Technology, trade and ‘urban poor’ in a general equilibrium model with segmented domestic factor markets

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Highlights

  • General equilibrium impacts of technical progress in urban formal sectors on the urban informal workers are discussed.

  • Vertical production linkages within the domestic urban economy and international outsourcing of production are considered.

  • The model allows for having the formal-informal segmentation in domestic labour and capital markets.

  • Numerical analysis using the model's parameters quantifies the changes in informal wages.

Abstract

Drawing on the evidence from Indian provinces, this paper, using a four-sector general equilibrium model with segmented domestic labour and capital markets, proposes that factor-specific technological progress only in the capital-intensive segment of the urban formal sectors may affect the urban informal workers adversely, while a trade induced progress in the vertically integrated skill-intensive formal sector benefits them. The numerical analysis further illuminates the importance of credit-product inter-linkage to channel the impact on urban informal wage. Such analysis also helps to infer the well-being of the urban poor, given its strong association with the trends in informal wages.

Introduction

It is well-known that in a developing economy the ‘informal sector’ hosts a substantial proportion of the workforce in unregistered activities, as the less regulated part of the economy where minimum wage laws and labour regulations are either totally absent or weakly implemented. Such sectors are mainly engaged in producing non-traded items in the economy. These sectors primarily comprise own-account enterprises, and also many subcontract firms (producing various parts and semi-processed components for the formal sector firms). As suggested by many authors (Agenor, 1996, Schneider and Enste, 2000 and the references therein) more than 70% of the workforce is engaged in the informal sector of a developing country (hereafter DC). In South Asian countries such as India, a significant proportion (about 85% in non-agricultural activities of India) of the working population are engaged in the informal sector. On 2010–11, the informal sector accounted for almost 94% of India's workforce (National Sample Survey (NSS) Report No. 549, 2010–11). Such sectors comprise mainly “wage hunters and gatherers” (Breman 1994), who are usually but not always uneducated, with little or no chance of a living wage and can hardly afford to remain unemployed.

One important implication of the 1991 economic reform in India has primarily been the productivity improvement, primarily capital-using (i.e. labour-saving) in nature, in the organised (formal) manufacturing and service sectors of the urban area; as evidenced in Pattnayak and Thangavelu (2005), Hulten and Srinivasan (1999) and so on. In light of the evidences provided in Hasan (2002), Goldar and Kumari (2003), Topalova (2010) and so on; such productivity surge in the Indian skill-intensive manufacturing or services industries during the liberalised regime has particularly been driven by greater access to the newer varieties of imported inputs from abroad, owing to the lowering of input tariffs. However, following such a technological change in the urban formal sectors, organisation of production between the organised and unorganised (informal) segments of the urban economy should be affected; which would, in turn, impart informal activities, wages and employment. Therefore, benefits of productivity improvement in the formal sectors should have percolated to the bottom of the income group working in the urban informal sectors. While it is difficult to assess such an impact at the micro level and in terms of various indicators of poverty and human development, by exploring the general equilibrium impact of productivity take-offs in the formal manufacturing sectors on the informal wage and employment, this paper, according to the definition of income poverty (people are poor if they earn abysmally low wages, which is common among the informal sector workers in developing countries like India), serves to draw an inference on the well-being of the ‘poor’ urban workers working in the informal sectors. This works in the present context because these workers do not have to be necessarily unemployed in order to be considered poor; prevalence of very low market determined wages describes the impoverishment of those people, who are engaged in informal activities. Vertical production linkages within the domestic urban economy as well as international outsourcing (fragmentation) of production in the formal (skill-intensive) sector have been incorporated within an encompassing general equilibrium model (of production and trade) for the urban economy of a developing country like India; while regarding the factor markets, the model not only allows for having formal-informal segmentation in domestic labour markets, but also for having imperfection in the informal sector capital (credit) market to execute this crucial issue.

India experienced productivity surge in the organised urban manufacturing (formal) sectors (covered under the Annual Survey of Industries (ASI) act) over the ten-year period from 2000 to 2010 in almost all the provinces (Fig. 1).1

Furthermore, labour productivity in the organised formal sectors has increased fairly evenly across the provinces of India between 1989 and 2010 as revealed in Fig. 2.

However, we observe a sharp increase in real informal wages in the urban areas during this period as observed in the following figure. To construct the variables for urban unorganised informal sector in the context of the sample under consideration, data from various rounds of surveys conducted by ‘National Sample Survey Organisation’ (NSSO) (1989–2010) of the Government of India for Non-Directory Manufacturing Establishments (NDMEs) (not covered under the ASI act and having strong inter-linkages with the organised sectors) in the urban areas have been utilised in this paper. This paper utilises NSS surveys for 1989–90, 1994–95, 2000–01, 2005–06 and 2010–11 across twenty-seven Indian provinces for this purpose. Detailed construction of variables (including that of the real informal wage) from survey data are available in Appendix II, Appendix III.

This seems a puzzle since we observe improvement in labour productivity in the formal sectors and increase in informal wages concurrently during the liberalised regime in Indian provinces.

However, Sundaram, Ahsan, and Mitra (2012) found strong positive correlation between formal and unorganised (informal) sector activities (employment, output and value added) at the industry-province level, which supports significantly the inter-linkage between formal and informal sectors. Also the reliance of formal sectors on informal sectors is much higher where labour laws are more stringent and organised sectors are relatively human capital (or skill) -intensive (Sundaram et al., 2012). This is because the formal sector firms with rigid labour markets and higher skill-requirement often find it profitable to farm out a part or whole of their production to the informal sector firms (that enjoy advantages of cheap labour supply) to avoid various regulations and associated costs. On the other hand, the informal firms are also dependent on formal firms for marketing their products and, in particular, for the supply of credit from the formal sector firms since the formal firms usually have an advantage over the informal firms in the credit market.

In this context, this paper constructs a broad measure of input purchases by the formal sectors from local informal firms. This variable, capturing the notion of vertical production linkages between urban formal and informal sectors, is the sum of

  • (a)

    Value of products sold by the registered factories in the same condition as purchased from the other local firms; and

  • (b)

    Cost of contract and commission work done by others on materials supplied by the factory.

  • (c)

    Total delivered value of all other materials (other than fuel), which have not been produced by the registered factories.

The first two items together constitute a measure of subcontracting.2

However, value added has been rising over time in both the informal and formal manufacturing sectors. On the other hand, employment in the formal sector has remained static or has even been slightly declining, while in the informal sector it has been rising steadily. Therefore, in case of value added, a percent-to-percent match in the growth of formal and informal manufacturing has been obtained, which is indicative of some degree of complementarity between the two sectors, while the growth in population or labour force has mainly been absorbed by the informal manufacturing sector. The positive growth rate in subcontracting activity during the liberalised regime in most of the Indian provinces can be observed in Fig. 4.3

A high rate of growth is also observed in accumulation of real fixed assets of urban NDMEs (relative to that in the registered factories), an approximation to capital accumulation in the urban informal sectors relative to that in formal sectors,4 across almost all the 27 provinces (Fig. 5) during the liberalised regime.

Therefore, we observe four concurrent events across Indian provinces during the liberalised regime: productivity improvement in the organised sectors, formal-informal production linkages in the urban area, movement of both capital and labour to the informal sectors, and sharp increase in informal wages. Hence, it becomes a challenge to the trade-theorist to channel the impact of technological progress in the organised sectors on the urban informal wage and subsequently employment in the urban informal sectors for a small, open developing economy like India – that typically suffers from rigid organised sector labour market and imperfection in credit market of the informal sector.

Against this backdrop, this paper explores the association between the urban informal wage and urban poverty at the provincial level to motivate the main research agenda, calculating the poverty head count ratios in the urban areas of Indian provinces for the years 2004–05 and 2011–12. As demonstrated in Fig. 6, the head count ratio has dropped across all the provinces except Nagaland. The increase in the urban informal wage between 2005 and 2010 (as shown in Fig. 3) in these Indian states can plausibly be one significant reason for the decrease in urban poverty headcount ratio, given the fact that the majority of the urban poor in India are engaged in the non-agricultural urban informal sector. This observation substantiates the choice of informal wage as a reasonable benchmark to conclude on the welfare implications of ‘urban poor’.

Given the concentration of informal workers in the urban economy and presence of urban poverty, the theoretical exercise will also enable to obtain an overall view of the well-being of the ‘urban poor’ as a consequence of productivity improvement in the urban organised non-agricultural sectors.

Goldberg and Pavcnik (2003) have explored the asymmetric impact of reform policies on the size of the informal sector. However, DCs like India are also plagued by capital market segmentation among the organised formal and unorganised informal sectors. It has been shown theoretically (Marjit, 2003, Marjit and Kar, 2004, Marjit et al., 2007a, Marjit et al., 2007b, Marjit and Kar, 2008a, Marjit and Kar, 2008b, Marjit et al., 2008) that informal wage can change depending on various degrees of capital mobility between formal and informal sectors. These studies use simple general equilibrium structure to answer a critical question – how do exogenous policy changes in the formal sector affect the wage and employment conditions in the informal sector? Marjit and Kar (2009) assessed the implication of a tariff-cut in the organised formal sector on informal wages, explaining the notion of different degrees of capital mobility between informal and formal segments of the economy and how they affect the outcome on informal wage. However, while the paper by Marjit and Kar (2009) attempted to check trade policy induced relative price effects on real informal wage, this paper highlights the productivity issue explicitly.

It should be mentioned that Marjit and Kar (2008a) explored the link between labour productivity growth and informal wage, emphasising the role of capital mobility between formal and informal segments of the economy. However, it has been illustrated in different studies that informal sector firms are integrated to the formal sector firms on a contractual basis. Therefore, it would be unrealistic to assume that the informal sector produces internationally traded final goods, capital is sector-specific and that the informal and formal credit markets are completely disintegrated even in the short-run (Marjit and Kar, 2008a, Marjit and Kar, 2009). This is because the informal sector money-lender borrows capital from the formal credit market for re-lending.5 Hence a part of the formal credit enters the informal credit market. Therefore, the ‘zero mobility’ case in Marjit and Kar, 2008a, Marjit and Kar, 2009 papers is unlikely to happen in reality. This paper has specifically attempted to address such ‘gap’ in the existing research.

There has been a pertinent debate on the desirability of various types of technological progress among labour economists and trade-theorists (Jones, 2006, Krugman, 2000). Trade-theorists, emphasising the importance of relative factor intensities in different sectors (Jones, 1965, Oladi and Beladi, 2009, Beladi et al., 2008) argue that a labour-augmenting type technological change in the labour-intensive sector will push the wages up. This result is in contradiction to the usual predictions of labour economists. Findlay and Jones (2000) argued that trade and labour theory outcomes will be merged for a major modification of production structure consequent upon such a technological progress. The most recent attempt has been made by Beladi, De la Vina, and Marjit (2012) in terms of a simple two-sector static general equilibrium model with formal/organised (unionised wage) – informal/unorganised (flexible wage) labour markets to show that technological progress leads to opposite movement in informal wage independent of relative factor-intensity ranking between organised and unorganised labour sectors.

But the simple two-sector set-up in Beladi et al. (2012) was not quite generic to portray the conditions of urban informal sector in a developing economy. It would be more realistic to classify the urban informal sector as comprising of an industrial segment that uses labour and capital to provide an intermediate input such as leather and rubber products, electrical equipment etc. to the formal sector firm, with the urban informal firm being tied to the formal firm by the system of subcontracting. Another aspect of the informal service sector comprises producing non-traded services such as street-vendors with almost no use of capital. These possibilities have been considered in Kar and Marjit (2009).

However, Kar and Marjit (2009) did not consider any dualism in the domestic capital market. The dominant feature of dualism in the capital market is the fragmented interest rate structure, featuring lower allocation of loanable capital to the informal sector at a higher relative rental rate. The informal producers lack access to credit from formal institutions. Therefore, they generally depend on the informal sources of credit, such as informal moneylenders, who charge exorbitantly high interest rates. Under this policy, the informal moneylenders act as financial intermediaries between the formal credit agency and the final borrowers of credit.6 This is the precise idea that has been put forward in the theoretical literature invoking the informal capital (credit) market as imperfect (for example, Basu and Bell, 1991, Basu, 1998, Chaudhuri, 2003). This paper specifically incorporates such dualism in capital (credit) market, thus capital mobility between the formal and informal sectors is triggered by the interest rate differential between the two capital (credit) markets, departing from the existing relevant theoretical contributions in this context. In fact, this is the best possible treatment of incorporating credit market dualism in the present set-up (given that the purpose of this paper is not to determine the interest rate prevailing in the informal credit market), both from the perspectives of tractability and reliability of the results. In order to avoid paradoxical circumstances, without any loss of generality, this paper models the informal intermediate input producing sector as having Leontief production technology (and thus fixed capital requirement in production).

Section 2 discusses theoretical model and the comparative static responses. Finally, Section 3 concludes.

Section snippets

The model

Consider a static general equilibrium model for a small, open developing economy with four sectors: two urban formal sectors and two urban informal sectors. Among the two informal sectors, one is an informal service sector (Sector 1) providing non-traded services by the unskilled (surplus) labour of the economy. Another sector (Sector 2) is within the industrial set-up, producing a non-traded intermediate input using unskilled labour and capital for the formal export sector. Within the formal

Concluding remarks

This paper investigates the implications of productivity surge in the formal sectors of the economy on the wellbeing of the workers in urban informal sectors using a four-sector general equilibrium model with labour and capital market distortions. The present research stems from the observation that the 1991 economic reform in India has contributed to the technological improvement in the organised sectors which has been quite substantial over the recent years. Albeit the existence of strong

Acknowledgement

This is an excerpt of my Doctoral dissertation (approved for PhD) at the University of Nottingham (UK). I am grateful to Prof Oliver Morrissey, Prof Chris Milner, Prof Catia Montagna, two anonymous referees and the Editor (Prof Hamid Beladi) of the International Review of Economics and Finance for their constructive comments on the earlier version of the paper. The paper has been communicated in the conferences of Delhi School of Economics, Indian Institute of Foreign Trade, Indian Statistical

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