Informality and the capitalist economy: A perspective from the Global South

3 Dual economy: The Lewis model

To learn more about Arthur Lewis’s contributions to economics, read Section 1.9 of The Economy 2.0: Microeconomics.

Our way of dividing up the economy into two parts has a long tradition in economics, starting with the Nobel Laureate, Arthur Lewis. In an influential paper written in 1954, Lewis provided a key insight about the process of economic development. Describing low- and middle-income countries in large parts of Asia, Africa, and Latin America, Lewis noted that:

there are large sectors of the economy where the marginal productivity of labour is negligible, zero, or even negative. Several writers have drawn attention to the existence of such ‘disguised’ unemployment in the agricultural sector, demonstrating in each case that the family holding is so small that if some members of the family obtained other employment the remaining members could cultivate the holding just as well. The phenomenon is not, however, by any means confined to the countryside. Another large sector to which it applies is the whole range of casual jobs—the workers on the docks, the young men who rush forward asking to carry your bag as you appear, the jobbing gardener, and the like. These occupations usually have a multiple of the number they need, each of them earning very small sums from occasional employment; frequently their number could be halved without reducing output in this sector.¹

Read Unit 6 of The Economy 2.0: Microeconomics for more details on how profit-maximizing wages are set by firms in the capitalist sector.

reservation wage

What an employee would get in alternative employment, or from an unemployment benefit or other support, were he or she not employed in his or her current job.

Lewis’s description highlights what distinguishes the informal sector from its capitalist counterpart. While he used the terms ‘subsistence sector’ and ‘modern sector’ to describe this dualism, the labels are not as important as the deeper distinction they point to. When a capitalist firm decides to hire a worker, it weighs the costs and benefits. An additional hired worker contributes to additional output, but also adds to production costs. An employer setting the wage to maximize profits will only take on an additional worker if that worker adds to its profits. The wage must be above the worker’s reservation wage, which can be their income in the informal sector in a dual economy, or the unemployment benefit in an economy with a welfare state.

labour market power

A firm has labour market power (sometimes called monopsony power) if it can reduce the wage it needs to pay its workers by lowering the number of workers that it employs. See also: monopsony power.

In a dual economy, the wage in the capitalist sector is above that in the informal sector to ensure the worker is motivated to exert effort for the employer: there is a cost to shirking on the job since if caught, the worker would lose their job and have to rely on income from the informal sector (such as by returning to the family farm or a shop owned by a relative). Given the set of wages that are sufficient to attract workers and deter shirking, the firm chooses the profit-maximizing combination of employment (number of workers) and wage from this set. The firm will not hire more workers than this. The set of wages the firm can choose from also depends on the workers’ net productivity (output per worker minus production costs associated with each worker) and on how much labour market power the firm has.

To learn more about how firms set wages to maximize profits and ensure workers put in sufficient effort, read Sections 6.10–6.12 of The Economy 2.0: Microeconomics.

However, informal enterprises do not function in the same manner. Owners of such enterprises do not fit the definition of employers or workers: neither they nor others engaged in these enterprises receive wages. Rather, everyone shares in the income received from economic activity, regardless of whether they are required in the production process. An uncle may take on a nephew in his shop even if the shop runs perfectly well without this additional labour (for example, even if the nephew’s contribution to output is negligible), just so the latter has something to do and perhaps learns a few skills. So, while the capitalist firm is motivated by profit maximization, the average self-employed worker is motivated by the needs of subsistence (meeting their family’s needs) or earning a livelihood.

Connecting this to the ILO classifications (in the ‘Find out more’ box in section 2), for the Lewis model, it does not matter whether a firm or a worker is covered under any specific law or regulation. Thus, for example, an unregistered firm employing even a few wage workers and driven by the profit motive is part of the capitalist sector. Conversely, a vegetable vendor plying their trade on their own on the streets of Mumbai may be registered with the city authorities, but from a dual economy perspective they are still part of the informal sector. Rather, what matters is whether the economic principle that governs the enterprise is profit maximization or income sharing, with the former placing the firm on the path to growth and technical change and the latter more or less reproducing the economy at the given level of productivity.

An important result follows from this kind of output sharing in the informal sector. Consider a family farm on which three members of the family are engaged. The output of the farm produced by their collective labour is shared among them equally, whether directly consumed as food or sold in the market and shared in the form of purchased goods and services. Lewis pointed out that in situations where the farm can just as well be cultivated with two people instead of three under current technological conditions, the third person is effectively unemployed. We could call this ‘disguised unemployment’. In this situation, if the third person were to find employment in the capitalist sector, this would result in an increase in total output as well as an increase in average labour productivity in the economy.

But since they do not have access to unemployment allowances or benefits from the government (which someone who is ‘openly unemployed’ is eligible for), they continue to work on the farm.

Thus, in a dual economy, the informal sector performs another crucial economic function. Most capitalist sector workers are not entitled to unemployment benefits and use the informal sector as a fallback option in case of job loss. This means that job losses in the capitalist sector may not result in an increase in the unemployment rate. Instead, there may be a rise in the share of the workforce in self-employment. An example of this is the COVID-19 pandemic during which millions of workers lost their jobs in the capitalist sector only to fall back on agricultural or other forms of self-employment to survive (as the next ‘Find out more’ box explains for the case of India).

Surplus labour and structural change: Modelling the dual economy

surplus labour

Workers who are engaged in production but do not increase total output may be referred to as surplus labour (particularly in the Lewis model of economic development).

For Lewis, the agriculture sector and urban informal sector are sources of surplus labour (effectively disguised unemployment) that can be drawn upon as the capitalist sector expands, without loss of output in the informal sector. This sets in motion a process of structural change wherein labour moves from low-productivity work in the informal sector to high productivity work in the capitalist sector (Figure 5).

We can model this process of structural change shown in Figure 5 by adapting the wage-setting/price-setting (WS–PS) model from Unit 1 of The Economy 2.0: Macroeconomics.

To learn more about the WS–PS model, including the concept of employment rent, read Sections 1.5–1.7 of The Economy 2.0: Macroeconomics.

A model of the dual economy

We adapt the WS–PS model to represent the dual economy by assuming that the alternative to working in a capitalist firm is not unemployment, but informal work (although some informal work may be disguised unemployment). A proportion, \(H\), of the labour force works in the capitalist sector, where output per worker is \(\gamma_0\). This is shared between firm owners and workers: workers are paid a wage of \(w_0\) and firm owners receive the rest (\(\gamma_0 – w_0\)). \(w_0\) is the price-setting real wage, resulting from firms choosing their prices to maximize profits, given the nominal wage.

The rest of the labour force (1 – \(H\)) works in the informal sector, receiving an income equal to average informal sector productivity, \(\gamma^I\), which depends on \(H\). When the number of workers in the informal sector is high, their income \(\gamma^I(H)\) is low, but as workers shift to the capitalist sector, the income of the remaining informal workers rises: in other words, informal sector income \(\gamma^I(H)\) increases with \(H\). Figure 6 shows productivity and incomes in both sectors.

employment rent

The economic rent a worker receives when the net value of their job exceeds the net value of their next best alternative (that is, being unemployed). Also known as: cost of job loss.

Equilibrium in the labour market occurs where the price-setting wage in the capitalist sector is equal to the wage that the firms must set to recruit and motivate workers. To do this, they must offer the fallback income \(\gamma^I(H)\) plus sufficient rent to motivate workers to work hard rather than risk having to return to informal work. The required rent also depends on \(H\): when \(H\) is low, the workers’ opportunities to get back into the informal sector in future are limited. As \(H\) increases, their alternative prospects improve and a higher rent is required to motivate them.

Figure 7 shows the wage-setting curve, lying above informal income \(\gamma^I(H)\). The rent for workers in the capitalist sector is the distance between these two curves, which increases with \(H\). The top panel shows the initial equilibrium occurs at point A, where the wage- and price-setting curves intersect. There are \(H_0\) workers in formal jobs earning \(w_0\), and \(1 – H_0\) in the informal sector earning \(\gamma^I(H_0)\).

The bottom panel of Figure 7 shows a process of structural transformation, precipitated by a rise in productivity in the capitalist sector.

• Output increases to \(\gamma_1\).
• At the initial wage, \(w_0\), firms’ profits increase.
• The capitalist sector expands (\(H_0\) to \(H_1\)) as new firms enter and existing firms increase output and employment.
• To draw in, and motivate, additional labour from the informal sector, the wage rises along the wage-setting curve.
• A new equilibrium is reached at B, with a higher wage \(w_1\), and higher capitalist sector employment \(H_1\). Productivity in the informal sector has risen too, to \(\gamma^I(H_1)\).

Note that initially, at high levels of employment in the informal sector, the wage-setting curve has a very shallow slope, suggesting that a rise in productivity in the capitalist sector is accompanied by a very small increase in wages. That is, individual workers may not see their wages rise by much over time, perhaps for several years. However, workers as a whole benefit because an increasing number of them are employed at the higher wage rate. Some evidence for this can be found in historical trends from England during the Industrial Revolution, when wage growth lagged behind productivity growth by several decades. More recently, a similar lag was also seen in the case of China, where growth picked up in the 1980s, while wages did not start rising until the early 2000s.^5 6

To learn more about trends in real wages in Britain during the Industrial Revolution, read Unit 2.7 of The Economy 2.0: Microeconomics.

Differences in productivity between sectors

The Lewis model in Figure 6 and Figure 7 assumed that labour productivity is lower in the informal sector than in the capitalist sector.

We can illustrate this difference by examining labour productivity for capitalist firms versus ‘own account’ enterprises run by self-employed worker-owners in the Indian manufacturing sector. Enterprise-level survey data from India’s National Sample Survey Organization shows that the median capitalist firm is three times more productive than the median self-employed enterprise. This difference in median productivity jumps to more than five times if we compare self-employed enterprises to capitalist firms with ten or more workers, illustrating the importance of scale even within the capitalist sector.

To learn more about how competition drives technological innovation in a capitalist sector, read Section 16.1 of The Economy 1.0 and Unit 9 of The Economy 2.0: Macroeconomics.

Why does the capitalist sector have higher levels (and growth rates) of labour productivity? The answer lies in more rapid rates of capital accumulation and technological change driven by the forces of market competition. On the flip side, low productivity levels as well as slower productivity growth in the informal sector are due to low levels of capital use and slow rates of capital accumulation.

You may wonder whether informal enterprises don’t need to compete in the market too. In that case, why don’t the same rules of competition and innovation apply to them as they do to capitalist firms? In other words, what prevents a self-employed individual from accumulating capital and skills, and growing to become a capitalist firm, creating much-needed jobs for the economy in the process?

To learn more about poverty traps, read Section 8.3 of The Economy 2.0: Macroeconomics.

randomized controlled trials

An experimental study of the effect of an intervention (such as a new policy). Experimental subjects are randomly assigned either to a ‘treatment group’ that receives the intervention, or a ‘control group’ that does not. The effect is assessed by comparing outcomes for the two groups.

Recent research using randomized controlled trials has shown that a threshold amount of capital is required to be able to accumulate further capital and grow. The inability of informal enterprises to reach this threshold results in a low-productivity ‘poverty trap’. The trap arises because these enterprises are not large enough to generate enough profits over and above what is required to keep the family going. This means they do not have the opportunity to accumulate capital and expand over time. Other barriers to scaling up include insufficient wealth to sustain the training and investment required for specialization and lack of information about market opportunities. Specialization is also risky. Poor households prefer to diversify and operate several tiny enterprises rather than specialize in one type of activity and risk losing everything.

To learn more about credit market exclusion and the principal–agent problem that underlies this, read Unit 9.9 of The Economy 2.0: Microeconomics.

asymmetric information

Information that is relevant to the parties in an economic interaction, but is known by some but not by others.

credit market excluded

A description of individuals who are unable to borrow on any terms.

But couldn’t an ambitious self-employed person with a good business idea simply borrow to finance expansion? The problem is that the market for loans suffers from asymmetric information. The borrower knows far more about their situation, their ability to repay, and how they will actually use the money, than the lender. In such circumstances, borrowers with a solid business plan may still end up being denied access to capital (in other words, be credit market excluded) because lenders find it hard to distinguish between good and bad borrowers. In Section 5 we will discuss some solutions to this problem.

To learn more about how low levels of capital goods and technology keep small firms trapped in low productivity and prevent them from scaling up, read Section 9.3 of The Economy 2.0: Macroeconomics.

There is a further structural barrier to expansion that faces informal enterprises. Since barriers to entry in the informal sector are much lower than in the capitalist sector (due to differences in scale), this results in many tiny enterprises competing in the market. The picture you should have in your mind is of five fruit sellers, each with their own mobile cart serving a neighbourhood, instead of one or two shops of a permanent nature. The existing demand for fruit is now spread over a larger number of workers, driving down incomes for all. This leaves very little in the way of profits or surplus that can be reinvested to expand scale.

So how do informal-sector enterprises with such low levels of productivity survive in the face of competition from more productive capitalist firms? There are two ways of understanding this puzzle. First, while individual enterprises can and do go out of business, there are not enough jobs in the capitalist sector for these displaced informal workers. And since low- and middle-income countries rarely have publicly provided unemployment benefits, a person who does not find a job in the capitalist sector is forced to eke out a living in the informal sector in order to survive. Second, while informal enterprises are less productive, they also have fewer costs, especially fixed costs such as rent, since many operate from the individual’s home or in other public spaces. And since self-employed individuals are, by definition, their own bosses, they can work long hours and pay themselves as little as needed to survive. A capitalist employer, on the other hand, must take account of the job offers being made by its competitors if it is to recruit and motivate workers.

The table in Figure 8 summarizes the main features of the two sectors in a dual economy.

Exercise 2 GDP growth and the dual economy

A small lower-middle-income country has a total workforce of 100,000 people of which 75,000 are in the informal sector and 25,000 in the capitalist sector. Over the course of one year, the workforce grows by 1.5% due to population growth. Assume that the output elasticity of employment (defined as employment growth divided by GDP growth) for the capitalist sector is 0.5. Use this information to answer the following questions.

1. If the share of workers in the capitalist sector increases from 25% to 26% after one year, how many workers are in each sector?
2. What would the associated growth rate of employment in the capitalist sector be?
3. Based on the output elasticity of employment, what should the growth rate of the capitalist sector GDP be?
4. Use a WS–PS diagram to illustrate your answers to Questions 1 to 3. Assume that GDP growth is due to technological improvements that increase the output per worker.