The two-sector model of economic growth developed by William Arthur Lewis (1915-1991) is a classical economic model, as opposed to a neoclassical one. Lewis believed that neoclassical economics does not accurately describe the condition of economically less-developed countries (LDCs) because it assumes that labor is in short supply. Lewis’s model posited two sectors in the economy of an LDC: the modern and the traditional. The modern sector is small and uses considerable amounts of capital, whereas the traditional sector is large and not capital-intensive; very little, if any, capital accumulation occurs in the traditional sector, while a large amount of excess labor exists there-which Lewis termed the “reserve army of laborers.” Diminishing marginal product exists in both sectors, and the marginal product of labor in the traditional sector is zero. Wages in the traditional sector are equal to the total product of labor in the traditional sector divided by the total amount of labor in that sector: Wtraditional= TPLtraditional/Ltraditional. As an incentive to get people to leave the traditional sector and work in the modern sector, wages in the modern sector are somewhat higher; the wage rate in the modern sector is equal to the traditional-sector wage rate plus an added premium: Wmodern= Wtraditional + Premium. In positing this, Lewis departed from the Neoclassical theory of wage determination in that, under Lewis’s model, wages are not set by the marginal product of labor.
An increase in the amount of capital in the modern sector would increase the marginal product of labor in the modern sector and thereby increase total output there-whereas it would not affect the traditional sector at all. Thus, for Lewis, capital accumulation in the modern sector is the method for growing a less developed economy without doing any real damage to the traditional sector. According to Lewis’s model, capital accumulation in the modern sector will lead to rising incomes as well as rising income inequality-signs of economic growth and development. At some point in time, there will be enough capital accumulation that the marginal product of labor in the modern sector will equal the marginal product of labor in the traditional sector at the traditional-sector wage rate. From that point on, the two sectors become integrated, marginal product of labor begins to determine the wage rate-as in Neoclassical economic theory-and the LDC becomes a more economically developed country.
Based on the Lewis model, if a country shows a lack of economic growth and development, it means that the country needs to modernize its traditional sector by industrializing; investment of additional capital can help it do so. The World Bank attempted to implement this principle by determining a given LDC’s “financing gap”-the amount by which the country’s domestic investment did not suffice to bring about the desired levels of economic growth. This amount would then be provided to the country via foreign aid.
The Discrediting of the Lewis Model
Today, the Lewis two-sector model has largely been rejected by academic economists. Applications of the Lewis model in the form of giving foreign aid to LDCs in an attempt to develop their modern sectors failed to bring about desired growth targets; in fact, many Sub-Saharan African countries are now economically worse off today than they were when the giving of foreign aid began. Of all the countries where the Lewis model was implemented, it achieved the predicted results only in Tunisia. This success could have occurred by sheer coincidence even if the Lewis model were absolutely wrong (Easterly 2002, in The Elusive Quest for Growth).
The studies of William Easterly have shown no statistical association between amount of foreign aid given to a country and actual investment that occurred in that country, as well as no association between investment in a country and economic growth in that country. According to Easterly, “there is no statistical association between growth in one four-year period and investment in the previous four-year period” (Easterly 2002). It is not even the case that investment is necessary but not sufficient to economic growth. “Nine-tenths of the countries examined in Easterly’s research violate the ‘necessary’ condition” (Easterly 2002) and have achieved economic growth without the prior investment that the Lewis model would predict as being necessary for such growth.
The Lewis model fails to address institutional problems in LDCs that prevent the use of foreign investment to stimulate economic growth. The research of Peter Bauer has shown that the economic problems of LDCs are not natural to them, but are rather a result of deeply flawed institutions-including enormous bureaucracies and highly interventionist states, a legacy of big colonial administrations. Governments of LDCs tend to crack down on private entrepreneurship and economic initiative and use foreign aid to enrich government officials and empower the state. In this sense, foreign aid can actually restrain and cripple economic growth rather than encourage it.
Lewis’s model was largely a formalization of Soviet development economics; the breakdown of the Soviet Union provided an empirical example of the failure of this approach to economic development and further discredited the Lewis model. By 1990, “almost everyone… had belatedly realized that the Soviet Union was still a poor country, not ‘an industrial power of the first order'” (Easterly 2002). Thus, the country whose policies inspired the Lewis model was shown to have been harmed by those very policies.