World War 2 affected peoples of all races, creeds and geographical land masses. Its aftermath lead to three occurrences which influenced the writings of Sir Arthur, these included decolonization, racial tensions and questions surrounding the role of government2. The end of the war spurred debate on what ideological consensuses should be invented to ensure a world war would never happen again and consequently issues such as racial justice, political independence, economic growth and the re-distribution of wealth were topical in the mid 1950’s to 1970’s3. Sir Arthur sought to contribute to this debate through his writings and musings by using economic theory to provide solutions to these pertinent issues. One of Sir Arthur’s most famous pieces is “Economic Development with Unlimited Supplies of Labour”. This paper was published in 1954 and was an attempt by Sir Arthur to adapt existing economic theory to the realities of developing countries, which had received little attention at that time. The piece sought to explain how societies can spur growth and development through use of two characteristics of developing countries namely a large subsistence sector and a small capitalist or entrepreneurial sector. The capitalist sector uses reproducible capital and pays for this use while the subsistence sector consists of low-skill persons who can, if they move over to the capitalist sector earn wages paid at some premium above the current subsistence earnings4.
2 The Model : Closed economy
2.1 Capital injections
Having defined these actors, Sir Arthur focused on the interplay between them, whereby an initial capital injection geared towards investments by the capitalist sector, generates returns which are then reinvested and thereby fuel a positive feedback loop, due to the returns on this investment continually being reinvested. He pointed out that returns on an investment and its effect on raising the stock of capital drive the need for more labour from the subsistence sector. To the extent that policymakers could encourage this virtuous cycle, he posits they could address the high unemployment in the region and raise wages.
Interestingly it appears that FDI flows and unemployment have had a positive relation in Latin America and the Caribbean (see Figure 1) which suggest that other factors may be at play.
Code
chart_fdi_unemploy <- fdi_unemploy_long |>filter(`Country Code`=='LCN',`Indicator Name`=='Foreign direct investment, net inflows (% of GDP)'|`Indicator Name`=='Unemployment, total (% of total labor force) (modeled ILO estimate)' ) |>ggplot(aes(x=Year, y=Indicators, color=`Indicator Name`))+geom_line(size=1.5, alpha=0.8)+labs(title ='FDI and Unemployment in Latin America \n and the Caribbean',subtitle ='Do FDI and unemployment move in lockstep?',color='',caption ='Source: World Bank Development Indicators')+theme_fivethirtyeight()+scale_y_continuous(labels = scales::comma)+scale_x_date(date_breaks ="7 years", limits =as.Date(c('1/1/1990', '1/1/2022'), format="%d/%m/%Y"),date_labels="%Y" )chart_fdi_unemploy+labs(y="% of GDP")
Figure 1: FDI and unemployment
It is interesting to note that unemployment levels Latin America and the Caribbean are often higher than both low income and OECD member countries, see Figure 2.
Code
chart_unemployment <- fdi_unemploy_long |>filter(`Country Code`=='OED'|`Country Code`=='LIC'|`Country Code`=='LCN',`Indicator Name`=='Unemployment, total (% of total labor force) (modeled ILO estimate)') |>ggplot(aes(x=Year, y=Indicators, color=`Country Name`))+geom_line(size=1.5, alpha=0.8)+labs(title ='Unemployment rates',subtitle ='Unemployment rates based on ILO estimates',color='',caption ='Source: World Bank Development Indicators')+xlab('%')+theme_fivethirtyeight()+scale_y_continuous(labels = scales::comma)+scale_x_date(date_breaks ="7 years", limits =as.Date(c('1/1/1990', '1/1/2022'), format="%d/%m/%Y"),date_labels="%Y" )chart_unemployment
Figure 2: Unemployment
The relatively high levels of unemployment are perhaps indicative of economic rigidities outside of FDI flows since flows to the region are on par with regional peers, see Figure 3.
Code
chart_fdi <- fdi_unemploy_long |>filter(`Country Code`=='OED'|`Country Code`=='LIC'|`Country Code`=='LCN',`Indicator Name`=='Foreign direct investment, net inflows (% of GDP)') |>ggplot(aes(x=Year, y=Indicators, color=`Country Name`))+geom_line(size=1.5, alpha=0.8)+labs(title ='FDI Flows Select Regions',subtitle ='FDI Flows % of GDP',color='',caption ='Source: World Bank Development Indicators')+xlab('%')+theme_fivethirtyeight()+scale_y_continuous(labels = scales::comma)+scale_x_date(date_breaks ="7 years", limits =as.Date(c('1/1/1980', '1/1/2022'), format="%d/%m/%Y"),date_labels="%Y" )chart_fdi
Figure 3: FDI Inflows Comparision
Sir Arthur also sought to examine why it was the case that some countries experienced high growth and development and others remained mired in poverty, despite most societies having this combination of a capital and subsistence sector. He concluded that this disparity in outcomes was a function of both the level and type of capital stock in the country and went on to show that the capital stock of a country was tied to its economic development, as development was associated with raising national savings and it is this national savings which then becomes the source of investment/capital.
Code
chart_capital <-savings_long |>filter(`Country Code`=='OED'|`Country Code`=='LIC'|`Country Code`=='LCN',`Indicator Name`=='Gross capital formation (% of GDP)' ) |>ggplot(aes(x=Year, y=Indicators, color=`Country Name`))+geom_line(size=1.5, alpha=0.8)+labs(title ='Gross fixed capital formation ',subtitle ='% of GDP',color='',caption ='Source: World Bank Development Indicators')+xlab('%')+theme_fivethirtyeight()+scale_y_continuous(labels = scales::comma)+scale_x_date(date_breaks ="9 years", limits =as.Date(c('1/1/1980', '1/1/2022'), format="%d/%m/%Y"),date_labels="%Y" )chart_capital
Figure 4: Gross fixed capital formation
In Figure 4 we examine gross fixed capital formation as a percentage of GDP in several regions and note that capital formation is low in Latin America and the Caribbean when compared to peers.
2.2 An Entrepreneurial class and Technological change
The interplay between savings and economic development was also influenced by the fact that the increase in savings due to growth occurred more in the top echelon of income earners who derived their incomes from investments and were not salaried. Sir Arthur therefore noted that the success of absorbing surplus labour and raising wages was tied to the presence of an entrepreneurial class of persons who had a requisite amount of savings and skills to invest. The piece then focuses on how the divergences in economic fortunes could be tied to whether there was an enabling environment to allow this class to flourish.
Code
chart_lf <- lf_capital_long |>filter(`Country Code`=='OED'|`Country Code`=='LIC'|`Country Code`=='LCN',`Indicator Name`=='Labor force participation rate, total (% of total population ages 15+) (modeled ILO estimate)', Year>year(1990) ) |>ggplot(aes(x=Year, y=Indicators, color=`Country Name`))+geom_line(size=1.5, alpha=0.8)+labs(title ='Labor force participation rate',subtitle ='% of total population ages 15+',color='',caption ='Source: World Bank Development Indicators')+xlab('%')+theme_fivethirtyeight()+scale_y_continuous(labels = scales::comma)+scale_x_date(date_breaks ="7 years", limits =as.Date(c('1/1/1990', '1/1/2022'), format="%d/%m/%Y"),date_labels="%Y" )chart_lf
Figure 5: Labor force participation rate
In Figure 5 we see that labor force participation rates have been flat in Latin America and the Caribbean suggesting that there have been mixed labor market dynamics in the region, which is somewhat supported by Figure 2 which show that the region has mixed success with unemployment.
In addition to having an entrepreneurial class, economic growth would be stronger in countries which adapt to and facilitate the assimilation of technological change while ensuring functioning capital markets. This assimilation of technology in his view creates increasing opportunities for capital to be invested profitably and consequently raise national income which serves to increase the level of capital which can then be reinvested by the entrepreneurial class. Sir Arthur focused heavily on the earnings received by this class given that the income they received from their business was significantly more than that of the earnings of salaried workers. The national earnings and subsequent savings of a nation which can then serve as the capital stock for reinvestment are largely tied to ensuring the success of the entrepreneurial class. This stems from the fact that capital grows faster than the rate of consumption as capitalist can reinvest surpluses and therefore quickly compound their returns, furthermore under the assumption of an unlimited supply of labour this rate of growth does not diminish over time. Perhaps ahead of his time, Sir Arthur realized that economic development favours net savers and therefore alters the distribution of income which can lead to income inequality. An economy’s development therefore often lies in the hands of persons who receive profits or rents.
Code
chart_savings <- savings_long |>filter(`Country Code`=='OED'|`Country Code`=='LIC'|`Country Code`=='LCN',`Indicator Name`=='Gross domestic savings (% of GDP)') |>ggplot(aes(x=Year, y=Indicators, color=`Country Name`))+geom_line(size=1.5, alpha=0.8)+labs(title ='Gross domestic savings',subtitle ='% of GDP',color='',caption ='Source: World Bank Development Indicators')+xlab('%')+theme_fivethirtyeight()+scale_y_continuous(labels = scales::comma)+scale_x_date(date_breaks ="7 years", limits =as.Date(c('1/1/1990', '1/1/2022'), format="%d/%m/%Y"),date_labels="%Y" )chart_savings
Figure 6: Labor force participation rate
Figure 6 show a clear disparity between savings in developing and developed nations vis a vis low income jurisdictions, which mirrors Sir Arthurs thoughts re savings and development.
2.3 Better social outcomes
Having spent time defining the role and contribution of the capitalist sector, a more precise explanation of how his framework facilitates better social outcomes can be expounded upon. The first channel for better social outcomes is that as more labour is absorbed into the capitalist sector societal earnings are raised as these persons now earn wages which are higher than subsistence. This development allows for a larger market for an enterprising class to sell goods and services which can fuel gains in national income. A society in his words saved little not because they were poor but because their capital sector was too small. This cycle would continue if the capitalist sector continually invests in profitable and productive opportunities. A distinction could be made between a truly capitalist class where surpluses are invested in productive activities and a society existing of a dominant class consisting of landlords and traders who do not reinvest as do capitalists.
The piece then considers how monetary and government action can affect the aforementioned cycles. Changes in the supply of money (credit) can increase capital formation as it is now financed through credit causing both capital formation and real income to grow. This under varying assumptions leads to a redistribution of income and drives up prices up to the point where output has risen significantly. Concerning the government the piece notes that a high level of marginal taxation ensures that inflationary pressures remain low as taxation serves to “mop up surplus funds which could lead to demand inflation”. Lewis then went on to show a positive link between relatively low levels of inflation and capital formation in the case where there is a large industrial/capital class. This comes about from the fact that inflation leads to uneven higher prices and consquently extra income which can be reinvested.
Chart 1 Inflation and capital formation
Code
chart_inflation <- inflation_long |>filter(`Country Code`=='LCN',`Indicator Name`=='Gross capital formation (% of GDP)'|`Indicator Name`=='Inflation, consumer prices (annual %)' ) |>ggplot(aes(x=Year, y=Indicators, color=`Indicator Name`))+geom_line(size=1.5, alpha=0.8)+labs(title ='Inflation and capital formation in \n Latin America and the Caribbean',subtitle ='Do inflation and gross capital formation move in lockstep?',color='',caption ='Source: World Bank Development Indicators')+theme_fivethirtyeight()+scale_y_continuous(labels = scales::comma)+scale_x_date(date_breaks ="7 years", limits =as.Date(c('1/1/1995', '1/1/2022'), format="%d/%m/%Y"),date_labels="%Y" )chart_inflation+labs(y="")
Figure 7: Inflation and capital formation
Interestingly Figure 7 seems to suggest that a positive relationship does exist between the two for the Latin American and Caribbean regions.
The positively reinforcing cycle of capital surplus, reinvestment, absorption of surplus labour and a widening gap between capitalist and subsistence levels of savings and capital formation can stop if;
Higher capital formation relative to population growth
Disadvantageous terms of trade to the capitalist sector
A more productive subsistence sector
3 The Model : Open economy
The previous analysis looked at a closed economic system. Lewis then extended the analysis to an open system5 whereby a country may internally have labour scarcity but may be surrounded by other nations with surplus labour at subsistence wages. Immigration can therefore limit the rise of internal real wages which will adversely affect the capital surplus and hence reinvestment and capital formation. Efforts therefore to stymie immigration result in high wages and lower profits, capital and output. The model in an open economy was expounded upon under several scenarios;
Two countries, no competition and no trade: exportation of capital often by the country with scarcer labour resulting in reduced demand for labour in the exporting country and thus suppressing wages.
Two countries, do not compete but trade: the country which exports capital to the other will benefit to the extent that the capital exports (investment) in in commodities which they import. If A invests surplus capital in B and this investment is in cocoa production but A also imports cocoa then A will benefit since the investment in cocoa will result in increased yields and lower prices.
Two countries produce the same goods and trade: relative prices will be influenced. A country which has surplus labour and is receiving capital investments may lead to an increase in subsistence productivity which would raise wages if this wage gain is excessive capital will move to countries which have lower real wages if movement is friction-less.
Two countries, produce competing goods, and sell to 3rd markets: the capital-exporting country will benefit if productivity gains in the subsistence sector cause higher wages in the capital importer. If the investment of the capital exporter is in a sector in which it imports the produce then it would lose since the prices of imports will rise.
4 Conclusion
In conclusion, the piece showed that an entrepreneurial class and well-functioning capital markets are key to better social outcomes.
Subsistence wages therefore set the floor for capitalist wages plus to premium to take into account higher cost of living in that sector. Lewis say that this establishes a negative incentive for the capitalist to suppress the efficiency of the subsistence sector. ↩︎
Lewis pointed out that in tropical economies the wages paid to sugar workers was so low because the subsistence wage of a tropical economy is low. That would change only if technology is applied to tropical subsistence to raise productivity etc↩︎
