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					   Development 1124

Ch 10, Rural-Urban Interaction
                     Dual economic models
• In theoretical growth models, there is usually no
  distinction between conditions in different sectors of the
   – the basic production functions usually refer to the total output of
     the economy as a function of total amounts of productive factors:
     Y=f(K,L) where Y is GDP, K and L total amounts of labor, capital
• But a characteristic feature of many low- and middle-
  income economies is large sectoral differences
• One sharp distinction is between the agricultural (rural)
  economy (sector) and the industrial (urban) one
• Another sharp distinction is between the formal and
  informal sectors in urban areas
• Chapter 10 looks at both of these distinctions; today we
  mostly focus on the first (agriculture vs industry)
                     Agriculture vs industry
• In all countries, firms in the modern industrial sector tend
  to be large
• All workers in such firms are employees who derive most
  of their income from the wages they are paid; there is a
  sharp distinction between wages and the returns to
• The owners of capital are usually represented by
  managers who supervise the workers and have authority
  to reward or punish them
   – managers are usually salaried employees as well, but may be
     compensated in ways that reflect the profits/success of the firm
• Note that the owners of capital can either be private
  individuals (who own shares), or banks; or capital may
  be owned by the state
                    Production in agriculture
• In most low- and middle-income countries, production in
  agriculture is organized differently
• First, one important difference is the relatively large
  importance of land as an input in agriculture
   – land itself can be very heterogenous; different types of land have
     different degrees of fertility and are suitable for different crops
   – another important difference in many countries is the great
     dependence of agriculture on the weather, and the associated
     uncertainty regarding the outcome of the production process
• In traditional agriculture, the amount of capital used is
  typically fairly small, though capital in the form of draft
  animals (as well as animals for food), small tractors, and
  irrigation pumps, can be important
• Another important form of capital is the fertilizer and
  seed that is needed in advance to grow crops
• In many countries (parts of South Asia, Indonesia,
  African countries), the basic production unit can be the
  family farm
   – economic activity on the family farm is based mostly on labor
     provided by family members on their own land; a substantial
     portion of the output produced may be consumed directly by the
     family itself (grains, milk, meat; “subsistence production”)
• However, in some of these countries, especially the
  densely populated ones, ownership of land may be
  concentrated and many families own little or no land
   – such families will then make their living either by working for
     landowners for a salary (“landless laborers”)
   – another form of production organization is “tenant farming”,
     under which landless farmers lease land from landowners, either
     under fixed-rent or share-cropping contracts
           Economic organization in agriculture
• Tenant farmers/share croppers often have very low
  incomes because each one only has access to a small
  plot of land, and also because they do not have access
  to credit on reasonable terms for seeds and fertilizer
• Also they may not receive good prices for the “cash
  crops” they sell through middlemen
• As the text notes, in many low- and middle-income
  countries, the rural-agricultural population makes up a
  much higher proportion of the total than in high-income
• It also usually accounts for a larger share of GDP than in
  rich countries, though its share of GDP is usually lower
  than its share of the total population
                   Organization of agriculture
• Rural areas also usually account for a much larger share
  of the population living in poverty than for the population
  as a whole
   – in part this reflects the relative lack of access to subsidized
     health care and to programs like retirement pensions
   – because educational opportunities typically are less in rural
     areas, poverty tends to continue from one generation to the next
• Although it’s possible to imagine economic progress
  through rising incomes per capita in the agricultural
  sector, in practice per capita income will only rise as
  more and more of the population becomes urbanized
  and get jobs in industry or in the urban service sectors
   – part of the reason for this is that the income elasticity of demand
     for agricultural products is less than one, and few countries
     become rich by exporting agricultural products
• On average, urban incomes are higher than rural
  income, but there are large inequalities in urban areas
• Many people in urban areas have jobs in government, or
  in private “modern” or “formal” sector firms
• However, in many countries many people in urban areas
  work in the “urban informal sector”
• Private formal-sector firms tend to be relatively large,
  and to be relatively capital-intensive; they (and the
  government) also tend to pay much higher wages than
  firms in the informal sector
• One question: how can formal-sector firms compete with
  informal-sector firms if their wage costs are higher?
     Urbanization and formal and informal-sector firms
• Answ: certain types of products can only be produced in
  large-scale modern sector firms
• For example, all heavy industry (metals, shipbuilding,
  construction of high-rise buildings, electricity generation)
  requires large-scale firms
• Also, small-scale firms using simple technology usually
  cannot meet the quality standards and volume
  requirements for export contracts
• Similarly, many products demanded by individuals as
  their incomes rise cannot effectively be produced (at
  uniform quality) in informal-sector firms
• Next question: why do modern-sector firms pay higher
  wages than in the informal sector?
           Formal and informal-sector urban firms
• One reason may be that there is minimum-wage
  legislation; also formal-sector workers may belong to
  labor unions who can negotiate good wages
   – minimum-wage legislation or legislation protecting labor unions
     may not be enforced in informal-sector firms
• Another reason noted by the text is that monitoring labor
  performance may be more costly in formal-sector firms,
  and that the cost of labor turnover may be higher in such
   – by paying higher wages, they give workers a stronger incentive
     to stay, and not to risk losing their jobs by not performing well
• Formal sector firms may also be profitable because they
  have better access to subsidized electric power,
  government contracts, and subsidized export markets
             Formal and informal-sector firms
• The text discussion of production arrangements in rural
  and urban areas is clearly relevant to the countries of
  South Asia, Indonesia, and Africa; they are only partially
  relevant to China
• In China, the organization of agriculture before 1950
  probably was similar to that in India, with very
  considerably inequality in land ownership and many
  tenant farmers with very low incomes
• However, after 1950 ownership of rural land was
  transferred to collectives and agricultural production was
  reorganized into collective farms
• After 1978, collective management of agriculture has
  been replaced by the family responsibility system (we
  will discuss this further below)
             Firm organization in urban China
• Although China now probably has a substantial urban
  informal sector, it does not appear to be nearly as large
  as in cities in India, Brazil, the Philippines, or Africa
• In those countries, many large cities have vast urban
  slums populated almost exclusively by people who make
  their living in the informal sector, and have very low
• One possible reason why the urban informal sector in
  China is much smaller may be due to the hu kou system
• But even in Beijing one can see many small shops,
  sidewalk fruit sellers, recyclers, and others who appear
  to be making a living on their own, and some of whom
  may not earn the equivalent of a minimum wage
              Agriculture-industry interactions
• The process of modernization through urban
  industrialization in dual economies has been central to
  the development effort in countries like India, China, and
  (especially), Russia
• An early study of this process is in the model by W. A.
  Lewis, Economic Development with Unlimited Supplies
  of Labour (1954)
• The Lewis model is like the Harrod-Domar and Solow
  models in that it focuses on growth that results from
  capital accumulation
• In the Lewis model, agricultural production is assumed to
  only require labor and land, while industrial production
  only requires labor and capital
                       The Lewis model
• In the Lewis model the savings that results in capital
  accumulation is made from profits (the returns to capital)
   – Lewis assumes that a share (perhaps 100%) of the profits of
     industrial firms is reinvested in new capital
   – This makes it different from the Harrod-Domar or Solow models
     in which a share of all income is saved and invested
• The profits of industrial firms depend on what share of
  industrial output is paid as wages to industrial workers
• Diagrammatically, industrial profits from a given amount
  of capital can be represented as the producer surplus
  below the MP curve of industrial labor, and above the
  industrial wage, measured in units of industrial output
• Lewis also assumes that new capital consists of output
  produced by the industrial sector
                                   With an initial amount of industrial capital, the
                                   marginal product of labor is MPL1. If the
MPL (units of industrial output)   industrial wage rate (in units of industrial
                                   output) is w*, the amount of labor hired is L1,
                                   and profits is area A. As profits are invested,
                                   industrial capital grows, raising the MPL to
                                   curve MPL2. This raises profits to area (A+B),
                                   which is again reinvested, and so on.
                                     The process continues this way as long as
                                   w* stays constant.





                                    L1                               industrial labor
                         Lewis model
• How is w* determined? According to the Lewis model,
  since industrial workers are attracted from the
  countryside, it depends on how much you have to pay
  rural workers (in units of industrial output) in order to
  attract them from the countryside
• Agricultural output depends on the amount of land
  (which is taken as fixed) and the amount of labor.
• Lewis considers the case of a densely populated country
  (like India, or China in an earlier era) in which there is so
  much labor per unit of land that diminishing returns to
  labor has brought the MP of labor in agriculture to zero
• Lewis now assumes that, even though agricultural MPL
  may be zero, every worker on the farm will receive a
  share of the output of the farm
                        Lewis model
• The assumption then is that a worker who leaves the
  farm loses his share of the farm’s output
• Hence, he will not leave the farm unless the industrial
  wage is high enough to compensate him for the loss of
  this share (which is assumed equal to the average
  product per worker on the farm)
• If we know the terms of trade between agricultural
  products and farm products (that is, how many units of
  industrial output are needed to pay for a unit of farm
  output), this gives us the wage rate w*, measured in
  units of industrial products
• Now the key idea in the Lewis model is that, because
  there is surplus labor in agriculture, the industrial wage
  rate will not rise even if some agricultural workers leave
  for the industrial sector
                        The Lewis model
• The logic is that, as long as the amount in of food in the
  country doesn’t fall, its price will not rise
• An implicit assumption here is that the income elasticity
  of demand for food is close to zero (why?)
• If the total population is constant or grows very slowly,
  the rural population will gradually become smaller and
  smaller as the industrialization process continues.
  Ultimately, this will lead to a higher price of food relative
  to the price of industrial output. As this happens, the
  wage rate (measured in units of industrial products) will
   – in the version of the model that is discussed on p 363, Fig 10-3
     in the book, this is referred to as the “first turning point”
                         The Lewis model
• When the industrial wage rate rises, the profit rate in
  industry will fall, which will reduce the growth rate in
• If the agricultural population becomes even smaller,
  ultimately the economy will reach a point at which the
  marginal product of labor in agriculture will become
  equal to the marginal product of labor in industry,
  converted using the relative price of food and industrial
   – this is referred to as the second turning point
• After this point, the industrial wage rate will rise even
  faster, until ultimately the profit rate will become so low
  that industrial employment will not rise further. But then
  the economy’s industrialization process is complete
                The Lewis model, concluded
• Even though there may be problems with the details of
  the Lewis model, it nevertheless draws attention to an
  important feature of the industrialization process: that the
  speed of the process may depend on what happens to
  agricultural output and food prices
• This question was a critical one in the industrialization
  process of the former Soviet Union between 1917 and
  1940, and in China after 1950 and until the 1970s
• In both places, attempts were made to sustain a process
  of industrialization by trying to increase the supply of
  agricultural products to urban areas
• In the Soviet Union this was done by requiring farmers to
  pay taxes in the form of forced deliveries of agricultural
  products which were brought to the urban areas
         Soviet Union, China and the Lewis model
• In China, agriculture was brought under collective
  management, and quotas were established for the
  delivery of food to the state, at regulated prices, to be
  supplied to urban residents
• Thus even though the industrialization process in both
  countries were governed by central plans, not market
  processes, the issues that governments in both countries
  faced were similar to those envisaged in the Lewis
• Although both the Soviet Union and China raised their
  industrial output substantially during the time they were
  centrally planned economies, both countries ultimately
  abandoned this approach and converted into more
  market-oriented systems of economic management
         Soviet Union, China and the Lewis model
• In both countries, part of the reason was that agricultural
  productivity did not seem to be rising fast enough to
  keep pace with the increased demand for food, forcing
  them to either import food or to raise urban food prices,
  creating upward pressure on industrial wages
   – rising industrial wages, in turn, would slow down the amounts
     available for reinvestment to finance further growth
• In China, one of the first steps of the reform process was
  to reorganize the system of agricultural taxation and
  production management
• The system of collective farming organized through the
  communes, production brigades, and production teams,
  was replaced by the rural family responsibility system
                China and the Lewis model
• Since the reforms of the late 1970s, China has sustained
  a rapid industrialization process that has moved large
  numbers of people from rural to urban area
• At the same time, the agricultural sector has been able
  to produce enough food to avoid substantial increases in
  food prices even though the agricultural labor force has
  been decreasing
• Within the framework of the Lewis model, this could only
  happen in one of two ways: either agricultural technology
  must have become much more productive than before,
  or food prices have been kept down through food
• There are some suggestions that the main explanation
  has been introduction of more productive agricultural
                McMillan, Whalley, and Zhu
• In an important paper (JPE 1989) MWZ suggested that
  to a large extent, the success of the process had to do
  with the improved incentive structure under the family
  responsibility system
• Specifically, they note that between 1978 and 1984,
  there was a 61% increase in China’s agricultural output
• This followed after two types of government policy
  change: a substantial increase in the prices paid by state
  for agricultural products; and introduction of the family
  responsibility system to replace the system of collective
  management of agricultural production
                       The MWZ analysis
• MWZ then argue that part of the output increase can be
  regarded simply as an increase in the quantity supplied
  in response to an increased price
   – the idea here is that even with collective management, an
     increase in price would create an increased quantity supplied, as
     communes would have an increased incentive to purchase more
     inputs and direct their members to put in more labor, in response
     to the higher prices
   – at the same time, however, a better alignment of individual
     incentives within the agricultural sector, through the family
     responsibility system, would also be expected to raise output
     even if prices had remained constant
• Their paper tries to use available data to decompose the
  output increase during the period into one component
  that was due to the price change, and another that was
  due to the economic reforms
• Their conclusion from the model they specify is that 78%
  of the increase in output was due to the improved
  institutional arrangements, while the remaining 22% was
  due to the change in prices
• Essentially, they derive this conclusion from seeing how
  agricultural output changed between 1978 and 1979
  when there was a 22% price change, but there had not
  yet been a significant change in the method of
  organizing agricultural production management (see p.
  793 in their paper; see also below).
• Their calculation is based on a model which specifies
  that each farm worker’s (“peasant’s”) effective labor input
  (denoted by ε) depends on both the price of farm
  products and the institutional arrangements
                      The MWZ model

Their model can be summarized by the following

            Q  (L ) b K 1b  q   b k 1b
            y  p  q  c
            U ( y,  )  y 
Q, L, K are agricultural output, labor, and non-labor
inputs; q is Q/L, etc. ε here measures each farmer’s
effective labor input. p is the agricultural price paid by the
state, while β>0 is a parameter that represents the
efficiency of agricultural organization
                      MWZ model, cont’d
• Specifically, they assume β=1 after the family
  responsibility reforms, while β<1 before the reform
• So β can be thought of as a measure of the strength of
  individual incentives in agriculture; it has an effect similar
  to a tax imposed on farmers
   – note, though, that β is unobservable
• The MWZ strategy is to assume that each farmers
  chooses ε so as to maximize utility. After substituting
  βpq+c for y in the utility function, and writing q as a
  function of ε and k, they derive an expression for the
  farmer’s optimal choice of ε as a function of k and the
  model’s parameters
• Substituting the result into the production function they
  obtain (see next page)
                  The MWZ model, cont’d

 Q  A'  b /( z b ) L K 1  A( p)b /( z b ) L K 1
 b /( z  b)   /( z  1)

whereA’ and A are constants that depend only on the
Based on data that they have regarding Q, L, K from 1978
to 1984 (see the Appendix to their paper), they then
estimate γ (how?). They also have data on p for each
  As noted, they set β=1 in 1984, but they cannot observe
β in the years before 1984. They also don’t know what z
is. So what now?
                          MWZ, cont’d
• Answ: they also have prices for each year, and know
  that price rose substantially between 1978 and 1979.
  They then make a key assumption: that β was the same
  in 1979 as in 1978.
   – The logic of this assumption is that the reform under which
     collective management was replaced by the family responsibility
     system did not begin until the early 1980s. Thus there should
     have been no change in β between 1979-1980
• But with this assumption, they can use data on Q, K, and
  L in 1978 and 1979 to get an estimate of the unknown
  parameter z
• Given this estimate of z, they then use data from 1978 to
  1984 to estimate the values of β in each year (until it
  reaches 1 in 1984, as they assumed)
                The MWZ model, concluded
• The estimated value of β in 1978-79, based on this
  procedure, is only around 0.30. The implication is that
  some 78% of the increase in China’s agricultural output
  between 1978 and 1984 was due to the improvements in
  efficiency that resulted from the introduction of the family
  responsibility system
• The remaining 22% of the output increase resulted from
  the increase in the prices paid by the state for
  agricultural products
• The MWZ model is of course different in many ways
  from what is assumed in the Lewis model. Nevertheless,
  their results is consistent with the idea that the
  agricultural reforms in the early 1980s was one important
  element in China’s subsequent success

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