Dual-sector model


The dual-sector model is a model in development economics. It is commonly known as the Lewis model after its inventor W. Arthur Lewis. It explains the growth of a developing economy in terms of a labour transition between two sectors, the capitalist sector and the subsistence sector.

History

Initially the dual-sector model as given by W. Arthur Lewis was enumerated in his article entitled "Economic Development with Unlimited Supplies of Labor" written in 1954, the model itself was named in Lewis's honor. First published in The Manchester School in May 1954, the article and the subsequent model were instrumental in laying the foundation for the field of development economics. The article itself has been characterized by some as the most influential contribution to the establishment of the discipline.

Assumptions

  1. The model assumes that a developing economy has a surplus of unproductive labor in the agricultural sector.
  2. These workers are attracted to the growing manufacturing sector where higher wages are offered.
  3. It also assumes that the wages in the manufacturing sector are more or less fixed.
  4. Entrepreneurs in the manufacturing sector make profit because they charge a price above the fixed wage rate.
  5. The model assumes that these profits will be reinvested in the business in the form of fixed capital.
  6. An advanced manufacturing sector means an economy has moved from a traditional to an industrialized one.
W. A. Lewis divided the economy of an underdeveloped country into 2 sectors:

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.

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 labour, promotes industrialization and stimulates sustained development.
In the model, the subsistence agricultural sector is typically characterized by low wages, an abundance of labour, and low productivity through a labour-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. 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

can be used instead of capital in the creation of new industrial investment projects, or it can be channeled into nascent industries, which are labour-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 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 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.

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 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.
  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.

    Criticism

The Lewis model has attracted attention of underdeveloped countries because it brings out some basic relationships in dualistic development. 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 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 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. Small farmers producing cash crops in Egypt have shown themselves to be quite capable of saving the required capital. The world's largest cocoa industry in Ghana is entirely the creation of small enterprise capital formation.
  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 realised. However, the model does provide a good general theory on labour transitioning in developing economies.

Empirical tests and practical application of the Lewis model

  1. Empirical evidence does not always provide much support for the Lewis model. Theodore Schultz in an empirical study of a village in India during the influenza epidemic of 1918–19 showed that agricultural output declined, although his study does not prove whether output would have declined had a comparable proportion of the agricultural population left for other occupations in response to economic incentive. Again disguised unemployment may be present in one sector of the economy but not in others. Further, empirically it is important to know not only whether the marginal productivity is equal to zero, but also the amount of surplus labor and the effect of its withdrawal on output.
  2. The Lewis model was applied to the Egyptian economy by Mabro in 1967 and despite the proximity of Lewis's assumptions to the realities of the Egyptian situation during the period of study, the model failed firstly because Lewis seriously underestimated the rate of population growth and secondly because the choice of capital intensiveness in Egyptian industries did not show much labor using bias and as such, the level of unemployment did not show any tendency to register significant decline.
  3. The validity of the Lewis model was again called into question when it was applied to Taiwan. It was observed that, despite the impressive rate of growth of the economy of Taiwan, unemployment did not fall appreciably and this is explained again in reference to the choice of capital intensity in industries in Taiwan. This raised the important issue whether surplus labor is a necessary condition for growth.
This model has been employed quite successfully in Singapore. Ironically however it has not been employed in Sir Arthur Lewis' home country of St. Lucia.