Foreign Direct Investment and Rural Farm and Nonfarm Sectors in a Developing Economy

The rural nonfarm sector has been increasingly becoming a key determinant of the economic development of a developing economy. It is supposed that with process economic development of the nonfarm sector would expand and employ a greater proportion of the workforce previously engaged in the farm sector. We have built up a three-sector Harris–Todaro type dual economy model for a small open economy to investigate the consequences of the liberalized investment policy resulting in higher foreign direct investment (FDI) on the competitive rural sector wage and the urban unemployment problem taking into consideration the “consumption linkage” between the rural farm and nonfarm sectors. We have found that FDI unambiguously raises the rural wage and leads to a contraction of the farm sector. However, the consequence on the urban unemployment problem crucially hinges on the elasticities of demand for the nonfarm product and the proportion of the workforce employed in the urban sector. We have then extended the basic model to consider the “production linkage” between the two sectors in lieu of the “consumption linkage”. The results of the basic model are found to be approximately valid even in this case. Finally, we have advocated a few policies that should be adhered to assist both the farm and the nonfarm sectors to grow simultaneously which would not only make the common workers better off and mitigate the unemployment problem but would also lessen the degree of income inequality existing among the different groups of the working population. © 2017, The Indian Econometric Society.