TOPIC 6: Lewis Two-Sector Model

Definition: Structural change models are a broad class of economic models that aim to understand how the composition of economic activity within a country changes over time.
Key Objectives: These models seek to understand:
- The determinants of the composition of economic activity (e.g., share of agriculture, industry, services).
- How a country's economic composition responds to external environmental changes, such as shifts in international trade terms or technological advancements.
- How a country's economic composition affects various social and economic phenomena, including GDP, per capita income, employment levels, and political stability.
Sectoral Organization: Economies are typically organized into groups of economic agents called 'sectors', each characterized by distinct production functions, labor absorption capacities, and capital intensity.

Overview: Developed by Sir Arthur Lewis in the mid-1950s, this model describes the process of economic development in a dualistic economy consisting of a traditional, overpopulated rural subsistence sector (agriculture) and a modern, urban industrial sector.
Core Concept: The model posits that economic development occurs through the transfer of surplus labor from the traditional agricultural sector, where its marginal product is zero or negligible, to the modern industrial sector, where it can be employed productively.

Production: Primarily agricultural, often characterized by low productivity and traditional production methods.
Labor Supply: Abundant and redundant labor supply. A key assumption is that the marginal product of labor (MPL_A) is zero, or very close to zero, for a significant portion of the workforce.
Wages: Subsistence wage levels, determined by the average product of labor within the sector, not its marginal product.
Surplus Labor: This sector acts as a reservoir of inexpensive labor that can be drawn upon by the modern sector without significantly reducing agricultural output.

Production: Characterized by higher productivity, capital-intensive production, and modern technologies.
Labor Demand: Driven by profit maximization, with firms hiring labor up to the point where the marginal product of labor equals the industrial wage (P \cdot MPLI = WI).
Wages: Wages in the modern sector (WI) are typically constant at a level slightly above the subsistence wage (WA) to incentivize labor migration. This wage premium is crucial for attracting workers from the traditional sector.
Profits: All profits generated in this sector are assumed to be reinvested into capital expansion, further increasing the demand for labor.

Stage 1: Surplus Labor Absorption:
- The modern sector expands by absorbing surplus labor from the traditional sector at a constant or slightly rising real wage.
- Industrial profits are high due to cheap labor and are reinvested, leading to capital accumulation and increased labor demand.
- This stage continues as long as surplus labor exists in the agricultural sector (MPL_A \approx 0).
Stage 2: Turning Point:
- The point at which all surplus labor from the traditional sector has been absorbed.
- The marginal product of labor (MPLA) in the agricultural sector begins to rise as less labor is available, leading to increased agricultural wages (WA).
- The constant wage assumption for the modern sector no longer holds; industrial wages (W_I) must start to rise to match or exceed the increasing agricultural wages.
Stage 3: Self-Sustained Growth:
- The economy transitions to a fully commercialized state where labor is no longer in surplus.
- Both sectors face competitive labor markets, and wages are determined by the marginal productivity of labor in both sectors.
- Growth becomes more balanced across sectors, leading to higher overall per capita income and living standards.

Assumption of Zero Marginal Product of Labor: Critics argue that MPL_A is rarely truly zero in practice, even in highly populated rural areas.
Overlooked Rural-Urban Migration Costs: The model often simplifies the social and economic costs associated with mass migration, such as housing, infrastructure, and social services.
Neglect of Capital Constraints: Assumes that capital for industrial expansion is readily available from reinvested profits, potentially overlooking external capital needs.
Dualism Persistence: In reality, dualism often persists, and structural transformation can be slow due to various institutional and policy barriers.
Limited Role of Technology: While implicit in modern sector growth, the model doesn't explicitly detail the role of technological progress in transforming either sector beyond capital accumulation.
Income Inequality: While focusing on growth, it often doesn't explicitly address the potential for increasing income inequality between sectors or within the modern sector during the transition.