Economic Development Theory

Lecture Three Dr. Patrick J Nolen

EC 902

January 29, 2007

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Business
Term Papers
They are currently online. Option One:
Discuss the following statement taking into account ethical, economic, and political concerns: Banning child labour will reduce the incidence of poverty, raise the average childs level of health, decrease school absence, and will not alter household structure.

Option Two:
Micronance

I will not be here from 20 March - 24 April. Term Papers are due 2 May Check on-line for details

Room Details
Room will change starting next week, though, we will have to use three dierent rooms throughout the semester.
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Outline

Dual Economy and Migration

Introduction Lewis Model Harris-Todaro Model

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Dual Economy and Migration

Developing countries tend to have two types of sectors: urban and rural. Urban sectors are very much like industrialized sectors within developed countries. Rural sectors are, in many ways, what makes a developing country a dierent. They tend to be agricultural, feudalist, primitive. There are two main models to consider in this section:
The Lewis Model The Harris-Todaro Model.

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Lewis Model
Assume a closed economy has two sectors: an industrialized sector (capitalist sector) and a rural sector (of subsitence farmers). Assume wm > wr
M denotes urban (modern) sector; R denotes rural sector.

Let L be the total population which we will assume is the entire labour force. Urban sector production function xm = fm (Lm , Ko ) Rural sector production function xr = fr (Lr ) f A rms prot is = fm (Lm , Ko ) wm LM Lm = wm m
Assuming urban wages are xed.

The following graph summarizes the entire Lewis model and how the urban and rural sectors are related. Note: The turning pointis when the Lewis model, technically ends in its explanation.
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Lewis Model

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Harris-Todaro (AER 1970)

This model deals with migration between the urban and rural sectors within a developing country and it models urban unemployment. Urban unemployment does not exist in the Lewis model. The HT model was motivated by the response to a government project that took place in Kenya in 1964. Kenyan governments goal: reduce urban unemployment in Nairobi. Trade unionists, capitalists and the government agreed to all raise employment by 15%. Result: Higher urban unemployment after the increase in the number of jobs. Reason: People migrated from rural areas into Nairobi to try and get urban sector jobs. This experience of directly attempting to lower unemployment by creating jobs has often had the opposite eect: increased unemployment.
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Harris-Todaro (AER 1970)

Two sectors: rural (R) and urban (M) Output: XR and XM Inputs: LR and LM L is total population and LR + LM L with Li 0 for i {R, M } (1) Production is Xi = fi (Li ) s.t. fi > 0 and fi < 0 for i {R, M } (2) Let w be the urban wage and have a wage oor so that w w ... wage rigidity axiom. Assume urban rms are in a competitive market fM (LM ) = w (3) In rural sector wages are fR (LR ) and fully exible no rural unemployment. Amount of labour in the urban sector is then, L LR L Probability of a worker nding an urban sector job is LM R L Workers maximize expected earnings if fR (LR ) < w LM R then LL migrate to urban area. Equilibrium is when fR (LR ) = w LM R ... (Technical Points) (4) LL
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Harris-Todaro (AER 1970)

Simplication and Aside

Dene rural wage as r = fR (LR ) No more migration occurs when LM L LR w LR = L LM r r =w That means that LR w = LM r by 15% LR by MORE than 15% THEN LR w = < 1 LM r For every one person who got hired in the urban sector, more than one person migrated from the rural sector.
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In Nairobi, IF LM

Harris-Todaro (AER 1970)

Let social welfare, U, depend on the output produced in an economy U = XR + XM IF wages were fully exible [Only (1), (2) to consider] : How would the government choose LR and LM to maximize social welfare, U? Since fi > 0 for i {R, M } then unemployment is never desirable LR + LM = L. (1 ) Further, this gives us that fM (LM ) = fR (LR ) (2 ) Thus the optimal amount of labour and production according to our welfare criterion, E = [LM , LR , XM , XR ], satises (1 ) and (2 ). With no wage rigidity then E would be the outcome and it is Pareto-Optimal Let E = LM , LR , XM , XR be the HT equilibrium. Lets compare E and E in the following graph. Notice that we will see that E is Pareto Sub-Optimal
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Harris-Todaro (AER 1970)

Note: As before we are going to use rectangular hyperbolas to nd the equilibrium in the following graph we did this in the Basu-Van paper and with when nding equilibria in other models (look back at the notes for instances of this). Thus, discussing retangular hyperbolas would be useful. A rectangular hyperbola has the feature that the rectangular area under a point, dened as the x y , is the same at all points on the hyperbola. An example of such a hyperbola is x y = 1. Consdier this when looking at how we nd the equalibria in the following graph.

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Harris-Todaro (AER 1970)

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Harris-Todaro (AER 1970)

What dierence does the elasticity of the marignal product in the rural sector make to our analysis?

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Harris-Todaro (AER 1970)

Policy Implications

E is not optimal because it is characterized by unemployment and the marginal product of labour in the urban sector is more productive than the marginal product of labour in the rural sector. What policies could shift the economy closer to reaching the equilibrium E ? Note: A main implication of the Harris-Todaro model is that no single policy could correct urban unemployment. One needs to look for policy combinations. This is because of the interconnectedness of the urban and rural sectors through migration. Thus, to obtain the optimal equilibrium E we need a dual subsidy: One needs to subsidize both urban and rural employment. That dual subsidy needs to be S w fM (LM ) to both the rural and urban sectors. This is illustrated in the following gure...
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Harris-Todaro (AER 1970)

Policy Implications

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Nutrition and Eciency Wages

Employer recognizes that there exists a correlation between wage and nutrition Correlation between wage and productivity because more food Healthier workers More productive workers. Assume x = f (E ) where E is the total number of ecient input units. Say h = h (w ) is the production function of a worker in the sense that her wage allows her to create eciency units.
In the sense that her wage eects her health and, thus, her productivity.

Say there exists a > 0 s.t. for all w a, h (w ) = 0 and for all w > a h (w ) > 0 where h (w ) 0 and h (w ) 0

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Nutrition and Eciency Wages

h h(w)

w a
Economic Development (EC 902)

w*
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Nutrition and Eciency Wages

Dene output as X (w , n ) = f (n h (w )), f > 0, and f Thus = f (n h (w )) wn and the rms problem is: MAXw ,n = f (n h (w )) wn From the F.O.C. we get
h (w ) w

<0

s.t. w w

= h (w ) The we have that w = max {w , w} AND n (w ) = n if w < w and n (w ) = n if w w . Where n solves f (n h (w )) = h(w ) and n solves f (n h (w)) = h(w ) w w

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Nutrition and Eciency Wages

N'(w)

N(w) w*

L n*
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Refer to slide 18 in Lecture 3 for a discussion of this topic: M axw;n = f (n h (w)) wn s.t. w w

Assume that there is an interior solution. That implies: @ (1) F.O.C. @n ! f 0 (n h (w )) h (w ) = w and @ (2) F.O.C. @h ! f 0 (n h (w )) h0 (w ) n = n where w and n are the solutions to the two rst order conditions above. Rearranging equation (1) gives us that f 0 (n substitute this into equation (2) to get: h (w )) =
w h(w )

and we can

w h0 (w ) n = n h (w ) w h0 (w ) = 1 h (w ) h (w ) h0 (w ) = w This shows us how we got the equation in the notes on slide 18. Since we assumed that there was an interior solution that means that this is true when w > w. If w w then we are at a corner solution. This means that the ideal wage is actually w = max fw ; wg