FEI-RANIS THEORY

Introduction
Lewis wanted to model development in an economy with a large agricultural sector and a
small "modern" sector (e.g., manufacturing). His model was subsequently formalized by
John Fei and Gus Ranis, who ended up at Yale. John Fei Gustav Ranis in an article
entitled “A Theory of Economic Development” analyze “the transition process through
which an underdeveloped economy hopes to move from a condition of stagnation to one
of self sustained growth.” This theory is an improvement over Lewis’s theory of
Unlimited Supplies of Labor because Lewis failed to present a satisfactory analysis of the
growth of the agricultural sector. The analysis that follows is based on the original article
and the development of a dual economy.
Ranis also made the first formal empirical application, looking at Japan, which around
1960 was still a heavily agrarian developing economy. Below I develop this framework
to apply to China. First, let's remind ourselves of our basic growth model, so that we have
it always in the back of our mind.

One-Sector Model: Robert Solow, Nobel Laureate - our Cobb-Douglas version

The two-sector model is an extension of the standard growth model with which we've
worked.

To help understand its structure, think of the starting point as subsistence economy in
which everyone is in agriculture, living a hand-to-mouth existence. For non-agricultural
output to increase, then, there has to be a surplus of resources above subsistence, so that
not all activity has to focus on agriculture.
For clarity, think of an economy where all manufacturing and commerce is located in a
city.
Two-Sector Model: W. Arthur Lewis, Nobel Laureate

In reality, during the last millennium agricultural by-employment was the norm. Farmers
(and their wives) were also weavers or basket weavers or carpenters or raised silkworms.
In the US they were shoemakers or clockmakers, while women canned food and sewed
garments Indeed, in many places a "putting out" system developed, where a merchant
would supply materials to households specialized in various stages of production, who
were dispersed about the countryside. This was a viable alternative to gathering laborers
at a central workplace, especially as it facilitated switching back and forth from farm
tasks to manufacturing as the daily agricultural cycle varied. Of course, it also required
high levels of inventory of goods in process, and controlling quality could also be
problematic. Furthermore, organizing the delivery and picking up of goods was hard. But
until recent decades such "proto industry" was often the dominant organizational form for
the production of many goods.

But in order to free up labor for such activities, agricultural productivity has to rise. From
a starting point where the entire population is farming full-time, let's say that better
implements are invented - a metal-tipped hoe - which allow a field hand to do more work
per hour. Then that worker can spend the time that is freed up on other, non-agricultural
tasks. Indeed, he or she can even move to the city, to formal industry. Higher productivity
allows labor to be pulled out of agriculture, with food flowing to the city as well as labor.
It's even better if land productivity rises - more food per hectare - because then some of
the land can be devoted to cotton or other non-food crops (mulberry for silkworms to eat;
fiber crops for rope & twine; grain for animal feed), which serve as inputs to industry.

Below are a series of queries, to get you to think through the model.

 The Engel curve

The share of income spent on food as income per capita rises.

 Think about the demand for food. How much more rice does a wealthy person
eat? What then happens to total demand for food as income rises? If there is
an increase in the total output of food, ceteris paribus, what then happens to
price?

 More generally, as China grows, what happens to the relative share of

agriculture in the overall economy?

 Productivity increases

 In competitive markets, w = MPL (marginal productivity or marginal revenue

product of labor). What happens on the margin to wages in the agricultural
sector if productivity increases [say, due to investment] but the total rural
population remains unchanged?

 Given fixed demand, if output increases, what happens to price (and wages)?

 How then can things be equilibrated?

 Relative productivity increases

 Typically labor productivity in manufacturing rises faster than that in

agriculture. What then happens to relative wages?

 Migration

 What happens to agricultural wages as workers leave for the city? (Remember
diminishing returns in labor.)

 Short-run equilibrium, rural

In the short-run, what happens in the countryside if:

 • Farmers are prevented from migrating (or, more accurately, prevented
from moving quickly) to the city?
• Farmers are unable to sell or lease the land they've been allocated?
(Villages still retain title to land; at least officially, land is leased to farm
families for 15 years, allocated initially on the basis of family size. In
reality on average land has been reallocated at least once in the past
decade, as family sizes change over time.)

 Short-run equilibrium, urban

In the short-run, what happens in the urban sector if:

• To wages, if there is a large group of farmers always ready to migrate?

• To relative urban-rural wages, if nevertheless barriers to migration

remain?

• Would you want to be a farmer in China? Why or why not? In the long
run, would your answer change (personal preferences for desk over
manual work aside)?

Modified Two-Sector Model

The Theory

“When there is a limitless supply of labor available to the industrial sector this allows
for the accumulation of capital and then will lead to economic growth.”
The theory relates to an underdeveloped labor-surplus and resource-poor economy in
which the vast majority of the population is engaged in agriculture amidst widespread
unemployment and high rates of population growth. The agrarian economy is stagnant.
People are engaged in traditional agricultural pursuits. Non-agricultural pursuits exist but
they are characterized by a modest use of capital. There is also an active and dynamic
industrial sector. Development consists of the re-allocation of surplus agricultural
workers, whose contribution to output is zero or negligible, to the industrial sector where
they become productive at a wage equal to the institutional wage in agriculture.

Assumptions

In presenting their theory of economic development, Fe lane Ranis makes the following
assumptions.
1. There is a dual economy divided into a traditional and stagnant agricultural sector
and an active industrial sector.
2. The output of the agricultural sector is a function of land and labor alone.
 3. There is no accumulation of capital in agriculture except in the form of land
reclamation.
4. Land is fixed in supply.
5. Agricultural activity is characterized by constant returns to scale with labor as a
variable factor.
6. It is assumed that the marginal productivity of labor becomes zero at some point.
If population exceeds the quantity at which the marginal productivity of labor
becomes zero, labor can be transferred to the industrial sector without loss in
agricultural output.
7. The output of the industrial sector is a function of capital and labor alone. Land
has on role as a factor of production.
8. Population growth is taken as an exogenous phenomenon.
9. The real wage in the industrial sector remains fixed and is equal to the initial level
of real income in the agricultural sector. They call it the institutional wage.
10. Workers in either sector consume only agricultural products.

Given these assumptions, Fei and Ranis analyze the development of a labor-surplus
economy into three phases. In the first phase, the disguised unemployed workers, who are
not adding to agricultural output, are transferred to the industrial sector at the constant
institutional wage. In the second phase, agricultural workers add to agricultural output but
produce less than the institutional wage they get. Such workers are also shifted to the
industrial sector. If the migration of workers to the industrial sector continues, a point is
eventually reached when farm works produce output equal to the institutional wage. This
begins the third phase which marks the end of the self sustained growth when farm
workers produce more than the institutional wage they get. In this phase, the surplus labor
is exhausted and the agricultural sector becomes commercialized.

(A)
A R

Land
B
Z C

N N1 N2 N

(B)

F
Total Output M TP

N
 O N1 N2

Labor Force
Figure: 17.1 (A & B)

Figure 17.1 (A) shows the functioning of the agricultural sector where agricultural goods
are produced by the application of labor (L) and land (Z). Labor is measured on the
horizontal axis and land on the vertical axis. The ray OR shows the stage of production.
The curve ABC is the production contour of agricultural goods. Assuming land to be
fixed at OZ, labor ON 1 produces the maximum output. The total productivity of labor is
represented by the TP curve in Figure 17.1(B) If more labor is employed beyond N1 with
land OZ, production would not increase. This is because the total productivity of labor
becomes constant beyond point M on the TP curve. Assuming that ON2 is the total labor
force engaged in agriculture. ON1 is the non-redundant labor and N1N2 is the redundant
labor force. N1N2 number of workers does not make any positive contribution to output
and their marginal physical productivity approaches zero beyond point M on the TP
curve. Such workers are disguised unemployed.

Economic development takes place when these workers are shifted from the agricultural
sector to the industrial sector in three phases. This is illustrated in Figure 17.2(A), (B) and
(C) where panel (A) depicts the industrial sector and panels (B) and (C) the agricultural
sector.
Let us take panel (C) where the labor force in the agricultural sector is measured from
right to left on the horizontal axis ON and agricultural output downward from 0 on the
vertical axis OY. The curve OCX is the total productivity curve (TPP) 3 of the
agricultural sector. The horizontal portion CX of the curve shows that the total
productivity of MN labor is zero. Thus MN labor is surplus and its withdrawal to the
industrial sector will not affect agricultural output. If however, it is presumed that the
entire labor force ON is engaged in the agricultural sector, it produces NX total
agricultural output. Assuming that the entire output NX is consumed by the total labor
force ON, the real wage is equal to NX/ON or the slope of the ray OX. This is the
institutional wage.

P2 W1

P1 Q
(A)Wage/ Marginal Output
P
T
W H

O M L K N
Labor Force
V
 (B) Average Output

A R
W
S
N O
M L K
Phase I Phase II Phase III
Labor Force

N M L K O

F
(C) D

B G
E
X Y
C
Figure: 17.2 (A, B & C)
The allocation process in three phases during the take off is depicted in panel (B) of the
Figure 17.2 where the total labor force is measured from right to left on the horizontal
axis ON and the average output on the vertical axis NV. The curve NMRU represents the
marginal physical productivity of labor (MPP) in the agricultural sector. NW is the
institutional wage at which the workers are employed in this sector.

In Phase I, NM workers are disguised unemployed. Their marginal physical productivity

is Zero, as shown by NM portion of the MPP curve in panel (B) or CX portion of the TPP
curve of panel (C). This redundant labor force NM is transferred to the industrial sector
shown as OM in panel (A) at the sane institutional wage OW (=NW).

In Phase II, the MPP of agricultural workers MK is positive in the range MR on the MPP
curve NMRU but is less than the institutional Wage KR (=NW) they get , as shown in
panel (B). So they are also disguised unemployed to some extent and are shifted to the
industrial sector. But the nominal wage in the industrial sector will not equal the
institutional wage in this phase. This is because agricultural output deciles with the
transfer of labor to the industrial sector. As a result, there is a shortage of agricultural
commodities leading to rise in their prices relative to industrial goods. This leads to the
worsening of the terms for the industrial sector, thereby requiring a rise in the nominal
wage in the industrial sector, thereby requiring a rise in the nominal wage in the industrial
sector. The nominal wage rises above the institutional wage OW to LH and KO. This is
shown by the upward movement of the supply curve of labor from WT to H and Q as ML
and LK labor gradually shifts to the industrial sector in panel (A). The movement on the
supply curve of labor WTW1 from T upward is “he Lewis turning point.”

When Phase III begins, agricultural works start producing agricultural output equal to the
institutional wage and ultimately more than the institutional wage they get. This marks
the end of the take-off and the beginning of the self-sustained growth. This is shown by
the rising portion RU of the MPP curve in panel (B) which is higher than the institutional
Wage KR (=NW). Consequently, KO of labor will be shifted from the agricultural sector
to the industrial sector at a rising nominal wage above KQ in panel (A) of the figure. This
leads to the exhaustion of the surplus labor in the agricultural sector which becomes fully
commercialized. According to Fei and Ranis, “The exhaustion of the labor surpluses must
be interpreted primarily as a market phenomenon rather than as a physical shortage of
manpower, it is indicated by an increase in the teal wage at the source of supply.”
Fei and Ranis point out that, as agricultural workers are shifted to the industrial sector,
there begins a surplus of agricultural commodities. This leads to the total agricultural
surplus (or TAS) in the agricultural sector. The excess portion of total agricultural output
over the consumption requirement of the agricultural labor force at the institutional wage
is the TAS is a function of the development process. The ATS is measured in panel (C) of
the figure by the vertical distance between the line OX and the TPP curve OCX. In phase
I when NM labor is transferred the TAS is BC. In phase II, as ML and LK workers are
shifted to the industrial sector, DE and FG amounts of TAS arise. “TAS may be viewed
as agricultural resources released to the market through the re-allocation of agricultural
workers. Such resources can be siphoned off by means of the investment activities of the
landlord class and /or government tax policy and can be utilized in support of the new
industrial arrivals.”

There is also the average agricultural surplus (or AAS). The AAS is the total agricultural
surplus available per head to workers allocated to the industrial sector. It is as if each
allocated worker carries his own subsistence bundle along with him. The AAS curve id
depicted as WASO curve in panel (B) of the figure. In phase I, the AAS curve coincides
with the institutional wage curve WA In phase II, when MK workers are transferred to
the industrial sector, The AAS begins to fall from A to S in panel (B) while TAS is still
rising from BC to DE to FG in panel (C).

In Phase III, AAS valises more rapidly from S to O in panel (B) and TAS also declines as
shown by the narrowing of the area from FG to ward O in panel (C) below phase III of
panel (B). The decline in both AAS and TAS is due to the rise in the MPP of agricultural
workers by more than the institutional wage which ultimately leads to the transfer of the
remaining surplus labor to the industrial sector.

Fei and Ranis call the boundary between Phases I and II as the “shortage point” when
shortages of agricultural goods begin as indicated by the fall of the AAS (the portion AS
of WASO curve) below the minimum institutional wage (NW), and the boundary
between Phase II and III as the “commercialization point” which signifies the beginning
of equality between MPP and the institutional wage in agriculture. Thus the Lewis
turning point coincides with the shortage point of Fei and Ranis, and the increase in the
industrial wage is speeded up at the commercialization point.

They show that if agricultural productivity is increasing, the shortage point and the
commercialization point coincide. This is because with the increase in agricultural
productivity the rise in MPP enables the output to rise to the level of the institutional
wage more quickly. It may be viewed as the shifting of MRU curve upward to the left in
Figure 17.2(B). On the other hand the AAS increases with the increase in total physical
productivity. This means that the ASO curve in Figure 17.2(B) shifts upward to the right.
If the rise in productivity is sufficient, the MRU and ASO curves in Figure 17.2(B) will
so shift upward that the shortage point A and the commercialization point R coincide and
Phase II is eliminated. So far as the industrial sector is concerned, the increase in
agricultural productivity has the effect of raising the industrial supply curve after the
turning point. This can be viewed as the shifting of the WTW1 curve downward to the
right below point T in Figure 17.2(A). According to Fei and Ranis “The economic
significance of the equality between our turning point and the commercialization point is
that, after the turning point, the industrial supply curve of labor finally rises as we enter a
world in which the agricultural sector is no longer dominated by non market institutional
forces but assumes the characteristics of a commercialized capitalist system. “ In other
words, the economic significance of the elimination of the second phase is that it enables
the economy to move smoothly into self sustained growth.

Balanced Growth

Fei and Ranis have further shown that their model satisfies the conditions of
balanced growth during the take off process .Balanced growth requires simultaneous
investment in both the agricultural and industrial sectors of the economy. This is
illustrated in Figure 17.3 where PP is the initial demand curve for labor and S1S1 the
initial supply curve of labor. They intersect at a where OM labor force is employed in the
industrial sector. At this level of employment, the industrial sector is getting a profit
equal to the area S1Pa. This profit is the total investment fund available to the economy
during the take off process. A part of this allocated to the agricultural sector thereby.
Raising agricultural productivity and shifting the supply curve of labor in the industrial
sector downward to the right from S1S1 to S2S2. the remaining part of the investment
fund is allocated to the industrial sector, thereby shifting the industrial demand curve
upward to the right from PP to P1P1 the S2S2 and P1P1 curves intersect at a1 lying on
the balanced growth path S1a3. At a1 the industrial sector adsorbs ML labor force which
has been released by the agricultural sector as a result of rise in agricultural productivity
following the allocation of investment fund to it. In Fig. 17.3, ML labor force absorbed in
the industrial sector exactly equals the labor force ML released from the agricultural
sector in Figure 17.2(B).

S1
 P2

P1 S2
Marginal Output
P a2
S1 a
a1 a3
P1 P2 P3

O M L K
Labor Force
Figure: 17.3

Thus as investment funds are continued to be allocated to both sectors through time. The
economy will move on the balanced growth path. But there is every likelihood, for the
actual growth path to deviate from the balanced growth path from time to time. “Such a
deviation, however, will call into play countervailing equilibrating forces which tend to
bring it back to the balanced growth path. The actual path is in face, likely to be
oscillating around the balanced growth path. ”For example, if as a result of
overinvestment in the industrial sector, the demand curve for labor shifts to P2P2 and
intersects the supply curve of labor S2S2 at a2 the actual growth path will be above the
balanced growth path. This will lead to a shortage of agricultural goods to a deterioration
of the terms of trade of the industrial sector and to a rise in the wage rate in this sector.
This will discourage investment in the Industrial sector and encourage investment in the
agricultural sector and thereby bring the actual path to the level of the balanced growth
path.

Framework of Macro Dynamic Thinking

Gustav Ranis and John Fei elegantly presented the framework of macro dynamic thinking
stemming from the problems of underdeveloped countries. They continued to argue in the
classical tradition as an extension of intellectual take off from the renowned models
which W. Arthur Lewis presented in 1954. The centralizing feature of the Ranis-Fei
model shows the migration of workers from agriculture to industry contemplating
problems, which may arise. This paper presents the findings of the Ranis-Fei model; its
assumptions, implications on the economy and the height of critical insight arising from
their publication.

The major flaw in the Lewis model reveals failure to capture the basic insight, thus a
misconception that he saw industrialization as a universal solution. The Lewis model
entails long run examination of economic development, tracing channels of poor
economies overtime becoming industrialized. Lewis examines a closed economy where
two fundamental assumptions interplay; the case for unlimited supply of labor and labor
supply at the constant wage rate or the subsistence wage. However, Ranis-Fei argues that
the Lewis model is inadequate due to failure of applying analytical attention to the
changing condition which unfolds in the process of agricultural development. Ranis-Fei
sets out to encapsulate Lewis’ failure by investigating the inherent rules of growth in
postulating elaborate definitions of commercialization, institutional wage rates, turning
points, take-off and self sufficiency.

Ranis-Fei forwarded three diagrammatic models depicting the industrial and agricultural
sectors, the focal point of their analysis. The diagrams are specifically lined up as points
on the horizontal axis represent the total population of the labor force distributed between
agriculture and industry within three notable phases. These phases display the
development of surplus labor with consideration of no changes in agricultural
productivity and population.

The first diagram follows from Lewis where we have industrial labor on the horizontal
axis (OW) and its marginal physical productivity (MPP) on the vertical axis (OP).
Employment of the industrial labor force (St) is determined by the demand curve of labor
or the MPP (dtf) and the supply curve of labor (Stt`S`). Lewis’ unlimited supply of labor
is determined by the horizontal portion of the supply curve, up to point ‘St’. The shifted
MPP curve from ‘f’ to ‘f`’ (d`t`f`) represents an increase in capital stock. When the supply
curve moves in an upward pattern of ‘turning point’, Lewis’ unlimitedness ends.

The third diagram represents the agricultural labor force, with output on the vertical axis.
Curve ORCX displays the total physical productivity of labor (TPP). The concave portion
of ORC shows gradualism of diminishing marginal productivity of agriculture whereas
the horizontal part of XC where marginal product vanishes. Any labor force in excess of
OD tends to be considered redundant, as withdrawal would not affect the agricultural
output.
A Critical Appraisal
The Fri Ranis model is an improvement over the Lewis model. The Lewis model ignores
the development of the agricultural sector and concentrates exclusively on the industrial
sector. The Feu-Ranis model shows the interaction between the two sectors in initiating
and accelerating development Moreover, its explanation of the Lewis turning point in
mote realistic. But the major merit of the theory is that it shows the importance of
agricultural products in capital accumulation in underdeveloped countries.

Despite these merits, the model is not free from criticisms which are discussed below.

1. Supply of land not Fixed

Fei and Ranis begin with the assumption that the supply of land is fixed during
the development process. In the long run the amount of land is not fixed, as the
statistics of crop acreage in many Asian countries reveal. For instance the index
number of area under crops (base 1961-62) in India rose from 82 in 1950-1-51 to
107.3 in 1970-71.

2. Institutional wage not above the MPP

The model is based on the assumption of a constant institutional wage which is

above the MPP during phases I and II of the development process. There is on
empirical evidence to support this assumption. In fact, in labor surplus
underdeveloped countries, wages paid the agricultural workers are much below their
MPP.

3. Institutional wage not Constant in the Agricultural Sector

The theory assumes that the institutional wage remains constant in the first two
phases even when agricultural productivity increases. This is highly unrealistic
because with a general rise in agricultural productivity farm wares also tend to rise.
For instance, the daily real wage rates (at 1966 prices) of agricultural workers for
various farm operations in Punjab during the period of the green revolution (1967-
72 ) increased by 41.7 per cent to 55.2 per sent.4

4. Closed Model

According Fei and Ranis the terms of trade move against the industrial sector in
the second phase when agricultural output declines and prices of agricultural
commodities rise, this analysis is based on the assumption of a closed economy where
foreign trade does not exist. But this assumption is unrealistic because
underdeveloped countries are not close but open economies which import agricultural
commodities when shortages arise.

5. Commercialization of Agriculture Leads to Inflation

 According to the theory, when the agricultural sector enters the phase it becomes
commercialized. But the economy is not likely to move smoothly into self sustained
growth because inflationary pressures will start. When many workers shift to the
industrial sector, the agricultural sector will experience shortage of labor In the
meantime the institutional wage also equals the MPP of workers and the shortages of
agricultural products arise. All these factors will tend to create inflationary products
within the economy.

6. MPP not Zero

Fei and Ranis observe that “with a fixed amount of land there will be some size
of population which is large enough to render MPP zero.” But Schultz does not agree
that in labor- surplus economies the MPP is zero. According to him if were so, the
institutional wage, may be in kind, if not in cash. Thus it is wrong to say that the MPP
is zero in the auricular sector.

Conclusion

However, these limitations do not undermine the importance of the Fei-Ranis

model for the economic development of labor-surplus countries. It systematically
analyses the development process from the take-off to self-sustained growth through the
interaction of the agricultural and industrial sector of an underdeveloped economy.

REFERENCE
1. http://home.wlu.edu/~smitkam/286/rural/part6.html

2. International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 7 (2007)© EuroJournals Publishing, Inc. 2007

3. http://www.eurojournals.com/finance.htm

4. http://www.econ.yale.edu/growth_pdf/cdp870.pdf

5. http://developmentafrique.com/wp-content/uploads/2009/10/RANISFEI.pdf