How Important are Dual Economy Effects for Aggregate Productivity?

This paper brings together development accounting techniques and the dual economy model to address the role that factor markets have in creating variation in aggregate total factor productivity (TFP). Development accounting research has shown that much of the variation in income across countries can be attributed to differences in TFP. An outstanding question is what creates these differences in TFP in the first place. The dual economy model suggests that aggregate productivity is depressed by inefficient factor markets that allocate too many factors to low productivity work in agriculture. Data show wide variation in marginal products of similar factors within many developing countries over the time period 1970-1990, offering prima facie evidence of this misallocation. Variation across countries in factor market efficiency is shown to account for 30 - 40% of the variation in income per capita. These dual economy effects can also explain 90 - 100% of variation in aggregate TFP across countries. Finally, this evidence shows that the inverse relationship of income per capita and the share of labor in agriculture across countries is driven by factor market inefficiencies and not by differences in relative productivities