3.3 Lewis Two-Sector Model

The Lewis Two-Sector Model explains economic growth in developing countries through labor transfer from traditional agriculture to modern industry. It shows how surplus rural labor fuels industrial expansion without wage increases, driving economic development through profit reinvestment and capital accumulation.

This model fits into broader development theories by highlighting the role of structural transformation in economic growth. It emphasizes how shifting resources from low-productivity to high-productivity sectors can spur development, a key concept in understanding the industrialization process of developing economies.

Dual-sector model structure

Traditional and modern sectors

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• The Lewis two-sector model divides the economy into a traditional, rural subsistence sector (agriculture) and a modern, urban industrial sector (manufacturing)
• The traditional sector is characterized by low productivity, surplus labor, and subsistence wages determined by the average product of labor
  • Subsistence wages are set at a level just sufficient to maintain the workers' basic needs
• The modern sector is characterized by higher productivity, capital accumulation, and profit maximization, with wages set marginally above subsistence levels
  • Higher productivity results from the use of more advanced technologies and production methods

Model assumptions

• The model assumes that the modern sector can expand by drawing surplus labor from the traditional sector without increasing wages until the surplus labor is exhausted
  • Surplus labor refers to workers in the traditional sector whose marginal product is close to zero
• It also assumes that all profits in the modern sector are reinvested in capital accumulation, driving economic growth and industrialization
  • Capital accumulation involves the acquisition of new machinery, equipment, and infrastructure
  • Reinvestment of profits is essential for the continued expansion of the modern sector

Labor transfer process

Surplus labor and marginal product

• Surplus labor in the traditional sector has a marginal product of labor close to zero, meaning their removal does not significantly reduce agricultural output
  • The marginal product of labor refers to the additional output generated by adding one more worker
• The modern sector can offer wages slightly above subsistence levels to attract workers from the traditional sector
  • The wage differential serves as an incentive for workers to migrate from rural to urban areas

Labor transfer dynamics

• As the modern sector expands, it continuously draws surplus labor from the traditional sector, keeping wages low and profits high
  • The influx of labor from the traditional sector ensures a constant supply of workers for the modern sector
• The process of labor transfer continues until the surplus labor in the traditional sector is exhausted, reaching the "Lewis turning point"
  • At this point, the marginal product of labor in the traditional sector begins to rise above subsistence levels
• The speed of labor transfer depends on factors such as the rate of capital accumulation, technological progress, and the growth of the modern sector
  • Faster capital accumulation and technological advancements accelerate the absorption of surplus labor

Surplus labor's role

Enabling industrial expansion

• The existence of surplus labor allows the modern sector to expand without facing rising labor costs, as wages remain at subsistence levels
  • The abundance of labor keeps wage growth in check, maintaining the modern sector's cost advantage
• Low labor costs enable the modern sector to generate high profits, which can be reinvested in capital accumulation and technological upgrades
  • Higher profits provide the necessary resources for the modern sector to expand its production capacity

Driving economic growth

• The reinvestment of profits drives the expansion of the modern sector, leading to increased industrialization and economic growth
  • As the modern sector grows, it contributes an increasing share of the country's GDP
• As the modern sector grows, it absorbs more surplus labor from the traditional sector, further fueling its expansion
  • The transfer of labor from low-productivity agriculture to high-productivity manufacturing boosts overall economic growth
• The process of surplus labor-driven industrialization continues until the turning point is reached, after which wages begin to rise and the growth dynamics change
  • Once the turning point is reached, the economy transitions to a new phase of development

Turning point factors

Exhaustion of surplus labor

• The Lewis turning point occurs when the surplus labor in the traditional sector is exhausted, and the marginal product of labor starts to rise above subsistence levels
  • At this stage, the traditional sector no longer has an excess supply of workers
• The rate of capital accumulation in the modern sector determines how quickly it can absorb surplus labor and reach the turning point
  • Faster capital accumulation allows the modern sector to expand more rapidly and absorb surplus labor at a higher rate

Productivity and population dynamics

• Technological progress in the modern sector increases labor productivity, allowing it to expand and reach the turning point faster
  • Advancements in technology enable the modern sector to produce more output with the same amount of labor
• Population growth in the traditional sector can delay the turning point by replenishing the pool of surplus labor
  • Higher population growth rates in rural areas can offset the transfer of labor to the modern sector

Policy interventions

• Government policies that promote education, infrastructure development, and rural-urban migration can accelerate the process of labor transfer and bring forward the turning point
  • Investment in human capital (education and skills) makes workers more productive and adaptable to the modern sector
  • Improved infrastructure (roads, electricity, communication networks) facilitates the movement of labor and goods between sectors
• The size of the traditional sector relative to the modern sector influences the time taken to reach the turning point, with larger traditional sectors requiring more time for the transition
  • Countries with a larger share of the workforce in agriculture may take longer to complete the transition to a modern, industrialized economy