Question

2. Using a Lewis labor surplus framework show graphically and explain how an increase in capital-augmenting agricultural (traditional sector) technology affects a country’s ability to achieve self-sustaining growth that is driven by modern sector capital accumulation.

Answer 1

Lewis published his model entitled: “Economic Development with Unlimited Supplies of Labour” in 1954. In his model Lewis divides the economy in an underdeveloped country in two sectors namely the Subsistence sector and the capitalist sector. Subsistence is identified with the agricultural sector of the economy while the capitalist sector implies mainly the manufacturing sector of the economy.

Capitalist sector also includes plantations and mining where hired labour is employed for purposes of production. The capitalist sector can either be private or public in nature. Subsistence sector, that the agricultural sector is considered to be labour intensive. It does not use reproducible capital. It uses poor techniques of production and has very low productivity.

Assumptions of the Lewis Model:

(A) Surplus Labour in the Subsistence Sectors:

The basic assumption of the model is that there exists surplus labour in the subsistence sectors. It includes labour whose marginal productivity is zero as well as that whose marginal productivity is positive but is less than the institutional wage. This labour comprises farmers, agricultural labourers, petty traders, domestic servants and women.

The surplus labour in the agriculture sector acts as a source of unlimited supply of labour for the manufacturing sector. By unlimited supply of labour, Lewis means that the supply of labour is perfectly elastic at a particular wages. This particular wage is somewhat higher than the institutional wage which each worker in the agricultural sector gets.

Lewis calls it as institutional wage because every worker gets this wage because of some institutional arrangements. This wages is equal to an average share of each worker in the total output in the subsistence sector. If market forces were allowed to operate in the subsistence sector labourers with zero margin productivity or those with a very low marginal productivity would not have received this wage.

(B) Importance of Saving:

Another important assumption that Lewis makes is about the savings generated in the capitalist sector and in the subsistence sector. The capitalist sector invests all its savings for its further expansion.

Those in the subsistence sector, on the other hand squander away their savings, if any in purchase of jewellery & for construction of temples etc. The propensity to save of the people in subsistence sector is also lower when compared with that of those in the capitalist sector.

Lewis in fact so much fascinated by the higher propensity to save of the capitalist sector that he even advocates a transfer of income from the subsistence sector to the capitalist sector. He feels that steps have to be taken to raise the rate of savings from 10% to 15% if the development of the economy has to be smooth.

The Working of the Lewis Model:

The explanation of working of the Lewis model is quite simple. He feels that if a wage higher than the institutional wage prevailing in the subsistence sector by a certain proportion of the institutional wage is fixed in the capitalist sector the capitalist sector will be able to attract an unlimited quantity, the labour from subsistence sector. This will enable the capitalist sector to expand. It will, in turn lead to the generation of more savings in the capitalists sector.

The additional saving, will not only help the entrepreneurs to invest more but also to improve the quality of capital invested. This will result in more employment of labour from the subsistence sector. This will lead to generation of more savings in the Capitalist sector which can be further invested leading to employment of more surplus labour and so on.

We is the wage rate fixed in the capitalist sector. It is higher than W which represents the institutional wage. The wage in the capitalist sector has to be higher than the instructional wage because only such higher wage can attract labour from the subsistence sector. At first; ON-I labour is employed. This will lead to the generation of surplus equal to AMIS, after the wages at the rate W have been paid.

According to Lewis this surplus AMIS will be reinvested either in old type of capital or may even be used to improve the existing techniques. All this will result in marginal productivity curve of labour moving M2. Now more labour at wage. We can employee, ON2 amount of labour will now be employed. More surplus will then be generated. It would be reinvested.

Marginal productivity of labour curve will shift to M3, more labour can now be employed. Still more surplus will be generated and re-invested and so on. The process of transfer of labour from the subsistence sector to the capitalist sector will continue for some time the till some obstacles, hindering this transfer appear.

Role of Bank Credit:

From the above analysis, one might get the impression that it is only through the surplus generated in the capitalist sector that the development of the capitalist sector takes place. This however is not correct.

The process of development can also start if the capitalist sector initially does not invest its savings in the capital but borrows from the banks. According to Lewis the basic problems is to employ the labour from the subsistence sector and this can be initially done through investment of funds borrowed from the banks.

Lewis is conscious of the fact that creation of bank credit will give rise to inflationary increase in prices. However, he is not much perturbed by this prospect. He is of the view that inflationary pressures will not continue forever.

A time will come when the additional savings generated by the investment of borrowed funds become equal to these very funds. At that time, prices will stop rising further. As he says, an equilibrium is reached when savings generated through the investment of additional bank credit become equal to the amount of bank credit itself.

He is also aware of another fact. Inflation can make the distribution of income unfair. However, he says, it will be good for the manufacturing sector if the distribution of income moves in favour of the capitalists. Of course, if inflation tilts the distribution of income in favour of the traders it will be bad for the economy. It will only lead to more speculative activities.

Slowing of the Pace of expansion of the Capitalist Sector:

According to Lewis, expansion of the capitalist sector will continue unhindered so long as the supply curve for labour from the subsistence sector is perfectly elastic i.e. so long as the labour can be transferred to the capitalist sector at a constant wage. Lewis, of course is conscious of the fact that under certain circumstances, the supply curve for labour can turn upwards.

These circumstances are:

(i) The pace of expansion of the capitalist sector is more rapid when compared with the rate of growth of population in the subsistence sector. The surplus labour in that case will ultimately be fully exhausted.

(ii) Technological development in the subsistence sector raise the productivity of labour with in that case will rise. We too will have to be raised them.

(iii) As population increase due to law of decreasing marginal return, prices of food and raw materials will rise. This will increase both W and W.

(iv) When workers in the capitalist sector start imitating the living pattern of the capitalist themselves, they may ask for higher wages.

If any of the above four factors start operating, then according to Lewis, the expansion of the capitalist sector will be slow down.