THEORY OF UNLIMITED SUPPLY OF LABOUR

THEORY OF UNLIMITED SUPPLY OF LABOUR

    Prof William Arthur Lewis, a British economist, in 1954 developed a very systematic theory of economic development with unlimited supply of labour. Like the classical economists, he believes that in many UDCs an unlimited supply of labour is available at a subsistence wage. Economic development takes place when capital accumulates as a result of withdrawal of surplus labour from the subsistence sector to the capitalist sector. Lewis started his theory with the assertion that the classical theory of perfectly elastic supply of labour at a subsistence wage holds true in case of a number of UDCs.  Such economies are overpopulated relative to capital and natural resources so that the marginal productivity of labour is negligible, zero or even negative. Since the supply of labour is unlimited, new industries can open without limit, at current wage, by drawing upon labour from the subsistence sector.

    Now the question is what determines the subsistence wage at which the surplus labour is available for employment in the capitalist sector? It depends upon the minimum earnings required for subsistence. The wage cannot be less than the average product of the worker in the subsistence sector. It may however be more than that if the labourers are to pay higher rents or food costs in industrial areas / towns. Though earning in the subsistence sector set a floor to wage in the capitalist’s sector, yet in practice the wage is more in the capitalist s sector.

    Capitalists aim at profit maximisation. It is they, who save and automatically invest. Since the marginal productivity of labour in the capitalist sector is higher than the capitalist wage, this results in capitalist surplus. The surplus is reinvested in new capital assets. Capital formation takes place and more people are employed from the subsistence sector. This process continues till the capital labour ratio rises and the supply of labour becomes inelastic and surplus labour disappears. The capital formation depends on capitalist surplus. The Lewis theory can be explained with the help of the following diagram.

    The horizontal axis measures quantity of labour and vertical axis its wage and marginal product. OS represents the average subsistence wage in the subsistence sector and OW the capitalist wage.

At OW wage in the capitalist sector, the supply of labour is unlimited, shown by the horizontal supply curve of labour WW. In the beginning, Oa  labour is employed in the capitalist sector, its marginal productivity is N₁Q₁ and total output OaQ₁N₁. Out of this, workers are paid wage equal to the area OWQ₁a.  The remaining area WN₁Q₁ shows surplus output. This is the capitalist surplus or the total profits earned. When the surplus is reinvested, the MP curve shifts upwards to N₂Q₂. The capitalist surplus and employment are now larger than before as WN₂Q₂ and Ob. Further reinvestments raise the MP curve and employment to N₃Q₃ and Oc and so on till the entire surplus labour is absorbed in the capitalist sector. After this, the supply curve WW will slope from left to right upwards like an ordinary supply curve and wage and employment will continue to rise with development.

    Thus, capital is formed out of profits earned by the capitalists. To Lewis, if technical progress is capital saving, it may not be considered as an increment in capital and if it is labour saving, it may be considered as an increment in the marginal productivity of labour. The technical progress tends to raise profits and increase employment in the capitalist sector.

Role of the State and Private Capitalists:  In UDCs, only 10% of the people with largest income save, who receive about 40% of N.I. The wage and the salary class hardly save 3% of N.I. The state capitalist can accumulate capital faster than the private capitalists since they can tax out of subsistence sector. Once a capitalist sector emerged it is only a matter of time before it becomes sizable.  So state capitalist and indigenous private capitalists create capital out of profits earned.

Capital Formation through Bank Credit:  Capital is created not only out of profits but also out of bank credit. In an UDC, which has abundant idle resources and shortage of capital, credit creation has the same effect on capital formation like profits. It will raise output and employment.  It may lead to inflationary rise in prices in the short run. In the long run, prices will fall as soon as capital goods start producing consumer goods.

End of Growth Process:  The theory shows that if unlimited supply of labour is available at a constant real wage and profits are reinvested in productive capacity, profits and capital formation will grow relative to N.I. But the process of growth cannot go on indefinitely. Once the surplus labourers are no more capital accumulation will stop. If the subsistence sector adopts new technique, real wage would rise in capitalist sector and surplus would reduce. If the capitalist sector expands so rapidly that it reduces the population in the subsistence sector, the AP will rise and SS and WW will rise and reduce profits.

In Open Economy: When capital accumulation is adversely affected in the domestic economy, it can continue by mass immigration or by exporting capital to UDCs with abundant labour at subsistence wage. But Lewis himself ruled out these possibilities. The mass immigration of unskilled labourers will be opposed by trade unions of high wage countries.

Criticisms:

    1 .The theory assumes a constant wage rate in the capitalist sector until the supply of labour is exhausted from the subsistence sector. This is unrealistic because the wage rate continues to rise over time in the industrial sector in the UDC even when there is open unemployment in its rural sector.

    2. Lewis assumed that capitalist surplus is reinvested in productive capital. But to Raynolds, if the productive capital happens to be labour saving, it would not absorb labour and the theory breaks down.
Skilled labourers in UDCs are not temporary problem as stated by Lewis, but pose a serious problem.
In UDCs, there is lack of enterprise and initiative to accumulate capital.

    3. As the multiplier process does not operate in LDCs properly, profits may be reduced and capital accumulation may stop before the surplus labour is absorbed.

    4. This is one sided theory as Lewis did not consider the development of agricultural sector.
Higher wages may not attract labour sufficiently as mobility of labour in the village is less.

    5. It is not correct to say that only the top 10% of the income earners save as the people with low income also save.

    Despite these limitations, the Lewis theory has the merit of explaining in a clear way, the process of development. It explains how capital formation takes place in UDCs where there is abundance of labour and scarcity of capital.