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The labour market in Developing countries: Wasted opportunities?

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Presentation on theme: "The labour market in Developing countries: Wasted opportunities?"— Presentation transcript:

1 The labour market in Developing countries: Wasted opportunities?

2 Lecture Outline/Questions (1) Agricultural Sector and labour (2) Connections between the urban and rural labour markets: Lewis and Harris-Todaro model. (3) Determinants of Informal sector employment (4) Linkages between the formal and informal sectors (5) Testing Dualism in LDC labour markets: Gindling (1991).

3 The labour market in Developing countries: Wasted opportunities? (1) Agricultural Sector and labour In developing countries but particularly in low-income countries that characterise large parts of the African continent, many economically active persons are located in rural areas. The Rural Labour Market Characterised by agricultural employment and migration. Agricultural work has many guises, which include: (i) subsistence farming, (ii) co-operative farms, (iii) sharecropping (iv) tenant farming (v) large-scale farming where there is a clear distinction between employers and employees.

4 The labour market in Developing countries: Wasted opportunities? Theoretically the literature on rural labour markets is weak – based on household models (e.g. Barnum-Squire, 1979). This model predicts households are either net importers or exporters of labour, with initial factor endowments important in who demands labour and who supplies labour. These models also assume that households maximise profits by deciding (i) on what and how to produce and then (ii) what consumption bundle is chosen – assume production and consumption can be completely separated (these markets are complete). Empirically in rural Africa this is not the case due to (i) risk (ii) asymmetric information and (iii) incentive problems.

5 The labour market in Developing countries: Wasted opportunities? This means rural labour markets are characterised by numerous types of labour market models in the agricultural sector. (i) Subsistence Farming: small-scale so no likelihood of any economies of scale. Productivity is low. Very low-tech production. Such subsistence farming provides the household with the primary source of food. Any excess food is likely to be sold in local market places. However many chronically poor households (low nutritional intake, under- weight, calcium deficient etc…) are in a vicious circle that begins with low calorie intake and under-nutrition, which directly affects productivity in what is highly physical work (Strauss and Thomas, 1999).

6 Effect of increase in one health unit on physical productivity: A comparison of initial poor and initial rich individuals Health units Physical Productivity Hp Hr

7 Effect of increase in one health unit on physical productivity: A comparison of initial poor and initial rich individuals – D.Ray calls a Capacity Curve (p489) Health units =f(wages) Physical Productivity W1 W2 W3 W1>W2>W3

8 The labour market in Developing countries: Wasted opportunities? Even when labourers can earn more from hiring out their labour to others they may well remain farming their plot of land because of the importance of producing/providing food for the household given agricultural production is uncertain - food security. This decision can appear uneconomic (irrational) but because of no insurance markets, lack of credit markets, asymmetric information and incentive problems is in fact not irrational at all. The risk of not having food security for the household will in itself lead to (now well-known) diversification of income sources – importance of non-farm income and issue of migration/remittances.

9 The labour market in Developing countries: Wasted opportunities? (ii) Sharecropping: A way of providing incentives to workers by employers so monitoring costs and screening costs are redundant. Theoretically this model is a way of overcoming market failures of asymmetric information and incentives problems. It provides landless workers with access to land and tools – so the landlord is providing, land, tools, possibly some credit and loans in harsh times. The employer gains by having non-seasonal workers all year round.

10 The labour market in Developing countries: Wasted opportunities? Often landlords will offer sharecropping to individuals/households he knows – social networks and issue of trust (new institutional economics) that reduces transactions costs. Kinship networks are particularly important here – so will offer sharecropping to a family member (prior to inheritance of land). The only problem with sharecropping comes about when the lack of economic power of the landless workers is exploited by the powerful land-owner – has to be a degree of good- will.

11 The labour market in Developing countries: Wasted opportunities? Also is an issue of land reform in many low income countries, that is deemed by the World Bank as being essential for development and growth – not land grab. However, there are cases where fertile agricultural land has been given back to the indigenous people only for a lack of resources, training, education, access to markets to prevent these people from exploiting the land (e.g. South Africa). Also the issue of people not being attracted back to rural areas by the promise of land from urban areas. Could be a sense of failure?

12 The labour market in Developing countries: Wasted opportunities? (iii) Tenant Farming Pay rent to the land owner, but is little or no security in tenure on the land. Hence poor incentive to invest in capital and technology and no improvement in productivity. The relationship between land owner and tenant is modelled using principal-agent theory. The tenant (agent) attempts to maximise his utility subject to effort levels and the contractual agreement with the land owner. The land owner (principal) tries to maximise his utility by manipulating contractual terms with consideration of the agents response to them under the constraint of guaranteeing to the agent reservation utility, meaning the utility the agent can obtain if he does not enter the contract (Otsuka and Hayami, 1988, p.32, Economic Development and Cultural Change).

13 The labour market in Developing countries: Wasted opportunities? (iv) Co-operative farming: Small land-owners form larger areas to cultivate so can exploit economies of scale in inputs and outputs. An issue of access to markets if any surplus is produced: transport infrastructure needs to be improved within rural areas and between rural and urban areas, where the surplus will be sold for more.

14 The labour market in Developing countries: Wasted opportunities? (v) Commercial Farming: Can lead to significant change in how rural labour markets work. E.G. Contract farming (employer contracts small landowner to produce crops providing them with new technology (inputs)) is good if the small landowner still retains some land for his/her own use and has other sources of income. If solely reliant on contract farming income then open yourself up to poor wages. Work can be casual (day or so), seasonal (month or two), or permanent (more than 3 months), see Duncan and Howell, (1992) ODI, Structural Adjustment and the African Farmer. [See Porter and Phillips-Howard (1997), World Development Vol 25(2), pp ].

15 The labour market in Developing countries: Wasted opportunities? The issue of what kind of employment contract to offer to workers is based on type of work done. If easily monitored (e.g. harvesting) then wages can be based on the market – these types of jobs can be casual. If not easily monitored (e.g. irrigation, pesticide use) then issue of potential shirking – efficiency wage theory.

16 The labour market in Developing countries: Wasted opportunities? The Model (variation of Shirking model of Shapiro and Stiglitz, 1984) To prevent shirking employer can offer permanent contracts – offers certainty of income in return for no shirking GIVEN NO ALTERNATIVE PERMANENT CONTRACT JOB. Permanent worker is paid Wp; Casual worker is paid Wc. Wp>Wc G is the gains from shirking ( high wage, low effort level). If caught shirking the worker will only ever get Wc for rest of working life or N periods. If G>N(Wp-Wc) then shirk Wp>=Wc+G/N, then no shirking G

17 The labour market in Developing countries: Wasted opportunities? Non-Farming Activities Found by a number of researchers in Africa that non-farm income/earnings is one of the most important components in rural household income – basis for hiring (cheap) farm labour. The overriding argument for households wanting to participate in non-farming activities in both rural and urban locations is that it diversifies sources of income – like spread betting or hedging your bets except this is done in order to decrease the likelihood of food insecurity. The issue of non-farming activities undertaken is related to dualism theory (Lewis) and worker-migration (e.g. Harris-Todaro (1970)).

18 The labour market in Developing countries: Wasted opportunities? (2)The Urban Labour Market: Characterised by (i) greater wage labour, (ii) greater formal sector employment, (iii) public and private sector (iv) urban self- employment (survivalist for the majority). Labour market characterised by market forces. However these markets are not unfettered: still issues of institutional structures of the labour markets, trade union organisations, employer organisations, collective bargaining coverage, labour market legislation (e.g. minimum wages, significant hiring and firing costs).

19 The labour market in Developing countries: Wasted opportunities? Arthur Lewis (1954) argued the urban (or the formal) wage was greater than the rural (informal) wage for 3 reasons:- (1) the payoff to experience was greater in the formal sector than the informal sector (2) labour unions and minimum wages ensure higher initial wages (3) psychological cost of transferring from the easy going life of the subsistence sector to the more regimented environment of the capitalist sector. Dualism within the urban labour market: in reality there are multi-tiered labour markets with some over-lap and therefore chance of switching, but only for the lucky few.

20 The labour market in Developing countries: Wasted opportunities? The formal Harris-Todaro (1970) model The urban wage is equal to the MP of workers and is greater than the rural wage. The basic premise is that if the Expected urban wage > Certain rural wage, then urban to rural migration will occur until the expected wages are equalised. Formally this means that: (1)

21 The labour market in Developing countries: Wasted opportunities? where represents the probability of being unemployed in the urban labour market. It is assumed in the Harris-Todaro model that being employed in the urban labour market is uncertain – not full-employment so is a cost to not being employed. Being employed in the rural labour market is assumed in the model to be certain – even though the MP in the rural labour market could well be 0 (under-employment). From the equation, the expected wages in the two sectors are equal when, (2) Eu=Urban formal sector employees, Lu=Urban formal sector labour force, (Eu/Lu)=probability of being employed in urban labour market.

22 The labour market in Developing countries: Wasted opportunities? Since it follows from the previous result that the probability of being employed in the urban labour market must be < 1. See this by re-arranging (2), There is open unemployment in the urban labour market.

23 The labour market in Developing countries: Wasted opportunities? If a policy of increasing the rural wage was adopted the prediction of the model is for urban unemployment to decline. Policy of rural development can theoretically solve the urban unemployment problem – Kenyan government adopted a rural development policy following the H-T model and unemployment did decline (Fields, 2005). The basic model has been extensively reviewed and additions to it include consideration of (i) the risk aversity of workers and (ii) different urban labour markets.

24 The labour market in Developing countries: Wasted opportunities? (3) Informal sector Think of this as a primary labour market (formal) and secondary labour market (informal): economic dualism or worse economic segmentation. Table 2.1 indicates the estimated extent of private formal sector wage employment in 5 African countries.

25 The labour market in Developing countries: Wasted opportunities? Table 2.1: Proportion of labour force in private formal sector wage employment, selected African economies, percentages, Kenya Tanzania Uganda Zambia Zimbabwe Source: 2001 World Employment Report: Life at work in the information economy, ILO, Geneva.

26 The labour market in Developing countries: Wasted opportunities? More complex theories of labour market dualism exist, e.g. Esfahani and Salehi-Isfahani, (Economic Journal 1989). This model looks at how observability of effort differs amongst formal and informal workers – Borrows from efficiency wage theory. Lower observability in the formal sector means firms pay higher wages so as to encourage effort with the price of shirking being employment in the informal sector at a lower wage. Formal sector jobs are more likely to be about mental capital rather than physical capital. Informal jobs are more physical and labour intensive and hence easier to observe effort.

27 The labour market in Developing countries: Wasted opportunities? Persistent involuntary unemployment in LDCs can also be explained by efficiency wage theory with the unemployed desiring to work in the formal sector only……. ……..Higher wages in this sector mean longer unemployment queues since it is worth trying to get a formal sector job rather than an informal sector job where current and future wages are very low.

28 The labour market in Developing countries: Wasted opportunities? (Q)What determines the informal sector of a less developed country? Determinants of the informal economy Schneider and Enste (March 2000, Journal of Economic Literature, pp77-114) argue that 4 factors feed into the informal sector: (1) Formal sector unemployment – there is no welfare net to catch the unemployed who thus have to become involuntarily employed in the informal sector to survive. In reality things are a little more complex with issues of household risk insurance, with the unemployed able to return to family/friends if cannot find employment in the formal sector. (2) Complicated/restrictive rules and regulations – these include labour legislation that may prevent more employment in the formal sector, registration costs of a business that force it into the informal sector.

29 The labour market in Developing countries: Wasted opportunities? (Q)What determines the informal sector of a less developed country? Determinants of the informal economy Schneider and Enste (2000) cont… (3) Decline of civic virtue – informal sector businesses take care of themselves only with no perceived benefit of formalising the business (selfishness?). (4) Rise in taxation in the formal sector – forces those formal sector businesses that are making very small profits into the informal sector as rising costs tip average cost above average revenue. See Figure 1.

30 The labour market in Developing countries: Wasted opportunities? Figure 1 MR=P=AR Output Costs/Revenues MC ATC ATC2 MC ATC Formal: post tax increase – LEAVE MARKET TO ENTER INFORMAL SECTOR Informal: post tax increase – COSTS DECLINE AS CHEAPER LABOUR AND NOT PAY TAXES, PRICE DECLINES TOO BUT PROFITS MADE MR2=P2=AR2 LOSS MC2 PROFIT

31 The labour market in Developing countries: Wasted opportunities? (Q)What determines the informal sector of a less developed country? Schneider and Enste (2000) cont… All these factors can effect the size of the informal sector. (2) and (4) represent the additional costs argument which forces employees and employers to leave the formal sector since profits (likely to be small in the first place especially for start-up projects) are reduced. This can result in economic agents choosing the informal sector in the short- run which then limits potential growth since the business is not legitimate – issue too of the informal sector having no rules and regulations, protection etc…more likelihood of crime which has large negative externalities for the country/region.

32 The labour market in Developing countries: Wasted opportunities? Essentially the informal sector persists and even expands as the rules and regulations of the formal sector become more complicated. One simple way to attract more informal sector businesses into the formal sector would be to adopt simple tax systems, particularly for small start-ups.

33 The labour market in Developing countries: Wasted opportunities? (4)Are there any linkages between the formal and informal sectors, e.g. can people switch from one sector to the other easily? Little mobility between the formal and informal sectors. As J.S.Mill said ….the really exhausting and really repulsive labours instead of being paid better than others are almost invariably paid the worst of all because performed by those who have no choice. Labour was segmented into different castes, and Mill argued:- …so strongly marked is the line of demarcation between the different grades of labourers as to be equivalent to a hereditary distinction of caste. Very different to how Adam Smith saw it: he argued the worst jobs would be paid the most since nobody would want to do them, i.e. supply constraint……did not reckon on a lack of job choice or of institutional barriers preventing job mobility (e.g. discrimination, caste, class…)

34 The labour market in Developing countries: Wasted opportunities? Evidence from the Inter-American Development Bank (2003) indicates that switching between the formal and informal sector does exist, with 16% of Mexican workers and 11% of Argentine workers moving in/our of informal sector employment. This merely says that 84% and 89% of these workers DO NOT SWITCH!!

35 The labour market in Developing countries: Wasted opportunities? As well as a lack of switching between the formal and informal sectors there is also the issue of negative feedback effects from being in the informal sector in the first place: Although workers in the secondary sector may initially be as good as workers in the primary sector, a process of divergence eventually molds the workers to their jobs, (Taubman and Wachter, 1986, pp.1192). Reduction in these workers skills and productivity resulting in ex post justification of these workers being in this sector. This however is the incorrect way to look at the evidence with an important determinant of sequencing being missed…

36 The labour market in Developing countries: Wasted opportunities? To take as read that secondary sector workers are justified in being in this sector because their productivity is less than equivalent primary sector workers is to miss one of the points of any dualistic labour market: THE FACT THEY WERE UNLUCKY NOT TO BE IN THE PRIMARY SECTOR IN THE FIRST PLACE (Gary Fields). The size of the wage differential between sectors determines the size of unemployment, with queuing for primary sector jobs observed as long as the expected value of waiting is greater than the wage rate in the secondary sector. The prospect of widening earnings/wage differentials between two essentially identical labour market entrants reveals a serious inefficiency.

37 The labour market in Developing countries: Wasted opportunities? Negative feed-back effect if in secondary labour market. Good quality workers Reduction in these workers skills since not necessary in the job:-MP reduced resulting in ex post justification of these workers being in this sector. Informal Sector Job Formal Sector Job Use skills and education and rewarded for this with higher wages and the possibility of more training: MP will increase and wage will increase Low Wage High Wage

38 The labour market in Developing countries: Wasted opportunities? (Q)What are the economic consequences of being informally employed? Some Answers (i)Job insecurity relative to formal sector workers. (ii) Results in huge uncertainty which effects (i) household production and consumption decisions (ii) human capital investment, (ii) returns to human capital (will be lower than in the formal sector), (iii) reduce the likelihood of switching to formal sector employment, ceteris paribus. (iii) Those workers unlucky to be employed in the informal (secondary) sector will see there likelihood of switching to the formal (primary) sector decline with tenure in the informal sector job – this has implications for estimating and importantly explaining wage differentials between identically educated and skilled workers in the two sectors.

39 The labour market in Developing countries: Wasted opportunities? Survivalist activities These are generally activities that provide workers with the means to survive, e.g. eat once a day. Characterised by street vending and hawking. Examples from Africa include selling single cigarettes on the side of the road, selling individual sweets, selling curios, fruit and vegetables, car parking attendants. This activity is highly uncertain in nature, is informal, can be subject to turf wars, or individual fights and is highly competitive. There are few taught skills in how to grow the enterprise. Few if any street vendors have access to any micro-finance or financial markets in order to invest in stock – this needs to be addressed in order to take advantage of the entrepreneurial spirit, but HOW?

40 The labour market in Developing countries: Wasted opportunities? (5) Some Evidence of Dualism in LDC labour markets Case study evidence includes: Gindling (1991, Economic Development and Cultural Change) Tannen (1991, Economic Development and Cultural Change). William Maloney, Are labour markets in developing countries dualistic?, and other working/research papers for the World Bank.

41 The labour market in Developing countries: Wasted opportunities? Gindling (1991) uses a multinomial logit approach followed by a earnings equation approach to test differences in what determines employment and earnings in and urban area of Costa Rica.

42 The labour market in Developing countries: Wasted opportunities?

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44 Work by Maloney indicates that there is little evidence in the labour economics literature of dualism. He argues that (particularly in South America) workers choose to work in the informal sector rather than formal sector. Reasons include: (1) low opportunity cost of working in the informal sector relative to the formal sector since education and thus productivity is low (2) formal sector workers pay implicit taxes that adds to the cost of being employed in this sector.

45 References Keijiro Otsuka and Yujiro Hayami, (1988), Theories of Share Tenancy: A Critical Survey, Economic Development and Cultural Change Vol. 37, No. 1 (Oct., 1988), pp Fafchamps, M., (1997), Introduction: Markets in Sub-Saharan Africa, World Development, Vol 25(5), pp Porter and Phillips-Howard (1997), Comparing contracts: an evaluation of contract farming schemes in Africa, World Development Vol 25(2), pp Arthur Lewis (1954), Lewis, W.A. (1954) 'Development with unlimited supplies of labor', Manchester School of Economics and Social Studies, 20: or go to Schneider, Friedrich and Dominik Enste (2000): Informal Economies: Size, Causes, and Consequences, The Journal of Economic Literature, 38/1, pp Taubman, P., Wachter, M. (1993) Segmented Labor Markets, in Ashenfelter, O., Layard, R.(1993) Handbook of Labor Economics, vol.2, Amsterdam: Elsevier Science Publishers, Leavy, J., and White, H., Rural Labour and Poverty in Sub-Saharan Africa, from Institute for Development Studies, University of Sussex website, T. H. Gindling, (1991), Labor Market Segmentation and the Determination of Wages in the Public, Private-Formal, and Informal Sectors in San José, Costa Rica, Economic Development and Cultural Change Vol. 39, No. 3 (Apr., 1991), pp Michael B. Tannen, (1991), Labor Markets in Northeast Brazil: Does the Dual Market Model Apply? Economic Development and Cultural Change Vol. 39, No. 3 (Apr., 1991), pp William Maloney, Are labour markets in developing countries dualistic?, and other working/research papers for the World Bank.


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