Foreign Capital Inflow Fiscal Policies A

The Manchester School Vol 75 No.
1 January 2007
1463–6786 17–46
FOREIGN CAPITAL INFLOW, FISCAL POLICIES AND

INCIDENCE OF CHILD LABOUR IN A DEVELOPING
ECONOMY*
by
SARBAJIT CHAUDHURI
Department of Economics, University of Calcutta
and
JAYANTA KUMAR DWIBEDI†
Department of Economics, B.K.C. College
Empirical evidence suggests that the incidence of child labour taken as a

whole has declined in the developing countries with economic growth due
to foreign capital. But, in some high-growth-prone areas, the problem
has been on the rise. A pertinent question is why liberalized investment
policies have produced dissimilar results in different cases. The present
paper is intended to provide an answer to the above question using a
three-sector general equilibrium framework with two informal sectors
and a non-traded final commodity. The paper is also designed to inves-
tigate the efficacy of an education subsidy policy and a lump-sum tax on
the richer people in controlling the problem of child labour. We find that
the effects of different policies on child labour crucially hinge on the
relative intensities in which child labour and adult labour are used in the
two informal sectors. However, we find that on the whole a policy of
subsidy on education is more effective in comparison with the policy of
economic growth with foreign capital in eradicating the prevalence of the
evil in the system.
1 Introduction
Child labour is presently a phenomenon pervasive mainly in the transitional
societies of the developing economies. India is one among these countries
where the concentration of child labour is the highest in the world. In recent
years, particularly after globalization, the issue of child labour has assumed
central importance in the social policy discussions and statutory provisions
and efforts have been directed towards its eradication and prevention.
According to ILO (2002) one in every six children aged between 5 and 17, or
246 million children, are involved in child labour.1 Out of 246 million about
170 million child workers were found in different hazardous works. Some 8.4
* Manuscript received 21.9.04; final version received 20.4.06.
†
The authors are indebted to an anonymous referee of this journal for his/her interesting and
constructive comments on an earlier version of the paper. Helpful editorial suggestions
from Professor Chris Orme are also gratefully acknowledged. However, the usual dis-
claimer applies.
1
If the ‘invisible’ workers who perform unpaid and household jobs are included, it is likely that
the estimate would shoot up significantly further.
© 2007 The Authors
Journal compilation © 2007 Blackwell Publishing Ltd and The University of Manchester
Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK, and 350 Main Street, Malden, MA 02148, USA.
17
18 The Manchester School
million children were caught in the worst forms of child labour including
slavery, trafficking, debt bondage and other forms of forced labour, forced
recruitment for armed conflict, prostitution, pornography and other illicit
activities.
It is a very commonly held view that child labour is fundamentally a
by-product of abject poverty, strongly suggesting that policy should focus on
economic development and increasing income. A distinctive paper in this
regard is that of Basu and Van (1998). They have shown that if child labour
and adult labour are substitutes (substitution axiom) and if child leisure is a
luxury commodity to the poor households (luxury axiom), unfavourable
adult labour markets, responsible for a low adult wage rate, are the driving
force behind the incidence of child labour. The World Development Report
1995 (World Bank, 1995) also recognized poverty as the greatest single force
which creates the flow of children into the work place.2
The last two decades have witnessed revolutionary changes in liberal-
izing trade and investment policies across countries, whether developed or
developing. The developing countries have chosen free trade as their devel-
opment strategy and been able to attract a huge amount of foreign direct
investment in the same period.3 It was believed that growth with foreign
capital would take the developing countries into higher growth orbits, the
benefits of which would definitely percolate down to the bottom of society,
thereby leading to reduction of poverty and poverty-driven child labour
incidence. The intuitive argument is as follows. Inflows of foreign capital
lead to an overall expansion of the economy. Formal sectors expand at the
cost of the informal sectors. Thus, more and more workers would now be
engaged in the higher-wage-paying formal sectors and the number of poor
working families from which children are sent out to work would decrease.
The consequence would be a decrease in the overall supply of child labour
in the economy. Although the prevalence of child labour in the developing
countries has in general decreased with economic growth, in some cases the
problem has been on the rise. In this connection, it is worthwhile mention-
ing the empirical finding of a study by Swaminathan (1998) in a city in
Gujarat, India. The economy of Gujarat, India, has grown at a very high
rate mainly due to large inflows of foreign investment in the post-reform
period. Despite high economic growth, Swaminathan (1998) has found that
the incidence of child labour has increased significantly in the city of
Bhavnagar after globalization. A pertinent question is therefore why
2
Bonnet (1993) and Basu (1999, 2000) also support the same view.
3
According to the World Development Report 1998–99, the amount of foreign direct investment
to the low-income countries has increased from 1502 million dollars in 1980 to 9433
million dollars in 1996. The corresponding figures for South Asian countries are 464 and
3479 million dollars, respectively. Besides, as per the UNCTAD (1999) and Oxfam Inter-
national (2002) reports, foreign capital accounts for 11 per cent of fixed capital invest-
ment (10 times the share in 1980), and almost one-third of that in the manufacturing
sector.
© 2007 The Authors
Journal compilation © 2007 Blackwell Publishing Ltd and The University of Manchester 2007
Foreign Capital and Incidence of Child Labour 19
growth with foreign capital has failed to lessen the gravity of the problem
of child labour in some cases while in general the incidence has decreased in
the developing countries in the liberalized regime. Unfortunately, econo-
mists have so far paid very little attention to analysing the effects of the
liberalized trade and investment policies on the incidence of child labour in
a developing economy. However, mention should be made of a paper by
Chaudhuri and Gupta (2004) where an attempt has been made to examine
the implication of a tariff reduction on the incidence of child labour in the
set-up of a two-sector general equilibrium model with child labour. They
have found that the effect of trade liberalization on the incidence of child
labour crucially hinges on the relative factor intensities of the two sectors.
However, the analysis of Chaudhuri and Gupta (2004) is based on the
assumptions that both the sectors use child labour in production activities,
all households supply child labour, there are no non-traded commodities
and adult labour and child labour are perfect substitutes. Some of these
assumptions may not be quite realistic in the context of a developing
economy. Also, they have not examined the implication of an inflow of
foreign capital on the incidence of child labour in the economy.
There is a theoretical literature, including Baland and Robinson (2000),
Ranjan (2001) and Jafarey and Lahiri (2002), which emphasizes the impor-
tance of capital-market imperfection as a contributing factor to inefficient
child labour. According to this line of thinking, the cost of providing educa-
tion to children including the opportunity cost, expected return to education
and the borrowing terms in the capital market are important determinants of
human capital accumulation and hence of children’s labour supply. By
acquiring education, children are able to enhance their wage-earning poten-
tial in later life. However, during the period of skill formation, the household
forgoes the income the child labour could have earned by working instead. In
order to calculate the pecuniary returns to education, the head of the working
family discounts the future increase in wages by a discount factor and com-
pares this return with the forgone child wages in the current period. If the
household has access to the credit market, the discount rate should be the
interest rate on borrowing. Therefore, given the discount rate, increased
educational opportunities are expected to lower the supply of child labour by
increasing the discounted returns in future. On the other hand, given the
returns to education, a provision of credit at a subsidized rate is also likely to
produce the same result. However, the explanation of the child labour inci-
dence in terms of credit market imperfection crucially hinges on the presup-
position that returns to education are sufficiently high, which, in turn,
assumes that the quality of schools is also satisfactory. But a few important
empirical studies4 have reported the abysmal state of the existing primary
4
A study of India by PROBE (1999) found that the state of basic education was appalling and,
even though parents valued education in its own right, they believed that their offspring
© 2007 The Authors
education system in the developing countries, including India. Besides, this

theory of child labour is based on the notion of a mutually altruistic house-
hold. It is implicitly assumed that when parents borrow against the future
incomes of their children, the repayment of the loan is a shared burden.
However, Baland and Robinson (2000) have argued that, in the absence of
mutual altruism, the provision of credit at a reasonable rate might not be
enough to rectify the occurrence of excessive levels of child labour. Prevailing
laws and attitudes in most societies do not allow parents to undertake debts
that can be passed on by them as the responsibility of their children in future.
What has been the impact of the liberalized trade policies on the inci-
dence of child labour across developing countries in the era of globalization?
To find an answer to this question, we should go through the empirical work
of Cigno et al. (2002). While analysing the cross-country data, they have
found that globalization can contribute to reducing child labour by increas-
ing the returns to education. According to them, the effect of globalization on
child labour will be much more pronounced in the developing countries
which take part in world trade with a comparatively larger share of educated
workforce than those with a largely uneducated workforce.
Although the relation of child labour to education and human capital
formation should ideally be analysed in a dynamic framework, the role of
education on the incidence of child labour can be examined even in a static
framework in an indirect way. We have already argued how an increase in the
return to education and/or a decrease in the interest rate in the capital market
and/or a reduction in the cost of education including the opportunity cost can
cause the child labour to decline. Thus, it can be argued that, given the return
to education and the discount rate (interest rate), the incidence of child labour
is expected to fall owing to a reduction in the cost of education. As the cost
of education includes the opportunity cost of not sending children to work, a
subsidy policy on education consisting of mid-day meals and/or provisions
for a cash stipend should tend to lower the effective child wage and hence
lower the cost of education indirectly. Moreover, in a society with high
fertility rate, poor perception of the parents about future benefits of chil-
dren’s education, low quality of schooling and households’ objectives to
maximize present income, one of the main motives behind the decision of the
poorer households in sending some of their offspring to public school is to
derive the immediate benefits of an education subsidy policy.5
were unlikely to benefit from education in its current state. UNICEF (1997) cited low
quality of schooling as an important reason for high dropout rates among primary school
students in the developing countries. Based on this observation, Jafarey and Lahiri (2002)
have shown that child labour can coexist with child schooling even if credit markets are
perfect.
5
In this context, mention should be made of an empirical paper by Ravallion and Wodon (2000)
who have found that the school enrolment subsidy substantially increased the number of
school-going children from the poorer section of the households in Bangladesh. But the
magnitude of the decline in the incidence of child labour as a proportion of the total amount
of enrolment subsidy was not very significant.
© 2007 The Authors
The present paper is designed to examine the implications of capital

accumulation through inflows of foreign capital and an education subsidy
policy on the poverty-induced child labour incidence in a developing
economy in a general equilibrium set-up. We consider a three-sector full-
employment model with child labour. The economy is divided into one
formal and two informal sectors. One of the two informal sectors (sector 1)
produces an exportable agricultural commodity using adult labour, child
labour and capital, while the other (sector 2) produces a non-traded final
commodity6 for the richer section of the population with the help of two types
of labour only. On the other hand, the formal sector (sector 3) produces a
manufacturing commodity using adult labour and capital and this is the
import-competing sector of the economy. So, in the two informal sectors,
adult labour and child labour are substitutes. In this set-up, we shall examine
the effects of an inflow of foreign capital and an education subsidy policy on
the aggregate supply of child labour in the economy. As the non-traded final
commodity produced in sector 2 is consumed only by the richer section of the
population, an imposition of a lump-sum tax on this group of the population
is expected to provide a desirable impact on the incidence of child labour
through a decrease in the demand for the commodity. The efficacy of this
policy has also been studied. It is found that the effects of all these policies
crucially hinge on the relative child labour intensities of the two informal
sectors with respect to adult labour. When the export sector is more child
labour intensive vis-à-vis the non-traded sector, an inflow of foreign capital
unambiguously lowers the incidence of child labour in the society. The edu-
cation subsidy policy is also expected to produce the same result. However,
an imposition of a lump-sum tax on the richer section of the population
produces a perverse effect. In contrast, an inflow of foreign capital may be
counterproductive when the non-traded sector is child labour intensive. But,
an education subsidy policy and/or a lump-sum tax on the richer people are
likely to produce the desired result on the supply of child labour in the
economy. A balanced-budget change in the education subsidy and the lump-
sum tax fortifies the possibility of a reduction in the incidence of child labour
in this case. So, the present theoretical analysis despite its limitations7
explains why a policy of growth with foreign capital may produce dissimilar
results on child labour under different circumstances and points to an edu-
cation subsidy policy as a possible solution to the problem of child labour in
the developing countries.
6
Domestic services, shoe shining, collection of seashells and prostitution in urban areas are
classic examples of such production activities.
7
We admit that, in terms of the present static framework, we are unable to capture the relation
of child labour to education and human capital formation in a satisfactory way. However,
we have taken over the role of education on the incidence of child labour in an indirect way.
We have explained this point in detail in the previous paragraph.
© 2007 The Authors
2 The Model
The economy we consider is a small open less developed economy, which is
divided into two informal sectors and one formal sector. There are two types
of labour available in the economy: adult labour and child labour. One of the
two informal sectors (sector 1) produces an agricultural commodity, X1, with
the help of adult labour, child labour and capital. However, there is substi-
tutability between adult labour and child labour. Sector 2 (another informal
sector) produces a non-traded final commodity, X2, with the help of child
labour and adult labour. Domestic services, prostitution, collection of sea-
shells and shoe shining are some of the classic examples of such production
activities.8 Generally these types of goods and services are consumed (used)
by the richer section of the working class employed in the higher-wage-paying
formal sector and by the owners of capital.9 The formal sector (sector 3) that
produces a manufacturing commodity, X3, is the import-competing sector of
the economy. It uses adult labour and capital in its production.10 Owing to
effective wage legislation and unionization of labour, the adult wage rate in
the formal sector is fixed at W*, which is greater than the competitive infor-
mal sector adult wage, W.11 The very low adult wage rate in the informal
sector (a developing economy phenomenon) forces the poor families to send
some of their offspring to the job market.
Production functions satisfy constant returns to scale with positive but
diminishing returns to each factor. Markets, except the formal sector
labour market, are perfectly competitive. The adult labour allocation
mechanism is of the following type. Adult workers first try to get employ-
ment in the formal manufacturing sector and those who are unable to find
employment in the said sector are automatically absorbed in the two infor-
mal sectors, as there is complete wage flexibility in the latter sectors. Adult
labour and child labour are completely mobile between the two informal
sectors but adult labour is imperfectly mobile between the formal and the
informal sectors. On the other hand, capital is completely mobile between
sectors 1 and 3. Owing to the small open economy assumption, prices of X1
and X3 are given internationally. As the commodity produced by sector 2 is
produced and consumed domestically, its price is determined within the
economy by demand and supply forces. The formal sector (sector 3) is more
capital intensive vis-à-vis the agricultural sector (sector 1) with respect to
adult labour in the physical sense. However, we at this stage do not make
8
These production activities use very little capital and so we can ignore capital as an input in this
sector.
9
See footnote 17 in this context.
10
The use of child labour is strictly prohibited in sector 3, as it is the formal sector of the economy.
11
Assuming that each formal sector firm has a separate trade union, the unionized wage function
may be derived as a solution to the Nash bargaining game between the representative firm
and the representative union in the formal sector industry. For details see Chaudhuri
(2003).
© 2007 The Authors
any assumption regarding the relative intensities at which child labour and
adult labour are used in the two informal sectors. In a subsequent section,
we shall consider both the cases separately and see how the results of the
model change under alternative factor intensity conditions. Finally, com-
modity 1 is chosen as the numéraire.
The following symbols will be used in the formal presentation of the
model.
aLi adult labour–output ratio in the ith sector, i = 1, 2, 3
aCi child labour–output ratio in the ith sector, i = 1, 2
aKi capital–output ratio in the ith sector, i = 1, 3
P1 1 (commodity 1 is the numéraire)
P2 price of the non-traded final commodity (determined endogenously)
P3 world price of commodity 3
W adult wage in the two informal sectors
W* unionized adult wage in the formal sector
WC child wage
R return to capital
L adult labour endowment of the economy
lC supply of child labour by each poor working family
LC aggregate supply of child labour
LI number of adult workers engaged in the two informal sectors
KD domestic capital stock of the economy
K economy’s aggregate capital stock (foreign plus domestic)
qji distributive share of the jth input in the ith industry, j = L, K, LC and
i = 1, 2, 3
lji proportion of the jth input employed in the ith industry, j = L, K, LC
and i = 1, 2, 3
S kji the degree of substitution between factors j and i in the kth sector, j,
i = L, LC, K and k = 1, 2, 3. For example, SL1C ≡ (WC aL1 ) ( ∂aL1 ∂WC ) ,
SL1 L ≡ (W aL1 ) ( ∂aL1 ∂W ) etc. S kji > 0 for j ⫽ i and S kjj < 0 .
Y aggregate income of the richer section of the population
Ci level of consumption of the ith commodity by each poor household,
i = 1, 3
∧ proportional change
2.1 Supply Function of Child Labour

In this section, we derive the supply function of child labour from the
utility-maximizing behaviour of the representative altruistic poor house-
hold. We assume that each working family consists of one adult worker and
a certain number of children. There are a L numbers of working famil-
ies, which are classified into two groups with respect to the earnings of
their adult members. The adult workers who work in the higher paid
formal manufacturing sector comprise the richer section of the working
© 2007 The Authors
population. In contrast, labourers who are engaged in the two informal

sectors constitute the poorer section. There is now considerable evidence
and theoretical reason for believing that, in developing countries, parents
send their children out to work out of sheer poverty. A distinctive paper in
this regard is that of Basu and Van (1998). Following their ‘luxury axiom’,12
we assume that there exists a critical level of family (or adult labour)
income, W̄ , from non-child labour sources, such that the parents will send
their children out to work if and only if the actual adult wage rate is less
than this critical level. We can easily assume that each worker in the formal
manufacturing sector earns a wage income, W*, sufficiently greater than
this critical level. So, the workers belonging to this group do not let their
children go to work. On the other hand, each adult worker in the informal
sectors earns W amount of wage income, which is less than W̄ , and there-
fore send off many of their children to the job market to supplement low
family incomes.
The altruistic adult member of the family (guardian) decides the number
of children to be sent to the work place. The rest of the children are sent to
school. We also assume that there is only a public educational system13,14
available to the children in the economy and that it is entirely financed by
government subsidy on this account. The richer workers do not send their
children to the job market. In the public education system in the developing
economies, there are provisions for the children from the poorer families to
get stipend, free educational goods and free mid-day meals. It is sensible to
assume that the higher the subsidy on education, E, the higher would be the
free educational facilities and the related benefits, B, associated with child
schooling. On the other hand, the larger the number of children sent to
school, the higher would be the aggregate benefits accruing to the poor
families. We make the simplifying assumption that the money value of such
benefits is strictly proportional to the number of children sent to school. The
utility function of the household is given by
12
An empirically testable hypothesis of Basu and Van’s model is that child labour arises if adult
household income falls below some benchmark level. This hypothesis has been tested by
different economists for different countries. Studies by Ray (1999) for India, Ray (2000) for
Pakistan and Peru, Addision et al. (1997) for Ghana and Pakistan and Bhalotra (2000) for
Pakistan have found the ‘luxury axiom’ of Basu and Van (1998) to be more or less
statistically valid.
13
Governments all over the world devote substantial resources to their education sector. This is
especially true in developing countries. In 1995, public spending on education accounted
for 15.7 per cent of total government expenditure in developing countries (see Bedi and
Garg, 2000). Furthermore, the majority of students in developing countries are educated in
publicly funded and publicly managed educational institutions. According to Jimenez and
Lockheed (1995), almost 90 per cent of all primary and 70 per cent of all secondary
enrolments in developing countries are in public schools.
14
The analysis in this paper, being static in nature, does not deal with an important aspect of child
labour—its relation to education and human capital formation. We have already discussed
this point in detail in Section 1.
© 2007 The Authors
U = U (C1 , C3 , ( n − lC ))
The household derives utility from the consumption of the two traded
(final) commodities and from the children’s leisure. As the poor households
do not consume the non-traded final commodity, it is not included in their
utility function. However, children’s leisure here does not imply that the
children who are not sent out to work are kept at home. They are sent to
school. The altruistic guardian of the family derives utility from this source
because at least some of his children have been kept out from the work
hazards. Besides, by sending some of the children to school, the family
secures current income gain from access to the different incentives that the
subsidized education scheme provides. For analytical simplicity let us con-
sider the following Cobb–Douglas type of utility function:
α β γ
U = A (C1 ) (C3 ) ( n − lC ) (1)
with A > 0 and 1 > a, b, g > 0; and a + b + g = 1. It satisfies all the standard
properties and is homogeneous of degree 1. The parameter g denotes
the degree of altruism of the guardian towards the well-being of his
children.
Ruling out the possibility for any child worker attending school to
undertake any part-time job, the budget constraint of the representative poor
household is given by the following:
C1 + P3C3 = (WC lC + W ) + ( n − lC ) B ( E ) (2)
where W is the income of the adult worker, WClC measures the income from
child labour and (n - lC)B(E) is the money value of the benefits derived by the
household from sending n - lC number of children to school. Note that B′(.)
is positive. Here the effective child wage rate is WC - B(E ).15
Maximization of the utility function subject to the above budget con-
straint gives us the following first-order conditions:
αU C1 = βU P3C3 = γ U ( n − lC ) [WC − B ( E )] (3)
From (3) we get the following expressions:
C1 = α ( n − lC ) [WC − B ( E )] γ (4)
C3 = β ( n − lC ) [WC − B ( E )] γ P3 (5)
Substitution of the values of C1 and C3 into the budget constraint and
simplification give us the following labour supply function:
n [(α + β )WC − B ( E )] − γ W
lC = (6)
WC − B ( E )
15
We assume that WC > B(E). Otherwise, no children are sent to the job market.
© 2007 The Authors
This is the supply function of child labour by each poor family. We now
analyse its properties. First, lC varies negatively with the adult wage rate, W.
A rise in W produces a positive income effect so that the adult worker sends
a larger number of children to school and therefore decides to send a lower
number of children to the work place. An increase in WC (or an increase in
WC - B(E)), on the other hand, produces a negative price effect, which
increases the supply of child labour from the family.16
There are LI ( = L − aL3 X 3 ) adult workers engaged in the two informal
sectors and each of them sends lC number of children to the
job market. Thus, the aggregate supply of child labour in the economy is
given by
n [(α + β )WC − B ( E )] − γ W
LC = ( L − aL3 X 3 ) (7)
WC − B ( E )
2.2 The General Equilibrium Analysis

Given the assumption of perfectly competitive markets, the usual price–unit
cost equality conditions relating to the three sectors of the economy are given
by the following three equations, respectively:
WaL1 + WC aC1 + RaK1 = 1 (8)
WaL2 + WC aC2 = P2 (9)
W *aL3 + RaK3 = P3 (10)

The demand for the commodity produced in sector 2 comes from the richer
section of the society.17 Hence the demand function for commodity 2 is as
follows:
D = D ( P2 , Y ) (11)
with usual price and income effects, i.e. ∂D/∂P2 < 0 and ∂D/∂Y > 0. It may be
pointed out that prices of the other two commodities also figure in the
demand function for commodity 2. However, as these are exogenously given,
they have not been included in the demand function.
Total income of the richer section of the society consists of wage income
of the formal sector workers and the rental income of the owners of domestic
16
One may verify that the results of this paper hold for any utility function that satisfies these two
properties.
17
It may be checked that the qualitative results of this model hold under different sufficient
conditions even if the poorer section of the working class is allowed to consume this
commodity.
© 2007 The Authors
capital. Denoting Y as the income of the said class, the expression for Y can
be written as18
Y = W *aL3 X 3 + RK D − T (12)
where T is the lump-sum tax on the richer section of the population.
In equilibrium, the supply of the non-traded final commodity must equal
its demand. So, we have
X 2 = D ( P2 , Y ) (13)
Using (12), equation (13) may be rewritten as follows:
X 2 = D ( P2 , W *aL3 X 3 + RK D − T ) (13.1)
Complete utilization of adult labour, capital and child labour implies the
following three equations, respectively:
aL1 X1 + aL2 X 2 + aL3 X 3 = L (14)
aK1 X1 + aK3 X 3 = K (15)
aC1 X1 + aC2 X 2 = LC (16)

Using (7), one may rewrite equation (16) as follows:
n [(α + β )WC − B ( E )] − γ W
aC1 X1 + aC2 X 2 = ( L − aL3 X 3 ) (16.1)
WC − B ( E )
In this general equilibrium model, we have 10 endogenous variables
(namely, W, WC, R, P2, D, Y, X1, X2, X3 and LC) and the same number of
independent equations (namely, equations (7)–(12), (13.1), (14), (15) and
(16.1)). The policy parameters are K, E and T. Equations (8)–(10) together
constitute the price system with four endogenous variables: W, WC, R and
P2. Clearly, this is an indecomposable production structure. R is obtained
from (10) as W* is given. It should be noted that, once R is known, sectors
1 and 2 can effectively be viewed as a Heckscher–Ohlin subsystem (HOSS).
So, W and WC can be obtained from equations (8) and (9) as functions of
P2. Then solving equations (14), (15) and (16.1) simultaneously, one can
find X1, X2 and X3 as functions of P2. The equilibrium value of P2 can be
obtained from (13.1). Y is now found from (12). One can get D from (11).
Finally, LC is obtained from equation (7). Note that once factor prices are
known the factor coefficients aji are also known as these are functions of the
input prices.
18
We assume that the rental income from foreign capital is fully repatriated and therefore it is not
included in Y.
© 2007 The Authors
3 Comparative Statics
According to the conventional wisdom, an overall economic expansion
induced by an inflow of foreign capital is likely to take the developing
countries into higher growth orbits, the benefits of which would percolate
down to the poor people. Thus, this policy is expected to exert downward
pressure on the incidence of poverty-induced child labour. On the other hand,
a policy of education subsidy is expected to reduce the supply of child labour
directly while a lump-sum tax on the richer section of the population, who
consume the non-traded final commodity produced using child labour (and
adult labour), is likely to lessen the gravity of the problem from the demand
side through a decrease in their disposable income. In this section, we shall
examine the efficacy of these policies to control the supply of child labour in
the given set-up.
Totally differentiating equations (8), (9) and (10) and solving by
Cramer’s rule, the following expressions can be obtained:
R̂ = 0 (17)
1
Wˆ = − θC1 Pˆ2 (18)
θ
1
WˆC = θ L1 Pˆ2 (19)
θ
where θ = θ L1 θC2 − θC1 θ L2 .
Differentiating equations (14), (15) and (16.1), solving by Cramer’s rule
and using (17)–(19), one can get the following expressions:19
1 ⎡ ⎛ λ ⎞ ⎤
Xˆ 1 = ⎢ λ L3 ⎜ λC2 − L2 ⎟ Kˆ + Z1Pˆ2 − λ L2 λ K3 G3 Eˆ ⎥ (20)
λ ⎣ ⎝ 1 − λL3 ⎠ ⎦
1 ⎡ ⎛ λ L1 ⎞ ⎤
Xˆ 2 = ⎢ λ L3 ⎜ − λC1 ⎟ Kˆ + Z2 Pˆ2 + (λ L1 λ K3 − λ K1 λ L3 )G3 Eˆ ⎥ (21)
λ ⎣ ⎝ 1 − λ L3 ⎠ ⎦
and
1
Xˆ 3 = ⎡( λ L2 λC1 − λ L1 λC2 ) Kˆ − Z3 Pˆ2 + λ L2 λ K1 G3 Eˆ ⎤⎦
λ ⎣
(22)
where
λ K3 − λ L3
λ = ( λ L2 λC1 − λ L1 λC2 ) (23.1)20
1 − λ L3
19
See Appendix A for derivation.
20
Actually, the expression for |l| is somewhat different but may be simplified to this present form.
See Appendix E in this context.
© 2007 The Authors
1
A1 = [(λ L1 SL1C + λ L2 SL2C ) (θ L1 + θC1 ) + λ L1 SL1 K θC1 ]
θ
λ K1 1 γ WC [W + nB ( E )]
A2 = (SKL θC1 − SK1 C θ L1 ) G1 = >0
θ lC [WC − B ( E )]
2
γW γ B ′E [W + nWC ]
G2 = >0 G3 = >0 (23.2)
lC [WC − B ( E )] lC [WC − B ( E )]
2
1
A3 = [λC1 SC1 L (θC1 + θ L1 ) + λC2 SC2L (θC1 + θ L1 ) + λC1 SC1 K θ L1 + G2θC1 + G1θ L1 ]
θ
⎛ λ L2 ⎞
Z1 = λ K3 ( A1λC2 + A3λ L2 ) + λ L3 A2 ⎜ λC2 − ⎟
⎝ 1 − λ L3 ⎠
⎛ λ L1 ⎞ ⎛ λK λL ⎞
Z2 = A2 λ L3 ⎜ − λC1 ⎟ − A3(λ L1 λ K3 − λ K1 λ L3 ) + A1 ⎜ 1 3 − λ K3 λC1 ⎟
⎝ 1 − λ L3 ⎠ ⎝ 1 − λ L3 ⎠
Z3 = − A2 ( λ L2 λC1 − λ L1 λC2 ) + A3λ L2 λ K1 + A1λ K1 λC2
Differentiating equation (11) and using (22) and (23.1), it is easy to check21
that the stability condition in the market for the non-traded final commodity
is as follows:
EY W *Lλ L3 Z
EP2 − Z3 − 2 = Δ < 0 (24)
λ Y λ
where EP2 and EY are the own price and income elasticities of demand for
commodity 2, respectively.
Differentiating equation (11) once more, using (21) and (22) and simpli-
fying, one can find22
Pˆ2 = Q1Kˆ + Q2 Eˆ + Q3Tˆ (25.1)
where
1 1 ⎡ ⎛ λ L1 ⎞ EYW *Lλ L3 ⎤
Q1 = λ L3 ⎜ − λC1 ⎟ − ( λ L2 λC1 − λ L1 λC2 ) ⎥ ⎫⎪
λ Δ ⎢⎣ ⎝ 1 − λ L3 ⎠ Y ⎦
⎪
G3 1 ⎡ EYW *Lλ L3 ⎤ ⎪
Q2 =
⎢
(λ L1 λ K3 − λ K1 λ L3 ) − λ L2 λ K1
⎥ ⎪⎪
λ Δ⎣ Y ⎦
⎬ (25.2)
(− ) (+ ) (+ ) ⎪
EY T ⎪
Q3 = <0 (using (24 )) ⎪
Δ Y ⎪
(− ) (+ ) ⎪⎭
21
This is derived in Appendix B.
22
See Appendix C for the derivation of equation (25.1).
© 2007 The Authors
Finally, differentiating equation (7) and using (18), (19) and (22), the follow-
ing expression23 may be obtained:
G G
LˆC = 1 θ L1 Pˆ2 + 2 θC1 Pˆ2 − G3 Eˆ
θ θ
λ L3 1
− ⎡( λ L2 λC1 − λ L1 λC2 ) Kˆ − Z3 Pˆ2 + λ L2 λ K1 G3 Eˆ ⎤⎦ (26.1)
1 − λ L3 λ ⎣
Now substituting P̂2 from (25.1) into (26.1) and simplifying, we get
⎡ λ L3 ⎤ ˆ ⎡
LˆC = ⎢( IWC + IW + I L )Q1 − K + ⎢( IWC + IW + I L )Q2
⎣ λ K3 − λ L3 ⎥⎦ ⎣
⎛ λ L3 λ L2 λ K1 ⎞ ⎤ ˆ
⎟ G3 E + [( IWC + IW + I L )Q3 ]T
− ⎜1 + ˆ (26.2)
⎝ 1 − λ L3 λ ⎠ ⎥⎦
where
G1 G2 λ L3 1
IWC = θ L1 IW = θC1 IL = Z3 (27)
θ θ 1 − λ L3 λ
We are now in a position to analyse the consequences of different poli-
cies on the incidence of child labour in the society. Any changes in the policy
parameters affect the aggregate supply of child labour in the society both
directly and indirectly. The indirect effects arise due to a change in the price
of the non-traded commodity and take place through changes in the adult
and child wage rates and the use of capital in the export sector (sector 1). In
order to find the overall impact of a policy, we need to identify each effect
separately. For that purpose one can find equation (26.1) quite handy. In
some cases, the different effects work in opposite directions and it is not
possible to predict the net outcome of a policy on child labour unequivocally.
However, we can at least find reasonable condition(s) under which qualitative
results may be predicted. In such cases we shall use equation (26.2).
From equation (7) we should note that the aggregate supply of child
labour in the economy, LC, depends on three factors. It depends negatively on
the informal sector adult wage, W, and positively on both the child wage, WC,
and the number of poor families supplying child labour, L − aL3 X 3 . So, a
decrease in WC and/or an increase in W and/or a decrease in L − aL3 X 3 causes
the aggregate supply of child labour to decline and vice versa. These three
broad effects may, respectively, be termed the child wage effect, the adult wage
effect and the adult labour reallocation effect. The first two effects can only be
of induced type while the last effect can be of both direct and induced types.
As sectors 1 and 2 together form a HOSS, the two wage rates change (in
opposite directions) only if there occurs a change in the price of the non-
23
Equation (26) is derived in Appendix D.
© 2007 The Authors
traded commodity, P2 (Stolper–Samuelson effect). So, the two wage effects

produce only indirect effects on child labour. The first two terms on the
right-hand side of equation (26.1) capture the child wage effect and the adult
wage effect, respectively. Moreover, a change in P2 also produces a Rybczyn-
ski type effect24 in the HOSS resulting in a change in the sectoral composition
of output. If sector 1 expands (contracts), it requires more (less) capital than
before which has to be released (absorbed) by sector 3. Consequently, sector
3 contracts (expands) both in terms of output and employment. This is the
induced adult labour reallocation effect which arises owing to a change in P2
and is captured by the second term within square brackets on the right-hand
side of (26.1).
Policies like an inflow of foreign capital and an increase in the subsidy
on education have both direct and indirect effects on the incidence of child
labour while an imposition of a lump-sum tax on the richer section of the
population has only indirect effects. An inflow of foreign capital produces a
Rybczynski effect and leads to an expansion of sector 3 and a contraction of
sector 1 as sector 3 is more capital intensive relative to sector 1 in the
physical sense. But the return to capital, R, does not change as it is deter-
mined from the zero-profit condition for sector 3 (equation (10)). As more
adult workers are now employed in sector 3, the number of working families
supplying child labour decreases. This is the direct adult labour reallocation
effect of an inflow of foreign capital that lowers the incidence of child labour
given the two wage rates and is captured by the first term within square
brackets on the right-hand side of (26.1). Sector 2 contracts in tandem with
sector 1 as the availability of the two types of labour decreases in the HOSS.
Now as the higher-wage-paying sector (sector 3) expands, the aggregate
income of the richer people rises which in turn raises the demand for the
non-traded final commodity. The price of the non-traded good, P2, rises
unambiguously which generates a Stolper–Samuelson effect and causes the
two wage rates to change. This produces two induced wage effects on the
supply of child labour. As explained above, an induced adult labour real-
location effect will also take place. These are the three induced effects of an
inflow of foreign capital that work through a change in P2.
On the other hand, an increase in the educational subsidy, E, ceteris
paribus, lowers the effective child wage rate, WC - B(E), and hence the supply
of child labour. This is the first direct effect of this policy and is represented
by the third term on the right-hand side of (26.1). This may be called the
effective child wage effect. It produces a Rybczynski effect in the HOSS
leading to a (an) contraction (expansion) of the more (less) child-labour-
intensive sector depending on the relative child labour intensities of the two
24
A Stolper–Samuelson effect contains an element of the Rybczynski effect if the technologies of
production are of the variable coefficient type. This is a well-known result in the theory of
international trade.
© 2007 The Authors
sectors. If sector 1 contracts (expands), some amount of capital is released

(absorbed) which is now absorbed in (released by) sector 3. So, sector 3
expands (contracts) in terms of both output and employment of adult labour
and consequently the number of working families supplying child labour
decreases (increases). This is the direct adult labour reallocation effect which
takes place without any changes in P2. This second direct effect of an educa-
tion subsidy policy is encapsulated by the third term within square brackets
on the right-hand side of (26.1). This causes the aggregate income of the
richer people to change and hence the demand for the non-traded final
commodity. The supply of this commodity has also changed. Consequently,
the price of this commodity changes and two induced wage effects on the
supply of child labour would take place.
Finally, a lump-sum tax on the affluent section of the population affects
the aggregate supply of child labour only indirectly through a change in P2.
We have already discussed in detail how a change in P2 generates a child wage
effect, an adult wage effect and an induced adult labour reallocation effect.
As both sectors 1 and 2 use adult labour and child labour and form a
HOSS, these can be classified in terms of factor intensities.25 The signs of
different effects, especially those of induced effects, depend crucially on the
relative factor intensities of these two sectors. Depending on this classifica-
tion there can arise two cases. We are now going to discuss these one by one.
For analytical simplicity, we assume that the per unit requirement of capital,
aK1 , is given technologically.26
Let us first consider the case where the export sector (sector 1) is more
intensive in the use of child labour relative to the non-traded sector (sector 2).
From equation (26.2) the following proposition can be proved.27
Proposition 1: When the export sector is more child labour intensive than
the non-traded sector with respect to adult labour, the incidence of child
labour in the economy (i) falls unambiguously due to an inflow of foreign
25
Available empirical evidence suggests that the concentration of child labour is the highest in the
rural sector of a developing economy and that child labour is used intensively directly or
indirectly in the agricultural sector. On the other hand, most adult employment in devel-
oping countries is still in agriculture. See the International Labour Office (2002) and
Government of India (2000) reports in this context. But, whether the ratio of child labour
to adult labour used in agriculture is greater than or less than that in non-agricultural
activities is quite inconclusive. So, we consider both the cases here and see how the effects
of different policies on child labour change under different factor intensity conditions.
26
It rules out the possibility of substitution between capital and other factors of production (i.e.
adult labour and child labour) in sector 1. Although this is a simplifying assumption, it is
not totally unrealistic. For cultivation with high yielding variety seeds, frequently used in
several areas of a developing economy, different inputs such as fertilizers, pesticides,
herbicides and water should be used in recommended doses. In other words, there are
complementarities between these inputs and these are not substitutable with the input,
labour. See Dasgupta (1977) for a detailed discussion on this aspect. It may be checked,
however, that the qualitative results of the model hold under different condition(s) even if
we allow substitutability between labour and capital.
27
See Appendix E for the mathematical proof.
© 2007 The Authors
capital, (ii) falls following an education subsidy policy if

λ L1 λ K3 ≤ EYW *Lλ L3 λ L2 λ K1 Y , and (iii) increases unambiguously due to impo-
sition of a lump-sum tax on the richer section of the population.
We have already explained how an inflow of foreign capital lowers the

incidence of child labour through the direct adult labour reallocation effect
and leads to an increase in the price of the non-traded commodity, P2. An
increase in P2, in turn, lowers the child wage rate, WC, and raises the informal
adult wage rate, W, following a Stolper–Samuelson effect as sector 2 is
intensive in the use of adult labour vis-à-vis sector 1. So the two induced wage
effects also exert downward pressures on the supply of child labour. In this
case, all the effects work in the same direction and together contribute to an
unambiguous decrease in the incidence of child labour in the economy.
On the other hand, an increase in the subsidy on education raises the
marginal benefit of sending children to school. Other things remaining
unchanged, this lowers the effective child wage rate and hence produces a
direct contractionary effect on child labour. A Rybczynski effect in the HOSS
takes place leading to a (an) contraction (expansion) of the more (less)
child-labour-intensive sector, i.e. sector 1 (sector 2). As sector 1 contracts,
some amount of capital is released which is now absorbed in sector 3. So,
sector 3 expands in terms of both output and employment of adult labour.
This is the direct adult labour reallocation effect which lowers the supply of
child labour. The aggregate income of the richer section of the population
rises as more adult workers are now employed in the higher-wage-paying
sector. This leads to an increase in the demand for commodity 2. Thus, we
find that there are two opposite effects on the price of commodity 2, P2, as
both the demand and the supply of this commodity have increased. However,
the positive effect of an increase in demand on P2 outweighs the negative
effect of an increase in supply under the sufficient condition as stated in
Proposition 1. As P2 rises, the competitive adult wage, W, rises and the child
wage, WC, falls following a Stolper–Samuelson effect. Thus, we find that all
the direct and indirect effects work in the same direction and together lead to
a reduction in the incidence of child labour subject to the sufficient condition
as mentioned above. However, it should be pointed out that one may get the
same result under a few other sufficient conditions as well.
Finally, a lump-sum tax, T, on the richer people has no direct effects on
child labour. However, it lowers the aggregate disposable income, Y - T, of
this section of the population and hence the demand for the non-traded
commodity. This leads to a fall in P2. As P2 decreases, W falls and WC rises
following a Stolper–Samuelson effect as sector 2 is intensive in the use of
adult labour with respect to child labour relative to sector 1 in this case.
Besides, sector 1 expands at the cost of sector 2 following a Rybczynski type
effect. This leads to a contraction of sector 3 as it has to release capital to the
expanding sector 1. As a consequence, the number of working families
© 2007 The Authors
employed in sector 3 falls. This means that more working families will now be
supplying child labour. In this case, all the three effects, namely the child
wage effect, the adult wage effect and an induced adult labour reallocation
effect, work in the same direction and together contribute to an unambiguous
increase in the incidence of child labour in the society. This is an interesting
result as it is counterintuitive to the common wisdom.
Now, we are going to analyse the case where the non-traded sector is
more child labour intensive with respect to adult labour vis-à-vis the export
sector. In this case, unlike the previous one, different effects of a policy
change work on the supply of child labour in opposite directions. Although
unambiguous consequences cannot be predicted, some counter-
intuitive results may be obtained subject to a few reasonable conditions.
For this purpose, we consider equation (26.2) and derive the following
proposition.28
Proposition 2: In a situation where the export sector is less child

labour intensive vis-à-vis the non-traded final good sector, the incidence
of child labour (i) rises owing to an inflow of foreign
capital if ( IWC + I L )Q1 ≥ λ L3 (λ K3 − λ L3 ), (ii) falls due to a hike in subsidy
on education if λ L1 λ K3 ≤ λ L3 λ L2 λ K1 EYW *L Y and ( IWC + IW + I L )Q2 ≤
λ L3 λ L2 λ K1 G3 [(1− λ L3 ) λ ] , and (iii) decreases following a lump-sum tax on the
richer people if ( IWC + I L )Q3 ≤ 0.
As explained previously, an inflow of foreign capital causes sector 3 to

expand in terms of both output and employment, exerts a downward pressure
on child labour through the direct adult labour reallocation effect and causes
both sectors 1 and 2 to contract. Besides, the aggregate income of the richer
section of the population, denoted Y, increases which raises the demand for
commodity 2. So, the price of commodity 2, i.e. P2, rises unambiguously.
When P2 rises, the competitive adult wage, W, falls and the child wage, WC,
rises owing to a Stolper–Samuelson effect as sector 2 is now more child labour
intensive vis-à-vis sector 1. So, the supply of child labour by each poor
working family rises due to the two induced wage effects. Sector 1 contracts
further following a Rybczynski type effect and releases some more capital to
sector 3. This causes a supplementary expansion of sector 3. This is the
induced adult labour reallocation effect which arises following an increase in
P2. Thus, we find that the two induced wage effects tend to increase the
incidence of child labour while both the direct and indirect adult labour
reallocation effects work in the opposite direction. The net result of these
effects will be an increase in the aggregate supply of child labour in the society
under the sufficient condition ( IWC + I L )Q1 ≥ λ L3 (λ K3 − λ L3 ). This condition
28
This is proved in Appendix E.
© 2007 The Authors
implies that the strength of the induced child wage effect is greater than the
joint strength of the two adult labour reallocation effects.29
A hike in the education subsidy, ceteris paribus, lowers the effective child
wage rate and hence lowers the supply of child labour by each poor family
through the effective child wage effect. This produces a Rybczynski effect in
the HOSS leading to a (an) contraction (expansion) of sector 2 (sector 1). This
also causes sector 3 to contract in terms of both output and employment of
adult labour as it has to release capital to the expanding sector 1. This leads
to a decrease in the demand for commodity 2 through a decrease in Y. Thus,
we find that both the demand and supply of commodity 2 fall and hence there
arise two opposite effects on P2. However, P2 falls under the sufficient con-
dition that λ L1 λ K3 ≤ EYW *Lλ L3 λ L2 λ K1 Y . As P2 falls, W rises and WC falls due
to a Stolper–Samuelson effect. There will be an additional expansionary
effect on sector 1 following a Rybczynski type effect in the HOSS that
requires sector 3 to release some more capital to sector 1. Sector 3 contracts
further in terms of both output and employment. This is the induced adult
labour reallocation effect. So, there are now more child-labour-supplying
families with each of them sending out a lower number of children to work
than before. The net outcome will be a fall in the incidence of child labour in
the society if ( IWC + IW + I L )Q2 ≤ λ L3 λ L2 λ K1 G3 [(1 − λ L3 ) λ ]. This condition
means that the two induced wage effects collectively dominate over the two
adult labour reallocation effects.30
Finally, the imposition of a lump-sum tax on the richer people lowers the
price of commodity 2, P2. This produces a Stolper–Samuelson effect in the
HOSS and leads to an increase in the competitive adult wage, W, and a
decrease in the child wage, WC, as sector 2 is now more child labour intensive
relative to sector 1. Thus, the supply of child labour by each poor family
decreases due to the two induced wage effects. Also, sector 1 expands and
sector 2 contracts following a Rybczynski type effect. Sector 3 contracts as it
has to release capital to the expanding sector 1. The number of child-labour-
supplying families, L − aL3 X 3 , increases as sector 3 contracts in terms of both
output and employment. This is the induced adult labour reallocation effect
that produces an upward pressure on child labour. The net outcome will be a
fall in the aggregate supply of child labour if ( IWC + I L )Q3 ≤ 0. This restriction
implies that the magnitude of the induced child wage effect is greater than the
extent of the induced adult labour reallocation effect. However, this result
also holds under an alternative sufficient condition as well (see Appendix E).
It is interesting to note that the effects of a lump-sum tax on the richer
people on the incidence of child labour in the economy completely differ in
the two cases considered above. When the export sector is more intensive in
29
This result holds even if the induced adult wage effect is stronger than the two adult labour
reallocation effects. In mathematical terms this is expressed as ( IW + I L )Q1 ≥ λ L3 ( λ K3 − λ L3 ) .
30
One may find other sufficient conditions incorporating the effective child wage effect.
© 2007 The Authors
the use of child labour vis-à-vis the non-traded sector, the policy works
unfavourably on child labour while it produces the desired result in the
opposite case. Hence, an education subsidy policy cannot be financed by
imposing a lump-sum tax when the export sector is more intensive in the use
of child labour than the non-traded sector. However, when the non-traded
sector is relatively child labour intensive, both the policies should be under-
taken concurrently and a balanced-budget change raises the possibility of
getting the desired result on the problem of child labour.
4 Concluding Remarks
There are now considerable evidence and theoretical reason for believing
that, in developing countries, parents send their children to work out of
utter poverty. It is also believed that an inflow of foreign capital will lead
to an overall economic expansion, benefits of which will percolate down to
the bottom of society, which in turn will put a brake on the incidence of
poverty-induced child labour. Over the last two decades, the developing
economies have been able to attract a considerable amount of foreign direct
investment by adopting liberalized investment policies. Although the inci-
dence of child labour on the whole has decreased in the developing coun-
tries with economic growth in relative terms, in some high-growth-prone
areas the incidence has been on the rise. A pertinent question is why lib-
eralized investment policies have produced contradictory results in different
cases. The present paper has made an attempt to provide an answer to the
above question using a three-sector general equilibrium model with two
informal sectors and a non-traded final commodity. In the two informal
sectors child labour is used along with adult labour. The non-traded com-
modity is consumed by the wealthier section of the population. Apart from
the analysis of foreign capital, the paper is also intended to investigate
the effectiveness of an education subsidy policy and a lump-sum tax on the
richer people as a means of financing the subsidy on education to control
the prevalence of the evil in the system.
The interesting results that emerge from the analysis of the paper are
as follows. An overall economic expansion with foreign capital might
produce paradoxical results on child labour under different circumstances.
While the policy lowers the incidence of child labour in the situation where
the traded sector is more child labour intensive than the non-traded infor-
mal sector, it might produce a counterproductive effect in the opposite case.
In contrast, an education subsidy policy is expected to produce the desired
result on child labour in both situations. However, when the traded sector
is relatively intensive in the use of child labour, the subsidy on education
should not be financed by a lump-sum tax on the more affluent people as
the latter policy might invalidate the favourable effect of the education
subsidy policy. But, in the other case both the policies can be undertaken
© 2007 The Authors
concurrently and a balanced-budget change is the best policy option in the

given set-up. So, the paper finds that an education subsidy policy is a more
effective instrument in comparison with the policy of economic growth with
foreign capital in combating the problem of child labour in a developing
economy. But, whether the subsidy on education should be financed by a
lump-sum tax on the wealthier people depends on the technological and
institutional factors of the economy.
Appendix A: Derivation of Certain Expressions

Totally differentiating (14) yields
∑a Li dX i = − ∑ Xi daL i
or
∑ (X a i Li L )Xˆ i = − (X 1 L ) [( ∂aL1 ∂W ) dW + ( ∂aL1 ∂WC ) dWC + ( ∂aL1 ∂R ) dR ]

− (X 2 L ) [( ∂aL2 ∂W ) dW + ( ∂aL2 ∂WC ) dWC ]
− (X 3 L ) [( ∂aL3 ∂R ) dR ] (A1)
Using the result that R̂ = 0 (see (17)) from the above expression we can write
λ L1 Xˆ 1 + λ L2 Xˆ 2 + λ L3 Xˆ 3 = − (λ L1SL1 L + λ L2 SL2L )Wˆ − (λ L1SL1C + λ L2 SL2C )ŴC (A2)
Substituting the values of Ŵ and ŴC from (18) and (19) into (A2) and simplify-
ing, we get the following:
λ L1 Xˆ 1 + λ L2 Xˆ 2 + λ L3 Xˆ 3 = − A1Pˆ2 (A3)
where
1
A1 = [(λ L1SL1C + λ L2 SL2C ) (θ L1 + θC1 ) + λ L1SL1 K θC1 ]
θ
(Note that SL1 L + SL1C + SL1 K = 0 ⇒ SL1 L = − (SL1C + SL1 K ) and SL2L + SL2C = 0 .)
Now differentiating (15) we get
λ K1 Xˆ 1 + λ K3 Xˆ 3 = Kˆ − λ K1 (SK1 LWˆ − SK1 CWˆC )
Substituting the values of Ŵ and ŴC from (18) and (19) into the above expression and
simplifying one gets the following:
λ
λ K1 Xˆ 1 + λ K3 Xˆ 3 = Kˆ + K1 (SK1 L θC1 − SK1 C θ L1 ) Pˆ2
θ
or
λ K1 Xˆ 1 + λ K3 Xˆ 3 = Kˆ + A2Pˆ2 (A4)
© 2007 The Authors

where
λ K1 1
A2 = (SKL θC1 − SK1 C θ L1 )
θ
Similarly differentiating equation (16.1) we get

λ
λC1 Xˆ 1 + λC2 Xˆ 2 + L3 Xˆ 3
1 − λ L3
= − (λC1 SC1 L + λC2 SC2L + G2 )Wˆ − (λC1 SC1C + λC2 SC2C − G1 )WˆC − G3 Eˆ (A5)
Substituting the values of Ŵ and ŴC into (A5) and simplifying, we get the following:
λ L3 ˆ Pˆ2
λC1 Xˆ 1 + λC2 Xˆ 2 + X 3 = [λC1 SC1 L (θC1 + θ L1 ) + λC2 SC2L (θC1 + θ L1 )
1 − λ L3 θ
+ λC SC1 θ L + G2θC + G1θ L ] − G3 Eˆ
1 K 1 1 1
This is rewritten as follows:

λ
λC1 Xˆ 1 + λC2 Xˆ 2 + L3 Xˆ 3 = A3Pˆ2 − G3 Eˆ (A6)
1 − λ L3
where
γWC [W + nB ( E )] γW
G1 = >0 G2 = >0
lC [WC − B ( E )]
2
lC [WC − B ( E )]
γ B ′E (W + nWC )
G3 = >0
lC [WC − B ( E )]
2
and
1
A3 = [λC1 SC1 L (θC1 + θ L1 ) + λC2 SC2L (θC1 + θ L1 ) + λC1 SC1 K θ L1 + G2θC1 + G1θ L1 ]
θ
(A3), (A4) and (A6) can be written in matrix notation as follows:

⎛ ⎞ ⎛ − A Pˆ ⎞
⎜ λ L1 λ L2 λ L3 ⎟ ⎛ Xˆ 1 ⎞
⎜ ⎟ ⎜ ⎟
1 2
⎜ ⎟⎜ ˆ ⎟ ⎜ ˆ ⎟
⎜ λ K1 0 λ K3 ⎟ ⎜ X 2 ⎟ = ⎜ K + A2Pˆ2 ⎟
(A7)
⎜ λ L3 ⎟ ⎜ ⎟ ⎜ ⎟
⎜ λC1 λC2 ⎟ ⎜ Xˆ 3 ⎟ ⎜ A3 Pˆ2 − G3 Eˆ ⎟
⎝ 1 − λ L3 ⎠ ⎝ ⎠ ⎝ ⎠
Solving (A7) by Cramer’s rule and simplifying, one gets

1 ⎡ ⎛ λ ⎞ ⎤
Xˆ 1 = ⎢ λ L3 ⎜ λC2 − L2 ⎟ Kˆ + Z1Pˆ2 − λ L2 λ K3 G3 Eˆ ⎥ (20)
λ ⎣ ⎝ 1 − λ L3 ⎠ ⎦
© 2007 The Authors

1 ⎡ ⎛ λ L1 ⎞ ⎤
Xˆ 2 = λ L3 ⎜ − λC1 ⎟ Kˆ + Z2 Pˆ2 + (λ L1 λ K3 − λ K1 λ L3 )G3 Eˆ ⎥
λ ⎢⎣ ⎝ 1 − λ L3 ⎠ (21)
⎦
and
1
Xˆ 3 = ⎡⎣(λ L2 λC1 − λ L1 λC2 ) Kˆ − Z3 Pˆ2 + λ L2 λ K1G3 Eˆ ⎤⎦ (22)
λ
where
⎛ λ ⎞
Z1 = λ K3 ( A1λC2 + A3λ L2 ) + λ L3 A2⎜ λC2 − L2 ⎟
⎝ 1 − λ L3 ⎠
⎛ λ L1 ⎞ ⎛λ λ ⎞
Z2 = A2 λ L3 ⎜ − λC1 ⎟ − A3(λ L1 λ K3 − λ K1 λ L3 ) + A1 ⎜ K1 L3 − λ K3 λC1 ⎟
⎝ 1 − λ L3 ⎠ ⎝ 1 − λ L3 ⎠
λ K1 λ L3
λ = λ K3 (λ L2 λC1 − λ L1 λC2 ) + [λC2 (1 − λ L3 ) − λ L2 ]
1 − λ L3
λ K3 − λ L3
= (λ L2 λC1 − λ L1 λC2 ) (see Appendix E) (23.1)
1 − λ L3
and
Z3 = − A2(λ L2 λC1 − λ L1 λC2 ) + A3λ L2 λ K1 + A1λ K1 λC2
Appendix B: Stability Condition in the Market for Commodity 2

Differentiating the demand function for commodity 2 given by equation (11), we can
derive
W *Lλ L3 ˆ T
Xˆ 2D = EP 2 Pˆ2 + EY X 3 − EY Tˆ (A8)
Y Y
Substituting X̂3 from (22) and simplifying, one obtains the following:
E W *Lλ L3
Xˆ 2D = EP 2 Pˆ2 + Y ⎡⎣(λ L2 λC1 − λ L1 λC2 ) Kˆ − Z3 Pˆ2 + λ L2 λ K1G3 Eˆ ⎤⎦
λ Y
T
− EY Tˆ (A9)
Y
Allowing only P2 to change and keeping all parameters unchanged, we find that
Xˆ 2D E W *Lλ L3
= EP 2 − Y Z3 (A10)
Pˆ2 λ Y
Similarly, from equation (21) one obtains the following:

Xˆ 2 Z2
= (A11)
Pˆ2 λ
© 2007 The Authors

For static stability we require that

Xˆ 2D Xˆ 2 E W *Lλ L3 Z
− = EP2 − Y Z3 − 2 = Δ < 0 (24)
ˆ
P2 ˆ
P2 λ Y λ
Appendix C: Derivation of Equation (25.1)

In equilibrium in the market for commodity 2, we have Xˆ 2D = Xˆ 2 . Now using (A9) and
(21) we can write
EY W *Lλ L3 T
EP2 Pˆ2 + ⎡⎣(λ L2 λC1 − λ L1 λC2 ) Kˆ − Z3 Pˆ2 + λ L2 λ K1G3 Eˆ ⎤⎦ − EY Tˆ
λ Y Y
1 ⎡ ⎛ λ L1 ⎞ ⎤
= λ L3 ⎜ − λC1 ⎟ Kˆ + Z2 Pˆ2 + (λ L1 λ K3 − λ K1 λ L3 )G3 Eˆ ⎥
λ ⎢⎣ ⎝ 1 − λ L3 ⎠ ⎦
or
⎛ E − EY W *Lλ L3 Z − Z2 ⎞ Pˆ
⎝ P2 λ Y
3
λ⎠
2
1 ⎡ ⎛ λ L1 ⎞ E W *Lλ L3 ⎤
= λ L3 ⎜ − λC1 ⎟ − Y (λ L2 λC1 − λ L1 λC2 ) ⎥ Kˆ
λ ⎢⎣ ⎝ 1 − λ L3 ⎠ Y ⎦
1 ⎡ E W *Lλ L3
λ L2 λ K1 ⎤ G3 Eˆ + EY Tˆ
T
+ (λ L1 λ K3 − λ K1 λ L3 ) − Y
λ ⎣⎢ Y ⎦⎥ Y
Using (24) the above expression may be rewritten as follows:

Pˆ2 = Q1Kˆ + Q2 Eˆ + Q3Tˆ (25.1)
where
1 1 ⎡ ⎛ λ L1 ⎞ E W *Lλ L3 ⎤
Q1 = λ L3 ⎜ − λC1 ⎟ − Y (λ L2 λC1 − λ L1 λC2 ) ⎥ ⎪⎫
λ Δ ⎢⎣ ⎝ 1 − λ L3 ⎠ Y ⎦
⎪
G3 1 ⎡ EYW *Lλ L3 ⎤ ⎪
Q2 = (λ L1 λ K3 − λ K1 λ L3 ) − λ L2 λ K1 ⎬ (25.2)
λ Δ ⎢
⎣ Y ⎥
⎦ ⎪
EY T ⎪
Q3 = <0 ⎪
Δ Y ⎭
Appendix D: Derivation of Equations (26.1) and (26.2)

Differentiating equation (7), we get
λ L3 ˆ
LˆC = GW ˆ ˆ ˆ
1 C − G2W − G3 E − X3 (A12)
1 − λ L3
Substitution of Ŵ, ŴC and X̂3 from (18), (19) and (22) into (A12) yields
© 2007 The Authors
G G
LˆC = 1 θ L1 Pˆ2 + 2 θC1 Pˆ2 − G3 Eˆ
θ θ
λ L3 1
− ⎡(λ L2 λC1 − λ L1 λC2 ) Kˆ − Z3 Pˆ2 + λ L2 λ K1G3 Eˆ ⎤⎦
1 − λ L3 λ ⎣
(26.1)
Rearranging terms we write

⎛G G λ L3 1 ⎞ ˆ λ L3 1
LˆC = ⎜ 1 θ L1 + 2 θC1 + Z3⎟ P2 − (λ L2 λC1 − λ L1 λC2 ) Kˆ
⎝ θ θ 1 − λ L3 λ ⎠ 1 − λ L3 λ
⎛ λ L3 1 ⎞
− ⎜1+ λ L λ K G3 Eˆ
⎝ 1 − λ L3 λ 2 1 ⎟⎠
Now substituting P̂2 from (25.1) into the above expression, using (23.1) and simpli-
fying, one finally gets
⎡ λ L3 ⎤ ˆ ⎡
LˆC = ⎢( IWC + IW + I L )Q1 − K + ⎢( IWC + IW + I L )Q2
⎣ λ K3 − λ L3 ⎥⎦ ⎣
⎛ λ L3 λ L2 λ K1 ⎞ ⎤ ˆ
⎟ G3 E + [( IWC + IW + I L )Q3 ]T
− ⎜1 + ˆ (26.2)
⎝ 1− λ L3 λ ⎠ ⎥⎦
where
G1 G2 λ L3 1
IWC = θ L1 IW = θC1 IL = Z3 (27)
θ θ 1 − λ L3 λ
Appendix E: Proof of Propositions 1 and 2

In this model, sector 3 has been assumed to be more capital intensive (in a physical
sense) vis-à-vis sector 1 with respect to adult labour. This implies the following:
λ K3 λ K1 λ λ 1 λ + λ L1
> ⇒ K3 > L3 ⇒ > L3 ⇒ λ L1 > λ K1 (λ L3 + λ L1 ) (A13)
λ L3 λ L1 λ K1 λ L1 λ K1 λ L1
and
λ L1 λ K1 λ + λ L3 1 λ L3
> ⇒ L1 > ⇒ λ K3 > ⇒ λ K3 > λ L3 (A14)
λ L3 λ K3 λ L3 λ K3 λ L1 + λ L3
(Note that lL1 + lL3 < 1.)

The expression for |l| is as follows:
λ K1 λ L3
λ = λ K3 (λ L2 λC1 − λ L1 λC2 ) + [λC2 (1 − λ L3 ) − λ L2 ] (A15)
1 − λ L3
Substitution of lL1 + lL2 in place of 1 - lL3 in (A15) and simplification yield
© 2007 The Authors

λ K3 − λ L3
λ = (λ L2 λC1 − λ L1 λC2 ) (23.1)
1 − λ L3
From the stability condition in the market for commodity 2, we have

EY W *Lλ L3 Z
EP 2 − Z3 − 2 = Δ < 0 (24)
λ Y λ
As both sectors 1 and 2 use adult labour and child labour as inputs, these together
form a HOSS given the rental to capital, R. So, these sectors can be classified in terms
of relative factor intensities.
Case I
We first consider the case where the export sector is more child labour intensive
vis-à-vis the non-traded sector with respect to adult labour. In other words,
aC1 aC2 λ λ (A16)
> ⇒ C1 > C2 ⇒ λ L2 λC1 − λ L1 λC2 > 0
aL1 aL2 λ L1 λ L2
In this case, we also have
θC1θ L2 > θC2 θ L1 ⇒ θ = θ L1θC2 − θC1θ L2 < 0 (A17)
From (A16) it is easy to find that
λ L2 λC2 1 − λ L3 1 λ L1
> ⇒ > ⇒ λC1 >
λ L1 λC1 λ L1 λC1 1 − λ L3
Alternatively
λC1 λ L1 1 1 − λ L3 λ L2
> ⇒ > ⇒ > λC2 (A18)
λC2 λ L2 λC2 λ L2 1 − λ L3
Assuming aK1 to be technologically given and using (24), (A13), (A14) and (A16)–
(A18), from (23.1), (23.2) and (25.2) it is easy to check that
( i) λ >0 ⎫
( ii) A1 < 0 ⎪
⎪
( iii) A2 = 0 ⎪
( iv ) A3 < 0 ⎪
⎪
( v) Q1 > 0 ⎪
⎬
EYW *Lλ L3 (A19)
( vi) Q2 > 0 if λ L1 λ K3 ≤ λ L2 λ K1 ⎪
Y ⎪
⎪
( vii) Z1 < 0 ⎪
( viii) Z3 < 0 ⎪
⎪
( ix ) IWC , IW , I L < 0 ⎭
© 2007 The Authors

With the help of (A19), from (20) and (25.1) we get the following results:
(a ) Xˆ 1 < 0 when Kˆ > 0 ⎫
⎪
( b) Xˆ 1 < 0 when Eˆ > 0 ⎪
(c ) Xˆ 1 < ( >) 0 when Pˆ2 >(< ) 0 ⎪
⎪
(d ) Pˆ2 > 0 when Kˆ > 0 ⎬
⎪ (A20)
EYW *Lλ L3 ⎪
(e) Pˆ2 > 0 ˆ
when E > 0 if λ L1 λ K3 ≤ λ L2 λ K1 ⎪
Y
⎪
(f ) Pˆ2 < 0 when Tˆ > 0 ⎪⎭
Using (A16), (A18) and (A19), from (21) and (22) we find that X2 decreases (increases)
while X3 increases (increases) following an inflow of foreign capital (an education
subsidy policy). Besides, an increase in P2 raises X3. We will use these results while
explaining Proposition 1 verbally.
Finally, using (A14) and (A19), from equation (26.2) the following results trivi-
ally follow:
(R.1) L̂C < 0 when K̂ > 0.
EYW *Lλ L3
(R.2) L̂C < 0 when Ê > 0 if Q2 3 0, i.e. if λ L1 λ K3 ≤ λ L2 λ K1 .
Y
(R.3) L̂C > 0 when T̂ > 0.
Note that, in (R.2),

EYW *Lλ L3
λ L1 λ K3 ≤ λ L2 λ K1
Y
is only a sufficient condition for LC to fall following an education subsidy policy.
Case II
Let us now consider the case where sector 2 is more child labour intensive relative to
sector 1 with respect to adult labour. This implies the case where
aC1 aC2 λ λ (A21)
< ⇒ C1 < C2
aL1 aL 2 λ L1 λ L2
In this case, we find that
© 2007 The Authors

θC1θ L2 < θC2 θ L1 ⇒ θ = θ L1θC2 − θC1θ L2 > 0 ⎫

λ L2 λC2 1 − λ L3 1 λ L1 ⎪
< ⇒ < ⇒ λC1 < ⎪
λ L1 λC1 λ L1 λC1 1 − λ L3 ⎪
λC1 λ L1 1 1 − λ L3 λ L2 ⎪
< ⇒ < ⇒ λC2 > ⎪
λC2 λ L 2 λC2 λ L2 1 − λ L3 ⎪
λ <0 ⎪
⎪
A1 > 0 ⎪
⎪
A2 = 0 (assuming aK1 to be given technologically ) ⎬ (A22)
A3 > 0 ⎪
⎪
Q1 > 0 ⎪
⎪
EYW *Lλ L3 ⎪
Q2 < 0 iff λ L1λ K3 ≤ λ L 2 λ K1
Y ⎪
Z1 > 0 ⎪
⎪
Z3 > 0 ⎪
⎪
IWC , IW > 0 IL < 0 ⎭
Using (A22), from (20) and (25.1) the following results are obtained:
(a ) Xˆ 1 < 0 when Kˆ > 0 ⎫
⎪
( b) Xˆ 1 > 0 when Eˆ > 0 ⎪
(c ) Xˆ 1 < ( >) 0 when Pˆ2 >(< ) 0 ⎪
⎪
(d ) Pˆ2 > 0 when Kˆ > 0 ⎬ (A23)
⎪
E W *Lλ L3 ⎪
(e) Pˆ2 < 0 when Eˆ > 0 if λ L1 λ K3 ≤ Y λ L2 λ K1 ⎪
Y
⎪
(f ) Pˆ2 < 0 when Tˆ > 0 ⎪⎭
Using (A21) and (A22), from (21) and (22) we find that X2 decreases (decreases)
while X3 increases (decreases) following an inflow of foreign capital (an education
subsidy policy). Besides, an increase in P3 raises X3. These results will be useful in
explaining Proposition 2 intuitively.
Using (A14) and (A23), from (26.2) it is easy to derive the following results:
(R.4) L̂C > 0 when K̂ > 0 if
λ L3
( IWC + I L )Q1 ≥
λ K3 − λ L3
or if
λ L3
( IW + I L )Q1 ≥
λ K3 − λ L3
© 2007 The Authors

(R.5) L̂C < 0 when Ê > 0 if (i)
λ L3 λ L2 λ K1 EYW *L
λ L1 λ K3 ≤
Y
and (ii)
λ L3 λ L2 λ K1G3
( IWC + IW + I L )Q2 ≤
(1 − λ L3 ) λ
(R.6) L̂C < 0 when T̂ > 0 if ( IWC + I L )Q3 ≤ 0 or if (IW + IL)Q3 2 0.
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© 2007 The Authors


Foreign Capital Inflow Fiscal Policies A

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Foreign Capital Inflow Fiscal Policies A

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The Manchester School Vol 75 No.

FOREIGN CAPITAL INFLOW, FISCAL POLICIES AND

Empirical evidence suggests that the incidence of child labour taken as a

education system in the developing countries, including India. Besides, this

The present paper is designed to examine the implications of capital

2.1 Supply Function of Child Labour

population. In contrast, labourers who are engaged in the two informal

2.2 The General Equilibrium Analysis

WaL2 + WC aC2 = P2 (9)

W *aL3 + RaK3 = P3 (10)

aK1 X1 + aK3 X 3 = K (15)

aC1 X1 + aC2 X 2 = LC (16)

traded commodity, P2 (Stolper–Samuelson effect). So, the two wage effects

sectors. If sector 1 contracts (expands), some amount of capital is released

capital, (ii) falls following an education subsidy policy if

We have already explained how an inflow of foreign capital lowers the

Proposition 2: In a situation where the export sector is less child

As explained previously, an inflow of foreign capital causes sector 3 to

concurrently and a balanced-budget change is the best policy option in the

Appendix A: Derivation of Certain Expressions

∑ (X a i Li L )Xˆ i = − (X 1 L ) [( ∂aL1 ∂W ) dW + ( ∂aL1 ∂WC ) dWC + ( ∂aL1 ∂R ) dR ]

© 2007 The Authors

Similarly differentiating equation (16.1) we get

This is rewritten as follows:

(A3), (A4) and (A6) can be written in matrix notation as follows:

Solving (A7) by Cramer’s rule and simplifying, one gets

© 2007 The Authors

Appendix B: Stability Condition in the Market for Commodity 2

Similarly, from equation (21) one obtains the following:

© 2007 The Authors

For static stability we require that

Appendix C: Derivation of Equation (25.1)

Using (24) the above expression may be rewritten as follows:

Appendix D: Derivation of Equations (26.1) and (26.2)

Rearranging terms we write

Appendix E: Proof of Propositions 1 and 2

(Note that lL1 + lL3 < 1.)

Substitution of lL1 + lL2 in place of 1 - lL3 in (A15) and simplification yield

© 2007 The Authors

From the stability condition in the market for commodity 2, we have

© 2007 The Authors

Note that, in (R.2),

© 2007 The Authors

θC1θ L2 < θC2 θ L1 ⇒ θ = θ L1θC2 − θC1θ L2 > 0 ⎫

© 2007 The Authors

(R.5) L̂C < 0 when Ê > 0 if (i)

(R.6) L̂C < 0 when T̂ > 0 if ( IWC + I L )Q3 ≤ 0 or if (IW + IL)Q3 2 0.

© 2007 The Authors

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