Urban development, excessive entry of firms and wage inequality in developing countries

• Author: Mong Shan Ee,Daniel Hollas,Hamid Beladi,Chi‐Chur Chao
• Date: 01 January 2020
• Published date: 01 January 2020
• DOI: http://doi.org/10.1111/twec.12778

SPECIAL ISSUE ARTICLE

Urban development, excessive entry of firms and

wage inequality in developing countries

Hamid Beladi

1

|

Chi-Chur Chao

2

|

Mong Shan Ee

3

|

Daniel Hollas

1

1

College of Business, University of Texas at San Antonio, San Antonio, Texas

2

Department of Economics, Faculty of Business and Law, Deakin University, Burwood, Victoria, Australia

3

Department of Finance, Faculty of Business and Law, Deakin University, Burwood, Victoria, Australia

KEYWORDS

developing economies, firm entry, urbanisation, wage inequality

1

|

INTRODUCTION

Urbanisation refers to a population influx from rural areas to urban cities to seek better opportuni-

ties. Urbanisation has been an unavoidable trend in both developed and developing economies. In

2015, 81.6% of the US population lived in cities, with an annual growth of 1.02%, while urban

population accounted for 55.6% in China, with a 3.05% annual rate of urbanisation.

1

In 2012, the

United Nations forecasts that by 2050, the level of urbanisation for developed and developing

countries would reach 85.9% and 64.1%, respectively.

2

In developing countries, urbanisation is necessary for economic development and is almost syn-

onymous to modernisation. Harris and Todaro (H‐T) (1970) developed a dual structure model for a

developing economy in which the modern urban manufacturing sector is much more advanc ed than

the traditional rural agricultural sector. In H‐T's model, urban workers receive an institutionally set

minimum wage rate that exceeds the market‐determined wage rate in the rural sector. Thus, by

shifting rural workers to urban, highly productive jobs, urbanisation can increase production effi-

ciency and hence national income (cf. Restuccia & Rogerson, 2013). This theory has been used to

explain the economic advances made in some Western developed countries.

However, critics of the above theory view urbanisation less favourably, for the following reasons:

1. Urbanisation results in urban unemploym ent, which can cause social problems that are detri-

mental to the economic welfare of society.

2. Urbanisation via urban development poli cies benefits urban firms at the expense of the rural

sector. This has a negative effect on rural workers.

1

See “The World Factbook”by Central Intelligence Agency. Retrieved 29 March 2016.

2

See “Urban life: Open‐air computers.”The Economist. 27 October 2012.

Received: 22 September 2016

|

Revised: 12 December 2018

|

Accepted: 15 December 2018

DOI: 10.1111/twec.12778

212

|

© 2019 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2020;43:212–238.

3. Urbanisation might attract new firms to the urban sector, leading to excessive entry of firms.

This can lead to a higher demand for skilled labour and capital, which improves their returns

relative to the returns to unskilled labour.

Thus, urbanisation can reduce the overall social welfare in the short term if the cost of urban

unemployment exceeds the benefits of production efficiency. Additionally, in the long term, urban-

isation can widen the wage gap between urban skilled labour and rural unskilled labour from

excessive entry of firms in the urban sector.

The issues related to urbanisation and urban development policies in developing economies are

widely covered in the literature on the subject. Using a Heckscher‐Ohlin framework with sectoral

mobile labour and capital as production inputs, Khan (1980a) finds that the economy can benefit

from providing subsidies to labour and capital. However, the issue of wage inequality is not

addressed in his model because labour is assumed to be homogenous. With regard to production

subsidies, Beladi and Marjit (1996) find that in a vertically linked H‐T model, a reduction in tariffs

on urban goods can reduce capital costs and hence reduce urban unemployment. Conversely,

Chang, Kaltanic, and Loayza (2009) claim that in the urban sector, a reduction in tariffs improves

production efficiency but worsens unemployment in an H‐T model that has labour as the only pro-

duction input. Further, the above studies assume perfect competition in the urban sector. Nonethe-

less, in reality, imperfect competition prevails in the urban manufacturing sector in both developed

economies and developing countries.

Urbanisation can expand firm production because of improved scale economies (Krugman,

1984), as well as attract new firms to the urban sector. However, favourable urban development

policies may lead to excessive entry of urban firms (cf. Mankiw & Whinston, 1986), which may

increase the demand for capital and skilled labour and hence raise their returns, thereby widen-

ing the gap between skilled and unskilled labours' returns. The effect of urbanisation on wage

inequality has been discussed in Kuznets (1955), which indicates urbanisation as one of the

forces that may lead to income inequality following an inverted‐U shape along the development

process.

The main contribution of this paper is to study the impact of urbanisation on income

inequality in a developing economy. Our focus is on the effects of government urban develop-

ment policies on the structural transformation of the economy, particularly on shifting rural

workers to urban, highly productive jobs. In addition, not only the labour can shift from rural

to urban sectors but firms can also enter. To this end, we connect the urbanisation‐excessive

entry argument to the distortion literature by Bhagwati (1971). Specifically, based on the exis-

tence of the institutionally set minimum urban wage, we suggest the possibility of a second‐

best policy prescription, such as subsidies to urban production, to tackle monopoly and unem-

ployment distortions, along with free mobility of production factors, such as capital, which is

in the national interest of social welfare.

This study demonstrates empirically that the implementation of favourable urban development

policies may widen the income inequality gap via the firm dynamics channel. Thus, our study dif-

fers from, but also is complementary to, the past literature examining the relationship between

urbanisation and income inequality, which has documented mixed results. For example, Wheeler

(2001) reports an average 2.7% increase in a worker's hourly wage in the metropolitan area of Uni-

ted States relative to the non‐metropolitan area when the population in metropolitan areas doubles,

while using census and surveys data, Baum‐Snow and Pavan (2013) demonstrate a positive rela-

tionship between city size and income inequality in the United States. Focusing on China, Cai,

Chen, and Zhou (2010) find that urbanisation is a factor that accounts for the increase in income

BELADI ET AL.

|

213