The Harris-Todaro Model

1. The Harris-Todaro Model If wages were perfectly flexible equal wages would be paid in industry and agriculture and there would be no unemployment

2. In a perfectly competitive market D A Urban formal wage ag wage W* C B

3. For a variety of reasons however workers in the urban formal sector are paid higher than equilibrium wages • Unions • government policy • incentives to workers to expend effort when labor cannot be directly supervised without tremendous costs. • The threat being fired. Then one would have to return to the country or find work in the urban informal sector.

4. At the same time, in the rural sector and the informal urban sector wages rise and fall according to supply and demand. Such conditions give rise to the following: D A W(bar) Urban formal wage ag wage WA C B LF LI LA

5. Here LF workers find employment in good jobs in the cities, LA remain behind in the countryside working at a lower wage of wA. Those who migrated from the countryside to the city find themselves employed in the urban informal sector D A W(bar) Urban formal wage ag wage WA C B LF LI LA

6. As a result, many people end up in relatively unproductive dead-end service sector jobs in the cities. Urban overcrowding due to high rates of migration from rural areas to cities and high informal sector employment is a fact of life in many low and middle income countries. (review table 2.4, page 39)

7. The Harris-Todaro model helps to explain this seemingly irrational phenomenon First, let’s define real per capita income in the rural sector: (PA/P)(QTA/NTR)

8. Definition of terms PA=agricultural prices P=general price level QTA=total agricultural production.

9. Next we define urban formal sector income wF*n*((NTC-Nu)/NTC)=wFn(1-u)

10. Definition of terms WF =the wage paid for good jobs in the city. N=the number of hours worked per period per worker u=the formal sector unemployment rate (other terms defined in class).

11. Finally let’s define urban informal sector income WI *n*u where wI=the wage per hour paid in the informal sector.

12. It is sensible to assume that migration continues as long as urban incomes are significantly higher than rural incomes. Or in otherwords migration occurs when wFn(1-u)+wInu >k[(PA/P)(QTA/NTR)]

13. Now think about u, the rate of unemployment in the formal sector • (1) The higher U is, the more people there are actively seeking formal sector employment that are unable to find it. • (2) The higher U is the lower the probability of a new migrant from the country finding a formal sector job. • (3) Without a social safety net, he or she will have to make work for themselves in the informal sector.

14. And because of the preceding wFn(1-u)+wInu Can be thought of as the wage one can expect if they move to the city. And the lower u is the higher the expected wage

15. The main point of Harris-Todaro is that if the expected urban wage ... • equals rural income there is no incentive to migrate. • is greater than rural income there is a great incentive to move from country to city • were less than rural incomes there would be an incentive to move in the other direction. (South Korea in recent years)

16. The expected urban wage depends on what type of job you land, that depends on probabilities and these are linked to current urban unemployment rate as defined above.

17. Therefore to understand the model set rural and expected urban incomes equal and solve the above for u, the urban unemployment rate U={wFn- (k[(PA/P)(QTA/NTR)]} /n(WF-WI)

18. From this result we can show the following: • U will increase if wF increases! • U will increase if n increases! • U will increase if k drops. • U will increase if QTA/NTR falls. • U will increase if wI increases! • U will increase if PA/P decreases.

19. One failing of the Harris-Todaro model assumes migrants are risk-neutral This means that the utility of a gamble where the payoff is $6000 is the same as the utility of $6000 guaranteed.

20. This is not realistic. Especially poor migrants will be risk averse Utility 2000 6000 10000 payoff

21. This means that to the degree potential migrants are risk-averse The less net migration out of rural areas will be given the gap between rural and urban wages. Consider k a measure of the degree of risk aversion.

22. Ray’s discussion of social capital Ray raises an interesting point in relation to this issue of risk aversion. He begins by pointing out that information is high and mobility is low in rural areas

23. In other words, every one knows your business in a small village and it is hard to move.

24. This means that • In terms of insurance and credit, rural areas provide a strong support network for the poor (this is his “social capital”) • If someone runs into trouble the community knows why.(If not due to your own negligence you will receive some support) • Low mobility also gives rise to “reciprocity”. One helps others in their time of need knowing that they will help them in return.

25. Once migration starts however This social capital will be eroded and thus, all else equal, lowers the cost of migrating since local rural support breaks down.