:

• Two sectors- traditional-labor surplus economy that co-exists with

modern/Industrial sector- There is an “economic dualism”.

• Labor surplus in traditional/agricultural sector. Much of this is unskilled.

• The Lewis model implies employment will expand until surplus labor is
absorbed in the modern or industrial sector.

Detailed Assumptions

• The model assumes that a developing economy has a surplus of

unproductive labor in the agricultural sector.

• These workers are attracted to the growing manufacturing sector where

higher wages are offered.

• It also assumes that the wages in the manufacturing sector are more or less
fixed.

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 • Entrepreneurs in the manufacturing sector make profit because they charge a
price above the fixed wage rate.

• The model assumes that these profits will be reinvested in the business in the
form of fixed capital.

• An advanced manufacturing sector means an economy has moved from a

traditional to an industrialized one.

The theory

W. A. Lewis divided the economy of an underdeveloped country into 2 sectors:

1. The capitalist sector

• Lewis defined this sector as "that part of the economy which uses
reproducible capital and pays capitalists thereof".

• The use of capital is controlled by the capitalists, who hire the services of
labour.

• It includes manufacturing, plantations, mines etc. The capitalist sector may

be private or public.

2. The subsistence sector

• This sector was defined by him as "that part of the economy which is not
using reproducible capital".

• It can also be adjusted as the indigenous traditional sector or the "self-

employed sector".

• The per-head output is comparatively lower in this sector and this is because
it is not fructified with capital.

• The "Dual Sector Model" is a theory of development in which surplus labor

from traditional agricultural sector is transferred to the modern industrial
sector whose growth over time absorbs the surplus labor, promotes
industrialization and stimulates sustained development.

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 • In the model, the subsistence agricultural sector is typically characterized by
low wages, an abundance of labour, and low productivity through a labor-
intensive production process.

• In contrast, the capitalist manufacturing sector is defined by higher wage

rates as compared to the subsistence sector, higher marginal productivity,
and a demand for more workers.

• Also, the capitalist sector is assumed to use a production process that

is capital intensive, so investment and capital formation in the manufacturing
sector are possible over time as capitalists' profits are reinvested in the
capital stock.

• Improvement in the marginal productivity of labour in the agricultural sector

is assumed to be a low priority as the hypothetical developing nation's
investment is going towards the physical capital stock in the manufacturing
sector.

Relationship between the two sectors

The primary relationship between the two sectors is that when the capitalist sector
expands, it extracts or draws labour from the subsistence sector. This causes the
output per head of labourers who move from the subsistence sector to the capitalist
sector to increase. Since Lewis in his model considers overpopulated labour
surplus economies he assumes that the supply of unskilled labour to the capitalist
sector is unlimited. This gives rise to the possibility of creating new industries and
expanding existing ones at the existing wage rate. A large portion of the unlimited
supply of labor consists of those who are in disguised unemployment in agriculture
and in other over-manned occupations such as domestic services casual jobs, petty
retail trading. Lewis also accounts for two other factors that cause an increase in
the supply of unskilled labour, they are women in the household and population
growth.
The agricultural sector has a limited amount of land to cultivate, the marginal
product of an additional farmer is assumed to be zero as the law of diminishing
marginal returns has run its course due to the fixed input, land. As a result, the
agricultural sector has a quantity of farm workers that are not contributing to
agricultural output since their marginal productivities are zero. This group of
farmers that is not producing any output is termed surplus labour since this cohort
could be moved to another sector with no effect on agricultural output. (The term

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surplus labour here is not being used in a Marxist context and only refers to the
unproductive workers in the agricultural sector.) Therefore, due to the wage
differential between the capitalist and subsistence sector, workers will tend to
transition from the agricultural to the manufacturing sector over time to reap the
reward of higher wages. However even though the marginal product of labor is
zero, it still shares a part in the total product and receives approximately the
average product.
If a quantity of workers moves from the subsistence to the capitalist sector equal to
the quantity of surplus labour in the subsistence sector, regardless of who actually
transfers, general welfare and productivity will improve. Total agricultural product
will remain unchanged while total industrial product increases due to the addition
of labour, but the additional labour also drives down marginal productivity and
wages in the manufacturing sector. Over time as this transition continues to take
place and investment results in increases in the capital stock, the marginal
productivity of workers in the manufacturing will be driven up by capital
formation and driven down by additional workers entering the manufacturing
sector. Eventually, the wage rates of the agricultural and manufacturing sectors
will equalize as workers leave the agriculture sector for the manufacturing sector,
increasing marginal productivity and wages in agriculture whilst driving down
productivity and wages in manufacturing.
The end result of this transition process is that the agricultural wage equals the
manufacturing wage, the agricultural marginal product of labour equals the
manufacturing marginal product of labour, and no further manufacturing sector
enlargement takes place as workers no longer have a monetary incentive to
transition.
Surplus labour and the growth of the economy

Surplus labour can be used instead of capital in the creation of new industrial
investment projects, or it can be channeled into nascent industries, which are labor-
intensive in their early stages. Such growth does not raise the value of the
subsistence wage, because the supply of labor exceeds the demand at that wage,
and rising production via improved labour techniques has the effect of lowering the
capital coefficient. Although labour is assumed to be in surplus, it is mainly
unskilled. This inhibits growth since technical progress necessary for growth
requires skilled labor. But should there be a labor surplus and a modest capital, this
bottleneck can be broken through the provision of training and education facilities.
The utility of unlimited supplies of labour to growth objectives depends upon the
amount of capital available at the same time. Should there be surplus labour,
agriculture will derive no productive use from it, so a transfer to a non-agriculture

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sector will be of mutual benefit. It provides jobs to the agrarian population and
reduces the burden of population from land. Industry now obtains its labour.
Labour must be encouraged to move to increase productivity in agriculture. To
start such a movement, the capitalist sector will have to pay a compensatory
payment determined by the wage rate that people can earn outside their present
sector, plus a set of other amounts includes the cost of living in the new sector and
changes in the level of profits in the existing sector. The margin capitalists may
have to pay is as much as 30 per cent above the average subsistence
wage, WW1 in figure which represents the capitalist sector is shown by N; OW is
the industrial wage. Given the profit maximization assumption, employment of
labor within the industrial sector is given by the point where marginal product is
equal to the rate of wages, i.e. OM.

Since the wages in the capitalist sector depend on the earnings of the subsistence
sector, capitalists would like to keep down productivity/wages in the subsistence
sector, so that the capitalist sector may expand at a fixed wage. In the capitalist
sector labor is employed up to the point where its marginal product equals wage,
since a capitalist employer would be reducing his surplus if he paid labor more
than he received for what is produced. But this need not be true in subsistence
agriculture as wages could be equal to average product or the level of subsistence.
The total product labor ONPM is divided between the payments to labor in the
form of wages, OWPM, and the capitalist surplus, NPW. The growth of the
capitalist sector and the rate of labor absorption from the subsistence sector
depends on the use made of capitalist surplus. When the surplus is reinvested, the
total product of labor will rise. The marginal product line shifts upwards to the
right that is to N1. Assuming wages are constant, the industrial sector now

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provides more employment. Hence employment rises by MM1. The amount of
capitalist surplus goes up from WNP to WN1P'. This amount can now be
reinvested and the process will be repeated and all the surplus labor would
eventually be exhausted. When all the surplus labor in the subsistence sector has
been attracted into the capitalist sector, wages in the subsistence sector will begin
to rise, shifting the terms of trade in favor of agriculture, and causing wages in the
capitalist sector to rise. Capital accumulation has caught up with the population
and there is no longer scope for development from the initial source, i.e. unlimited
supplies of labor. When all the surplus labor is exhausted, the supply of labor to the
industrial sector becomes less than perfectly elastic. It is now in the interests of
producers in the subsistence sector to compete for labor as the agricultural sector
has become fully commercialized. It is the increase in the share of profits in the
capitalist sector which ensures that labor surplus is continuously utilized and
eventually exhausted. Real wages will tend to rise along with increases in
productivity and the economy will enter into a stage of self-sustaining growth with
a consistent nature.[6]
Capital accumulation

The process of economic growth is inextricably linked to the growth of capitalist

surplus, that is as long as the capitalist surplus increases, the national income also
increases raising the growth of the economy. The increase in capitalist surplus is
linked to the use of more and more labor which is assumed to be in surplus in case
of this model. This process of capital accumulation does come to an end at some
point.
This point is where capital accumulation catches up with population so that there is
no longer any surplus labor left. Lewis says that it the point where capital
accumulation comes to a stop can come before also that is if real wages rise so
high so as to reduce capitalists' profits to the level at which profits are all
consumed and there is no net investment.
This can take place in the following ways:

1. If the capital accumulation is proceeding faster than population growth

which causes a decline in the number of people in the agricultural or
subsistence sector.
2. The increase in the size of the capitalist or industrial sector in comparison to
the subsistence sector may turn the terms of trade against the capitalist
sector and therefore force the capitalists to pay the workers/laborers a higher
percentage of their product in order to keep their real income constant.

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 3. The subsistence sector may adopt new and improved methods and
techniques of production, this will raise the level of subsistence wages in
turn forcing an increase in the capitalist wages. Thus both the surplus of the
capitalists and the rate of capital accumulation will then decline.
4. Even though the productivity of capitalist sector remains unchanged, the
workers in the capitalist sector may begin to imitate the capitalist style and
way of life and therefore may need more to live on, this will raise the
subsistence wage and also the capitalist wage and in turn the capitalist
surplus and the rate of capital accumulation will decline.

The Lewis Model of Modern-Sector Growth in a Two-Sector Surplus-Labor

Economy

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However it has been criticized on the following grounds:

1) Economic development takes place via the absorption of labor from the
subsistence sector where opportunity costs of labor are very low. However,
if there are positive opportunity costs, e.g. loss of crops in times of peak
harvesting season, labor transfer will reduce agricultural output.

2) Absorption of surplus labor itself may end prematurely because competitors

may raise wage rates and lower the share of profit.

It has been shown that rural-urban migration in the Egyptian economy was
accompanied by an increase in wage rates of 15 per cent and a fall in profits of 12
per cent.(Wages in the industrial sector were forced up directly by unions and
indirectly through demands for increased wages in the subsistence sector, as
payment for increased productivity).

• In fact, given the urban-rural wage differential in most poor countries, large
scale unemployment is now seen in both the urban and rural sectors.

3) The Lewis model underestimates the full impact on the poor economy of a
rapidly growing population, i.e. its effects on agriculture surplus, the
capitalist profit share, wage rates and overall employment opportunities.
Similarly, Lewis assumed that the rate of growth in manufacturing would be
identical to that in agriculture, but if industrial development involves more
intensive use of capital than labor, then the flow of labor from agriculture to
industry will simply create more unemployment.

4) Lewis seems to have ignored the balanced growth between agriculture and
industry. Given the linkages between agricultural growth and industrial
expansion in poor countries, if a section of the profit made by the capitalists
is not devoted to agricultural development, the process of industrialization
would be jeopardized.

5) Possible leakages from the economy seem to have been ignored by Lewis.
He assumes boldly that a capitalist's marginal propensity to save is close to
one, but a certain increase in consumption always accompanies an increase
in profits, so the total increment of savings will be somewhat less than
increments in profit. Whether or not capitalist surplus will be used

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 constructively will depend on the consumption- saving patterns of the top 10
percent of the population. But capitalists alone are not the only productive
agents of society.

6) The transfer of unskilled workers from agriculture to industry is regarded as

almost smooth and costless, but this does not occur in practice because
industry requires different types of labor. The problem can be solved by
investment in education and skill formation, but the process is neither
smooth nor inexpensive.

• The model assumes rationality, perfect information and unlimited capital

formation in industry. These do not exist in practical situations and so the
full extent of the model is rarely realized.

• However, the model does provide a good general theory on labour

transitioning in developing economies