Review of the literature

1. (a) Demand-side linkages: There is a vast literature that argues that agriculture provides a ‘home market’ for the formal industrial sector and thereby mitigates its ‘effective demand problem’ through the following channels:

2. (1) Redistribution of income away from the net savers in the presence of differential propensities to consume formal sector output across different economic classes. This redistribution is initiated by a shift in the terms of trade between the agriculture and the formal sector (Reference Bose and RakshitBose, 1989; Reference RakshitRakshit, 1982; Reference TaylorTaylor, 1983).

3. (2) Mutual exchange of surpluses between the formal sector and the agriculture. As agricultural production rises, more of its output is sold to the formal sector, raising agricultural income. Consequently, demand for the formal sector output rises (Reference Bhaduri and SkarsteinBhaduri and Skarstein, 2003; Reference Kaldor and KaldorKaldor, 1996 [1984]; Reference RajRaj, 1976).

4. (b) Supply-side linkages: agriculture provides supply-side support for the formal industrial sector:

5. (1) The agricultural sector supplies wage-goods and raw materials for the formal sector. These essential products are provided to the formal sector through simple inter-sectoral exchange (Reference Chakravarty and ChakravartyChakravarty, 1977; Reference Kalecki and OsiatynskiKalecki, 1993 [1954]).

6. (2) Food-constraint pushes up food prices in the face of growing demand from the formal sector, which leads to either an upward wage-price spiral (Reference Kalecki and OsiatynskiKalecki, 1993 [1954]) or deterioration of terms of trade for the formal sector resulting in a ‘profit squeeze’ (as in Reference Ricardo and SraffaRicardo, 1815). Conversely, a cheap and abundant food supply ensures transfer of surplus from the agriculture to the formal sector (Reference PreobrazhenskyPreobrazhensky, 1965 [1926]; Reference Ranis and FeiRanis and Fei, 1961).

Our departures

(a) We depart from the assumption of the presence of a redistributive channel which is supposed to boost demand for formal sector output. Consider a situation where all the contending classes (capitalists and workers in the formal sector and farmers) form separate but equally strong lobbies. In such a situation, these classes can collude, the political expression of which is a ‘coalition government’. In a regime of ‘coalition politics’, each of the contending groups tries to maintain its relative socio-economic position. Therefore, we assume rigidity of the formal sector real-wage and product-wage and, hence, rigidity of the agriculture–formal sector terms of trade. However, we will relax this assumption of rigidity of distributive parameters in our third section.

Empirical evidence, as captured through Tables 4 and 5, using Indian data, supports our assumption of distributive inflexibilities. We have calculated mean and coefficient of variation from the series of data on agriculture–non-agriculture terms of trade and on non-agricultural real wages adjusted by using consumer price index. We find out that the decadal fluctuations of all these data sets have been reduced considerably after the 1970s.

Table 4. Index of TOT between agriculture and non-agriculture from 1982–1983 to 2005–2006 (base: triennium ending 1990–1991 = 100).

TOT: terms of trade.

Table 5. Index of annual real non-agricultural wage rates in terms of consumer price index of industrial workers (1973–1974 to 2003–2004).

(b) Next, we assume the absence of capital flows between the agriculture and the formal sector. Essentially, this means balanced trade between these two sectors. Balanced trade is assumed to remove the possibility of extracting a trade surplus by any sector from any other.

(c) Now we come to our third contention. Our claim is that simple exchange with balanced trade between the agriculture and the formal sector cannot create any extra demand for the latter. In fact, a popular perception is that a bumper crop facilitates industrial revival because it leads to an increase in income or purchasing power in the agrarian sector, raising demand for the formal sector goods.^{Footnote 3} This argument is based on the implicit assumption of constant terms of trade. The assumption is necessary because a bumper crop, ceteris paribus, will change the terms of trade against agriculture. This, in turn, will reduce the purchasing power of the agricultural sector, given inelastic demand for food from the formal sector.

However, even if we allow for the assumption of constant terms of trade, increased agricultural output is translated into actual additional purchasing power only after it is sold to the formal sector. Moreover, the purchase of additional agricultural output by the formal sector means a leakage from the expenditure on the formal sector incurred by that sector itself. This reduces the demand for formal sector output. On the other hand, when additional income that accrues to the agricultural sector through sale of additional food to the formal sector is, in turn, spent on formal sector products, demand for formal sector commodities rises. However, ultimately there is no impact on demand for formal sector output, as the two effects counter-balance each other.

Together, all these departures and contentions imply a complete absence of all the agriculture–formal sector demand-side interactions discussed in the literature.

When agriculture experiences a bumper harvest, even though it is capable of supplying more food to the formal sector, the additional food fails to be absorbed by the latter because of the lack of any consequent rise in demand for formal sector output, that could push up its production. Lack of rise in complementary demand for formal sector product from any of the inside or outside sources will restrict increase in demand for food as well. Thus, the formal sector and agriculture simultaneously suffer from the ‘realisation crisis’ (Reference Bhaduri and SkarsteinBhaduri and Skarstein, 2003; Reference Chakrabarti, Acharyya and MoitraChakrabarti, 2001, Reference Chakrabarti2011). On the other hand, expansion of the formal sector crucially depends on an exogenous supply of food, absence of which triggers off either profit squeeze in the formal sector or a price-wage spiral across the economy. Thus, even if agriculture cannot be the ‘home market’ for the formal sector, it provides crucial supply-side support.

Kalecki: concept of ‘domestic exports’

We assume, for the time being, that the primary problem for the formal sector is lack of effective demand while the agricultural sector’s supply of food to industry is sufficient.^{Footnote 4} In such a situation, the only option left for the expansion of the demand-constrained formal sector in a closed economy is the path of government intervention, given agriculture’s inability to provide a ‘home market’ for it.

The ‘home market’ for industry is defined as any non-industrial sector within the national economy vis-a-vis which domestic industry can enjoy an ‘export surplus’. The agrarian sector cannot be this ‘home market’ since it cannot finance its trade deficit vis-a-vis industry, given that the agrarian sector of the developing countries in general lacks the power to issue any financial asset like shares and bonds. Hence, the government sector is the proper candidate to play the role of ‘home market’. It can purchase goods from the industrial sector, given its monopoly power over printing money. In its trade with government, domestic industry ‘exports’ goods against ‘import’ of money. This ‘export’ which is, by definition, an ‘export surplus’ is what Kalecki terms ‘domestic exports’ (Reference KaleckiKalecki, 1971 [1934]).

Kalecki: agricultural supply-constraint

Kaleckian analysis rules out agriculture as a possible ‘home market’ for industrial product. However, there is clear recognition of agriculture as the source of supply of wage good or ‘food’ to the industrial sector. In other words, Reference Kalecki and OsiatynskiKalecki (1993 [1954]) recognises that agriculture may act as a supply-constraint on industry.

Now, given this whole context, we posit a capitalistic formal sector and try to capture its relationship with agriculture. We find that, given our departures/assumptions, a rise in agricultural production creates the potential for formal sector expansion only from the supply-side. However, on the demand-side, realisation of this potential without involving a change in distribution of income requires adequate adjustment of real government expenditure on formal sector output. Thus, this domestic export not only mitigates the problem of effective demand for formal sector output but also removes the realisation problem of agriculture. Our initial objective is to unite the two in a single framework and to develop the framework analytically through the incorporation of the informal sector as mentioned above. This incorporation of the informal sector will be found to generate crucial insights for the discourse on agriculture–industry linkage. On the other hand, this comprehensive framework also brings in the issues of informal–agriculture and formal–informal relations and thereby helps in understanding the nature and locus of the informal sector itself – the main target of this article.

Interaction among formal sector, agriculture and government.^{Footnote 9}

Excess capacity in the formal sector implies a given labour-output ratio l, and we take l = 1 through an appropriate choice of unit. Hence

(1) $\text{L}=\text{Y}$

Here L and Y are the formal sector’s total employment and output, respectively.

Using equation (1), the marked-up price (p) over unit wage-cost (w) in the formal sector can be represented as

(2) $\text{p}=(1+\tau )\text{w}$

Here τ is a constant mark-up.

Workers’ demand for a targeted real-wage in the formal sector is given by

(3) $\text{w}/{\text{p}}_{\text{f}}=\beta$

Here p_f is the food-price and β is a positive constant.

Using equations (2) and (3), real-wage in terms of the formal sector output and terms of trade between agriculture and the formal sector can be written, respectively, as

(3.1) $(\text{w}/\text{p})=1/(1+\tau )=\alpha$

(3.2) $({\text{p}}_{\text{f}}/\text{p})=1/\left[\beta \right(1+\tau \left)\right]=\theta$

α and θ are exogenously determined.

The basic income–expenditure accounting equation for the formal sector using the features listed in the section ‘Basic features of our economy with both the formal and informal sectors’ can be written as

(4) $\begin{array}{c}\text{Total formal sector output}={\left(\begin{array}{c}\text{Total formal sector wage}-\\ \text{bill in terms of formal sector output}\end{array}\right)}^{10}+\\ \left(\begin{array}{c}\text{Total formal sector investment in terms of}\\ \text{formal sector output}\end{array}\right)+\\ \left(\begin{array}{c}\text{Total government expenditure on}\\ \text{formal sector output}\end{array}\right)\end{array}$

We assume that real investment (I) in the formal sector and nominal government expenditure (G) on the formal sector output are exogenously given at I⁰ and G⁰. These assumptions along with equations (1), (3.1) and (3.2) transform equation (4) as follows

(5) $\text{Y}=\text{L}=(\text{w}/\text{p}).\text{L}+{\text{I}}^0+({\text{p}}_{\text{f}}/\text{p}).({\text{G}}^0/{\text{p}}_{\text{f}})=\alpha .\text{Y}+{\text{I}}^0+\theta .({\text{G}}^0/{\text{p}}_{\text{f}})$

Solution of equation (5) gives

(6) $\text{L}*=[{\text{I}}^0+\theta .({\text{G}}^0/{\text{p}}_{\text{f}}\left)\right]/(1-\alpha )$

Now, food-demand per worker employed in the formal sector, given equations (3.1) and (3.2), can be expressed as

(7) ${\text{a}}_{\text{f}}={\text{a}}_{\text{f}}(\text{w}/\text{p},{\text{p}}_{\text{f}}/\text{p})={\text{a}}_{\text{f}}^0\left(\text{a positive constant}\right)$

Hence, aggregate food-demand from the formal sector is

(8) ${\text{D}}_{\text{f}}{=\text{a}}_{\text{f}}^0.\text{L}*={\text{a}}_{\text{f}}^0.[{\text{I}}^0+\theta .({\text{G}}^0/{\text{p}}_{\text{f}}\left)\right]/(1-\alpha )$

There is an inverse relation between food-price and aggregate food-demand from the formal sector. As food-price falls, the money-wage is reduced, reducing formal sector price as well. Consequently, given the volume of nominal domestic exports, the real domestic exports rise, raising the level of formal sector employment following equation (8) and, hence, increasing the demand for food.

Now, we assume that for the time being a fixed amount of marketable surplus of food is supplied to the formal sector,^{Footnote 11} which can be written as

(9) $\text{F}={\text{F}}^0$

Using equations (8) and (9), the food-market equilibrium condition is

(10) ${\text{F}}^0{=\text{D}}_{\text{f}}{=\text{a}}_{\text{f}}^0.[{\text{I}}^0+\theta .({\text{G}}^0/{\text{p}}_{\text{f}}\left)\right]/(1-\alpha )$

Equation (10) determines the equilibrium food-price ${\text{p}}_{\text{f}}^{*}$ . It can be represented in a simple food-market demand–supply diagram with linear approximation (Figure 2).

Figure 2. Food-market equilibrium representing the agriculture–formal sector interaction.

The equilibrium food-price, ${\text{p}}_{\text{f}}^{*}$ , determines equilibrium money-wage, w*, in the formal sector, given equation (3). w*, in turn, determines equilibrium price, p*, the formal sector output-price, given equation (2). Consequently, the equilibrium size of real government expenditure, g*, is endogenously determined as g* = G⁰/p*. This equilibrium level of real domestic exports, in turn, can determine the equilibrium levels of employment and output in the formal sector using equation (5).

Figure 3. Effect of expansionary policy on the formal sector represented through food-market equilibria.

We start with the food-market equilibrium position E₁ with equilibrium food-price ${\text{p}}_{\text{f}}^{*}$ Now, G rises, with F = F⁰. This leads to a rise in p_f. The process continues until one arrives at ${\text{p}}_{\text{f}}^{*}\prime$ such that the size of real domestic exports and, hence, the equilibrium levels of employment and output in the formal sector shrink back to their original values.

Figure 4. Effects of a bumper harvest on the formal sector shown through food-market equilibria.

Consider a case of downward flexibility of the formal sector money-wage. Let us assume a bumper harvest, raising the value of F to F¹. As a result, the equilibrium food-price falls from ${\text{p}}_{\text{f}}^{*}$ to ${\text{p}}_{\text{f}}^{*}\prime$ . Given the distributive factors, this reduces w and, subsequently, p also falls. This, in turn, expands the size of real domestic exports and, hence, the levels of formal sector output and employment rise. Correspondingly, we get the movement of food-market equilibrium from E₁ to E₂.

However, with downward rigidity of w, a fall in p_f due to a bumper harvest does not automatically increase real domestic exports. In that case, adequate expansion of the home market can only be achieved by a proper expansion of nominal government expenditure. The required expansion is such that the food-market clears at ${\text{p}}_{\text{f}}^{*}$ and the equilibrium position moves to E₃.

Interaction between agriculture and the informal sector

Let us now turn to the agriculture–informal sector interactions separately from the agriculture–formal sector linkage as discussed above. This separation is a hypothetical one, which will be relaxed subsequently.

First, from the condition of labour-surplus in the informal sector, we can specify constancy of food requirement rate at the minimum subsistence level. Hence, a_fi = a. This is the constant per capita food consumption rate in the informal sector.

The absence of fixed (limiting) capital in the informal sector implies fixity of the labour-output ratio (l_i). Thus, l_i = b, a constant.

We also assume without loss of generality that the fraction of intra-sectoral utilisation of output in the informal sector for self-consumption and reproduction (β_i) is constant. Hence, β_i = c, a constant.

All these combined together indicate that the real average cost of production in the informal sector due to food and non-food consumption and use of implements and raw materials is structurally determined and is constant. Furthermore, as there is no surplus, the food and non-food consumption-cost and implements and raw materials costs solely determine the informal sector product-price. This price can be expressed as p_i = [p_f.a.b + p_i.c]. Here p_i is the informal sector output-price and p_f is the food-price as before. Assuming, b = 1 (for simplicity), we have

(11) ${\text{p}}_{\text{i}}/{\text{p}}_{\text{f}}=\text{a}/(1-\text{c})=1/\text{t}\left(\text{say}\right)$

Thus, absence of fixed capital and the assumption of surplus labour along with the fixity of the fraction of intra-sectoral utilisation of output jointly imply a given terms of trade between the informal sector and agriculture.^{Footnote 12} Moreover, at these given terms of trade, the supply of net output, s, for the informal sector will be perfectly elastic and hence its value is demand-determined. Consequently, the s curve will be horizontal on the ‘s–p_i/p_f’ plane (Figure 5). Furthermore, a particular amount of food supply to the informal sector always induces a definite volume of trade between agriculture and the informal sector. As the perfectly elastic s and, hence, the informal sector output, y, and the corresponding employment, m, are demand-determined, the equilibrium values of these variables are solely set by the portion of marketable surplus of food or, more precisely, that of agricultural income transacted with the informal sector.

Figure 5. Informal sector–market equilibrium representing the agriculture–informal sector interaction.

As the supply of informal sector output is perfectly elastic and as it is determined only by the food supply, we get a crucial result that demand for food from the informal sector is also perfectly elastic. Agriculture does not face any demand problem so far as the informal sector is concerned. Thus, we have a sharp dichotomy between the agriculture–formal sector and the agriculture–informal sector inter-linkages.

Agriculture–informal sector and agriculture–formal sector interactions: a fundamental contrast

In our framework, agriculture acts as a source of food and raw materials and of demand for the informal sector. However, as we bring in the issue of agricultural supply, we implicitly incorporate in our analysis the question of the realisation of income by farmers. Only if the potential income is realised, is there the possibility of generating demand for the informal sector products. In our analysis, the crucial characteristic of the consumption motive for both the informal sector petty-producers and the (non-capitalistic) farmers closes this gap. There is no realisation problem for agriculture so far as the informal sector is concerned.

However, the absorption of agricultural surplus in the formal sector is not at all guaranteed. Agriculture may suffer from a ‘realisation crisis’ so far as its interaction with the formal sector is concerned. Mere supply of agricultural commodities does not automatically imply their sale in the capitalistic formal economy, as production in this sector is organised with accumulation motive and not for consumption as such.

A capitalistic economy would not invest and grow unless there is any (ex ante) guarantee of absorption of its ‘surplus’; mere (equivalent) exchange of its output with inputs like food and agro-raw materials cannot serve that purpose. If the capitalistic formal sector suffers from any inherent problem of insufficient demand and if no external support (such as net exports or government expenditure) is forthcoming, the simple supply of agricultural surplus can ensure demand for only an equivalent amount of formal sector output without assuring the absorption of the ‘surplus’ per se. Because of this non-realisability of ‘surplus value’, simple supply of agricultural surplus cannot induce capitalistic expansion.

Back to our model

From our preceding analyses, we know that the value of aggregate demand for informal sector output is equal to the part of aggregate agricultural income that is spent on it.

Hence

(12) ${\text{p}}_{\text{i}}.\text{d}=\text{e}.({\text{p}}_{\text{f}}.\text{F})$

Here d signifies the aggregate demand for the informal sector output and e is the fraction of the aggregate agricultural income spent on the informal sector output or that of the aggregate marketable surplus of food transacted with this informal sector.^{Footnote 13}

From the basic feature (g) of the section ‘Basic features of our economy with both the formal and informal sectors’, we know that aggregate agricultural income is earned by selling a marketable surplus which is purchased by the agents of both formal and informal sectors. This income, in turn, is spent on the products of formal and informal sectors. As we have formulated earlier, the division of this income depends on the relevant terms of trade. Hence, we can write

(13) $\text{e}=\text{e}({\text{p}}_{\text{f}}/\text{p},{\text{p}}_{\text{f}}/{\text{p}}_{\text{i}});\text{with}{\text{e}}_1<0\text{and}{\text{e}}_2>0$

But, putting equations (3.2) and (11) into equation (13), we get

(14) $\text{e}={\text{e}}^0$

Now, rearranging equation (12), substituting equations (14) and (11) into it and assuming a fixed marketable surplus of food, F⁰, we have

(15) $\text{d}=({\text{p}}_{\text{f}}/{\text{p}}_{\text{i}}).{\text{e}}^0.{\text{F}}^0=\text{t}.{\text{e}}^0.{\text{F}}^0={\text{d}}^0$

This gives a vertical d⁰ curve on the ‘d–p_i/p_f’ plane (Figure 5).

From our characterisation of s (the net output in informal sector) as demand-determined and using equation (15), we get equilibrium s as

(16) ${\text{s}*=\text{d}}^0=\text{t}.{\text{e}}^0.{\text{F}}^0$

This equilibrium is shown graphically in Figure 5.

As s is the net output in the informal sector, gross output (y) and employment (m) can be derived, given c (the constant fraction of the informal sector output utilised intra-sectorally).

Now, in the presence of an informal sector, only the fraction (1 − e) of the aggregate food supply is directed to the formal sector instead of the full F⁰. Thus, the formal sector faces a shrinkage of food supply to [(1 − e⁰).F⁰] from F⁰ (which would have been the supply of food to the formal sector in the absence of informal sector). This supply-side squeeze reduces the formal sector’s potential employment and output. Contrarily, if we assume that given an informal sector–agriculture complex, the formal sector–agriculture composite is incorporated into the economy, the former circuit gets constricted. The introduction of the formal sector siphons off crucial food supply from the informal sector and destroys it. On the other hand, the formal sector simultaneously fills the shortage of non-food owing to the contraction of informal sector through a supply of formal sector goods and services to agriculture (exactly as in Reference Hymer and ResnickHymer and Resnick, 1969).

Thus, we have a basic conflict between the formal and informal sectors in terms of employment and output in the presence of (the generic) agricultural supply-constraint.

In our above analysis, the two complexes, the agriculture–formal sector linkage and the agriculture–informal sector interactions, are treated as separate entities. This was essential to clarify certain crucial characteristics of these two sets of interactions in the context of the centuries old debate on agriculture–industry linkage. It was also necessary to explicate the fundamental conflict between the formal and informal sectors. But we need to relax this hypothetical segregation in order to analyse certain policy issues.