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The Lewis Model of Economic Development

Introduction to the Lewis Model:

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.

Salman Azam Joiya

Economist
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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:

An LDC is conceived to operate in two sectors:

(1) A traditional agricultural sector, and

(2) A much smaller and also more modern industrial sector.

“Surplus labour” (or disguised unemployment) means the existence of such a huge population
in the agricultural sector that the marginal product of labour is zero. So, if a few workers are
removed from land, the total product remains unchanged.

The essence of the development process in such an economy is “the transfer of labour
resources from the agricultural sector, where they add nothing to production, to the more
modern industrial sector, where they create a surplus that may be used for further growth
and development.”

In Lewis model the transformation process or the process of structural change starts by an
autonomous expansion in demand in industry as a result of changes in domestic consumer tastes,
in government purchases, or in international markets.

The central point is that labour (here considered homogeneous and unskilled) shifts from
agriculture into industry. The supply of labour from agriculture to industry is “unlimited” (i.e.,
completely elastic) at the given urban wage (about 30 to 50% higher than the rural wage), owing
to the relative sire of the agricultural labour forces at the margin.

The phenomenon is frequently labelled “disguised unemployment in agriculture”. Redundant

supplies of unskilled labour to industry at existing wages hold down industrial labour costs. But
higher demand and higher prices in industry result in higher profits.

When these profits are ploughed back into industrial capital formation, demand for industrial
output (both for consumption goods by newly employed workers and investment by capitalists)
rises, causing further shifts of labour out of agriculture into industry.

The process comes to a halt when agricultural productivity rises to a point where the supply price
of labour to industry increases, i.e., a point at which agricultural alternatives of output and
income are sufficiently attractive to the would-be industrial workers to keep them in farming. In
the absence of rural-urban differences in the cost of living, this occurs when the marginal product
of labour in the two sectors are equal.

Salman Azam Joiya

Economist
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Lewis postulates the existence of a subsistence sector with surplus labour and he sees in this the
seed for the subsistence sector. One major characteristic of the capitalist sector is that it uses
reproducible capital and that it produces profit.

Since there is surplus labour from the subsistence sector, the capitalist sector draws its labour
from the subsistence sector and it is assumed that as a result of rapid increases in population in
already densely populated countries the supply of unskilled labour is unlimited.

So capitalists can obtain even increasing supplies of such labour at the existing wage rate, i.e.,
they will not have to raise wages to attract more labour. So, the capitalist sector can expand
indefinitely at a constant wage rate for the unskilled labour.

The actual (market) wage rate will be determined by earnings in the subsistence sector. But
‘earnings’ here means the average product and not the marginal one, in subsistence sector
receives an equal share of what is produced.

Lewis has assumed and made the point that capitalists will have to pay a margin of about
30% above average subsistence pay, because the surplus workers need some incentive to move
and in any case part of the difference is needed to compensate them for the higher cost of living
in urban areas.

Another point to note is that in the subsistence sector labour is employed up to the point where
its marginal product is zero. Contrarily, in the capitalist sector labour will only be employed up
to the point where its marginal product equals the wage rate—the familiar relationship derived
from the marginal productivity theory. If wages exceed marginal productivity a capitalist
employer would be reducing his surplus since he paid labour more than he received for what was
produced.

This surplus is the key to the Lewis model of development. In Fig. 14 OS is the average
product of the subsistence sector—the amount a man would receive there. Here, OW is the
capitalist wage.

We start with a fixed quantity of capital, and in this situation the demand for labour is
represented by the marginal productivity schedule of labour NQ. Under profit-maximising
conditions, labour will be applied to the point where the wage, W, equals marginal
productivity, i.e., Q1, corresponding to Oa number of workers. Workers in excess of O a will earn
whatever they can in the subsistence sector.

Development takes place since part of what is produced accrues to the capitalist in the form
of a surplus (WN, Q1 in Fig.14). This amount is reinvested. This reinvestment produces an
increase in the amount of fixed capital and causes a shift in the marginal product of labour curve
form N1Q1 to N2Q2 in the next period.

Salman Azam Joiya

Economist
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More labour will now be employed and the surplus increases, leading to a further shift of the
curve to N3Q3, causing more labour to be drawn in from the subsistence sector has been drawn
into the capitalist sector. When that happens pay in the subsistence sector will start to rise,
causing wages in the capitalist sector to rise, and then the first phase of development will have
ceased as the supply curve of labour has ceased to be horizontal, but has turned up wards.

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.

Salman Azam Joiya

Economist
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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.

Impact of the Open Economy:

The open economy can encourage the immigration of labour. If this happens, it will help in the
expansion of the capitalist sector. But immigration may not be so easy. If in that case the pace
of expansion of the capitalist sector slows down, capital may move out of the country as the
economy is an open one. This may in turn lead to balance of payments problems and the problem
of stability of rate of exchange.

Critical Review of the Lewis’s Model:

Some of the objections against Lewis’s model are as follows:

(1) The assumption that disguised unemployment exists in the agriculture sector has not
been accepted by many economists. Schultz, Viner, Heberler and Hopper are a few of such
economists. According to them, the production in the subsistence sector will be affected when
labour is withdrawn from it.

(2) Lewis ignored the cost involved in training the unskilled worker transferred from the
subsistence sector. Even if it is obtained at a constant wage rate, so for as its transfer from the
subsistence sector is concerned, the supply curve may slope upwards so far as the capitalist,
sector is concerned if the cost of training rises as more and more labour is transferred.

Salman Azam Joiya

Economist
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(3) When labour is transferred from the subsistence sector share of agricultural output
falling to each one left in the agricultural sector will go a rising. This means the institutional
wage will go on rising with every transfer and so will be the wages paid in the capitalist sector.

(4) The model assumes that, besides labour, there is unlimited supply of entrepreneurs in the
capitalist sector. This is not true in the case of many of the underdeveloped countries.

(5) It is wrong to assume that a capitalist will always re-invest their profits. They to can
indulge in un-productive pursuits. They can use their profits for speculative purposes.

(6) It is also wrong to assume that landlords always squander away their savings. The role of
landlords of Japan in industrialisation of the country is well known.

(7) The model assumes that there already exists a market for the industrial products in the
country. This is wrong. People of an underdeveloped country may not be able to purchase the
products perturbed by the expanding capitalist sector. Foreign markets, too, may not be available
to the capitalist sector in the beginning.

(8) Inflation is not liquidating, as has been assumed by Lewis, Experience of various, countries
shows that if once prices start rising, it, becomes difficult to control them.

(9) It is not easy to transfer labour from the subsistence Sector to the capitalist sector by
offering them an incentive of a little higher wage.

Mobility of labour is very low. Many factors like family affection, difference in language, caste,
religion etc. affect it adversely.

(10) Every underdeveloped country does not have surplus labour in the subsistence sector.
As such, the model does not apply to countries which are sparsely populated.

The only positive point in the model is its ‘general’ emphasis on the role of saving in economic
development and on the potential that overpopulated countries have in developing themselves
with the help of surplus labour.

Salman Azam Joiya

Economist