Dualism in development dynamics

In the previous section you studied the role of various actors such as the market, state, and community in development dynamics. Another important aspect of development dynamics is dualism, where two opposite system coexist. The two types of dualism discussed in this section of development dynamics are

i) traditional versus modern sector
ii) the one sector model versus the dual sector model of growth

The Traditional versus the Modern Sector

The process of transforming an economy to portray development involves significantly more than a mere increase in incomes and subsequently, consumption levels. It includes certain aspects that make for a living standard, or, quality of life. This constitutes, among others, changes in the way people conduct their life and social relations, manage their wants by commercialisation and urbanisation, organise their political roles, etc. This process of change in the form of institutions and customs embodies modernisation.

Economic change and modernisation are often viewed as autonomous processes that interact in a myriad ways. These interactions, under various conditions either synergise, or, negate the march towards development.

Consider an economy consisting of two sectors that are distinguished in two ways: technological and institutional. One sector has a modern technology, and is assumed to be relatively more productive. People engaged in this sector are geographically scattered, function anonymously, and possess poor information about each other. In contrast, the other sector is traditional, and uses less productive technology. However, people engaged in this sector are relatively less dispersed geographically, and have relatively good information on their neighbours.

Now, consider a situation when some people in the economy seek loans (either to augment current consumption, or, to enhance capital infusion in their activity). Loan transactions, in any situation, run some risk of default by some borrowers. As a result, lenders may be reluctant to lend to those unable to furnish sufficient collateral. In such a situation, superior information in the traditional sector that enables lenders to monitor borrowers better, extends worthy borrowers as good, or better access to credit than they may hope for in the modern sector.

The quality of credit may, thus, be better in the traditional sector. In contrast, credit in the modern sector would be more productive, albeit associated with higher risk. There appears to be a trade off in the traditional sector and the modern sector, between relatively better quality of credit, and the relative potential to raise productivity. Now, consider the possibility of migration, which is arguably a one way flow from the traditional to the modern sector. Only those facing strong incentives would move out of the traditional sector. Two groups, at the extreme ends on an income (or wealth) scale are likely to make this transition.

First, the wealthy, also assumed to be more productive, may be motivated to exercise the option to migrate, and further raise their productivity. On the contrary, the poorest may also migrate as they have nothing to lose from the transition. This, however, assumes that transition is costless. In reality, though, there are likely to be some transition costs that may inhibit migration. Second, more people transit to the modern sector if the interest rate is either very low, or, very high. At low interest rates, the temptation to default is weak and, therefore, the advantage in the traditional sector from better monitoring is small.

In contrast, when interest rates are very high, consumption loans may be unaffordable. In the absence of any uptake, such loans may be rendered redundant. As long as there are a sufficiently large number of people in the traditional sector, high quality information may exist for most of the people, and on average the economy-wide market for consumption loans may work well. This allows lenders to charge a higher rate of interest than otherwise. If the rate of interest in the modern sector is higher, people may then be reluctant to transit from the traditional sector. This may consist of equilibrium with a lower than desirable socially optimal rate of transition out of the traditional sector.

Now, suppose everyone in the traditional sector was forced to move to the modern sector. From the lenders point of view, because of lower quality of information, there may be fewer credit-worthy people, that is, those who present lower credit risks. But, competition among lenders to patronise these (more reliable / less risky) people may drive down interest rates. Then, more people may access consumption loans, even in the modern sector. The number of people working in more productive sectors may rise, and social surplus could be larger. The dynamics of development in this model is a two-way interaction between the process of growth and the process of institutional change. On one hand, the rate of growth of the economy depends on the number of people who take advantage of new technology. Growth, then, may be constrained by the institutional difference between traditional and modern sectors. On the other hand, long term survival of traditional institutions depends on the rate of growth.

As the economy grows, capital becomes abundant and the price of loans in both sectors falls. Declining interest rates reduce agency costs in modern sector, and comparative advantage of the traditional sector in provision of loans also diminishes. People may be further encouraged to migrate to the modern sector. Therefore, in development dynamics, both the traditional and modern sector coexist and complement and supplement each other. For faster development, the growth rate of both the sectors is essential.

One Sector vs. Two Sector Models

The Ramsey-Cass-Koopmans (RCK) model, sometimes referred to as the one sector model of growth, is a simple, flexible model amenable to a wide range of assumptions. The RCK model continues to be popular in modern economics with its representation of the economy as an optimal control problem. It is utilised to analyse the performance of an economy with rational and utility maximising individuals. It constitutes a representative household, or, individual, who has time for labour, and an endowment of capital from a previous period. Such a household or, person may choose between labour and leisure, and between consuming, or, saving current output. Labour produces output and saving this output generates wealth.

Attributes of the representative household, or individual are inherent throughout the economic system. Individuals have endowments of labour (l) and capital (k). Let, labour earn a wage, w, and capital commands an interest rate, r. The income (y) of the individual is then y = wl + rk. However, capital also depreciates at a rate ä. It  is further assumed that r > ä, or else there would be little incentive to hold capital. All income that is not immediately consumed is saved, and invested in the form of k.

Now, rational individuals value future consumption less than present consumption. This is referred to as time discounting. Assume that the representative household discounts future consumption at the rate, ñ. It, then, follows that r must equal ñ + ä. Suppose, r exceeds ñ + ä, then this may lead to excessive saving by postponing current consumption. On the contrary, if r is less than ñ + ä, then people may consume excessively leaving very little savings.

Every individual is intuitively driven to maximise utility (Ut) over time (t). Utility is derived out of current consumption and leisure. Growth in this model is essentially determined by savings that are ploughed back into the Economy. On the contrary, the Dual Sector model, developed by Lewis, is a model framed to explain the growth of a developing economy. The two sectors in such an economy are:

(i) a traditional agricultural sector; and (ii) a modern industrial sector.

The traditional agricultural sector is characterised by surplus labour that transits to the modern industrial sector. Over time, growth of the industrial sector absorbs surplus labour from the traditional agricultural sector, fostering further industrialisation and stimulating sustained development.

Apart from abundant labour, the traditional agricultural sector is also characterised by relatively low wages and low productivity, although it utilises a labour intensive production process. In contrast, the modern industrial sector is characterised by a relatively higher wage rate, and rising productivity. Initially, there exists a demand for more workers in the industrial sector, though, it is assumed to be utilising a relatively capital intensive production process. Profits made by capitalists are reinvested as capital stock in the modern industrial sector.

However, the traditional agricultural sector is less amenable to investment and capital formation, and a low priority is accorded to improving the marginal productivity of labour in this sector. Thus, the hypothetical developing nation’s investment goes towards physical capital stock in the industrial sector.

The traditional agricultural sector which is traditional in nature is constrained by the availability of cultivable land. Further, the marginal product of labour in the traditional agricultural sector (that is, the increase in farm output from employing an additional farm labourer) is assumed to be zero. This follows from the law of diminishing marginal returns that runs out its full course on the fixed land input.

With marginal productivity set at zero, there exist a number of farm workers who do not contribute to agricultural output. This group is denoted as surplus labour and this cohort could move to another sector without any decline in agricultural output

To take advantage of higher wages from the industrial sectors, over time, workers may tend to transition from the agricultural to industrial sector. Total agricultural product would remain unchanged, while total industrial product would rise due to the additional labour force. But, additional labour may also drive down marginal productivity and wages in the industrial sector. Over time, the marginal productivity of workers in the industrial sector would be determined by two factors:

(a) an increase due to investment fostering capital formation; and

(b) a decline, due to more workers transiting from the traditional agricultural sector.

Eventually, the wage rate in the agricultural and industrial sectors would equalise, as workers leaving the agricultural sector would drive down productivity and wages in the industrial sector, while raising marginal productivity and wages in the agricultural sector. The end result of this transition process is that, agricultural wage equals industrial wage, and the marginal product of labour equates across agricultural and industrial sectors.

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