The labour market in Developing

countries: Wasted opportunities?

The labour market in Developing countries: Wasted
opportunities?

Lecture Outline/Questions

(1) Agricultural Sector and labour

(2) Connections between the urban and rural labour markets:

Lewis and Harris-Todaro model.

(3) Determinants of Informal sector employment

(4) Linkages between the formal and informal sectors

(5) Testing Dualism in LDC labour markets: Gindling (1991).

The labour market in Developing countries: Wasted
opportunities?

(1) Agricultural Sector and labour

In developing countries but particularly in low-income

countries that characterise large parts of the African continent,
many economically active persons are located in rural areas.

The Rural Labour Market

Characterised by agricultural employment and migration.

Agricultural work has many guises, which include: (i)

subsistence farming, (ii) co-operative farms, (iii) sharecropping
(iv) tenant farming (v) large-scale farming where there is a clear
distinction between employers and employees.
The labour market in Developing countries: Wasted
opportunities?

Theoretically the literature on rural labour markets is weak – based on

household models (e.g. Barnum-Squire, 1979).

This model predicts households are either net importers or exporters of

labour, with initial factor endowments important in who demands labour
and who supplies labour.

These models also assume that households maximise profits by deciding (i)
on what and how to produce and then (ii) what consumption bundle is
chosen – assume production and consumption can be completely
separated (these markets are complete).

Empirically in rural Africa this is not the case due to (i) risk (ii) asymmetric
information and (iii) incentive problems.
The labour market in Developing countries: Wasted
opportunities?

This means rural labour markets are characterised by numerous types of

labour market models in the agricultural sector.

(i) Subsistence Farming: small-scale so no likelihood of any economies of

scale. Productivity is low. Very low-tech production.

Such subsistence farming provides the household with the primary source
of food.

Any excess food is likely to be sold in local market places.

However many chronically poor households (low nutritional intake, under-

weight, calcium deficient etc…) are in a vicious circle that begins with low
calorie intake and under-nutrition, which directly affects productivity in
what is highly physical work (Strauss and Thomas, 1999).
 Effect of increase in one health unit on physical
productivity: A comparison of initial ‘poor’ and
initial ‘rich’ individuals

Physical
Productivity

Hp Hp’ Hr Hr’
Health units
 Effect of increase in one health unit on physical productivity: A comparison of initial ‘poor’
and initial ‘rich’ individuals – D.Ray calls a Capacity Curve (p489)

W3
W2
W1
Physical
Productivity

W1>W2>W3

Health units
=f(wages)
 The labour market in Developing countries: Wasted
opportunities?

Even when labourers can earn more from hiring out their labour
to others they may well remain farming their plot of land because
of the importance of producing/providing food for the
household given agricultural production is uncertain - food
security.

This decision can appear uneconomic (irrational) but because of

no insurance markets, lack of credit markets, asymmetric
information and incentive problems is in fact not irrational at all.

The risk of not having food security for the household will in
itself lead to (now well-known) diversification of income sources
– importance of non-farm income and issue of
migration/remittances.
The labour market in Developing countries: Wasted
opportunities?

(ii) Sharecropping: A way of providing incentives to workers by

employers so monitoring costs and screening costs are
redundant.

Theoretically this model is a way of overcoming market

failures of asymmetric information and incentives problems.

It provides landless workers with access to land and tools – so

the landlord is providing, land, tools, possibly some credit and
loans in harsh times.

The employer gains by having non-seasonal workers all year

round.
The labour market in Developing countries: Wasted
opportunities?

Often landlords will offer sharecropping to

individuals/households he knows – social networks and issue
of trust (new institutional economics) that reduces
transactions costs.

Kinship networks are particularly important here – so will

offer sharecropping to a family member (prior to inheritance
of land).

The only problem with sharecropping comes about when the

lack of economic power of the landless workers is exploited
by the powerful land-owner – has to be a degree of ‘good-
will’.
The labour market in Developing countries: Wasted
opportunities?

Also is an issue of land reform in many low income countries,

that is deemed by the World Bank as being essential for
development and growth – not land grab.

However, there are cases where fertile agricultural land has

been given back to the indigenous people only for a lack of
resources, training, education, access to markets to prevent
these people from exploiting the land (e.g. South Africa).

Also the issue of people not being attracted back to rural areas
by the promise of land from urban areas. Could be a sense of
failure?
 The labour market in Developing countries: Wasted
opportunities?

(iii) Tenant Farming

Pay rent to the land owner, but is little or no security in tenure on the land.
Hence poor incentive to invest in capital and technology and no improvement in
productivity.

The relationship between land owner and tenant is modelled using principal-agent
theory.

The tenant (agent) attempts to maximise his utility subject to effort levels and the
contractual agreement with the land owner.

The land owner (principal) “tries to maximise his utility by manipulating

contractual terms with consideration of the agent’s response to them under the
constraint of guaranteeing to the agent ‘reservation utility,’ meaning the utility the
agent can obtain if he does not enter the contract” (Otsuka and Hayami, 1988,
p.32, Economic Development and Cultural Change).
The labour market in Developing countries: Wasted
opportunities?

(iv) Co-operative farming: Small land-owners form

larger areas to cultivate so can exploit
economies of scale in inputs and outputs.

An issue of access to markets if any surplus is

produced: transport infrastructure needs to be
improved within rural areas and between rural
and urban areas, where the surplus will be sold
for more.
The labour market in Developing countries: Wasted
opportunities?

(v) Commercial Farming: Can lead to significant change in how rural labour markets
work.

E.G. Contract farming (employer contracts small landowner to produce crops

providing them with new technology (inputs)) is good if the small landowner still
retains some land for his/her own use and has other sources of income.

If solely reliant on contract farming income then open yourself up to poor wages.

Work can be casual (day or so), seasonal (month or two), or permanent (more than
3 months), see Duncan and Howell, (1992) ODI, Structural Adjustment and the
African Farmer.

[See Porter and Phillips-Howard (1997), World Development Vol 25(2), pp. 227-
238].
The labour market in Developing countries: Wasted
opportunities?

The issue of what kind of employment contract to

offer to workers is based on type of work done.

If easily monitored (e.g. harvesting) then wages can

be based on the market – these types of jobs can be
casual.

If not easily monitored (e.g. irrigation, pesticide use)

then issue of potential shirking – efficiency wage
theory.
The labour market in Developing countries: Wasted
opportunities?

The Model (variation of Shirking model of Shapiro and Stiglitz, 1984)

To prevent shirking employer can offer permanent contracts – offers certainty of income in
return for no shirking GIVEN NO ALTERNATIVE PERMANENT CONTRACT JOB.

Permanent worker is paid Wp; Casual worker is paid Wc.

Wp>Wc

G is the gains from shirking ( high wage, low effort level).

If caught shirking the worker will only ever get Wc for rest of working life or N periods.

If

G>N(Wp-Wc) then shirk

Wp>=Wc+G/N, then no shirking
G<N(Wp-Wc) then not shirk
 The labour market in Developing countries: Wasted
opportunities?

Non-Farming Activities

Found by a number of researchers in Africa that non-farm

income/earnings is one of the most important components in
rural household income – basis for hiring (cheap) farm labour.

The overriding argument for households wanting to participate

in non-farming activities in both rural and urban locations is that
it diversifies sources of income – like spread betting or ‘hedging’
your bets except this is done in order to decrease the likelihood
of food insecurity.

The issue of non-farming activities undertaken is related to

dualism theory (Lewis) and worker-migration (e.g. Harris-Todaro
(1970)).
 The labour market in Developing countries: Wasted
opportunities?

(2) The Urban Labour Market:

Characterised by (i) greater wage labour, (ii) greater formal sector
employment, (iii) public and private sector (iv) urban self-
employment (survivalist for the majority).

Labour market characterised by market forces.

However these markets are not unfettered: still issues of

institutional structures of the labour markets, trade union
organisations, employer organisations, collective bargaining
coverage, labour market legislation (e.g. minimum wages,
significant hiring and firing costs).
The labour market in Developing countries: Wasted
opportunities?

Arthur Lewis (1954) argued the urban (or the formal) wage was greater than
the rural (informal) wage for 3 reasons:-

(1) the payoff to experience was greater in the formal sector than the informal
sector

(2) labour unions and minimum wages ensure higher initial wages

(3) ‘psychological cost of transferring from the easy going life of the
subsistence sector to the more regimented environment of the capitalist
sector’.

Dualism within the urban labour market: in reality there are multi-tiered
labour markets with some over-lap and therefore chance of ‘switching’, but
only for the lucky few.
 The labour market in Developing countries: Wasted
opportunities?

The formal Harris-Todaro (1970) model

The urban wage is equal to the MP of workers and is greater than the rural
wage.

The basic premise is that if the Expected urban wage > Certain rural wage,
then urban to rural migration will occur until the expected wages are
equalised.

Formally this means that:

E (Wu )  (1   )Wu   .0  E (Wa )  1.Wa

(1)
 The labour market in Developing countries: Wasted
opportunities?

where  represents the probability of being unemployed in the urban labour market.

It is assumed in the Harris-Todaro model that being employed in the urban labour market is uncertain – not
full-employment so is a cost to not being employed.

Being employed in the rural labour market is assumed in the model to be certain – even though the MP in the
rural labour market could well be 0 (under-employment).

From the equation, the expected wages in the two sectors are equal when,

(1   )Wu  Wa
where (1   )  Eu / Lu
so, ( Eu / Lu )Wu  Wa (2)

Eu=Urban formal sector employees, Lu=Urban formal sector labour force, (Eu/Lu)=probability of being
employed in urban labour market.
 The labour market in Developing countries: Wasted
opportunities?

Since Wu  Wa it follows from the previous result that the

probability of being employed in the urban labour market must
be < 1.

See this by re-arranging (2),

( Eu / Lu )Wu  Wa
( Eu / Lu )  Wa / Wu , if Wa / Wu  1 then
( Eu / Lu )  1,

There is open unemployment in the urban labour market.

The labour market in Developing countries: Wasted
opportunities?

If a policy of increasing the rural wage was adopted the

prediction of the model is for urban unemployment to decline.

Policy of rural development can theoretically solve the urban

unemployment problem – Kenyan government adopted a rural
development policy following the H-T model and
unemployment did decline (Fields, 2005).

The basic model has been extensively reviewed and additions

to it include consideration of (i) the risk aversity of workers
and (ii) different urban labour markets.
The labour market in Developing countries: Wasted
opportunities?

(3) Informal sector

Think of this as a primary labour market (formal) and

secondary labour market (informal): economic
dualism or worse economic segmentation.

Table 2.1 indicates the estimated extent of private

formal sector wage employment in 5 African
countries.
 The labour market in Developing countries: Wasted
opportunities?

Table 2.1: Proportion of labour force in private formal sector wage employment, selected African economies,
percentages, 1980-1995

1980 1986 1990 1993 1994-95

Kenya 9.3 9.0 9.1 9.1 9.2

Tanzania 2.0 1.7 4.3 4.8 4.0

Uganda - - 10.8 9.4 9.2

Zambia 12.2 - - 7.9 7.3

Zimbabwe 29.9 25.2 24.7 23.9 20.8

Source: 2001 World Employment Report: Life at work in the information economy, ILO, Geneva.
 The labour market in Developing countries: Wasted
opportunities?

More complex theories of labour market dualism exist, e.g. Esfahani and
Salehi-Isfahani, (Economic Journal 1989).

This model looks at how observability of effort differs amongst formal and
informal workers – Borrows from efficiency wage theory.

Lower observability in the formal sector means firms pay higher wages so as
to encourage effort with the price of shirking being employment in the
informal sector at a lower wage.

Formal sector jobs are more likely to be about mental capital rather than
physical capital.

Informal jobs are more physical and labour intensive and hence easier to
observe effort.
 The labour market in Developing countries: Wasted
opportunities?

Persistent involuntary unemployment in LDCs can also

be explained by efficiency wage theory with the
unemployed desiring to work in the formal sector
only…….

……..Higher wages in this sector mean longer

unemployment queues since it is worth trying to get a
formal sector job rather than an informal sector job
where current and future wages are very low.
 The labour market in Developing countries: Wasted
opportunities?

(Q) What determines the informal sector of a less developed country?

Determinants of the informal economy

Schneider and Enste (March 2000, Journal of Economic Literature, pp77-114) argue
that 4 factors feed into the informal sector:

(1) Formal sector unemployment – there is no welfare net to catch the unemployed
who thus have to become involuntarily employed in the informal sector to survive.

In reality things are a little more complex with issues of household risk insurance, with
the unemployed able to return to family/friends if cannot find employment in the
formal sector.

(2) Complicated/restrictive rules and regulations – these include labour legislation that
may prevent more employment in the formal sector, registration costs of a business
that ‘force’ it into the informal sector.
 The labour market in Developing countries: Wasted
opportunities?

(Q) What determines the informal sector of a less developed country?

Determinants of the informal economy

Schneider and Enste (2000) cont…

(3) Decline of ‘civic virtue’ – informal sector businesses take care of

themselves only with no perceived benefit of formalising the business
(selfishness?).

(4) Rise in taxation in the formal sector – forces those formal sector
businesses that are making very small profits into the informal sector as rising
costs tip average cost above average revenue.

See Figure 1.
 The labour market in Developing countries: Wasted opportunities?

Figure 1

ATC2
Costs/Revenues

ATC

LOSS
ATC
MR=P=AR

PROFIT MR2=P2=AR2

MC
MC
MC2
Informal: post tax increase – COSTS Output
Formal: post tax increase – LEAVE
DECLINE AS CHEAPER LABOUR AND
MARKET TO ENTER NOT PAY TAXES, PRICE DECLINES TOO
INFORMAL SECTOR BUT PROFITS MADE
 The labour market in Developing countries: Wasted
opportunities?

(Q) What determines the informal sector of a less developed country?

Schneider and Enste (2000) cont…

All these factors can effect the size of the informal sector.

(2) and (4) represent the additional costs argument which ‘forces’ employees
and employers to leave the formal sector since profits (likely to be small in the
first place especially for start-up projects) are reduced.

This can result in economic agents choosing the informal sector in the short-
run which then limits potential growth since the business is not legitimate –
issue too of the informal sector having no rules and regulations, protection
etc…more likelihood of crime which has large negative externalities for the
country/region.
 The labour market in Developing countries: Wasted
opportunities?

Essentially the informal sector persists and even

expands as the rules and regulations of the
formal sector become more complicated.

One simple way to attract more informal sector

businesses into the formal sector would be to
adopt simple tax systems, particularly for small
start-ups.
 The labour market in Developing countries: Wasted
opportunities?

(4) Are there any linkages between the formal and informal sectors, e.g. can people
switch from one sector to the other easily?

Little mobility between the formal and informal sectors.

As J.S.Mill said

“….the really exhausting and really repulsive labours instead of being paid better than others
are almost invariably paid the worst of all because performed by those who have no choice”.

Labour was segmented into different castes, and Mill argued:-

“…so strongly marked is the line of demarcation between the different grades of labourers as
to be equivalent to a hereditary distinction of caste”.

Very different to how Adam Smith saw it: he argued the worst jobs would be paid the most
since nobody would want to do them, i.e. supply constraint……did not reckon on a lack of
job choice or of institutional barriers preventing job mobility (e.g. discrimination, caste,
class…)
The labour market in Developing countries: Wasted
opportunities?

Evidence from the Inter-American Development

Bank (2003) indicates that switching between
the formal and informal sector does exist, with
16% of Mexican workers and 11% of Argentine
workers moving in/our of informal sector
employment.

This merely says that 84% and 89% of these

workers DO NOT SWITCH!!
 The labour market in Developing countries: Wasted
opportunities?

As well as a lack of switching between the formal and informal

sectors there is also the issue of negative feedback effects from
being in the informal sector in the first place:

“Although workers in the secondary sector may initially be as good as

workers in the primary sector, a process of divergence eventually molds the
workers to their jobs”, (Taubman and Wachter, 1986, pp.1192).

Reduction in these workers’ skills and productivity resulting in ex

post justification of these workers being in this sector. This
however is the incorrect way to look at the evidence with an
important determinant of sequencing being missed…
 The labour market in Developing countries: Wasted
opportunities?

To take as read that secondary sector workers are justified in

being in this sector because their productivity is less than
equivalent primary sector workers is to miss one of the points of
any dualistic labour market: THE FACT THEY WERE
UNLUCKY NOT TO BE IN THE PRIMARY SECTOR
IN THE FIRST PLACE (Gary Fields).

The size of the wage differential between sectors determines the

size of unemployment, with queuing for primary sector jobs
observed as long as the expected value of waiting is greater than
the wage rate in the secondary sector.

The prospect of widening earnings/wage differentials between

two essentially identical labour market entrants reveals a serious
inefficiency.
 The labour market in Developing countries: Wasted
opportunities?

Negative feed-back effect if in secondary labour

market.
Good quality workers

Informal Sector Job Formal Sector Job

Use skills and education and

Reduction in these workers’ skills since not
rewarded for this with higher wages
necessary in the job:-MP reduced resulting
and the possibility of more training:
in ex post justification of these workers
MP will increase and wage will
being in this sector.
increase

Low Wage High Wage

The labour market in Developing countries: Wasted
opportunities?

(Q) What are the economic consequences of being informally employed?

Some Answers
(i) Job insecurity relative to formal sector workers.

(ii) Results in huge uncertainty which effects (i) household production and
consumption decisions (ii) human capital investment, (ii) returns to human
capital (will be lower than in the formal sector), (iii) reduce the likelihood
of switching to formal sector employment, ceteris paribus.

(iii) Those workers unlucky to be employed in the informal (secondary)

sector will see there likelihood of switching to the formal (primary) sector
decline with tenure in the informal sector job – this has implications for
estimating and importantly explaining wage differentials between
identically educated and skilled workers in the two sectors.
 The labour market in Developing countries: Wasted
opportunities?

Survivalist activities

These are generally activities that provide workers with the means to survive, e.g. eat once a
day.

Characterised by street vending and ‘hawking’.

Examples from Africa include selling single cigarettes on the side of the road, selling individual
sweets, selling curio’s, fruit and vegetables, car parking attendants.

This activity is highly uncertain in nature, is informal, can be subject to turf wars, or individual
fights and is highly competitive.

There are few taught skills in how to ‘grow’ the enterprise.

Few if any street vendors have access to any micro-finance or financial markets in order to
invest in stock – this needs to be addressed in order to take advantage of the entrepreneurial
spirit, but HOW?
The labour market in Developing countries: Wasted
opportunities?

(5) Some Evidence of Dualism in LDC labour markets

Case study evidence includes:

Gindling (1991, Economic Development and Cultural Change)

Tannen (1991 , Economic Development and Cultural Change).

William Maloney, “Are labour markets in developing countries dualistic?”,

and other working/research papers for the World Bank.
 The labour market in Developing countries: Wasted
opportunities?

Gindling (1991) uses a multinomial logit

approach followed by a earnings equation
approach to test differences in what determines
employment and earnings in and urban area of
Costa Rica.
The labour market in Developing countries: Wasted opportunities?
The labour market in Developing countries: Wasted opportunities?
 The labour market in Developing countries: Wasted
opportunities?

Work by Maloney indicates that there is little evidence in the

labour economics literature of dualism.

He argues that (particularly in South America) workers choose to

work in the informal sector rather than formal sector.

Reasons include: (1) low opportunity cost of working in the

informal sector relative to the formal sector since education and
thus productivity is low (2) formal sector workers pay implicit
taxes that adds to the cost of being employed in this sector.
 References
Keijiro Otsuka and Yujiro Hayami, (1988), “Theories of Share Tenancy: A Critical Survey”, Economic Development and Cultural Change
Vol. 37, No. 1 (Oct., 1988), pp. 31-68.

Fafchamps, M., (1997), “Introduction: Markets in Sub-Saharan Africa”, World Development, Vol 25(5), pp. 773-734.

Porter and Phillips-Howard (1997), “Comparing contracts: an evaluation of contract farming schemes in Africa “, World
Development Vol 25(2), pp. 227-238

Arthur Lewis (1954), “Lewis, W.A. (1954) 'Development with unlimited supplies of labor', Manchester School of Economics and Social
Studies, 20:139-192.

or go to http://www.uni-leipzig.de/~sozio/mitarbeiter/m72/content/dokumente/568/Lewis1954.pdf

Schneider, Friedrich and Dominik Enste (2000): Informal Economies: Size, Causes, and Consequences, The Journal of Economic
Literature, 38/1, pp. 77-114.

Taubman, P., Wachter, M. (1993) Segmented Labor Markets, in Ashenfelter, O., Layard, R.(1993) Handbook of Labor Economics,
vol.2, Amsterdam: Elsevier Science Publishers, 1183-217.

Leavy, J., and White, H., Rural Labour and Poverty in Sub-Saharan Africa, from Institute for Development Studies, University of
Sussex website, www.ids.ac.uk/ids/pvty/pvrurallabour.html

T. H. Gindling, (1991), “Labor Market Segmentation and the Determination of Wages in the Public, Private-Formal, and Informal
Sectors in San José, Costa Rica”, Economic Development and Cultural Change Vol. 39, No. 3 (Apr., 1991), pp. 585-605.

Michael B. Tannen, (1991), “Labor Markets in Northeast Brazil: Does the Dual Market Model Apply?” Economic Development and
Cultural Change
Vol. 39, No. 3 (Apr., 1991), pp. 567-583.

William Maloney, “Are labour markets in developing countries dualistic?”, and other working/research papers for the World
Bank.