The labour market in Developing countries: Wasted opportunities?

1
The labour market in Developing countries Wasted
opportunities?
2
The labour market in Developing countries Wasted
opportunities?

• 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
Physical Productivity
Hp
Hp
Hr
Hr
Health units
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)
W3
W2
W1
Physical Productivity
W1gtW2gtW3
Health units f(wages)
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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. 227-238.

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.

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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.
• WpgtWc
• 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
• GgtN(Wp-Wc) then shirk
• WpgtWcG/N, then no shirking
• GltN(Wp-Wc) then not shirk

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 gt Certain rural wage, then urban to rural
  migration will occur until the expected wages are
  equalised.
• Formally this means that
• (1)

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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)
• EuUrban formal sector employees, LuUrban
  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 lt 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, 1980-1995
  1980 1986 1990 1993 1994-95
Kenya 9.3 9.0 9.1 9.1 9.2
Tanzania 2.0 1.7 4.3 4.8 4.0
Uganda - - 10.8 9.4 9.2
Zambia 12.2 - - 7.9 7.3
Zimbabwe 29.9 25.2 24.7 23.9 20.8
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
ATC2
Costs/Revenues
ATC
LOSS
ATC
MRPAR
MR2P2AR2
PROFIT
MC
MC
MC2
Output
Informal post tax increase COSTS DECLINE AS
CHEAPER LABOUR AND NOT PAY TAXES, PRICE DECLINES
TOO BUT PROFITS MADE
Formal post tax increase LEAVE MARKET TO ENTER
INFORMAL SECTOR
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
  etcmore 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
  constraintdid 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
Formal Sector Job
Informal 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
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.
High Wage
Low 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?

43
The labour market in Developing countries Wasted
opportunities?

44
The labour market in Developing countries Wasted
opportunities?

• 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. 31-68.
• Fafchamps, M., (1997), Introduction Markets in
  Sub-Saharan Africa, World Development, Vol
  25(5), pp. 773-734.
• Porter and Phillips-Howard (1997), Comparing
  contracts an evaluation of contract farming
  schemes in Africa , World Development Vol 25(2),
  pp. 227-238
• Arthur Lewis (1954), Lewis, W.A. (1954)
  'Development with unlimited supplies of labor',
  Manchester School of Economics and Social
  Studies, 20139-192.
• or go to http//www.uni-leipzig.de/sozio/mitarbe
  iter/m72/content/dokumente/568/Lewis1954.pdf
• Schneider, Friedrich and Dominik Enste (2000)
  Informal Economies Size, Causes, and
  Consequences, The Journal of Economic Literature,
  38/1, pp. 77-114.
• Taubman, P., Wachter, M. (1993) Segmented Labor
  Markets, in Ashenfelter, O., Layard, R.(1993)
  Handbook of Labor Economics, vol.2, Amsterdam
  Elsevier Science Publishers, 1183-217.
• Leavy, J., and White, H., Rural Labour and
  Poverty in Sub-Saharan Africa, from Institute for
  Development Studies, University of Sussex
  website, www.ids.ac.uk/ids/pvty/pvrurallabour.html
  
• 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. 585-605.
• Michael B. Tannen, (1991), Labor Markets in
  Northeast Brazil Does the Dual Market Model
  Apply? Economic Development and Cultural
  ChangeVol. 39, No. 3 (Apr., 1991), pp. 567-583.