India’s development situation highlights the importance of understanding the transitions that contributed to its current economic composition. Because the transition from a primarily agricultural to primarily service sector economy occurred in the early 1980s, I choose to focus on India’s development after its independence in 1947 (“India,” 2014; Mukherjee, 2010a). I apply the Lewis two-sector model and other aspects of Lewis’ development theory to better understand India’s sectoral transition and maintenance of a large agricultural share of GDP.
In his survey of growth factors in developing economies, Lewis (1965) applied his two-sector model, empirical evidence, and capital-labor ratio theory to the expansion of the modern sector in economic development. Although he addressed some of the major criticisms of his model, he did not adequately account for the importance of human capital and sociopolitical institutions in a nation’s development. When applied to India’s economy, Lewis’ two-sector model and its limitations provide insight into India’s sectoral transitions.
Introduction to Lewis’ Two-Sector Model
Lewis (1965) hypothesized that human capital, foreign investment, and entrepreneurship contribute to economic development, especially through the expansion of the modern sector. He reinforced his argument using the Lewis two-sector model, capital-labor ratio theory, and empirical evidence (Lewis, 1965). He concluded that these factors have contributed to growth, which supports the role of government investment in non-preferential public infrastructure and private and foreign investment in modern sector capital (Lewis, 1965).
Lewis employed his two-sector model to explain growth and development in developing nations. The basic Lewis two-sector model is based on several assumptions. First, two sectors compose the economy—the traditional (agricultural) sector and the modern (industrial) sector (Todaro & Smith, 2012). Second, each sector is described by a production function determined by labor supply, with constant technology and capital, in each period (Todaro & Smith, 2012). Third, there is an excess supply of labor in the traditional sector due to a high population concentration in rural areas (Todaro & Smith, 2012). Fourth, the industrial sector labor market is perfectly competitive (Todaro & Smith, 2012). Fifth, the industrial sector labor market faces a perfectly elastic supply at a higher real wage level than the agricultural sector (Todaro & Smith, 2012). Sixth, firms in the industrial sector reinvest all profit in the next period (Todaro & Smith, 2012).
These assumptions lead to the insight that industrialization plays a key role in economic growth by the following reasoning. The equilibrium quantity of labor in the agricultural sector is the quantity at which the marginal productivity of labor is zero (Todaro & Smith, 2012). The equilibrium wage in the agricultural sector is equal to the average productivity of labor at this quantity (Todaro & Smith, 2012). Because wage in the industrial sector is fixed at a higher wage than that in the agricultural sector, workers are expected to move from the agricultural sector to the industrial sector (Todaro & Smith, 2012). Capital reinvestment expands the modern sector production function and demand for labor increases each period, accommodating the inflow of workers such that there is no unemployment (Todaro & Smith, 2012). The process of employment and capital reinvestment leads to economic growth until the agricultural sector no longer faces an excess supply of labor (Todaro & Smith, 2012).
Lewis (1965) extended and addressed limitations to this basic model by describing how additional sources of physical capital, entrepreneurship, human capital, and foreign trade affect growth in the context of his model. He extended his basic model to open economies with two points. First, he explains how capital and public infrastructure investment through increases in the savings rate, foreign investment (incentivized by the lower amount of capital in developing nations and assumption of diminishing marginal returns to capital), and foreign aid can expand the production function (Lewis, 1965; Todaro & Smith 2012). Second, he argued that, although developed nations have a history of importing primary products from developing nations, comparative advantage for agriculture and other primary-product sectors in non-tropical climates may drive sector transition in developing nations (Lewis, 1965). He concluded that developing nations have incentive to focus on manufacturing and eventually provide their own or import raw materials (Lewis, 1965). Third, he addressed a limitation in his original model by arguing that the production function in the agricultural market can be expanded by increased technology, which indicates a role for agricultural investment (Lewis, 1965).
Lewis identified two major concerns in human capital investment. First, he argued that a lack of domestic, large-scale entrepreneurship harms the formation of an industrial sector (Lewis, 1965). He offered solutions including foreign investment in manufacturing and government stimulation by “improved infrastructure, market research, feasibility studies, technical advice, and financial aid” (Lewis, 1965, p. 2). Second, he argued that human capital in the form of skill has been limited by expansion of the markets requiring these skills and the matching of these markets with emphasis on technical education in addition to literacy (Lewis, 1965). He argued that the training and skill required for technology expansion in the modern sector is limited (Lewis, 1965). He concluded that governments should focus on primary education to prevent unemployment due to workers seeking high-skill jobs that expand at a slower rate than lower skill jobs in the industrial sector (Lewis, 1965).
In addition to clarifying and extending his model, Lewis addressed limitations of his assumptions. Faster movement of labor from the agricultural sector to the modern sector than modern sector growth can accommodate may explain empirical unemployment in the modern sector (Lewis, 1965). He also argued that wage increases in the modern sector may be due to non-competitive factors, which may cause a responding wage increase in the agricultural sector to decrease employment in both sectors (Lewis, 1965). He discussed how investments in labor-saving technology may contribute to modern-sector unemployment (Lewis, 1965). He offered the solution that, using his model’s assumptions as a guideline for sustained growth, developing nations’ governments and firms should hold wages in the modern sector constant and responsive to those in the agricultural sector (Lewis, 1965). He also argued that investment in agricultural productivity-increasing technologies reinforces the labor supply transition to the modern sector (Lewis, 1965). Lewis countered criticisms of his two-sector model and explained its insights into the role of physical and human capital, foreign investment, and entrepreneurship in economic growth.
Lewis addressed limitations to his original model, but did not provide adequate recognition of the importance of human capital and social institutions in structural transitions. In the extension of his model, he explained how foreign aid application to public infrastructure and foreign investment contribute to growth in the production function (Lewis, 1965). The earlier Harrod-Domar model had already highlighted this point and neither model accounted for barriers to foreign and public infrastructure investment due to uncertainty in developing markets’ economic and political stability (Lewis, 1965; Todaro & Smith, 2012).
Lewis’ insights into human capital investments are also limited. First, he assumed that large-sector entrepreneurs are lacking due to knowledge or will (Lewis, 1965). He did not acknowledge that the brain drain might have caused the loss of these potential entrepreneurs to other markets (Lewis, 1965; Todaro & Smith, 2012). The loss of Satya Nadella to Microsoft and Indian e-commerce entrepreneur Kunal Bahl’s recent comment that he returned to India from the United States due to the expiration of his undergraduate education visa suggest that this phenomenon should be investigated (Bergen, 2014; Clark, Langley, & Ovide, 2014). Second, Lewis assumed that the modern sector labor force requires minimal education (Lewis, 1965). He did not account for developing nations’ expanding service sectors (which may be considered beyond the industrial sector), which require significant skill levels (Arora & Bagde, 2010; Lewis, 1965). Third, he assumed that human capital investments should modulate with the development of the agricultural sector for full employment in the industrial sector (Lewis, 1965). This assumption did not acknowledge that nations may value equal opportunity for education above the expense of unemployment or may prefer to increase capital investment rather than restrict labor and education choices.
Finally, Lewis (1965) did not justify his assumption that there are decreasing marginal returns to factors of production (Todaro & Smith, 2012). Network effect and coordination theory and empirical evidence have indicated that, with coordinated human and physical capital investment, increasing marginal returns are achievable (Todaro & Smith, 2012).