A Theory of Economic Development

American Economic Association A Theory of Economic Development Author(s): Gustav Ranis and John C. H. Fei Source: The American Economic Review, Vol. 51, No. 4 (Sep., 1961), pp. 533-565 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1812785 Accessed: 07/06/2010 04:05 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org The American Economic Review VOLUME LI SEPTEMBER 1961 NUMBER FOUR A THEORY OF ECONOMIC DEVELOPMENT 13Y GUSTAV RANIS AND JOHN C. H. FEI* This paper attempts to make a contribution towards the theory of growth by rigorously analyzing the transition process through which an underdeveloped economy hopes to move from a condition of stagnation to one of self-sustaining growth. Since the totality of economies bearing the "underdeveloped" label admittedly defies easy generalization, we shall be primarily concerned here with the labor-surplus, resource-poor variety in which the vast majority of the population is typically en- gaged in agriculture amidst widespread disguised unemployment and high rates of population growth. We hope to accomplish our task by drawing liberally on the stock of already accepted ideas and theni pro- ceeding to weave them into a general explanatory model of economic growth. Our analysis begins with an economy's first departure from quasi- stagnation or the initiation of the so-called take-off process.' Rostow defines this as a period of two or three decades during which the economy transforms itself in such a way that economic growth becomes, sub- sequently, more or less automatic; its characteristics are a reduction of the rural proportion of the population, a doubling of savings rates and the first marked and continuous flowering of industry stimulated by the availability of surplus labor [11, pp. 25-32]. This well-known intui- tive notion has been chosen as our point of departure. For our basic ana- lytical tool-kit, however, we draw heavily on the work of Arthur Lewis. In his celebrated articles Lewis [3] [4] presents a two-sector model and investigates the expansion of the capitalistic or industrial sector as it is nourished by supplies of cheap labor from the subsistence or agricultural * The authbrs are assistant professor at Yale University and associate professor at Antioch College, respectively. This paper wias initiated while both were associated with the Institute of Development Economics, Karachi, Pakistan. Comments by Bela Balassa and John M. Montias of Yale University are gratefully acknowledged. 1 This is not to understate the importance of a prior preconditioning period (see [1] and [9]) when potentially expansionary institutional forces are being mobilized and render the system capable of a significantly positive response to a random stimulus. 534 THE AMERICAN ECONOMIC REVIEW sector.2 Development consists of the re-allocation of surplus agricultural workers, whose contribution to output may have been zero or negligible, to industry where they become productive members of the labor force at a wage equal (or tied to) the institutional wage in agriculture. This process continues until the industrial labor supply curve begins to turn up. Lewis, however, has failed to present a satisfactory analysis of the subsistence or agricultural sector. It seems clear that this sector must also grow if the mechanism he describes is not to grind to a premature halt. Pursuit of this notion of a required balance in growth then leads us to a logically consistent definition of the end of the take-off process. Finally, the economy must be able to solve its Malthusian problem if the process of development along a balanced-growth path is to prove successful. Considerations of this nature have given rise to the so-called "critical minimum effort" theory [2], which deals with the size of the effort required to achieve a more-than-temporary departure from stag- nation. We shall show, in the course of our analysis, that the concept of a critical minimum effort does not presuppose some absolute magnitude of effort but contains a built-in time dimension permitting the size of the effort to vary with the duration of the take-off process. The contribution of this paper, then, is to construct a theory of economic growth of which the above ideas, rigorously formulated, constitute component parts. In Section I we present the basic struc- tural assumptions of our model with emphasis on analysis of the role of the "neglected" agricultural sector. Section II genieralizes the previ- ously "static" analysis by admitting the possibility of a change of pro- ductivity in the agricultural sector. In Section III we introduce changes in industrial productivity and the notion of a "balanced growth cri- terion" by means of which the termination of the take-off process is formally defined. Section IV proceeds with a precise mathematical formulation of our theory which enables us to make certain quantitative conditional predictions as a first test of its empirical relevancy. Finally, in Section V, we integrate population growth as well as some other real- world complexities into our model and investigate the notion of the critical minimum effort in relation to the length of the take-off process. I. The Basic Assumptions Our formal explanatory model is presented with the help of Diagram 1. Diagram 1.1 depicts the industrial sector and Diagrams 1.2 and 1.3 2 We wish to underscore the absence of any necessary one-to-one relationship between the subsistence sector and agriculture, or between the capitalistic sector and industry in most less-developed economies. The existence of substantial islands of commercialized production in the primary sector and of sizable subsistence enclaves in the small-scale and service indus- tries does not, however, bar Lewis, or us, from using this short-hand terminology. INDUSTRIAL SECTOR P S' d 0 . s~~~~~~~ 0 f W f f Population - N AGRICULTURAL SECTOR V n ~~~~~~~I I I/ 1.2 / Y U z A I 0 Phase Phase Phase one two three - Popu lation G D I P A 0 00 ~ ~ ~ ~ ~ X; ~ ~~HX x B DIAGRAM I 536 THE AMERICAN ECONOMIC REVIEW the agricultural sector. The first is the familiar Lewis diagramn measuring industrial labor on the horizontal axis OW and its marginal physical productivity (MPP) on the vertical axis OP. The demand curve for labor (i.e., the MPP curve dtf), together with the supply curve of labor (Stt'S'), determines the employment of the industrial labor force (St). Since the marginal physical productivity curve depends on the size of the capital stock cooperating with the labor force, an increase in the capital stock leads to a shift of the MPP curve to the right, e.g. to d't'f'. Lewis' "unlimited" supply curve of labor is definied by the horizontal portion of the supply curve, i.e. St. When this supply curve turns up, unlimitedness comes to an end. Our first problem is to investigate the conditions of this turning point. This leads us to focus attention on the agricultural sector. In Diagram 1.3 let the agriculttural labor force be measured on the horizontal axis OA (reading from right to left), and let agricultural out- put be measured on the vertical axis OB (downward from 0). The curve ORCX describes the total physical productivity of labor (TPP) in the agricultural sector. This curve is assumed to have a concave portion ORC showing a gradually diminishing marginal productivity of agricul- tural labor and a horizontal portion XC where marginal product vanishes. The portion of any labor force in excess of OD may be con- sidered redundant in that its withdrawal from agriculture would not affect agricultural output. At the initial (or break-out) point let the entire labor force OA be committed to agriculture, producing a total agricultural output of AX. Let us assume that the agricultural output AX is totally consumed by the agricultural labor force OA. Then the real wage is equal to AX/OA or the slope of OX. The persistence of this wage level is sustained by in- stitutional or nonmarket forces since under competitive assumptions the real wage would fall to zero, at equality with MPP. We shall call this the institutional wage. Let point R on the total output curve be the point at which the MPP equals the institutional wage, i.e. the dotted tangential line at R is paral- lel to OX. We can then define AP as the disguisedly unemployed agri- cultural labor force since, beyond P, MPP is less than the institutional wage.3 Note that Diagrams 1.1, 1.2, and 1.3 are "lined up." Any point on the horizontal axis of Diagrams 1.1 to 1.3 represents a particular way in which the total population or labor force OA is distributed between the two sectors; for example, at point P (Diagrams 1.2 and 1.3) the 3 Redundancy is a technological phenomenon, i.e., determined by the production function. Disguised unemployment, on the other hand, depends upon the production function, the institutional wage, and the size of the agricultural population. In other words, it is an economic concept. RANIS AND FEI: ECONOMIC DEVELOPMENT 537 agricultural labor force is OP and the (already allocated) industrial labor force is AP. If, at the break-out point, the entire population, OA, is engaged in the agricultural sector, the allocation process during take-off can be represented by a series of points, A, G, D, I, P, etc., on OA, gradually moving towards 0.4 The important concepts of disguised unemployment, redundant labor force and institutional wage can be more clearly depicted with the aid of Diagram 1.2, in which agricultural output per worker is measured on the vertical axis AN. Let ADUV be the marginal physical productivity (MPP) curve of labor in the agricultural sector. Let the vertical distance AS equal the institutional wage (shown also as PU, equal to MPP of agricultural labor at U, lined up with P and R in Diagram 1.3). Three phases in the re-allocation process may now be distinguished: (1) Phase 1 is the range for which MPP=0, i.e., the total productivity curve in Diagram 1.3 is horizontal. This phase marks off the redundant labor force, AD. (2) Phase 2 is the range for which a positive MPP is less than the institutional wage. Phases 1 and 2 together mark off the exist- ence of the disguisedly unemployed labor force, AP. (3) Phase 3 is the range for which MPP is greater than the institutional wage rate assumed to prevail at the break-out point. We assume that the institutional wage AS prevails during phases 1 and 2 and a wage rate equal to MPP prevails in phase 3. Only when the disguisedly unemployed have been absorbed, i.e. in phase 3, does the marginal contribution of labor to output become as great as or greater than the institutional real wage. As a result, it is then to the advantage of the landlord to bid actively for labor; the agricultural sector can be said to hlave become commercialized as the institutional wage is aban- doned and competitive market forces yield the commonly accepted equilibrium conditions. Under these assumptions the agricultural real wage in terms of agricultural goods is defined by tlle curve SUV in Diagram 1.2, consisting of a horizontal portion SU and a rising portion; UV. This curve may be called the supply-price curve of agricultural labor. It indicates for each level of real wage the amount of labor that may be released from the agricultural sector. The transition into phase 3 constitutes a major landmark in the de- velopmental process. With the completion of the transfer of the dis- guisedly unemployed, there will occur a switch, forced by circumstance, in employer behavior, i.e. the advent of a fully commercialized agri- cultural sector. This landmark may be defined as the end of the take-off process. XVe know no otner way to establish a nonarbitrary criterion for an economy reaching the threshold of so-called self-sustaining growth.5 4 The present assumiptioni of an unchaniging population will later be relaxed. 5 Whether or not growth can ever really be "self-sustaining," in Rostow's phrase, is basi- 538 THE AMERICAN ECONOMIC REVIEW Returning now to Diagram 1.3, we see that, as agricultural workers are withdrawn, a surplus of agricultural goods begins to appear. That portion of total agricultural output in excess of the consumption re- quirements of the agricultural labor force at the institutional wage is defined as the total agricultural surplus (TAS). The amount of TAS can be seen to be a function of the amount of labor reallocated at each stage. For example, if agricultural workers to the extent of AG are withdrawn in phase 1 and re-allocated, JG is required to feed the remaining agri- cultural workers and a TAS of size JF results. The TAS at each point of allocation in phases 1 and 2 is represented by the vertical distance between the straight line OX and the total physical productivity curve ORCX. (For phase 3, due to the rise of the wage rate, TAS is somewhat less than this vertical distance and equals the vertical distance between the curve OQ and the total productivity curve). TAS may be viewed as agricultural resources released to the market through the re-allocation of agricultural workers. Such resources can be sipnoned off by means of the investment activities of the landlord class and/or government tax policy and can be utilized in support of the new industrial arrivals.6 The average agricultural surplus, or AAS, may now be defined as the total agricultural surplus available per head of allocated industrial workers. The AAS curve is represented by curve SYZO in Diagram 1.2. In phase 1 as TAS increases linearly with the allocation of the redundant labor force from A to D we can picture each allocated worker as carrying his own subsistence bundle along with him. The AAS curve for phase 1 thus coincides with the institutional wage curve SY. In phase 2, however since the MPP in agriculture of the now allocated workers was positive there will not be sufficient agricultural output to feed all the new in- dustrial arrivals at the institutional wage level. Thus, while TAS is still rising, AAS begins to fall.7 It can, moreover, readily be seen that cally not a problem amenable to the tools of traditional economic analysis. The role of saving rates and per capita income levels in setting it in motion remains undefined. All we are saying here is that, after the turning point, the real wage in agriculture is determined by impersonal competitive market forces, a qualitative transformation which constitutes a necessary (if not sufficient) condition for growth to become automatic and routinized. It is this point which Lewis [4, p. 26] seems to have in mind when he speaks of "two different stages of eco- nomic development with two different sets of results" and describes the second stage as a situation in which "all the factors of production are scarce [and] . . . wages are no longer constant as accumulation proceeds." 6 While it could easily be accommodated by the model, we neglect resource transfer costs as well as the possibility that it may be impossible to induce those left behind in agriculture to release the entire surplus. 7 The following analogy with individual-firm analysis may be drawn to show more clearly the relationship between the nmarginal, total and average concepts involved. We may think of the total agricultural output curve (ORCX) and the total agricultural consumption curve (OX) in Diagram 1.3 as analogous to the total revenue curve and the total cost curve, respec- tively. Then the gap between these curves is the total profit curve which is equivalent to our RANIS AND FEI: ECONOMIC DEVELOPMENT 539 during phase 3 AAS declines even more rapidly (and TAS also declines) as the now commercialized wage in agriculture becomes operative. We may now consider the derivation of the Lewis turning point in the agricultural sector. Lewis himself [4, pp. 19-26] explains the turning point rather loosely as occurring when one of the following events puts an end to the horizontal supply curve of labor: (a) the worsening of the terms of trade for the industrial sector, and (b) the exhaustion of the labor surplus in the agricultural sector. But in our model any such ex- planation must take into account the basic determination of the entire industrial labor supply curve by the conditions postulated for the non- industrial sector. The "worsening of the terms of trade" for the industrial sector occurs as the result of a relative shortage of agricultural commodities seeking exchange for industrial goods in the market. In our model, it will be recalled, this surplus is measured by total agricultural surplus (TAS) and, on a per-industrial-worker basis, average agricultural surplus (AAS). There is a tendency, then, for the industrial supply curve to turn up as phase 2 is entered because this is the time when there begins to appear a shortage of agricultural goods measured in AAS-causing a deterioration of the terms of trade of the industrial sector and a rise in the industrial real wage measured in terms of industrial goods. We thus see that the disappearance of the redundant labor force in the agricultural sector is a cause of the Lewis turning point. The "exhaustion of the labor surplus" must be interpreted primarily as a market phenomenon rather than as a physical shortage of man- power; it is indicated by an increase in the real wage at the source of supply. If we assume that the real wage of the industrial worker is equal to the agricultural real wage,8 then there is a tendency for the industrial supply curve of labor (Stt'S' in Diagram 1.1) to turn upward when phase 3 is entered. With the disappearance of the disguisedly un- employed labor force and the commercialization of the agricultural sec- tor, the agricultural real wage begins to rise (see Diagram 1.2). This leads to an increase in the industrial real wage level if the industrial employer TAS curve. The total profit curve reaches a maximum when marginal cost equals marginal revenue. This occurs at point U in Diagram 1.2-because SU is the marginal cost curve and ADUV is the marginal revenue curve. The AAS curve in Diagram 1.2 is equivalent to an ''average profit curve." 8 "Governed by" may be a more realistic description. Lewis [3, p. 150] points out that urbanization, transfer costs, etc. may require an industrial real wage at a constant (he believes approximately 30 per cent) margin or "hill" above the institutional wage in agriculture; while,