Urbanization patterns in the Third World: Fostering efficient growth

This paper anlayzes the role of the International Financial Corporation (IFC) in promoting economic development in developing countries with the private sector. IFC promotes growth of new companies, indigenous companies, and helps to introduce more capital from private sources into developing countries. Many countries need to develop capital market institutions such as stock exchanges, securities companies, leasing companies, and financial intermediaries of one kind or another. IFC has a special department, partly financed by the World Bank, that has provided expertise in these areas to a number of countries.


This paper anlayzes the role of the International Financial Corporation (IFC) in promoting economic development in developing countries with the private sector. IFC promotes growth of new companies, indigenous companies, and helps to introduce more capital from private sources into developing countries. Many countries need to develop capital market institutions such as stock exchanges, securities companies, leasing companies, and financial intermediaries of one kind or another. IFC has a special department, partly financed by the World Bank, that has provided expertise in these areas to a number of countries.

Andrew Hamer

During the final two decades of this century, an estimated 1.1 billion persons will be added to the urban population of the developing world. In virtually all these regions, urban population growth between 1980 and 2000 will match or exceed the existing levels. Urban growth is rather an abstract concept, but the concentration of more people in larger cities is very visible. There are already 125 cities in the developing world with more than one million inhabitants each; these centers have a total population of 355 million. United Nations forecasts for the developing world predict that by the year 2000 the number of cities with more than one million residents will approach 300, and have a combined population of almost one billion.

Third World urbanization is taking place at much lower per capita income levels than those of developed countries in periods when their urban growth was comparably fast. Thus, even in the best of circumstances, planners and policymakers in developing nations face more difficult trade-offs than their earlier counterparts in the industrial world in dealing with urban management issues. These problems are compounded by the weak analytical framework within which decisions on urban management are taken.

Most of the anxiety concerning urban settlement patterns in developing countries is based on the belief that these do not conform to some “optimal” geographic distribution of population. This is generally defined as a landscape covered with a network of small- and medium-sized cities whose size depends on the country’s population. These centers, each growing at similar “moderate” rates, would, according to this view, collectively produce at least as much output as would a pattern of urbanization dominated by large cities. The purported advantage of the optimal pattern would be that the rural sector could evolve without the need to shift large groups of workers to large cities. According to this scenario all areas, urban and rural, could be upgraded simultaneously, and public services provided faster and more cheaply than if urbanization were concentrated in large centers.

In the name of this vision of “balanced” urban growth, some economic policymakers advocate regulations and licenses to limit immigration and employment growth in large centers. But the full implementation of this strategy is usually frustrated by competing interest groups within the government, who see in the concentration of urban population and production a powerful potential for cost savings. By increasing production costs, the redirection of activity to smaller centers would, they believe, impede economic growth.

Urban economists maintain that both positions have faulty analytical foundations. The optimum geography school, they argue, misunderstands the determinants and consequences of migration to large cities. By extension, it also ignores the crucial role played by the location decisions of producers of goods and services in shaping city size. As outlined below, large cities grow because it is advantageous to operate many businesses in such an environment. This is true even when such location decisions are evaluated using price signals corrected to eliminate distortions such as subsidies. The decisions of many native and immigrant workers to locate in such cities can be justified, as well. In particular, migrants tend to move from places perceived to have limited economic opportunity to areas where options are broader. These individuals are usually well-equipped to start anew. Once settled, migrants tend to fare as well as their nonmigrant counterparts in the city. Furthermore, their places of origin also benefit, through reduced population pressure and the inflow of remittances.

None of this is meant to deny that rapid city growth is difficult to accommodate. In larger cities, the unit costs of additional infrastructure may be relatively high. Nevertheless, even in such cities, services can be provided, at affordable standards, without drawing on subsidies paid by the nation as a whole.

This does not mean that only large cities are socially efficient in accommodating nonagricultural economic and demographic growth. Concentrationists assume that the clustering of nonagricultural economic activity in a few large cities, which occurs when import-substituting industrialization is imposed on an economy with few suitable locations, would remain the norm even under less distorted macroeconomic policies. But in the general economists’ view, the problem lies in condoning policies that indiscriminately pour huge subsidies into import substitutes that are otherwise unprofitable over the foreseeable future. Since the cheapest places to manufacture these products tend to be large cities, where infrastructure, skilled labor, government favors, and markets are most accessible, forced industrialization ends up promoting the premature growth of large urban centers and retarding potential urban growth elsewhere. Such an approach leads to inefficiency because it discriminates against the rural sector, and thus against smaller regional cities, in favor of an industrial development that is often inappropriate over the short and medium term, given the resource endowment of even the most advanced regions of developing countries.

Urban economists advocate a different approach. For them the key questions are whether cities, regardless of size, are effectively managed; whether local authorities can raise resources and tailor expenditures to foster economic development, building on past growth; and whether the macroeconomic environment biases the location of economic activity. In the final analysis, the spatial distribution and concentration of population and production is an outcome of the organization of the economy, as well as of geographic constraints. City sizes and urban settlement patterns cannot be “willed” into being; they are dependent on the economic system.

Stages of urbanization

In most countries, during the early stages of development, the degree of urbanization appears to be closely associated with the rate of economic activity. Rapidly growing economies urbanize more quickly than slowly growing ones; and urbanization responds more immediately to economic growth at low levels of per capita income than at higher levels. In the course of development, there is a systematic shift from natural resource-based activities to secondary (industrial) and tertiary (service-based) ones. These locate in cities and towns for a straightforward reason: productivity is enhanced by the concentration of people and capital. Such “agglomeration economies” that flow from proximity to a source of production are enhanced by technologies that permit increased output per unit of land in secondary and tertiary production.

The size, number, and distribution of cities are also affected by national or regional production patterns, namely, by the tradable goods and services that cities export to other areas, as well as the demand generated for purely local goods and services. The development process that increases overall urbanization also changes the composition of tradables produced in urban centers. This has implications for the types of urban centers that are likely to grow relatively rapidly at each stage.

Assuming a country is well endowed with natural resources and manpower, its urban evolution typically follows a predictable pattern. Early urbanization will be closely linked to servicing agriculture, processing natural resources for regional or international markets, and producing simple manufactures that are competitive with potential imports. Such activities might include mining and agroprocessing, the production of construction materials, beverages, textiles and handicrafts, and the repair and production of simple structures and machines.

At this stage, many of the constraints associated with such an underdeveloped economy are indeed best overcome in the larger centers. They have a relatively large and diversified pool of labor; information is available about new markets or technologies; and more infrastructure is in place than in the less visible, smaller centers. Large centers also generally combine sizable local markets with access to the outside world. Major ports, for example, can generate income from shipments of exports, while making imports available to local producers without exacting a high surcharge for domestic land transportation.

These factors suggest that the leading productive activities of early industrial development will be located in large centers. The exceptions include (1) plants using inputs that are perishable or undergo large weight losses in processing; (2) establishments processing resources shipped directly to export markets; (3) enterprises marketing products at prices competitive with those of products shipped over great distances; and (4) agribusiness and local administrative services. As long as industries can produce substantially more cheaply by being concentrated in a few large centers, the basis for extensive trade between many cities is limited, and the development of rapidly growing, specialized secondary centers postponed.

Assuming moderate competence in the public sector, development constraints should ease in the periods that follow. Production will become more diversified; engineering, metallurgy, and other modern subsectors will appear; and the centers will expand. Metropolitan establishments will create branch plants or transfer their operations to these nearby areas, taking advantage of lower land, labor, and transport costs. Local entrepreneurs in these same emerging, but still dependent, communities will expand their activities, responding to the new opportunities offered by improved accessibility, better public services, and the selective cost’ savings available outside the major centers.

But the process of growth in self-standing secondary centers will be slower, and depend primarily on local entrepreneurs and investors. Secondary centers will only begin to emerge as the production and marketing processes of an increasing number of activities become more standardized; as transport and communications become easier; and as local investments in public services and trained manpower are increased. There will then no longer be an automatic link between lower production costs and greater city size.

As development proceeds, a variety of industrial firms find that they can be most efficient if they locate themselves with firms producing similar products, in smaller urban centers, where land is inexpensive and labor available at relatively low wages. Improved roads and communications allow these “peripheral” producers to reach ever-wider domestic and international markets. The stage is thus set for secondary centers to specialize in particular types of relatively routine activity, reap the benefits of lower costs associated with the concentration of production within an industry, and trade extensively. Large centers then find new sources of comparative advantage by attracting selected high-growth activities, in many of which production is still cheaper in major cities. These activities involve the production of unstandardized, advanced technology items; sophisticated business services; and goods subject to rapid changes in input or output characteristics. Metropolitan markets also continue to attract a variety of small firms producing consumer goods.

Role for public policy

During the earlier stage of development, when decentralized industrialization is limited by the fact that most economic activity has to be concentrated, it is quite useless to try to force it away from large cities. But as more infrastructure is installed, and experience with industrial processes increases, the encouragement of secondary centers becomes consistent with maximizing national economic growth. To foster the expansion of tradable goods and services in secondary cities—and local activities that respond to that growth—public services must be improved and regional and interregional access enhanced. At one level, this may appear intuitively obvious; better infrastructure reduces the overall costs of doing business. Less apparent is the important role these improvements play in attracting and retaining highly skilled workers, managers, and entrepreneurs, whose absence can be a critical constraint on the growth of productive activities in secondary centers.

Studies in both developed and developing countries have demonstrated that highly skilled and unskilled labor are rather poor substitutes for each other. This means that the additional production of tradables requires fairly rigid combinations of skills; it is thus constrained by factors in short supply, typically skilled labor. Skilled workers base their decisions, at least partly, on the amenities offered by different work centers. Spontaneous, decentralized growth therefore depends on overcoming the “disamenities” of secondary centers, often by extending and improving public services. As these improve, local businesses can reduce the wage packages they offer to skilled workers. At some stage, the resulting savings may not only allow greater scope for expansion for individual firms, but may even determine the viability of many lines of activity in any given urban center.

Public policies have important effects on the development of particular cities—even where they are not designed to—through attracting scarce skills. Such implicit effects are difficult to measure with precision, since the eventual impact of these policies depends on the even more indirect ways in which factors of production (labor, capital, and land) adjust to them. Some general conclusions can be reached, however, on the most effective policies.

The first is that any measure promoting a given activity will benefit the urban area in which it is located. The requirements of different production processes vary widely across industrial subsectors, as do the supplies of particular inputs across cities. At one extreme, some inputs—such as easy access to an international port or to central government officials—may be available at only a few locations. Policies promoting firms dependent upon such inputs may result in long-term advantages for those urban areas.

As already mentioned, experience in a range of developing countries suggests that most heavily protected activities tend to be located in large urban centers, where they can satisfy their exceptional need for imports, sophisticated factors of production, and access to officials who grant discretionary favors. This effect implies that the greater the bias in favor of import substitution, the greater the incentive to concentrate production and population in a major metropolis.

Clearly, a shift in the emphasis of public policy away from a protectionist trade regime would benefit secondary cities. The full effects of a change in policies would take time to be felt, especially if the overall level of economic development is low. Even if trade protectionism were reduced, for instance, diversified industrialization outside a handful of cities would be constrained by poor access to national or international markets, limited availability of local infrastructure, and a persistently uneven distribution of skilled workers. Nevertheless, reductions in market distortions, implemented primarily to enhance macroeconomic performance, would also help to disperse production geographically over the long run. With reasonably uniform, and relatively low, protection for all sectors, for example, industrial activities would emerge that could provide the basis for the efficient growth of smaller centers. Simultaneously, careful management of the development process would allow for investments that would gradually ease locational constraints. In the long run, more cities would be able to accommodate more producers, and modernization would no longer coincide with growth in one or two centers.

Similar comments could be made about the organization of financial institutions making long-term loans in developing countries. Both cities and the establishments within them must be able to match self-generated resources with loans, to finance long-term growth. Cities are rarely encouraged to compete with one another for access to loans, and most investments are paid for by handouts from the central government, which tends to discriminate in favor of large cities, especially the capital. Business finds that public development banks discriminate in favor of enterprises capable of establishing and maintaining face-to-face contact in the principal financial centers. Because of various institutional restrictions, commercial banks in secondary centers do not fill this void by providing long-term capital. As a result, in secondary cities, all but the very largest firms are frozen out of the market for long-term funds, even when their real returns are high.

These examples illustrate one point: if any individual sectoral policy is ill-advised on macroeconomic grounds, and hampers the development of most urban centers, the latter is one more reason to consider reform. Ignoring the implicit impact of such policies on urban centers means encouraging the selective reinforcement of particular cities at the expense of others, even when there is no efficiency rationale for doing so.

Effective interventions

At any given time, only a few public initiatives will be possible, and unfortunately, the very conditions that call for remedial action limit the funds and the competent personnel available to implement it. In addition, urban growth is the outcome of decisions by millions of individual households and businesses concerning location; these processes are so complex and so interdependent that policies can do little more than set the broad parameters for such decision making.

For these reasons, the temptation to assign an optimal size to each city as a goal of public policy, and to back that up with city-specific licenses, prohibitions, and subsidies, should be resisted. Experience has shown that the implementation costs of such “direct” approaches are prohibitively high, while the benefits would be small compared with those that would emerge from improved macroeconomic and sectoral policies.

In fact, the relative attractiveness of cities depends most on policies that have little of the gloss and glamor of traditional “spatial” policies. Although there is no quantitative model that can be used to predict the changes in relative city sizes that would be caused by particular policy reforms, the net effect of more efficient macroeconomic and sectoral policies is to encourage more decentralized urban development in the long run. This decentralized development will occur not because it is politically desirable but because it allows the actual growth of national output to approach its potential.

Some recommendations are possible on the basis of an analysis of the potential of and limitations to effective public policy.

• Large dividends can be reaped by gradually improving the access of secondary centers to domestic and international markets. These will reduce the importance of physical proximity to the main consumer markets, which otherwise largely dictates location.

• Improved transport and communications must be accompanied by a reduction in the role played by discretionary incentives, which depend on access to government bureaucrats. These incentives distort production, decisions, while encouraging business to locate near the centers of government power.

• Price incentives that encourage economic activities to become concentrated in large cities, especially those incentives associated with international trade regulation, should be modified to reduce the bias against secondary centers.

• A reform of macroeconomic and sectoral policies must include measures that free the rural sector from punitive domestic controls, heavy implicit or explicit export taxes, severe constraints on the use of yield-boosting inputs, and poorly planned systems of credit. A healthy rural sector provides a base for the expansion of firms in secondary cities, while improving overall national growth prospects.

• Government should be encouraged to develop industrial zones and discrete estates only in areas of proven growth or well-documented potential. The opportunity cost of underutilized public investment in industrial infrastructure is so high that developing countries cannot afford to invest to induce firms to move to areas with limited potential. At most stages of development, the areas with potential for industrial growth are clear; elsewhere, the obstacles to growth are such that even radical improvements in infrastructure will not promote it.

• Public industrial investment should not be made to accommodate arbitrary regional dispersal objectives. It can be argued that public enterprises have a special role to play in pioneering the development of nontraditional locations. However, if this is taken to mean that public ventures should indefinitely accept sharply lower profits, such a view is debatable, if not unacceptable. Public ventures should be sited in areas of known development potential, except where the inputs used (e.g. minerals) justify an unusual location.

• Improved access to public services and education in individual urban areas plays an important role in increasing the relative attractiveness of secondary centers over time. To avoid waste, to leverage scarce central government resources, and to direct investments to growth areas, cities should compete with one another for grants and loans. This process of “self-selection” would force localities to make substantial efforts to mobilize resources, both to match grants and to pay off loans.

In the end, spatial patterns of population and employment are the indirect outcome of the policies, geographic features, and stage of development that shape the behavior of households and enterprises. The history of explicit spatial policies demonstrates conclusively that promoting locations to achieve some arbitrary spatial goal is often counterproductive. Instead, policies should ensure a macroeconomic environment that supports efficient and broad-based growth, and back this by a gradual expansion of interregional investments in transportation, communications, local infrastructure, and education. Most city-specific investments should be contingent on substantial local financing; subsidization of the urban sector, or any of its component parts, should be avoided. This approach should effectively moderate the growth of cities whose expansion, at the margin, is costly, and will minimize the subsidization of city dwellers by rural residents. It is with such mundane prescriptions, applied consistently over time, that the spatial constraints on development can be removed without reducing economic growth.

International Debt and the Developing Countries

edited by Gordon W. Smith and John T. Cuddington

This book presents a well-balanced blend of theory, country experience, and econometric analysis to address the problem of international debt. Applies new microeconomic theories of international borrowing and lending to recent experience. Suggests ways to reduce future debt crises.

Includes case studies of Argentina, Brazil, Chile, the Republic of Korea, and Mexico.

Focuses on:

  • the domestic and external roots of the current problem

  • the dynamics of debt crises

  • proposals to improve the international system for transferring resources to developing countries

Finance & Development, March 1985
Author: International Monetary Fund. External Relations Dept.