Economic Development and Income Inequality in Less Developed Countries

Marshall J Boyd 1184615 November 26, 2010 ECON 414 Dr. L.S. Wilson

In this paper I will be examining theories that attempt to explain methods of development in less developed countries as it effects income inequality.. This has been a topic of much discussion in economics over the past fifty years and many theories have been proposed; Simon Kuznets measured inequality against average income, John Harris and Michael Todaro offered an explanation for employment and rural urban migration, Arthur Lewis proposed a theory for development based off the idea of surplus labour existing in less developed countries. Each of these theories has an effect on the income inequality in less developed countries. It is my opinion that reaching the lowest level of income inequality with the highest level of employment is the most desirable outcome. W. Arthur Lewis proposed his theory of development in his paper ³Economic Development with Unlimited Supplies of Labour.´ This theory had the assumption of unlimited supplies of labour, obviously; Lewis argued that this assumption was useful and outlined why labour in less developed countries could be argued to be unlimited. His first point on this was the large numbers of labourers on farms, as domestic servants, as dock workers, messengers for a company, and petty retail workers; each of these industries could retain the same level of output with fewer workers, Lewis argues that the number of workers could be cut in half without losing any productivity, the other workers need only work harder. Secondly, Lewis argues that the women in less developed countries could be employed much more gainfully out of the home than by doing the menial tasks that are often left to them in the home; traditional jobs of women, to ³grinding grain, fetching water, making cloth, making clothes, and cooking meals´ could be done more cheaply and, at times, better by ³economies of specialization´ and hiring firms which would carry out these tasks. Lewis¶ last pool of labour comes from the increased health of a

developed nation; as the nation develops the number of births over deaths increases and so the population and the labour pool grows. (Lewis, 1954, 142-145) The main argument of Lewis is that capital accumulation is able to happen in a closed economy because there is a large pool of unskilled labour that is willing to work at subsistence wages; rather, slightly above subsistence wages, these labourers are all able to maintain subsistence without being employed by the capitalist sector and as such must be paid slightly higher to encourage them to throw off their easy going lifestyle and adopt ³the more regimented and urbanised environment of the capitalist sector.´ (Lewis, 1954, 148-150) On the other hand, the capitalist had incentive to destroy the subsistence wage of the economy and hold down the productivity of labourers outside the capitalist sector; if they only had to pay subsistence wages and they could lower the level of subsistence, it was in their best interest to do so and pay lower wages to their employees. The profits from the capitalist sector, arguably the marginal product of capital as the marginal product of labour is paid to the employees, can be invested in capital accumulation. This capital can then be put to work employing a larger portion of the population; capital accumulation can happen at a very quick rate as higher wages don¶t need to be paid to employees. Capital accumulation will continue until the labour surplus is all used up; this can occur for several reasons but the most important is that if the subsistence sector becomes smaller their average product per capita increases solely due to the fact that there are fewer people with the same level of output. Once the marginal product in the subsistence sector begins to match that within the capitalist sector the wages in the capitalist sector must begin to rise to match; at this point the surplus labour is all or nearly used up. This is not the end of Lewis¶ model though, now we look at the open economy.

In the open economy wages are able to remain lower because there is still, presumably, surplus labour in other countries; this foreign surplus labour can be used to keep wages down in one of two ways. The first way is that unskilled labour can be imported into the country and capital accumulation can progress just the same as before. This often does not happen, though, for as Lewis points out ³trade unions are bitterly hostile to immigration;´ the unions know that if they keep unskilled labour out they can force their own wages to increase. (Lewis, 1954, 177) The second way that foreign labour surplus can be leveraged to keep wages down is through foreign investment; trade unions are not hostile against capital being invested outside the country. The capital accumulation would then begin in a foreign country following the same path as it did in the domestic country. Further, as capital is no longer being accumulated in the domestic country the wages in that country will remain stagnant. This theory is nice because it is simple. It relies solely on capital accumulation for development in a country; once there is enough capital accumulation unemployment or under employment will evaporate and the whole population will be employed with a higher than subsistence wage. It makes a wonderful case for increasing the level of capital in a country and improving the lot of everyone. However, it does not improve the lot of everyone equally; it depends upon inequality for growth. It makes the assumption that only some few shrewd capitalists are capable of investing capital in the best manner and as a result these few capitalists are able to enjoy a much higher quality of life than their employees. Indeed, it even mentions that it is in the best interest of the capitalist, and perhaps the entire country, that those people not employed by capitalists be rendered less productive to increase the rate of capital accumulation. It is my opinion, shared by many others, that development should not be merely about increasing the productive capacity of a country but also about increasing the quality of life. (Lewis, 1954,

142) Lewis¶ model increases the quality of life for a few quite quickly and for the rest quite slowly relying on this poor quality of life to allow for development. Fortunately it has been shown that the average person, when given the opportunity, will invest to increase one¶s own productivity rather than squander the opportunity as Lewis seems to assume would be the only result. In the article Lewis even pokes fun at the idea of those that have wealth using that wealth to benefit others even when they are unproductive. He finds it amusing that anyone would wish to help others for the sole reason that it is within their capacity to do so. (Lewis, 1954, 142) Lewis does not discuss in depth the effects his model would have on income inequality but it is clear from his model that inequality would be rampant and exist in three major ways; the capitalist would have the highest income, the employees of the capitalist would have a good deal less, and those employed in the subsistence sector would have the least by a large margin. Simon Kuznets formed a theory directly explaining income inequality in less developed countries. His theory was that as the per capita level of income rises in a country the level of income inequality will first rise and then fall; when this is plotted on a graph it shows as an inverted U. The argument was that when the majority of residents are engaged in the agricultural sector the level of wealth is approximately equally distributed. As rural workers migrate into the city and become employed in the urban, industrial sector the level of inequality increases as the wages are higher in the city. Eventually a point is reached when the majority of workers are employed in the urban, industrial sector and the level of inequality peaks and begins to fall; as more and more rural workers migrate to the city the level of inequality will continue to fall until it reaches a more or less equal distribution again. The logic is much in the same line as that of Lewis¶ model; capital creation will allow for employment with a higher marginal productivity. (Kuznets, 1955, 12-14)

Kuznets constructed a chart that showed the distribution of income in a society. He assumed two sectors, agricultural and not agricultural, and assumed that each sector had two different rates of pay that were consistent throughout the sector, the not agricultural was assumed (probably correctly) to be higher than the agricultural. He then shows the average income in the society when various proportions of the population are engaged in these two sectors. When most are employed in the agricultural sector the average income is very near that of the wage rate of the agricultural sector; as people shift to be employed outside the agricultural sector the average income shifts to become nearer that of the not agricultural sector. He then breaks down the share of income that each quintile of the population would have as the population is employed in these various proportions; not surprisingly, the model that he constructed shows just what he predicted That is, the income inequality of a society starts low increases and decreases as people shift jobs. This seems entirely logical and based on his model makes perfect sense. (Kuznets, 1955, 12-14) This theory was ³5 per cent empirical information and 95 per cent speculation, some of it possibly tainted by wishful thinking.´ (Kuznets, 1955, 26) Kuznets relied a great deal on very little data and as such was very tentative in putting forward his theory; time has shown us that while it makes logical sense it is not corroborated by the empirical data. (Bruno, Ravallion, and Squire, 1998, 137) Many countries have shown an improvement in income equality, some have remained stagnant, and others have shown a greater inequality. There is no relationship that can be easily discerned between growth and inequality. (Bruno, Ravallion, and Squire, 1998, 137) Thankfully, the poor are not condemned to inequality for net growth to occur in a country. John Harris and Michael Todaro proposed a theory on development that also has implications for income distribution in less developed countries. Harris and Todaro argue that people will not leave the agricultural sector when the wages are better in the urban sector but will

leave when the expected wage is higher. More people will migrate to the urban sector in the hopes that they will get a job because that job will pay better than their agricultural work does. Agricultural work pays equal to the marginal product of labour, assumed in the paper to be ³always positive and inversely related to the size of the rural labor force´ (Harris, Todaro, 1970, 126), that is as more and more agricultural workers move to the city the marginal product of labour in the agricultural sector increases. The urban wage is equal to the marginal product in the urban sector, however, it is constrained to be equal to or higher the politically determined minimum wage, Harris and Todaro only deal with the situation where the marginal product is equal to the minimum wage. (Harris, Todaro, 1970, 128) The expected urban wage is found by multiplying the urban wage by the urban employment rate, that is number of employed people divided by employed plus job seekers. Equilibrium is reached and urban rural migration ends when the agricultural wage is equal to the expected wage. (Harris, Todaro, 1970, 129) This model leaves a number of people unemployed in the urban sector; in fact, it is impossible, without more market intervention to employ all of the urban population. (Harris, Todaro, 1970, 137) As soon as more people are hired the urban employment rate increases and more people will migrate into the urban sector as a result of the increased expected wage. Harris and Todaro mention that the single market failure of a set minimum wage is the root cause of the problem of urban unemployment; without this problem the labour market would clear and there would be no migration that would be left unemployed. However, they also recognize that this is a policy that is likely to remain in place despite any advice they might give so they give advice that would work to solve this problem while keeping the minimum wage in place. The first piece of advice is to institute a wage subsidy for the capitalist employers in the urban sector; as a minimum wage causes the wage to be higher than the marginal productivity in

the urban sector there is less profit to be invested in capital accumulation. This problem can be avoided by paying back some amount of money to the employer to make up for this lost profit and allow more capital accumulation to occur. A second, and probably less desirable policy, is that of migration restriction; if people are just not allowed to migrate into the city in unemployable numbers than there will be no, or at least negligible, unemployment in the urban sector. They do not recommend this policy lightly citing ³grave reservations about the ethical issues involved in such a restriction of individual choice and the complexity and arbitrariness of administration´ (Harris, Todaro, 1970, 135) of such a policy. Both of these policies while having beneficial effects on the economy will not solve the problem as standalone policies; they complement each other. The wage subsidy policy will increase the level of industrial

employment but will have a negative effect on the unemployment levels and the migration restriction policy will have reduce the level of unemployment but will have no effect on the level of employment. Harris and Todaro make a very good case for the causes behind urban unemployment and recognize that while the politically determined minimum wage may not be the policy designed to reach the highest level of employment it does have other benefits; the most important in my opinion being the increased level of consumption gained by workers. The paper does very well in describing what causes the unemployment and in discussing ways to reduce overall unemployment. The paper discusses that capital accumulation will increase unemployment but this can only increase to a certain point. The marginal product of the rural sector increases with each subsequent departure of people migrating to the urban sector; eventually the rural marginal product will be so high as to prohibit the migration to the urban sector. Not all the agricultural workers will leave agriculture to work in a factory; there will still be people to feed and the profit

that would be gained by remaining in the agricultural sector would be such that people will eventually stop leaving the farm. The model that is proposed works up until a certain point and then it can no longer function; labour is not unlimited and will eventually run dry. It could be argued that this point would be difficult and expensive to reach but I think that it is a point worth aiming for. If the cost is high and there is little incentive for the capitalist to reach this point it only makes the argument that the state should be involved that much stronger. Full employment is an ideal that should be striven for and so the state should be a player in the industrial sector to be able to hire on the unemployed labour that exists in the urban area. With the state hiring the excess labour in the urban area the country could reach full employment and a high level of production while still remaining competitive. Each of these three proposals is logical and yet each of them have flaws. Those flaws can be wishful thinking, as in the case of Kuznets, or a sort of callousness for the welfare of the people, which I think can be observed in all three theories. The authors are all concerned only with the growth of the country and this happens to have some effect on the income distribution in the economy. The authors are not concerned with increasing the general welfare of people but more with increasing the average welfare of the country, typically by increasing the welfare of the already well off. The development of a nation is not only the growth of the economy, though this is, arguably, an important aspect. Development should be thought of more broadly as increasing the welfare of the nation, through full employment, through wages that allow for all needs to be met but, as we see most clearly from Kuznets, this is not considered important; it is considered to be superfluous and unimportant if it does not encourage the most efficient use of resources. The welfare of the workers is ignored but the welfare of the employers is considered important as they are the drivers of economic growth. Unfortunately, income inequality in less

developed countries will remain until there is a widely accepted model of development that takes into account the welfare and the equitable distribution of income among the entire population.

References Michael Bruno, Martin Ravallion, and Lyn Squire, ³Equity and Growth in Developing Countries: Old and new Perspectives on the Policy Issues´, in Vito Tanzi andKe-young Chu, eds., Income Distribution and High-Quality Growth, MIT Press: Cambridge Massachusetts, 1998. John R. Harris and Michael P. Todaro, ³Migration, Unemployment and Development: A TwoSector Analysis´, The American Economic Review, 1970, 60, 126-142. Simon Kuznets, ³Economic Growth and Income Inequality´, The American Economic Review, March 1955, 45, 1-28. W. Arthur Lewis, ³Economic Development with Unlimited Supplies of Labour´, Manchester School of Economic and Social Studies, May 1954, 22, 139-191.

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