This paper uses a framework that goes beyond rural-urban dualism and highlights the role of small town
economy (STE) in understanding structural change in a rural economy such as Bangladesh. It provides a
theoretical and empirical analysis of the role of agricultural productivity in structural transformation in
the labor market, with a focus on the differences between a village economy and a small town economy.
The empirical work is based on a general equilibrium model that formalizes the demand and labor market
linkages: the STE draws labor away from the rural areas to produce goods and services whose demand may
depend largely on rural income. The theory clarifies the role played by the income elasticity of demand and
the elasticity of wage with respect to productivity increase in agriculture. For productivity growth to lead
to a demand effect, the elasticity of wage has to be lower than a threshold. When the demand for goods
and services produced in small towns comes mainly from the adjacent rural areas, the demand effect can
more than offset the negative wage effect, and lead to higher labor allocation to the production of town
good. Using rainfall as an instrument for agricultural productivity, the empirical analysis finds a significant
positive effect of agricultural productivity shock on rice yield and agricultural wages.