Development Economics

Development Microeconomics
(by) Bardhan and Udry
Chapter 4

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 Marginal product vs. total output
„ Marginal product of „ Total output
labour Total
Labour force in agriculture
→ Diminishing this way
MPL output
g

Labour force in agriculture

→ Diminishing this way

g L
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 Lewis-Fei-Ranis model [1]
„ Assumption.
– There are surplus labourers in the agricultural
sector whose marginal productivity is zero.

„ Implication.
– These labourers can be shifted to the industrial
sector.
» No change in agricultural output.
» No change in industrial wage rate.

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Lewis-Fei-Ranis model [2]
wage
D3 Labour supply
D2
D1

h’
h

g L

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 Lewis-Fei-Ranis model [3]
„ Policy implications
– Importance of agricultural productivity
– High wage rate is incompatible with
industrialisation.

„ Empirical evidence
– Horizontal labour supply curve questionable

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 Lewis-Fei-Ranis model [4]
„ Lacunae
– Skill compatibility
– Choice of industrial technology
– Comparative advantage

„ Puzzle
– Coexistence of widespread unemployment and
downward stickiness of wages

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 Efficiency wage [1]
„ Production function
– Q = F(nλ(W)), F’ > 0, F’’ < 0, λ’(W) > 0
– Q ≡ output; W ≡ wage rate
n ≡ number of hours/weeks of labour employed
λ ≡ labour efficiency

„ Choice variables
– n and W

„ Firm’s problem
– Max (F – nW), assuming price of output equals 1
– First order conditions will yield W* (efficiency wage)

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 Efficiency wage [2]
„ Efficiency wage
– At W = W*, the firm minimises
λ the ratio W/λ(W), i.e., the cost
of one efficiency unit of labour

λ(W)
„ Changes in W/λ(W)
– Initially, λ(W) = 0, and hence
ratio is infinite
– For W < W*, λ(W) rises rapidly
but W is still high relative to
λ (W)
– For W > W*, λ(W) falls
relative to W because of
W* W
diminishing marginal
productivity

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 Efficiency wage [3]
„ Involuntary unemployment „ Implication
Wage
– The demand for labour is
D(W) inelastic for wages below
S(W) W*, and has the usual
downward sloping shape for
W > W*

W*
„ Extension
– W* will be higher
whenever:
» Firms face a search cost
Aggregate R(W)
Employment » R’(W) < 0 and R(W)
Involuntary convex (i.e., R’’(W) > 0)
unemployment

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 Efficiency wage [4]
„ Land ownership
– Continuum from 0 to 1

landed „ Wage and productivity

landless
labourers gentry – μ ≡ minimum cost of buying
one efficiency unit of labour
μ – μ* ≡ aggregate marginal
product of effective labour
μ*

„ Unemployment
– Voluntary and involuntary

„ Land reforms
0 – Reduce involuntary
m1 m2 1 unemployment
small and
marginal
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 Efficiency wage [5]
„ Empirical evidence

– Response of wage rates to changes in demand and

supply conditions in the labour market not as stable as
the physiological relationship between nutrition and
productivity
» Both for casual labourers and people with long-term contracts
who are more likely to get efficiency wage

– Unemployment probabilities and wage diversity not as

influenced by land and asset holding as predicted
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 Impact of social norms [1]
„ Observation
– Despite developing economies being labour surplus, efficiency
wages exist; labourers do not undercut each other to reduce wages
to market clearing levels

„ Labourer behaviour
– Perceives a wage vector w = (W1, …., Wi, …., WN)
– On the basis of wi, labourer i estimates her own probability of
employment
– Her expected payoff is given by the following:
– Pi(w) = pi(w)Wi + (1 – pi(w))W0
– when Wo ≡ reservation wage

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 Impact of social norms [2]
„ Inference
– If all labourers have a reservation wage of W0, and if that is also
the market clearing wage, any Wi > W0 would be better, for a
positive p

„ Problem
– Wi > W0 can be sustained only if no labourer undercuts the others’
wages

„ Enforcement
– Threat to reduce Wi = W0 for all periods (t + j) if labourer i
undercuts others in period t
– Whether the threat has any effect would depend on the rate at
which labourer i discounts the future
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 Impact of social norms [3]
„ Problems with the model
– Assumes common knowledge which may not hold if there is a lot of
migration
– The threat that a labourer will forever be penalised by everyone by
reducing the wage rate to W0 is not credible
– There is scope for cooperation between employers and some labourers
who are promised a wage rate a little higher than W0 in perpetuity

„ Other issues
– Social acceptability of inter-personal variation in wage rates
– Social processes that match employers and employees along the lines of
location, ethnicity, religion etc
– Emergence of de facto insider-outsider models in labour markets, where
insiders are used to identify the more productive outsiders, and monitor
the latter at a later stage

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 Labour tying [1]
„ Explanation I
– Employer concern about availability of skilled labourers in the
peak season
– Promise of wage in excess of (marginal) productivity in the lean
season, in exchange for guaranteed supply in the peak season

„ Explanation II
– Labourers are more risk averse than employers
– They accept relatively low wage during peak season in exchange
for guaranteed employment in the lean season
– Casual labourers exist in equilibrium because it is costly to hoard
labour
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 Labour tying [2]
„ Explanation III
– Efficiency wage has to be paid to labourer in lean season because
consumption (or nutrition) enhances productivity with a lag

„ Modelling labour tying - I

– In peak season, contracted wage exceeds market clearing wage
– A labourer has incentive to renege on the contract, after benefiting
from it during lean season
– The premium offered in the tied contract has to be sufficiently
large to discourage the labourer from reneging on the contract
– The higher cost of the contract has to be traded off with the
potential cost of not having enough labourers during peak season
– In equilibrium, there will be an active casual labour market

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 Labour tying [3]
„ Modelling labour tying – II
– Two periods
– Work in first period is complex and difficult to monitor, but
outcome is known at the end of second period
– Work in second period simple and easy to monitor
– Tied labour works for employer in both periods, but casual labour
only in second period
– If outcome is “bad” at the end of second period, tied labourer may
lose his contract
» The threat is real if loss of contract makes the labourer worse off
» The threat is credible if the employer can easily find other similarly
productive labourers to replace him
– On account of incentive premium, and given the fact that having
casual labourers makes the threat credible, there is casual labour in
equilibrium
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 Labour tying [4]
„ Impact of economic development
– Greater labour tying
» Tighter labour markets
» Increase in complexity of production, leading to increased
demand for job-specific skills
– Less labour tying
» Greater outside opportunity for labourers, increasing
reservation wages (and incentive premium)
» Greater ‘voice’ and ‘exit’ as opposed to ‘loyalty’
» Greater access to capital and technology, making production
structure less labour intensive

„ Implications for income distribution

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