At the start of the 20th century, 1 out of 8 people in the world lived in urban areas, and by the 1950s, it was nearly 1 in 3. Now, it is 1 in 2. In the coming decades, virtually all population growth will be in urban areas. In East Asia, the urban population is expected to increase by about 450 million people over the next two decades, meaning that a city the size of Paris will be added every month.
In South and Central Asia, the increase is expected to be nearly 350 million, and in Sub-Saharan Africa almost 250 million. Yet unlike the industrialized world where urbanization unfolded over many decades (thereby allowing public and private sector institutions to mature gradually), the process in developing nations is far faster and is unfolding against a backdrop of rapid population growth, lower incomes, and fewer opportunities for international migration.
While urbanization is a long-studied concept, it remains poorly understood. For increases in population density give rise to social, environmental and administrative challenges that are easily recognizable, such as public sanitation problems, inadequate supplies of formal housing, traffic congestion and crime. In other words, the “costs of grime, time and crime”.
These challenges and costs mask the fact that the process of urbanization – if well managed by policymakers and public institutions – can have hugely positive impacts on national development and poverty-reduction efforts.
In wealthier nations, urban areas account for a greater share of national GDP than in less developed countries, with the urban share of national output approaching 80% in OECD countries versus around 50% for lower income countries. Additionally, recent studies have documented how changes in urbanization levels reflect changes in the proportion of GDP generated by and the proportion of the workforce in industry and services. In other words, a country urbanizes as its economy and workforce become more centered on industry and services (as opposed to agriculture and primary activities). In its 2008 report, the Commission on Growth and Development affirmed that “no country has industrialized without also urbanizing.”
But is urban growth merely a byproduct of increased urban economic activity, or does the process of urbanization actually fuel economic success? To understand the economic impact of urbanization, one must first understand the concept of economies of scale, an economic term that describes the situation in which the average per-unit cost of production falls with increased levels of production. In other words, it costs less for a large-scale manufacturer to produce extra units than it does for a small-scale producer.
Producers also tend to choose their location to be near their customers and suppliers in order to reduce transport costs. By extension, the producers’ suppliers have an incentive to be geographically close to the producers (who are their customers), as these input suppliers also seek the benefits of scale economies. This natural market incentive for input suppliers, manufacturers and consumers to geographically aggregate is the driving force behind the creation of cities and towns. Economies of agglomeration is the term used to describe the benefits that firms obtain when locating near each other.
For example, competing financial service firms benefit from being in close spatial proximity to each other in New York, London and Nairobi because the volume of co-location stimulates the growth of legal firms and software firms that provide specialized services to the financial sector. Additionally, by providing a thick market, these locations attract skilled labor, the mobility of which facilitates the sharing of practices and ideas.
Agglomeration benefits also arise from the spatial concentration of a large number of different industries, as urban diversity can foster the exchange of ideas and technology and can protect local economies from sector-specific shocks. It also diversifies the supply of skilled labor and encourages the entry of specialized service providers and consultants. For example, a firm looking to hire an architectural engineer might be hard-pressed to find any engineer, let alone an architectural engineer, if located in a remote rural area. In contrast, hiring such a specialist is likely to be far easier if the employer is located in Tokyo, Toronto or Bangkok.
In sum, economic research and historical observation show that urbanization can yield increased returns to scale by facilitating more efficient flows of goods and services, matching of workers to jobs, and engendering spillovers of knowledge and good practices. As such, urbanization can form a virtuous and self-reinforcing cycle with economic growth and modernization.
However, the spatial concentration of people and firms does not, in and of itself, automatically bring about the benefits of scale economies and economic agglomeration. As mentioned above, increases in population density also give rise to pressing social, environmental and administrative challenges, which if not addressed by adequate public services, institutions and infrastructure, can overwhelm local services and the costs of grime, time and crime can suffocate economic growth. Therefore, if urbanization is to be a smooth process that contributes positively to local and national economic development, well-functioning public sector institutions and governance structures must be in place. This reality highlights the need for improved public governance in the developing world.