Why is Agricultural Productivity So Low in Poor Countries? The Case of India

It is well known that the gap in agricultural labor productivity accounts for most of the output gap between rich and poor countries. Furthermore, development economists have pointed out that the low agricultural productivity in poor countries stems from the persistence of small non-mechanized farms. We propose and quantify a novel explanation for this phenomenon. We begin with a premise that residing in a rural area provides access to a network that effectively insures its residents against income fluctuations. If living in the rural area provides access to "insurance", households are less willing to migrate to the city - where labor earnings risk is uninsured. As a result, labor remains cheap in agriculture, and the incentives for switching to capital-intensive methods of farming are weak. In order to understand the quantitative importance of this mechanism, we calibrate the model to Indian data and study an abstract policy intervention - provision of complete insurance against earnings risk in the city. Our framework successfully accounts for the urban-rural consumption gap. The policy intervention decreases the share of workers in agriculture from 0.59 to 0.52, increases capital demand per firm by 79 percent, the average farm size increases by 9 percent and the labor productivity gap between the two sectors decreases by 32 percent.