Lewis model and China:

Theory and Application

Eliot Oh

Professor Carl Riskin

China’s growth pattern and the Lewis model readily go together. China’s rapid

urbanization and capital accumulation fits the results of the model and its large agricultural

population is consistent with the unlimited supply of labor assumption. The Lewis model,

however, is deceptively simple and adding a few extensions makes its application progressively

more complicated. With these extensions, China may not meet every criteria of the model and it

is difficult to determine whether the model is fully applicable or not. In this paper, I will address

the applicability of the model and its extensions to the Chinese circumstances. The first section

will explain the model in its simplest form and then apply it to China. The second section will

extend the model to include bank credit and state intervention. The final section will discuss the

Lewisian Turning Point (LTP), its causes, and implications on income inequality.

Lewis Model

The simple version1 of the model postulates a rural and manufacturing sector in a closed-

economy. The central assumption is the unlimited supply of labor, meaning that all levels of

labor demand can be met without wage increases. Initially, in the rural sector, the marginal

productivity of labor (MPLA) is near zero and thus a constant near-subsistence wage is

assumed for each worker. In the manufacturing sector, the capitalists are assumed to invest all

profits into hiring and full-employment is achieved in the urban areas. As the manufacturing

sector expands, it needs to attract rural labor that will choose to migrate because of the premium

to their existing earnings . Due to the unlimited supply of labor, rural to urban migrations will

continue without leading to wage increases, leading to an overall capital accumulation process.

1 The basic assumptions of the simple version are fairly straightforward and will not be covered. Assumptions such as an existence of a currency,

basic commodities markets, information channel between the two sectors, and some transport infrastructure can be readily assumed in most countries and the important question is on how well-developed and efficient they are.

Historical conditions

China’s historical condition follows the model in a number of ways. First in the rural

sector, the initial conditions meet the unlimited supply of labor, low MPLA, and near-subsistence

earnings criteria. Second, large-scale intersectoral migrations contributed to the capital

accumulation process.

In the wake of the reform period, over 80% of the population lived in the countryside and

lived in poor conditions. The high birth rates from 1949 to the early 1970s and the tens of

millions of relocated urban youths created a virtually unlimited supply of labor and drove down

MPLA to an inconsequential level.2 The lack of proper access to tractors and fertilizers and the

lack of proper incentives further depressed MPLA. Due to the extremely labor-intensive nature of

agriculture, it was virtually impossible for additional workers to raise agricultural production,

while the equal pay system discouraged anyone from working harder than the absolute

minimum.

Through the 1980s, large-scale migrations led to capital formation without raising the wage

rates. The first wave of migrations were not rural to urban migrations, but were intersectoral

migrations from farms to the Town and Village Enterprises (TVEs) which usually located in

rural areas or in small cities. Due to their free nature, the TVEs played an important role in

inducing migrations throughout the 1980s. Unlike to the tightly regulated State-owned

Enterprises (SOEs), the TVEs were not part of the state planned economy, but could supply the

market demanded amount at monopoly prices and had a high profit margin. In addition, they

were more efficient than SOEs and at their high level of marginal return to capital enabled them

to absorb a large portion of the rural labor surplus.3 As local governments saw them as vehicles

2 Even though the population increased from 648 million to 924 million from 1960 to 1975, grain per capita output fluctuated around 100

kilograms per year, demonstrating that MPLA was indeed very low.3 According to Zhang and Tan (2007), the average labor productivity growth of from rural non-farm enterprises is 11.9 from 1978 to 2001, while

for the urban industry it is 8.9%. The productivity growths for TVEs and SOEs are most likely lower than these numbers as they include private

to eradicate regional poverty, they actively defended them against any detrimental central

policies. Both features enabled TVEs to expand rapidly, growing from only 9% of industrial

output in 1978 to 28% in 1996, and to employ more rural laborers, employing 4.9% in 1985 and

7.3% of the rural population in 19954. In addition, Dacosta and Carroll (2001) found that TVE

investment rates had a positive correlation to the particular province’s economic growth,

inferring that TVE capital accumulation played a significant role in output growth. Data on

worker wages in TVEs are not available and must have varied by region, but given the increasing

investment rates, they can be assumed to have been near constant. However, by the early 1990s,

subject to growing competition, TVEs could no longer absorb all the surplus labor and rural

laborers were forced to migrate to industrialized cities, in particular, the export-oriented regions

near the southern coast. Since then, interprovincial migrations5 have increased from around 3

million in 1990 to nearly 40 million by 2000, while migrant worker wages have remained fairly

constant6.

These migrations, however, would not have been possible had government regulations on

migrations not been relaxed. Throughout the early 1980s, the central government strictly limited

any rural workers from engaging in any other occupation. Gradually, they allowed rural workers

to work in TVEs, a measure which increased intraprovincial migration and in the early 1990s

allowed rural workers to migrate to the cities, a measure which increased interprovincial

migration. Throughout the 1990s, the government changed its stance from allowing migration to

actively encouraging it. In the early 1990s, a number of county-level experiments were

enterprises, however, the labor productivity for TVEs will still be higher than that of SOEs.4 I was unable to find any reliable estimates for the rural labor surplus. Although many studies have attempted to estimate the rural labor surplus,

each uses a different estimation technique and has widely divergent results. The state estimation records a slight increase in rural surplus labor from the late 1970s to the mid-1990s, but Rawski and Mead (1998) point out that the state overestimates the numbers. 5 Interprovincial migrations, for the most part, refer to rural to urban migrations. The majority of China’s developed cities are in the coastal

regions and migration to those regions would be classified as interprovincial migrations.6 Due to the lack of statistics on migrant workers, it is hard to determine how their wages have changed. However, in 2005, Li Deshui, the former

commissioner of the National Bureau of Statistics believes that the wage level of migrant workers has not changed over the past 20 years. (People’s Daily Online 2005)

conducted to develop rural human resources for later migrations. Local governments began to

issue more temporary living certificates to migrant workers and in 1998, the central government

issued a regulation stating that migrants with legal housing, employment, and living more than

one year at destination place were allowed to move their household registration. At the same

time, enforcement of the Hukou System was relaxed, allowing rural workers to more freely

migrate. Ever since, rural to urban migrations have been a significant phenomenon in China and

migrant workers currently account for 19% of the rural population.7

Extensive version

The more complicated version extends the model to include bank lending and state

intervention. Each extension will include additional assumptions that may alter the results of the

simple model.

The first extension enables banks to lend money to firms. This assumption has an

important connotation, since firms are no longer limited to their profits in creating additional

capital. Previously capital creation came about through profits and at the expense of

consumption. Now capital accumulation can occur without affecting consumption. In addition,

introducing bank credit makes the stability of the banking sector more important to the

mechanism of the model, since any instability in the banking system can disrupt the capital

accumulation process. Finally, it makes the model more consistent with reality, as in reality bank

lending finances a large portion of the capital accumulation process.

In order to assume bank stability, two conditions must be met. First, the bank must be able

to accurately assess the default possibilities and charge a risk-adjusted interest rate. Second, in

7 National Bureau of Statistics 2007. All data without specified sources derive from the National Bureau of Statistics book or The Chinese

Economy: Transitions and growth by Barry Naughton

response to the bank rates, the firm must be able to calculate the time-discounted future returns

from its investment and make a profit after paying off its loans. Overall, both the firm and the

bank must accurately price potential risks and reserve enough capital for the worst-case scenario.

A well-functioning risk market, however, is not a readily applicable assumption, even in the

most developed banking sectors as evidenced from the 2007 sub-prime loan crisis and the 2008

liquidity crisis.

This is particularly true if both the firms and the banks are owned by the state. Due to

political reasons, banks might lend to unsound companies at rates that do not reflect credit risks.

If the banking sector is forced to supply cheap credit, the corporate sector will be encouraged to

take unnecessary loans and invest in riskier assets, as demonstrated in the sub-prime loan crisis

of 2007 which resulted from the Federal Reserve holding down interest rates for an extended

period of time. In addition, the soft budget constraints, the implicit assumption of state assistance

if the firm is in trouble, will undermine firm incentives to become competitive. Both processes

work together as banks are usually forced to lend to companies who are uncompetitive as a result

of their soft budget constraints. The miscalculation in relevant risks will disrupt capital

accumulation for two reasons. First, it will divert resources towards unprofitable projects that

will drain overall profits and displace workers who had they been part of a profitable project

would be contributing to the capital accumulation process. Second, if the mispricing is

significant, the bank may go bankrupt and all of its assets will have to be sold at a fraction of its

face value. Since most banks accumulate a large amount of debt, one bank defaulting can cause a

whole wave of defaults, if its liabilities are high and the recovery rate of its assets are low. As a

result, bank credit tightens and even the most competitive firms might not be able to receive

loans. Even though the state can step in to recapitalize the banks, during that process, banks still

will be conservative in their lending, an attitude that will under allocate capital and negatively

affect the capital accumulation process.

The next extension8 assumes the production of heterogeneous goods in the two sectors and

the state intervention in the market. First, we will assume the rural sector to produce food, the

urban sector to produce manufactured goods, and both sectors to engage in trade. Second, the

state will have monopoly power over the price of urban goods and wages. Since the state’s

objective is to promote rapid capital accumulation and wages are the only expenditure, the state

will want to suppress urban wages, a measure that cannot be done without lowering rural

earnings. The cycle will be as followed. The state seeks to lower wages to the minimum level at

which rural to urban migration will occur. Since lowering rural earnings enables the state to

lower wages without disrupting migration, the state will set the price of urban goods to a high

level which will adversely affect the rural sector’s terms of trade. The price of food will decrease

and the farmer’s income will decrease. Essentially, by squeezing the rural sector and the urban

workers, the state is able to speed up capital accumulation.

Applying the Lewisian extensions

Applying the bank credit extension focuses the issue on the existence of an efficient

banking sector. In China, bank lending still accounts for 78.1% of all funds raised through the

financial market, while equity and debt issuance account for only 12.4%9 and state presence in

the sector is quite significant. The main issues of efficiency deal with the bank’s ability to make

“good lending decisions” and state intervention in the banks.

8 Extending the model to include technological progress, importation of foreign capital, and a high household savings rate adds little insight to the

overall model. All three extensions do not affect wage rates and merely speed up the capital accumulation process, due to the unlimited supply of labor. The other three extensions are mere experiments that validate the strength of the unlimited supply of labor concept. In addition, the international trade extension will not be addressed due to space limitations.9 Naughton. (2005) Treasury bonds account for the remaining 9.5%.

“Good lending decisions” simply refer to the bank’s ability to price and manage credit

risks of the loans. It requires a profitable business model, internal oversight, proper incentives,

and overall supervision, three of which China’s banking sector lacks. The current business model

profits solely from the interest rate differential between the lending and savings rate. The model

yields steady profits because the state artificially holds down deposits rates10 and determines the

interest margins. At the same time, the other three factors undermine the efficiency of Chinese

banks. First, the internal oversight of individual loans is not capable of managing a large volume

of sub-standard loans. Once the loans are granted, there is in general a lack of oversight over

them. Procedures for assessing changes in creditworthiness are limited and the proper definition

of non-performing loans (NPLs) differs among institutions. Second, the incentive structure

rewards only higher loan volume, but not the proper assessment of evaluating future risks. In

addition, the low salaries of the loan officers and managers provide incentives towards

corruption, a major cause for the increase of non-performing loans. Third, the sector lacks

overall transparency and disclosure rules as well as accounting standards. It is not difficult to

move a large portion of loans or loan-related financial derivatives off the balance sheet to

disguise the bank’s financial health.

However, the biggest risk to efficient lending derives from a large state presence that can

distort loan issuances for political reasons. Most banks in China are owned by the state, a fact

which brings in the role of politics into the lending decision. The non-performing loans crisis in

the late 1990s demonstrates the potential of the three reasons to balloon into a debt crisis. The

initial cause, although is still debated in academia, points towards the state’s influence on the

banking sector to finance many otherwise bankrupt SOEs. Due to fixed prices and a soft budget

constraint, SOEs had little control over and lacked incentives to maximize profits. As a result, by

10 China’s deposit rate is very low compared to other developing countries.

1985, SOEs suffered through negative pre-tax cash flows. Yet for numerous reasons11, the state

wanted them to continue operation and use cheap credit from the banking sector to support

them.12 Many of these loans were economically unsound and later became non-performing loans.

According to Lardy (1998), the four major banks which accounted for 54% of all bank assets and

liabilities had 860 billion RMB worth of non-performing loans by the end of 1995 out of the 3.9

trillion RMB worth of loan outstanding, an NPL to loan ratio of 22%. The ratio probably

increased by 1998 as two-thirds of all SOEs reported negative profits that year. If the NPLs

defaulted with an average probability of 50%, a relatively low probability given the bad financial

conditions of the SOEs, the fours banks would need an 11% reserve requirement to stay solvent,

a relatively high proportion given that banks have a high debt-to-equity ratio. The previously

mentioned three reasons were also in play to further exacerbate the crisis. As a result of the NPL

crisis and low profitability of SOEs, from 1992 to 2000, total capital formation as a percentage of

GDP steadily declined from 40% in 1992 to 32% in 2000. Fortunately, the central government

stepped in to recapitalize the banks and restructure the SOEs, measures that raised capital

formation rates back to 1991 levels. Yet, as of 2004, NPLs, according to the China Banking

Regulatory Commission, still account for 13% of total loans. With the major causes of the late

1990s crisis still intact, another NPL crisis can arise and it is not for sure how much it will drive

down the capital formation rate.13

The state intervention extension will be structured into two parts. The first part will deal

with if China has shifted the terms of trade against the rural sector to move agricultural surpluses

to the manufacturing sector. The second part will deal with whether China suppressed

11 Several theories (Brendt and Zhu, 2000) may explain China’s continued employment growth in the state sector. First, the social welfare system

in urban areas is organized around SOEs. Second, governments obtain political benefits from SOEs. By providing employment and above-market wages in state-owned firms, the government builds up political capital in them. As a result, the government is reluctant to shut them down.12

By 1993, the portion accounted for 3% of GNP (Brendt and Zhu, 2000)13

Due to the lack of data, I will not cover the potential of another NPL crisis arising from the 2008 stimulus package in China. Various estimates differ vastly on the volume of NPLs ranging from a negligible sum to a large sum that could trigger the second NPL crisis.

manufacturing wages to bring down rural earnings. Since its early years, the PRC has squeezed

out the rural sector in favor of the manufacturing sector. From the late 1950s to the late 1970s,

collectivization sought to extract as much agricultural surplus out of the farmers. It would

procure all food production at a below market fixed price and sell it at a higher price in the urban

areas, putting the differential revenue into capital accumulation. By the late 1970s, the measure

virtually eliminated any agricultural surplus and the state needed to revive the surpluses to

transfer them to the manufacturing sector. Consequently, in the late 1970s, agricultural reforms

preceded industrial reforms and allowed the farmers to keep the surpluses after procurement. The

reform was widely successful and increased rural income by 15% from 1976 to 1985. From the

mid-1980s, as the agricultural surplus surged, the state began to focus on manufacturing sector.

However, it did not need to forcibly extract surplus from the rural sector, as it still bought food at

the below-market fixed prices and could transfer those gains towards investments. This act of

squeezing14 the farmer did not negatively affect agricultural production as farmers had control

over any additional harvest beyond the procured amount, but nevertheless speeded up the capital

formation process.

Applying the second part is a bit more complicated. First even though “urban wages/

manufacturing wages” have previously referred to the wage of anyone working in the urban area,

in the Chinese reality, the wage markets for an urban worker and migrant worker are separate.

Second, migrant workers produced export good which had no direct effect on the terms of trade

with the rural sector. Third, the lack of compiled statistics or estimates of migrant wages prior to

2001 also makes the extension difficult to make. To account for reality, different labor markets

for urban and migrant workers and international trade would have to be introduced to the model.

14 China no longer relies on the active suppression of agricultural surpluses to increase capital formation. Since the mid-1980s, the price

restrictions have relaxed and by the 1990s, more than 90% of all traded goods have a market price.

However, due to the complexity of introducing these assumptions, I will assume that migrant

workers and urban workers belong to the same labor market, produce homogenous goods, and

trade only with the rural sector. Under this assumption, Lin and Yu (2008) have found that both

the first and second proposition were valid in China. The weight the government put on

investment was greater than its weight on increasing worker’s welfare which was respectively

greater than its weight on increasing farmer’s welfare. Simply put, the government emphasized

capital accumulation at the expense of consumption. A large portion of the decrease in

consumption came about through the reduction in urban wages rather than the suppression of

rural income and active suppression of urban wages and rural earnings did play an important role

in China’s capital accumulation process.

Lewisian Turning Point

The Lewisian Turning Point comes about when the economy is no longer able to sustain

the unlimited supply of labor. It becomes replaced by the classical limited supply of labor and

the labor supply curve changes from a perfectly elastic one to a perfectly inelastic one that leads

to increases in wages as the demand for labor increases. Capital and output growth, following the

Solow model, will continue to increase, but will be lower than before due to higher wages and

will gradually decrease until all investments become depleted by the depreciation in capital and

population increase. The LTP may arise for three possible reasons, all discussed in Arthur Lewis’

1954 article. The first reason is that capital accumulation rates might outpace population growth

and deplete the unlimited supply of labor. The second is that the terms of trade might shift in

favor of the rural sector and raise rural earnings. The third reason is that technological

development can raise MPLA to level equal to urban wages. There is no comprehensive reason

for why a LTP comes about and in this section I will explore each possibility.

The first possibility is a demographic reason in which case population growth is unable to

support the unlimited supply of labor assumption. In the model, capital accumulation is

dependent on the large waves of migration to supply the manufacturing sector’s need for labor.

Once capital accumulation rates outpace population growth, the physical number of people in the

rural sector will decrease and their average product per capita will increase. The rise in living

standards brings subsistence earning up to urban levels. In order to attract additional labor, wages

will increase which will further decrease the rural population and again increase the average

product per capita. Wages and rural earnings both increase throughout the cycle and the classical

limited supply of labor assumption holds. Subsequently, following the Solow model, capital

accumulation will continue until all investments are used up to account for depreciation and

population growth.

The second possibility concerns the shift in terms of trade to the rural sector. Let us go

back to the second extension of the two sector’s engagement in trade and assume no state

intervention. Due to higher wages, rural workers will migrate to the urban sector and assuming

there is no productivity gain in agriculture, food demand will increase faster than the food supply

does. The rising food demand will increase the relative price of food and shift the terms of trade.

As food prices increase, rural earnings will increase and eventually equalize with urban wages.

The capitalists then will have to raise wages to attract additional labor and will have less to

invest with. The wage increase will increase the demand for food and shift the terms of trade to

more favor the rural sector. The cycle will continue until capitalist profits are dissipated by wage

expenditures, capital depreciation, and population growth.

The third reason concerns the productivity gains in agriculture. Assume that the rural

sector learns of new management techniques from the capitalist sector or get a hold of new seeds

or fertilizers. Putting in the same number of hours, farmers can now produce more agricultural

goods and MPLA will increase as well as rural earnings. If the productivity gain is a one-time

phenomenon, wage will remain steady at the increased rate. If, however, the rural sector

experiences sustained productivity gains, wages will continually increase, as MPLA and rural

earnings rises. The cycle will continue until all profits are used to pay wages, replace depreciated

capital, and provide for the newborn population.

LTP in China

Recent wage increases since the early 2000s have brought some to argue that China is at its

LTP. (Cai, 2008) Migrant worker wages that had been fairly constant for thirty years have been

increasing rapidly, particularly in the export-oriented regions of Guangdong and Shenzhen. In

response, according to Cai (2008), wages have substantially increased from 644 nominal yuans

per month in 2001 to 1015 yuan per month in 2007, a 37% increase in six years and an average

annual increase of 7.8%. Despite the financial crisis in 2008, these trends remain largely

undisrupted.15 In this section, I will apply the LTP scenarios to China’s circumstances and

examine which scenario is the most well suited one.

Low population growth is definitely a plausible reason, as China has been experiencing

low birth rates since the early 1980s. The central argument lies in the declining support ratios

and the decreasing rural population. The support ratio is the ratio between the working age

population and the elderly and refers to how many working age people it requires to support an

elderly person. A high ratio signifies an abundant supply of labor and a decreasing burden of

15 New York Times online. “Defying Global Slump, China has Labor Shortage.” (2010)

support, while a low ratio signifies lower supply of labor and a greater burden of support. Due to

the high birth rates until the early 1980s and increasing life expectancy16, China’s working

population has increased by a rate of 2% between 1982 to and 2005. At the same time, China’s

support ratio has increased from a little over 1.0 to 1.35 and as Mason (2008) indicates, the

increase in working age population probably17 made a significant contribution to a country’s

growth. The downside to this is that the baby boomers will one day retire and have to be

supported by a smaller future generation. According to (Feng and Mason, 2008), the support

ratio is expected to plateau at around 2013 and gradually decline until 2025 when it begins a

rapid decline. All these facts point to a large elderly population supported by a smaller working

age population. Numerically, the working age population cannot fill in for all the jobs the elderly

once held and the capitalists will have to rely on increasing rural to urban migration to fill in for

the gap. The rural demography, however, is even more discouraging than that of the urban

sector. The growth of working-age population has decreased from 2000 to 2005 at -0.1%, a rate

expected to accelerate in the future.18 According to (Cai, Du, Wang, 2009), the predicted

probability of migration by age for all educational categories is declining rapidly with age.

(Figure I) Migration probabilities are highest for those with the most education, but since this

category is not too large, the total number of predicted migrants will consist of only 13% of the

total rural labor force. Rural migrations will not be able to fill in the labor void and a large wage

increase will be necessary, a change that will bring down capital accumulation.

The second possibility, the shift in terms of trade, has been thwarted due to direct state

intervention. It is in the state’s interest to promote development at the expense of agriculture and

16 Normally, increasing life expectancies would increase the elderly population, but in China in the 1970s average life expectancy was in the

early 40s and an increase in life expectancy increased the number of working age population.17

Mason estimates the contribution of the increase in working age population in East Asian economies. The same logic can be carried over to China.18

Naughton (2005)

as shown in the second extension and its application, the state has intervened to prevent the terms

of trade from favoring the rural sector. Not all can be attributed to direct state intervention as the

surge in food production played an important part. If the growth in agricultural production was

greater than the rate of urbanization, the price gap between food and manufactured goods will

not rise too dramatically, due to the abundant supply of food. Since the government has restricted

urbanization throughout the 1980s and some parts of the 1990s, the urbanization rate has not

increased very rapidly.19 At the same time, in the late 1970s, it enacted the “household

responsibility system” which increased agricultural productivity by contracting individual pieces

of land to rural households. As long as a certain amount of the harvest was paid, each household

could sell their surplus at the market. Consequently, faster growth in agricultural production than

the urbanization rate eased the government’s role of maintaining favorable terms of trade to the

urban sector and enabling the capitalist sector to maintain high investment rates.

The third possibility, productivity gain in agriculture, has played a supporting role in

easing the government’s role in suppressing food prices. The increase in agricultural production

by nearly a third between 1978 and 1984 can be attributed largely to productivity gains. During

the same period, the use of mechanical power, fertilizer and the total irrigated land increased by a

factor of two, enabling fewer workers to produce greater output20. Despite these increases, the

rural to urban income gap, the prime motivator for migrations, has widened since 1986. In 1986,

rural workers, on average, earned 49% of what urban workers earned, but by 2004 they only

earned 31% of what urban workers earned.21 According to Zheng and Tan (2007), the increase in

labor productivity in urban industries has surpassed rural productivity growth rates by a near

19 Urbanization rates increased from 17% to 28% from 1978 to 1995. Comparatively, Korean rates from 1955 to 1975 increased from 24.5% to

48.4%.20

In per capita terms, agricultural output grew from less than 1000 kilograms of grain per year in 1977 to 200 kilograms per year by 198821

Naughton (2005)

factor of two (8.9% vs. 4.7%) In addition, marginal product of labor in the agricultural sector

stagnant compared to that of the urban industry. (Figure II) Its effect on capital accumulation

has been indirect and therefore it is difficult to conclude that the productivity gains played a

major role bringing about the LTP.

Implications

In all three instances, the mechanism is clear that an improvement in rural earnings will

increase urban wages which will lead to a LTP. Simply put, in order to prevent the LTP from

coming about, rural earning must be suppressed and those surpluses transferred to the urban

sector and only when that process is no longer possible does a LTP come about. The state

intervention policy has largely done this. However, since the rural sector has lower income than

the urban sector, the transfer of surpluses carries an income distribution connotation. The

Lewisian trajectory accompanies the Kuznets curve. Initially, the transfer of agricultural

surpluses suppresses the poorest population’s income, while it raises the capitalist’s, the richest

population, income. Income inequality therefore rises, a process denoted by the first half of the

Kuznets curve. At the LTP, rural income rises at the expense of the capitalists and income

inequality begins to fall, a process denoted by the second half of the Kuznets curve.

Applying the matter to China, income inequalities have not decreased yet as China is still

in its initial stage of the LTP, but is expected to gradually decrease. These results will largely

fulfill the rebalancing policies aimed at reducing the rural-urban gap. Initially, the process will be

slow, but with continued government rebalancing policies and assuming the stability in the

banking sector, the rural-urban gap will rapidly decrease. (Figure III) The interesting question is

whether or not a slower growth rate will accompany the falling inequalities. According to the

Lewis model, it will, as inequality reduction will occur as resources are distributed from the

capitalists sector to the rural sector. The increase in rural earnings will come at the expense of

lower profits due to higher wages. Capital accumulation rate will decrease and growth will slow

down.

Conclusion

The Lewis model is a fascinatingly simple model with complicated extensions. Applying a

number of extensions has preliminarily shown that the Lewis model can be accurately applied to

China, given the stability of the banking sector. Further extensions not covered in this paper may

add some additional complications, but for the most part, the model’s central tenet that unlimited

supply of labor holds down wages and contributes to rapid capital accumulation holds in China.

In addition, that the LTP increases wages and reduce capital accumulation rates is also true, at

least from recent findings. An interesting question will be the income inequality dimensions of

the LTP. As I briefly discussed, decreasing inequalities may come at the expense of capital

accumulation. It is an interesting matter to examine that could potentially derail China off its

high growth pattern. Since the thought that China will quickly overtake US assumes continued

high growth and the LTP is directly arguing against the possibility, it will be interesting to

examine what effects the reduction in income inequality has for China, the US and the

international economic relationships.

Figure I

QuickTime™ and a decompressor

are needed to see this picture.

Figure II

QuickTime™ and a decompressor

are needed to see this picture.

Figure III

QuickTime™ and a decompressor

are needed to see this picture.

BibliographyBoyreau-Debray, Genevieve and Shang-Jin Wei. “Pitfalls of a State-dominated Financial

System: The Case of China.” Brandt, Loren and Xiaodong Zhu. “Redistribution in a Dencentralized economy: Growth

and Inflation in China under Reform.” Journal of Political Economy. Vol. 108, no. 2, 2000Bradsher, Keith. “China’s Industrial heart Facing Acute Shortage of Factory Workers.”

New York Times online. Feb. 26, 2010Cai, Fang. “Approaching a Triumphal Span.” UN research paper no. 2008/09. 2008Cai, Fang, Albert park, and Yaohui Zhao. “The Chinese Labor Market in Reform Era.”

China’ Great Economic Transformation. Edited by Loren Brandt and Thomas Rawski. Cambridge: Cambridge University Press. 2008

Cai, Fang, Du Yang, and Wang Meiyan. “Human Development Research Paper 2009: Migration and Labor Mobility in China.” UNDP Research Paper. 2009

Cook, Sarah. “Surplus Labour and Productivity in Chinese Agriculture: Evidence from Household Survey Data.”

Chu, Ng Ying, Li Sung-Ko, and Tsang Shu-Ki. “The Incidence of Surplus Labor in Rural China: A Nonparametric Estimation.” Journal of Comparative Economics, 28, 2000

Decosta, Maria and Wayne Carroll. “Township and Village Enterprises, Openness and Regional Economic Growth in China.”

Feng, Wang and Andrew Mason. “The Demographic Factor in China’s Transition.” China’ Great Economic Transformation. Edited by Loren Brandt and Thomas Rawski. Cambridge: Cambridge University Press. 2008

Findlay, Ronald. “On W. Arthur Lewis’s Contribution to Economics.” Scandinavian Journal of Economics. 1980

Kuznets, Simon. “Economic Growth and Income Inequality.” American Economic Review, 45 (1), 1955

Lardy, Nicholas. “China’s Unfinished Economic Revolution.” Washington D.C.: Brookings Institution Press. 1998

Lewis, W. Arthur. “Economic Development with Unlimited Supplies of Labour.” The Manchester School of Economics and Social Studies, Vol. 22. 1954

Lin, Justin and Miaojie Yu. “The Economics of Price Scissors: An Empirical Investigation for China.” China Center for Economic Research. 2008

Mason, Andrew and Tomoko Kinugasa. “East Asian Development: Two Demographic Dividends.” Journal of Asian Economics. Vol. 19, issues 5-6. 2008

Naughton, Barry. “The Chinese Economy: Transition and Growth.” Cambridge and London: MIT Press. 2007

Park, Albert and Kaja Sehrt. “Tests of Financial Intermediation and Banking Reform in China.” Journal of Comparative Economics. 29, 2001

Putterman, Louis. “On the Past and Future of China’s Township and Village-owned Enterprises.” World Development, Vol. 25, No.19, 1997

Rawski, Thomas and Robert Meade. “On the Trail of China’s Phantom Farmers.” World Development. Vol. 26, No. 5.1998

Taylor, Lance. “Food Price Inflation, Terms of Trade and Growth.” The Theory and Experience of Economic Development: Essays in Honor of Sir W. Arthur Lewis. Edited by Mark Gersovitz, Carlos Diaz-Alejandro, Gusta Ranis, Mark Rosenzwei. London: George Allen & Unwin. 1982

Xu, Min. “Resolution of Non-Performing loans in China.” Stern School of Business Dissertation. 2005

Zhang, Xiaobo and Kong-Yam Tan. “Incremental Reform and Distortions in China’s Product and Factor Markets.” World Bank Economic Review. 2007