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8 The Urban Economy Transformed Much of development economics is concerned with fostering economic growth, alleviating poverty, and improving the general standard of living of people in low- and middle-income countries. Employment and earnings from labor are central concerns because for most households, labor earnings represent the largest portion of total income, and poverty is often the result of insufficient access to adequate employment. As urban population projections make clear, the urban economies of many developing countries are facing an unprecedented challenge to generate a sufficient number of new jobs at reasonable wages to absorb a growing and better- educated labor force. The purpose of this chapter is to examine several of the critical elements in the nature of urban labor supply and employment. Of course, no single chapter can do justice to the complexities of urban economic relations, and the attempt made here is far from comprehensive. From the great variety of issues associated with urban economies, we focus on a selected few that have the greatest demographic resonance. In many ways, the urban economy shapes urban demography. Urban eco- nomies generate the resources upon which governments draw to extend public services, whether in family planning, education, or health, and to undertake in- vestments in the public health infrastructure. The scale of the urban economy can enable specialization in economic activities and foster the growth of private mar- kets, with the markets in health services being of particular significance. At the level of families, income from labor and economic enterprises provides a means of purchasing health, education, and other services. The incomes of women, when considered in relation to those of men, have much to do with the returns to marriage. The economic returns to schooling have been a central theme in this report, and we have repeatedly emphasized their importance to family strategies involving lower fertility but greater schooling per child. Urban incomes and edu- cational returns also affect migration, whether from rural areas or from other urban 300

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THE URBAN ECONOMY TRANSFORMED 301 areas. For these reasons, no study of urban demography can neglect its economic . . unc erpmmngs. To set the discussion in context, we begin with an introductory section that sketches the main sectoral and spatial features affecting labor markets and urban economies. This section highlights the analogies between the social externalities that arise from urban diversity and proximity and the economic externalities that arise from the same general sources. As will be seen, there is an economic role for social networks, one of the mechanisms highlighted in previous chapters. Our treatment of sectoral and spatial factors must be brief, but several superb literature reviews can be consulted for more detail (see, for example, Williamson, 1988; Eberts and McMillen, 1999; Becker and Morrison, 1999~. Unemployment and poverty in urban labor markets in developing countries are often attributed to la- bor market failure, but our review highlights how the differences between labor markets in high- and low-income countries have probably been overemphasized. Economists are now reexamining the structure of wages and earnings within urban labor markets in low-income countries to assess more carefully the role of human capital and institutional factors in determining earnings. Many of the issues now being raised have long been themes in research on industrially more-developed economies. In the following section, attention turns to urban growth and the economic re- turns to schooling. The potential contribution of education to improving economic productivity, lowering income inequality, and promoting growth and development is well known, and almost all governments allocate a considerable share of their budgets to public expenditures on education. For many capital- and natural- resource-starved countries, human resources may represent the only route to suc- cessful development. As noted above, the economic returns to schooling are also important determinants of demographic behavior. They influence parental assess- ments of the payoffs for investment in children's education and fertility decline. Also, to the extent that schooling returns are higher in urban than in rural areas or differ across cities, they exert influence on both the rate and direction of migration. Yet when the urban supply of educated labor is increasing rapidly, as it appears to be in most developing countries, one wonders how high returns to schooling can be maintained. This section explores the issues by way of case studies. Migration, another central element in the size and nature of the urban labor force, is discussed in the next section, where we reassess the conceptual frame- works that so dominated thinking in the 1970s and 1980s the Todaro (1969) and Harris and Todaro (1970) migration models. Given the changing nature of urban systems, to what extent are the assumptions made by Todaro and Harris- about the attractions of urban "formal-sector" jobs and dualistic conceptions of the urban economy still valid and useful? In considering the issues, we examine migration as it is influenced by urban economic structure, review what is known of urban economic mobility and income dynamics, and then explore (in the next sec- tion) dualistic assumptions about segmented urban labor markets. Here we look

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302 CITIES TRANSFORMED critically at the proposition that sectoral barriers and rigidities are a root cause of urban economic inequalities, and examine the evidence for increasing hetero- geneity in the urban informal sector. We next review several case studies showing how labor demand and supply factors have come together to generate inequality in urban Brazil, Taiwan, and China, countries that can offer rich longitudinal data on urban earnings. The penultimate section of the chapter examines international facets of urban economies, factors that doubtless will increasingly condition urban labor markets in developing countries in the future and affect their labor absorption capacity. We present evidence on the urban implications of foreign direct investment, discuss the role of globalized networks of high-end business services, and examine how heightened exposure to world markets with their attendant benefits, costs, and uncertainties can affect the lives of urban residents disproportionately. The final section of the chapter presents conclusions and recommendations. SECTOR AND SPACE At the outset, we must distinguish sectoral from spatial influences. To see why, consider Engel's law that the income elasticity of demand for manufactured goods and services is greater than that for primary products. When demand conforms to Engel's law, an increase in a country's income per capita shifts the composition of its demand toward manufacturing and services and away from agriculture, mining, and related sectors. Shifts in the demand for labor (and other inputs) in each sector accompany these changes in final demand. Although it is tempting to think of manufacturing and services as urban activi- ties and to conclude that national income growth leads inexorably to urbanization, nothing in Engel's law actually implies this. Engel effects are aspatial. Addi- tional argument is needed to show why manufacturing and services tend to be located in cities, that is, in spatially concentrated clusters of labor and production. Spatial concentration offers some cost and productivity advantages, but because these come bundled together with disadvantages (e.g., congestion, negative exter- nalities), the spatial side of the story has its own logic. Engel effects that steadily shift the composition of demand can at first be expressed in spatial concentration and higher levels of urbanization, but later be expressed in the spatial deconcen- tration of the urban population, if not in lower levels of urbanization as such. In this section, we first examine sectoral effects, aiming mainly to show how urbanization can be a natural consequence of national economic growth or, more precisely, a consequence of the factors that produce national growth. We then take up spatial effects by considering both the benefits and costs of urban spatial con- centration. A review of the productivity advantages associated with spatial clus- tering suggests that urbanization may well be a cause of national economic growth in addition to being a consequence. The mechanisms involved are the spatial

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THE URBAN ECONOMY TRANSFORMED 303 counterparts to the forces highlighted by the "new growth theory" in economics (e.g., Lucas, 1988~. In sorting through the many linkages between national and urban growth, we really cannot hope to disentangle cause from consequence. Even so, it may be useful to review the strong associations that have been documented repeatedly in the literature. We note four points. First, where national statistical systems permit such a decomposition, studies have shown that the urban share of the na- tional economy can be far greater than its population share alone would suggest. In the case of Mexico, a careful analysis of 1998 economic census data at the municipality level by Sobrino (2002) shows that the five largest metropolitan ar- eas accounted for 53 percent of national value added in industry, commerce, and services while housing only 28 percent of Mexico's population (United Nations, 2001~. Mexico's 10 largest cities, with only one-third of the country's population, generate 62 percent of national value added. Figures such as these underscore the importance of city economies to national levels of income. Even from an ac- countant's perspective, it is difficult to conceive of national economic activity and urban activity as somehow occurring in separate spheres. Second, because the size of the urban informal sector tends to be poorly mea- sured in national income accounts we discuss the informal sector later in this chapter there is reason to think that the urban share of the national economy may often be underestimated. One study of West Africa reconstitutes the production and trade flows of 1960 by applying social accounting matrix techniques (sour, 1994~. These revisions suggest that national gross domestic product (GDP) was understated by as much as 30 to 50 percent in the national income accounts. The revised methods reveal that West African cities provided two-thirds of real GDP, rather than the mere 38 percent indicated in the conventional accounts. Third, to get a sense of the urban contribution to national growth, one can look at cross-country data on growth in value added (World Bank, 2000a). Of the total growth in national value added among low-income countries from 1980 to 1998, fully 86 percent is attributable to growth in industry and services.! The urban contribution must be somewhat less than this because some services and industries are located in rural areas. Nevertheless, the figure suggests the extent to which national economic growth derives from urban growth, and it conveys something of the force of Engel's law. Fourth, a number of statistical studies have found that higher levels of na- tional income and faster national growth spur urbanization. Among the many studies that have examined such correlations, we single out the following few. Moomaw and Shatter (1996), using data from 90 countries for 1960, 1970, and 1980, show that the urban share of the population increases with national income per capita; the share is also increased by industrialization, trade orientation, and ~ Excluding India and China, calculations by the panel put the industry and services share of growth at 83 percent.

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304 CITIES TRANSFORMED foreign capital inflows. Brockerhoff (1999) examines the population growth rates of a large number of developing-country cities. He finds that growth in gross na- tional product (GNP) per capita encourages city growth. In earlier work, Becker and Morrison (1988) reach a similar conclusion for the countries of sub-Saharan Africa. Gaviria and Stein (2000) also find a strong positive effect of growth in GDP per capita on the population growth rates of large cities.2 Although studies such as these do not firmly establish the direction of causation, they do show that the association between urban and national economic growth is robust and worthy of attention. Sectoral Effects Kelley and Williamson (1984) give a highly instructive account of the sectoral factors involved in urban growth. They formulate what is termed a "computable general equilibrium" model and use simulations to illustrate their main analytic points.3 These authors consider the case of a hypothetical country that is a price taker in international markets, which is to say that the prices of its agricultural and manufactured goods are taken to be externally determined. Changes in the relative price of manufactured goods affect the relative demand for labor in man- ufacturing. If manufacturing is indeed an urban activity, then an increase in the relative price of its products leads to faster urban growth and, in time, to a higher urban population share. In this way, changes in the international terms of trade between manufactured and agricultural goods can have an impact on the national level and pace of urbanization. Two types of technological progress are considered in the Kelley-Williamson framework. Neutral or "balanced" technical change which enhances the pro- ductivity of both agricultural and manufacturing activities to the same extent acts much like an increase in average national income and exerts an influence on relative demands for labor through Engel effects. Unbalanced technical change, in which faster progress is made in manufacturing than in agriculture, is expressed in labor markets by faster growth in the demand for manufacturing jobs. This fo- cused impact on manufacturing is augmented by the Engel effects that generally accompany technological progress. In the Kelley-Williamson simulations, unbal- anced technological change is shown to exert a powerful influence on the pace of urban growth. Technological change is less potent, however, when prices are determined in domestic rather than world markets, especially when those domestic markets are 2The Gaviria and Stein estimate retains its strength in the presence of country fixed effects. A1- though urban population growth and national income growth are correlated because both depend on country-specific fixed factors, there is clearly more to the story than this. 3 The model contains a number of sectors, but for convenience we refer here only to manufacturing and agriculture. Other sectors play key mediating roles. In particular, the prices of nontradeable goods and services, such as urban housing, are bid up as the model's population shifts to urban areas. These changes in the urban cost of living keep the extent and pace of urbanization in check.

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THE URBAN ECONOMY TRANSFORMED 305 competitive. In such cases, technological progress favoring manufacturing will reduce marginal costs in that sector; under competitive pressures, the result will be lower prices for manufactured goods. Price declines, in turn, slow growth in the derived demand for manufacturing jobs. The differences in the effects of technological progress can be seen by comparing the price-taking, open-economy model of Kelley and Williamson with a similar model developed for India (Becker, Williamson, and Mills, 1992) in which prices are determined largely in domestic markets. In the latter case, technological progress continues to exert some influ- ence on urban population growth, but this influence is mild by comparison with the price-taking open-economy case. Just how technological change takes place in poor countries has been much debated. A number of studies suggest that when these countries are able to export manufactured goods, supplier-customer linkages are established that facilitate the adoption of new technologies and spread commercial know-how (Pack and Page, 1994; Tybout, 2000~. The recent literature is ably summarized by Rauch (2001), who describes how exports can give firms and entrepreneurs an entree to interna- tional business networks. Technological progress is generally thought to be skill- biased, in the sense that adoption of new technology raises the relative demand for educated, skilled labor (Johnson, 1997~. This may explain in part why cities possess (and attract) better-educated workers. But as Rodrik (1997) points out, it is very difficult to separate the effects of technological change from those of phys- ical capital accumulation, which is also thought to be strongly complementary to skills (Fallon and Layard,1975~. The process of capital accumulation is acknowledged to be central to eco- nomic growth some authors (e.g., Young, 1995) assign it the leading role and of course a large portion of any country's investment in plant, equipment, and in- frastructure will be found in its cities. But the size of a country's capital stock is one matter and its spatial concentration another. The agglomeration economies that urban sites offer to private firms (discussed in the next section) provide a par- tial explanation for the urban concentration of capital. However, these private ad- vantages depend crucially on governments' complementary capital investments in urban public services and infrastructure (Eberts and McMillen, l999~. Productive cities must be highly capital-intensive. An urban bias in government expenditures may further concentrate capital in cities, as discussed below. But does urbanization itself help mobilize the savings from which such in- vestments are made? It is certainly reasonable to think so.4 As documented in Chapter 4, city populations are more concentrated in the working and saving ages than are rural populations, and they contain relatively fewer young dependents. 4 Two gaps between domestic savings and investment are worth mentioning here. First, urban savings are not necessarily invested domestically; capital flight is evident in sub-Saharan Africa, where, as Collier and Gunning (1999b) show, about 39 percent of all domestic savings is invested outside the region. Second, as discussed later in this chapter, foreign direct investment is an increasingly important source of capital in the cities of some developing countries.

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306 CITIES TRANSFORMED BOX 8.1 Industrialization and Social Capital in Indonesia There is much interest in the linkage between social capital and industrialization, but as yet very little by way of data with which to explore this linkage. Cross-sectional studies have suggested that the two are positively associated, but such studies leave it unclear whether social capital supports economic development, economic development gives rise to social capital, or the two are linked in a system of mutual causation. Exploiting unusual panel data on Indonesian districts in the period 1985 to 1997, Miguel, Gertler, and Levine (2001) find that growth in a district's manufacturing employ- ment appears to spur the development of local social capital, as measured by participation in arts and recreational groups and some types of credit cooperatives. However, the spa- tial impact is uneven. Because some districts become sites of flourishing manufacturing growth while others do not, social capital also grows unevenly. Outmigration occurs as mi- grants seek manufacturing jobs in nearby districts, and migration, in turn, erodes individual incentives to invest further in social capital in the origin districts. The loss of social capital is particularly evident for informal credit and mutual assistance groups, which depend for their survival on an assumption of stable and reciprocal exchange. Upon examining the other direction of causation, the authors find no compelling ev- idence that social capital either attracts or fosters manufacturing growth. (As they ac- knowledge, establishing causation is difficult even with longitudinal data.) A complicating factor is that the local groups studied in this research are often chapters or affiliates of na- tional groups, and are overseen by their national boards and by government. Hence, local groups probably cannot be viewed as groups that fade or flourish according to purely local circumstances. In national populations, at least, lower dependency ratios have been shown to fos- ter higher average savings rates (Higgins, 1997; Deaton and Paxson, 2000; Lee, Mason, and Miller, 2000~. Urban incomes are higher than rural on average, and this must also encourage savings (Loayza, Schmidt-Hebbel, and Serven, 2000b). In addition, cities house the financial institutions that should allow savings to be monetized rather than held in the form of illiquid physical assets. In formulating their general equilibrium model, Kelley and Williamson (1984: 59-60, 218-20) thought it safe to assume that urban households have higher savings rates than rural households. All this notwithstanding, however, one finds surprisingly little research in which urban savings rates are compared directly with rural rates.5 Indeed, the recent evidence suggests that the savings rates of rural households may well be higher than urban rates. In analyses based on cross-national datasets, Loayza, Schmidt-Hebbel, and Serven (2000a,b), show that with other things held constant, the level of urbanization is negatively associated with average savings rates. 5Severe conceptual and measurement difficulties the valuation of flows from consumer durables such as urban housing (Gersovitz, 1988), the measurement of business savings (retained profits), and the absence of spatially disaggregated data on government savings render such comparisons uncommon.

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THE URBAN ECONOMY TRANSFORMED 307 Loayza and Shankar (2000) explore the case of India in detail, using time- series data for 1960-1995. They find private savings rates to be positively asso- ciated with the share of agriculture in GDP. From such aggregate data, it would appear that rural Indians, who lack other means to diversify the risks they con- front, engage in more precautionary savings than do urban residents. Weather and related sources of risk introduce a substantial element of uncertainty in rural areas, and rural economies often lack the protective institutions found in cities. In China, replacement of the commune system with a system of household responsibility reforms that spurred income growth but also removed some insti- tutional protections against risk evidently led to sharp increases in rural savings rates (Kraay,2000~. By contrast, the protections extended in urban areas through work units and state subsidies left these populations without the same incentives to save, at least until recently. According to Kraay, urban household savings rates remained well below rural rates into the mid-199Os. Unfortunately, the data avail- able to Kraay did not include savings among urban temporary migrants, who un- doubtedly save higher fractions of their income than do permanent residents. If a household's educational expenditures were considered alongside its mon- etized savings, might this broader view show that urban savings rates rival rural rates? Tsai, Chu, and Chung (2000) explore the possibility for Taiwan, and dis- cover that metropolitan households engage in less monetized saving but make greater investments in their children's schooling. Schooling investments can sub- stitute in several ways for savings, especially given the obligation for educated Taiwanese to repay their parents by providing them with support in old age. Still, the result is surprising because Taipei and the country's other large cities contain many financial institutions that should facilitate savings.6 Spatial Effects: Agglomeration Economies To examine how the sectoral effects sketched above are expressed in spatial terms, we turn to the theory of agglomeration economies, which addresses the productiv- ity and cost advantages derived from the spatial concentration of production and labor. The main elements of this theory date to the pioneering work of Marshall (1890), Weber (1909), Christaller (1933), and Losch (1954) in economic geog- raphy. The outlines of the theory were set forth in Chapter 2, and here we need only mention the extensions and specific features that appear to be of particular salience for developing countries. In a world with transportation and communication costs, agglomerating ten- dencies arise from several sources. Scale economies in production can lead firms to concentrate their activities instead of spreading production across spatially dis- persed small plants. If production is broadly conceived to include the recruit- ment and training of labor, the maintenance of inventories, and the formulation of 6See Gersovitz (1988) for a review of other attempts to include educational expenditures with monetized savings.

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308 CITIES TRANSFORMED contractual relations with other firms, and if transport and communication costs affect each of these elements, firms can derive many productive advantages from locating in large, diverse economic clusters. As discussed in Chapter 2, the ad- vantages of spatial concentration can be grouped into two categories: localization economies, which pertain to the benefits of clustering with other firms in a given industry, and urbanization economies, which have to do with the benefits obtained from the size and diversity of the cluster. Localization economies arise when spa- tial concentration gives firms easier access to industry-specific inputs, such as specialized labor or services. Urbanization economies stem from the need for inputs used across industries and sectors, such as generalized legal and financial services and well-educated labor. Some of these productivity benefits are market- mediated, termed pecuniary externalities, whereas others are pure externalities, which often take the form of informational spillovers. Agglomerating forces can be either strengthened or weakened by the natural heterogeneities of space. For instance, rivers and natural harbors often form the kernel of urban economies. Yet when valuable mineral deposits are geographi- cally isolated, firms engaged in their extraction may find it necessary to establish operations in locations remote from cities. Although the spatial outcomes differ, in each case firms choose their locations by balancing scale economies against transport costs. Because sites with natural advantages tend to attract more firms and people, it can be very difficult to separate natural advantages from localization and urbanization effects. Even where longitudinal data are available, they seldom provide sufficient over-time variation in urbanization and localization measures for their effects to be clearly distinguished. One study attempting to isolate the role of natural advantage, that of Ellison and Glaeser (1999) for the United States, finds that as much as one-fifth of the geographic concentration of production, and quite possibly more, can be explained by such natural, location-specific features. Still, even this estimate leaves a large portion of concentration to be explained by localization and urbanization economies, as well as by other factors. A point much stressed in reviews of the literature (notably that of Eberts and McMillen, 1999) is that the advantages of clustering may or may not materialize, depending on the availability and quality of public services. Public provision and regulation of transport is one example of critical infrastructure; another is the re- liable delivery of such inputs as electricity and water (World Bank, 1994: 30-31~. As discussed in Chapter 5, the provision of basic public services is far from being complete in the cities of most poor countries, especially when account is taken of the reliability and adequacy of supply, and it is likely that there are significant clustering advantages still to be realized in most cities. Other publicly provided services such as health and education services may have significant comple- mentary effects on the costs of production. For instance, highly educated work- ers may much prefer to live where their children can be assured of good-quality schools. To live elsewhere, they might insist on a wage premium that would raise costs for firms. In short, when public services are unavailable or unreliable, the

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THE URBAN ECONOMY TRANSFORMED 309 advantages of spatial concentration are likely to remain largely theoretical and to be threatened by congestion and the other diseconomies of agglomeration. Evidence for developing countries What is the special relevance to poor countries of the general points made above? In high-income countries, transportation costs have greatly declined as a share of total costs, and this has weakened one rationale for spatial concentration (Quigley, 1998~. In most poor countries, however, transportation and communication costs surely remain high. Are economies of scale in production then sufficiently great to induce spatial concentration? On this point the empirical evidence suggests caution. In reviewing a number of empirical estimates for developing-country manufacturing, Tybout (2000) finds evidence that scale economies are either slight or altogether absent.7 Without stronger evidence of scale effects, a theory built on transport costs and conventional scale economies alone appears inadequate. At least for the moment, the more promising findings are contained in the literature on cross-firm and cross-industry spillovers. Several empirical studies of localization and urbanization effects have been conducted in Brazil and India, although studies are regrettably scarce in the remainder of the developing world (Henderson, 1982, 1988; Shukla, 1996; Mitra, l999~. In his analysis of Brazilian cities, Henderson (1982,1988) detects little evidence of urbanization economies, but finds substantial evidence of within-industry localization economies. For the industries he studies, the elasticity of a firm's output with respect to local employ- ment in its industry (his preferred measure of localization) generally exceeds one- tenth. With reference to India, Shukla (1996) examines the elasticity of a firm's output with the size of the surrounding urban population, this being a measure of urbanization economies. She also finds significant positive elasticities averaging about one-tenth and ranging as high as one-fifth in the case of the basic metals and alloys industries. These are effects of considerable substantive importance, as can be appreciated by comparing the productivity of a firm located in a town with that of an otherwise identical firm located in a large city. In tests comparing urbanization with localization measures, Shukla finds that the urbanization effects are larger in 11 of the 13 industries she examines. Mi- tra (1999) also examines the case of India, estimating production functions for electrical machinery and cotton and cotton textiles. His estimates suggest that economies of urbanization are greater in cities of intermediate size than in either smaller or larger cities. For instance, electrical machinery firms derive the great- est productivity benefits from locating in cities of 1.5-2.5 million; for firms in the cotton-related industries, the maximum benefit is obtained from cities of 2.5- 5.0 million. Although Mitra and Shukla stress urbanization economies in their 7Likewise, in high-income settings, scale economies in manufacturing are perhaps less important than they once were, owing to declining fixed costs in computing and the use of techniques permitting smaller, more specialized production runs.

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310 CITIES TRANSFORMED work, Henderson is not alone in emphasizing localization economies. A study of Mexican manufacturing by Grether (1999) shows that within-industry spatial concentration generates substantial productivity benefits. Eberts and McMillen (1999) call attention to a curious gap in research on de- veloped countries: agglomeration effects are examined in some studies and the effects of public infrastructure in others, while very few studies test for public- private complementarities. The situation is hardly different in poor countries. Us- ing an array of measures of provision of infrastructure and social services, Shukla (1996) examines the implications for industry productivity in Maharashtra. In this Indian state, public-sector capital inputs are shown to enhance the productivity of private firms. Water supply, roads, electricity, and health and educational facilities are evidently gross complements in their direct impact on private output; they ap- pear to be substitutes for private industries and public enterprises. Jimenez (1995) and the World Bank (1994: 15) review similar findings from a range of developing and developed countries. What is lacking, however, is direct evidence on whether public capital itself enhances the returns to spatial clustering. Spatial concentration and growth: Dynamic elements Over the past decade, the dynamic effects arising from agglomeration have at- tracted an increasing amount of research attention. The surge of interest is of- ten dated to the emphasis on scale and externalities in new theories of economic growth (Lucas, 1988), but economists have long been intrigued by the idea that proximity and diversity can combine in forms of social learning that generate innovation. Alfred Marshall (1890) anticipated the current interest by more than a century, writing on both the static and dynamic aspects: . . . great are the advantages which people following the same skilled trade get from near neighborhood to one another. The mysteries of the trade become no mysteries: but are as it were in the air.... Good work is rightly appreciated, inventions and improvements in machin- ery, in processes and the general organization of the business have their merits promptly discussed: if one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas. Modern theoretical treatments have drawn out the implications of such social in- teraction for innovation (e.g., Jovanovic and Robb, 1989~. As noted in Chapter 2, one important theme is that spatial proximity and urban diversity are especially important in the design and testing phases of product development and become less important once the production process has been standardized (Duranton and Puga, 20014. Empirical tests of these ideas are not yet common, in part because

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344 CITIES TRANSFORMED cautious pace, and some appear to be decidedly reluctant participants in global networks of exchange. Historical legacies, sunk costs, and policy stances vary so greatly among poor countries that no general pronouncements about globalization and its urban consequences are really possible. The spatial implications are especially complex. Even a partial list suggests just how many contingencies need to be taken into account in thinking about the local spatial expressions of international linkages. Reductions in trade barriers give local firms access to larger markets and enable them to exploit economies of scale. Yet when firms that were formerly protected make their international debuts, the less efficient among them will likely be driven back to a purely domes- tic role. When firms in high- and low-income countries are linked in customer- supplier relationships, this link can provide a conduit for the transfer of technology and economic learning, whether about production processes, markets, or commer- cial strategies. But technology transfer is probably less broadly beneficial when it involves local firms that extract and export raw materials as compared with firms that export manufactured goods. In some countries, manufactured exports are produced in enclaves with easy access to raw materials (or sited across national borders from high-income consumers), whereas the firms that were once shel- tered by import substitution policies are found in the large metropolises (Becker and Morrison, 1999: 1719~. The returns to having superior transport and com- munications infrastructure are likely to favor the large cities of most countries, at least until investments can be undertaken in their smaller cities. But if this obser- vation would appear to suggest a measured and orderly spatial progression, con- sider that in some cases notably in China's Pearl River delta massive programs of infrastructural investment as part of the development of the greater Hong Kong metropolitan region have been put in place with surprising speed, enabling smaller cities to exploit specialized niches and linkages in the international economy. In what follows, then, we attempt no general predictions. Rather, we high- light a few of the developments associated with globalization that appear likely to impinge on urban demography. We first consider how foreign direct invest- ment can shape local economic space. Next, we examine an emerging sector of high-end business services a notably dynamic element in some large cities with effects that ripple across their populations. Finally, we explore what is known about the risks and economic volatility to which urban populations are exposed as they engage more fully with the international economy. Foreign Direct Investment As Douglass (1997) argues, the influence of international linkages on city growth is often overlooked or summarized too glibly in indicators such as ratios of exports to GDP. He writes (p. 12~: Missing from the analysis have been a wide array of equally powerful international relations formed through direct investment in production

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THE URBAN ECONOMY TRANSFORMED 345 BOX 8.4 Foreign Direct Investment: Shaping Indonesia's Cities In Indonesia, the period from the 1970s to the l990s saw foreign direct investment (FDI) emerge as a powerful force, which encouraged the growth of a network of large cities but generally neglected rural areas and smaller cities (Douglass, 19974. In the 1970s about three-quarters of total foreign investment went to two sectors: natural resource extraction (mining and forestry) and resource processing (the chemicals, minerals, and metals manufacturing sectors); and textiles, which accounted for about one- quarter of all foreign investment. Investments in manufacturing were concentrated mainly in Jakarta and the surrounding province of West Java. Key port cities along Java's northern coast also attracted investment, as did cities in Sumatra and Kalimantan from which oil, timber, and some cash crops were shipped. FDI was substantially more spatially concen- trated, according to Douglass, than were domestic firms. In particular, foreign investment neglected the densely settled rural areas of Java, Bali, and eastern Indonesia, which lacked significant natural resources. By 1985, no less than 76 percent of manufacturing employ- ment was found in Java, and of this, some 86 percent was urban based (Douglass, 1997: 1274. The consequences were seen in rapid outmigration from rural Java to Jakarta and the cities on Java's northern coast. The early 1980s saw steep declines in commodity prices, including oil, accompanied by a dwindling of FDI in the outer islands. Indonesia began to reconfigure its develop- ment strategies to emphasize export-oriented manufacturing, an activity in which its newly literate labor force might prove attractive to foreign investors. The country soon became a favored site for Japanese investment. By the latter part of the 1980s, Japan was pro- viding over a third of all foreign investment in Indonesia, and FDI was also flowing in even greater quantities, in total, from Taiwan, Korea, Hong Kong, and Singapore. But the export-oriented manufacturing and foreign investment projects were highly concentrated in spatial terms, being located mainly in Jakarta, Bandung, and Surabaya (Douglass, 1997: 135-6~. More recently, rural dwellers within range of these large cities have been increasingly involved in urban employment, whether as daily and weekly commuters or as short-term residents, thanks to improvements in transport and communication. Such urban connec- tions have clearly improved the incomes of rural families (Douglass, 1997: 1374. However, the costs of urban concentration have been high. It is doubtful that the concentration of In- donesian manufacturing in a few large urban centers can be sustained for long, given the stress it places on the urban natural environment and the need for enormous investments in public services to keep pace with expanding populations. and services, licensing agreements, concessionary contracts for the extraction of natural resources, and finance by transnational enter- prises, their home governments, and international donor agencies. All of these linkages have, in fact, been expanding much more rapidly than international trade, and when seen together they comprise an increasingly formidable set of parameters.... One important strand in this set of relations that of foreign direct investment (FDI) is explored in Box 8.4 for the case of Indonesia. In this instance, a pattern

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346 CITIES TRANSFORMED of foreign investment has emerged with clear spatial delineation, unfolding in dis- tinct phases marked by an increase in the urban concentration of investment. We know of no broader treatment than this of the spatial implications of international linkages and capital flows, but as in Indonesia, it is likely that foreign investment often has an urban focus. As Kaminsky, Lyons, and Schmukler (2001: Figures 1 and 2) show, private capital flows to developing countries have become increasingly important and now account for some 80 percent of the total flows, including official aid. These private flows are a mix of FDI and other financial streams that wend through the capital markets, involving bank and trade-related lending together with portfolio flows, the latter of considerable importance to the economies of Latin America and the East Asia Pacific region. As discussed by the World Bank (2002a), private capital flows are cyclical and sensitive to the macroeconomic and financial conditions of high-income countries, as well as to local risk factors. FDI, although less volatile than portfolio flows, is also subject to pronounced cyclical swings. The peak in FDI to developing countries was reached in 1999, and just 2 years later, invest- ments had fallen by 8 percent from that peak (World Bank, 2002a: 37~. Recent projections indicate that strong FDI growth will probably resume in East Asia and in some countries of other regions. For the foreseeable future, however, only a few developing countries can expect to receive any substantial foreign investment. At present, FDI is highly concentrated in only a handful of very large countries: Brazil, China, and Mexico alone absorb about half of all FDI flows to developing countries (World Bank, 2002a: 39~. For the countries that can attract them, such investment flows provide important additional capital, but they also present additional risks of exposure to the economic volatilities transmitted through world financial networks (De Gregorio and Valdes,2001~. Globally Linked Business Services Many corporate firms in high-income countries (and some of their counterparts in developing countries) have penetrated multiple regional and international mar- kets, operating directly or through affiliates. International firms operating in local markets often require services that are tailored to these markets and purchased from local suppliers. The globalization of finance; the growth of transnational investment; the spatial dispersal of factories, service outlets, and offices; and the creation of facilitating information technology all have contributed to a demand for specialized business services (Roberts, 1994; Hampton, 1996; Bagchi-Sen and Sen, 1997; Bowe, 1998; McKee, Garner, and McKee, 2000~. As discussed in Chapter 2, high-end business services can be viewed as com- plex bundles of inputs. These bundles may involve contributions from several types of specialized professions, and where speed is of the essence in production, only the communications infrastructure and diverse economies of large cities are

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THE URBAN ECONOMY TRANSFORMED 347 BOX 8.5 The Internationalization of the Informal Economy Information technologies, adopted by some migratory networks and diasporas, allow inter- nationalization of the informal economy. A striking example is provided by the networks of Mouride Senegalese migrants, who use Internet connections in Dakar to manage trading in money and goods among New York, Dakar, and Touba (Tall, 20004. The internationalization of informal sectors is also tied to growth in transnational or- ganized crime. Prostitution, child trafficking, smuggling, and arms dealing are now glob- alized phenomena. The production and distribution of illegal drugs have important con- sequences for urban economies through the creation of jobs and the consumer demands of those directly employed. Drug trafficking is probably the principal export of Colombia and Myanmar, where the resources thus generated are invested in real estate and large- scale industrial enterprises. In Colombia, a system of "Mafia-providence" (Le Bonniec and Sauloy, 1992) transforms crime and corruption into factors of economic moderniza- tion. In Lagos and Cape Town, trafficking in narcotics provides incomes far in excess of normal formal-sector salaries, and finances enterprises in the trade and transport sectors (Fottorino, 19914. likely to be able to provide the requisite input mix.50 Once the services have become routinized, however, some elements in their production can be relocated outside the large cities to take advantage of lower rents and congestion costs (Du- ranton and Puga, 2001~. It is the nonroutine, innovative, and customized aspect of business services that tends to keep them concentrated in the larger cities. In many major cities, then, a new economic core of corporate service activities is being formed, sometimes displacing older manufacturing and administrative ac- tivities. In some cases, the scale, power, and profitability of the new corporate core activities are so visible as to suggest the emergence of a new urban economy. To be sure, even in the most dynamic of cities, the corporate services sector is but one part of the larger city economy. Cities with a core of international business func- tions retain much of their former economic character and still have a great deal in common with cities lacking that core. But as international networks strengthen, the growth paths of internationally linked cities appear likely to diverge from those of other cities. (See Box 8.5.) Although less clearly apparent in the smaller cities, the emergence of an in- ternationally linked, modern services sector has become evident in those cities as well. Furthermore, regionally focused firms share many of the characteristics of firms with more widely dispersed operations and contacts. Although the regional firms need not negotiate all the complexities of international borders and country regulations, they, too, have regionally dispersed networks of operations that re- quire centralized control and servicing. Hence, regional firms have also fed the demand for business services in their corporate headquarters and regional offices. 50See Black and Henderson (1999a) for the United States.

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348 CITIES TRANSFORMED The transformation of urban real estate is one vivid indicator of the emerging services sector. Housing is being constructed and remodeled to the tastes of new high-income professionals; firms selling high-profit goods and services are out- bidding lower-profit firms for desirable commercial space. Neighborhood shops tailored to local needs are being replaced by upscale boutiques and restaurants catering to high-income urban elites. The political economy of these developments is no less important. A growing share of a city's total payroll and tax revenues can be accounted for by the new specialized service core. The high-end business service sector is an increasingly important factor in shaping urban economic diversity and inequality. Exposure to Risk from World Markets Because many large cities act as the interface between their national economies and the international markets, their populations are directly exposed to the vari- abilities of these markets. To be sure, rural populations can also be profoundly affected by international developments, such as changes in the world prices of primary products. Rural economies, being less diverse than urban economies, are arguably more vulnerable to certain types of shocks. Cities possess financial and some social welfare institutions that can mitigate risks and help smooth con- sumption (Gibson, 2001~. In general, however, the spatial concentration of city populations must enhance the local economic multipliers that transmit economic downturns (and upturns) from one subgroup to another. Urban economies are more monetized than rural economies, and rural strategies for weathering a crisis (e.g., growing food for own consumption) are not available to many of the urban poor. Also, the construction and real estate sectors notorious for their boom- and-bust cycles and sensitivities to the state of capital markets are far more im- portant to city than rural economies, as are the inventories held by manufacturing firms. City economies would appear to contain some especially volatile sectors that might raise risks for urban residents overall. As countries negotiate their way toward liberalization and a deeper engage- ment with world markets, they adopt adjustment policies that mediate the effects of international markets and cause these effects to impinge differently on rural and urban populations. A number of African countries, for instance, have eased marketing restrictions and lifted price ceilings on agricultural goods, thereby re- moving much of the bias against agriculture that was so prominent in the 1970s (Collier and Gunning, l999b). But even as these reforms work to the benefit of some rural residents, they can hurt urban residents who rely on subsidized food and other goods. In many of the recent economic crises seen across the develop- ing world, international market forces and domestic policies are mingled in a way that makes it very difficult to anticipate the urban consequences. The complexities are well illustrated in the case of Zambia(McCulloch, Baulch, and Cherel-Robson, 2000), where developments in international markets combined

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THE URBAN ECONOMY TRANSFORMED 349 with a host of policy reforms to generate rising rates of urban poverty. The collapse of world copper prices long that country's largest and most valuable export in the late 1970s eventually led Zambia to adopt a series of structural adjustment programs beginning in the mid-1980s, which included the removal of ceilings on the prices of maize and other agricultural commodities and major re- forms that improved agricultural marketing. These long-overdue reforms clearly benefited rural residents. For urban consumers, however, the removal of subsidies on maize meal sharply increased the cost of living and sparked rioting in Lusaka and other major towns of the Copperbelt. On the international front, Zambia lifted many foreign exchange controls in the early 1990s, removed licensing and quan- tity restrictions on exporting and importing, and reduced and greatly simplified tariffs on imports. These new policies were intended to lay the foundation for future growth in exports and employment. But in the near term, as McCulloch, Baulch, and Cherel-Robson (2000: 11) write: . . . the collapse of the manufacturing sector has been dramatic. Com- panies operating behind high levels of protection have been unable to withstand the simultaneous shocks of trade liberalization and the re- moval of subsidized credit. Employment in formal manufacturing fell over 40 percent . . . the textile industry has almost collapsed. Urban poverty rates in Zambia (calculated from three surveys with data on house- hold consumption expenditures) rose from 47 percent in 1991 to 63 percent in 1998; meanwhile, rural rates of poverty fell from 88 to 77 percent (McCulloch, Baulch, and Cherel-Robson, 2000: Table 3b). The experience of Indonesia during the Asian financial crisis also shows how urban and rural populations can be affected differently by international develop- ments. The Indonesian phase of the crisis is usually dated to the collapse of the rupiah in January 1998, after which there ensued a period of rapid inflation, tight- ening credit, and government control over lending that paralyzed banking and nearly brought the construction sector to a halt. Levinsohn, Berry, and Friedman (1999) studied the price effects associated with this crisis and found that contrary to what is often thought, the very poor do not occupy niches in the urban economy that are somehow sheltered from international economic shocks. Indeed, increases in the cost of living during the crisis were greatest for the urban poor, somewhat smaller for the urban nonpoor, and smaller still for rural households. The impacts on employment, wages, and earnings are closely examined by Thomas, Beegle, and Frankenberg (2000) and Smith, Thomas, Frankenberg, Beegle, and Teruel (2000~. Over the decade leading up to the Asian financial cri- sis, substantial wage growth benefited Indonesian men and women. As the crisis unfolded through 1998, employment rates that were already high remained so. The impact of the crisis was not seen in employment as such, but rather in wage rates, which fell by some 40 percent in urban and rural areas. This spectacular

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350 CITIES TRANSFORMED decline in wages all but erased the gains made by men over the preceding decade and nearly erased the gains for women as well. The urban declines in wages were slightly larger than the rural declines, and of course in cities, a much higher fraction of workers earn wages (Smith, Thomas, Frankenberg, Beegle, and Teruel, 2000~. Wages fell for almost all urban groups, although the percentage declines were evidently larger for low-skilled wage earners, especially among men without government jobs (Thomas, Beegle, and Frankenberg, 2000~. For the urban self-employed, hourly earnings fell about as much as wages, on average, although again upper and lower tiers of self- employment can be distinguished, with greater declines occurring in the latter (Thomas, Beegle, and Frankenberg,2000~. In rural Indonesia, the self-employed (mainly farmers) appear to have been left largely unaffected by the Asian financial crisis, and rural family incomes tended to fall less than wage rates, probably be- cause rural households could activate multiple coping strategies. Urban residents could not protect themselves to the same degree, although both Smith, Thomas, Frankenberg, Beegle, and Teruel (2000) and McGee and Firman (2000) detect an increase in urban agricultural work, which might be interpreted in terms of coping strategies.5i Frankenberg, Beegle, Thomas, and Suriastini (1999) ask whether Indonesian children were more likely to leave school in the peak year of the crisis (1998) as compared with the previous year. They find marked increases in school dropout rates in both the urban and rural areas of Indonesia, with the increases being rela- tively small at the primary level of schooling but quite substantial at the secondary level. Urban dropout rates rose more than did rural rates, and although increases were recorded across the economic spectrum, dropout rates rose much more for poor families. Curiously, however, the negative effects of the crisis on children's education were not seen in their health. Frankenberg, Beegle, Thomas, and Suri- astini (1999) show that although use of public and preventive health services de- clined in the crisis, no deterioration in children's health was apparent. Children's height for age and weight for height showed little change from 1997 to 1998, and measures of anemia actually exhibited some improvement. The possibility of such mixed responses to macroeconomic crisis is empha- sized by Schady (2002), who examines changes in urban children's school en- rollment in Peru from 1988 to 1992. Peru's crisis was as severe as that faced by Indonesia and might have been expected to produce the same sort of reac- tions. Yet Schady finds little change in enrollment rates in Lima and other Peru- vian cities. Perhaps, as he argues, macroeconomic crises lower the opportunity 5iSumarto, Wetterberg, and Pritchett (1999) present findings from a large-scale qualitative survey conducted in each of Indonesia's 4025 subdistricts (kecamatan). The data drawn from interviews with local officials in each subdistrict suggest that households in the middle range of income re- sponded to the crisis by working more, reducing consumption, drawing down savings, and selling assets. In the view of these local officials, the poor households in their districts had far fewer options available to them.

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THE URBAN ECONOMY TRANSFORMED 351 BOX 8.6 Cross-Border Migration Flows Between Kazakhstan and Russia Employing unusually detailed time-series data from Kazal~stan, Musabek, Becker, Seiten- ova, and Urzhumova (2001) show how migration is influenced by economic conditions there and in neighboring Russia. Monthly data are available on aggregate flows from 1995 to 1999. The migration flows are substantial: on net, 13 percent of Kazal~stan's urban population (and 9 percent of its rural population) emigrated between 1990 and 1999, with by far the largest outflow going to Russia. Urban Kazal~stanis have higher propensities to migrate to Russia and are far more sensitive to wages and exchange rate movements than are their rural counterparts. This is especially true for young adults (aged 18-294. Migration responds to changes in relative Kazal~stani/Russian mean wages with a lag of about 7 months and an elasticity estimated to be near unity on average. Migration is also highly responsive to changes in relative capital investments per worker and to movements in exchange rates. costs of schooling by reducing the earnings from children's employment.52 The marginal benefits of schooling can also be affected if the crisis is expected to be long-lasting. Indeed, when earnings decline more for those with few skills and low education, it is conceivable that a crisis may even raise the perceived returns to schooling. Few studies have explored the spatial implications of economic crisis in any depth by asking whether certain types or sizes of cities appear more vulnerable. In the formerly socialist countries of West Asia, the prolonged crises associated with economic restructuring appear to have hit the secondary cities harder than the capitals. Bishkek, the capital of Kyrgyzstan, experienced severe difficulties in the first few years of the post-Soviet era, but as its economy steadied, it began to attract migrants from the secondary cities, where local industry had utterly collapsed with dim prospects for recovery. Between 1989 and 2000, Bishkek added about 130,000 people, while the secondary cities of Kyrgyzstan lost 55,000 residents (Government of the Kyrgyz Republic, 2000~. Levels of poverty in Bishkek have been low in comparison with rural rates and those of other cities, and its wage rates have been relatively high even when adjusted for differences in human capital (Anderson and Becker, 2001~. If anything, the gaps in living standards between Bishkek and the remainder of Kyrgyzstan may well have widened over the 1990s. In many ways, then, the economic crisis and adjustments in Kyrgyzstan appear to have reestablished the favored position of the capital city that was so characteristic of the Soviet era. In Kazakhstan, both urban and rural areas have lost population, and there are now substantial migratory flows both to and from Russia (see Box 8.6~. The total urban population declined from 9.8 million in 1992 to only 8.4 million in 1998 52This argument requires a narrow definition of opportunity costs: when adult earnings also decline, children's earnings that are lower in money terms can have a large effect in terms of household well- being.

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352 CITIES TRANSFORMED (Government of Kazakhstan 1999, and unpublished data). But the capitals of Almaty and Astana continued to grow, at least during the second half of the 1990s, and again it was the secondary cities that lost population. Health recovery appears to have been stronger in the country's large cities (Becker and Urzhumova, 2001~. In both Kyrgyzstan and Kazakhstan, capital-city residents have generally fared better than those in secondary cities during a very difficult period of transition. CONCLUSIONS AND RECOMMENDATIONS Conclusions The urban demographic bonus is both a boon and a challenge for developing- country cities. As population projections make clear, the urban economies of low- and middle-income countries can expect a very large increase in the sup- ply of labor over the next several decades. In addition, as fertility declines, child dependency ratios will decline, and a larger proportion of the population will tem- porarily move into the working ages (Bongaarts, 2002~. In some Asian settings, declining fertility has also been credited as a major contributor to sustained eco- nomic growth (Mason, Merrick, and Shaw, 1999; Bloom end Williamson, 1998~. Slower growth in the number of school-age children has enabled greater educa- tional investment per child, and lower dependency ratios have produced higher national savings rates and reduced temporarily the need for certain types of pub- lic expenditures. In this sense, an extraordinarily large cohort of working-age adults produces a one-time demographic bonus. But for countries to realize their demographic bonus, their economies must be strong enough to absorb the grow- ing workforce without experiencing increased unemployment or depressed wages. Rapid economic and political changes increase the complexity of the challenge. Urban labor markets and returns to schooling in developing countries are dependent not only on labor supply, but also on technological change and capi- tal formation. This chapter has examined several key elements in the nature and magnitude of the structure of labor demand and supply in low- and middle-income countries. Urban labor markets determine individual and family incomes, which establish incentives for migration and profoundly influence decisions about in- vestments in children's schooling and family size. A popular view is that urban labor markets in developing countries are riddled with imperfections and that unemployment and poverty are the direct result of labor market failure. Yet our review has highlighted the considerable uncertainty that surrounds the functioning of urban labor markets in these settings. Urban economies have changed greatly since the formulation of the highly influential models of Todaro (1969) and Harris and Todaro (1970~. Although rapid growth in the supply of labor might appear to threaten the economic returns to school- ing, our analysis shows that where macroeconomic growth has been moderate or strong, the urban returns to schooling have generally been maintained, and in

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THE URBAN ECONOMY TRANSFORMED 353 some cases returns to university education have increased. On the other hand, where macroeconomic growth has been weak, as in much of sub-Saharan Africa, rapid increases in the supply of better-educated urban labor have resulted in a marked decline in the returns to schooling. Evidently, accumulation of physical capital and technological progress can sustain educational returns even in the face of rapid shifts in labor supply, but if these are lacking, returns to schooling will be threatened. Although there is substantialfftuctuation in individual incomes in urban areas, rural-to-urban migrants are able to attain earnings comparable to those of native urbanites after an adjustment period. Surprisingly little attention has been paid to individual income dynamics within urban areas. The few longitudinal studies available do not clearly reveal higher rates of upward or downward mobility in cities as compared with rural areas; in both there is a great deal of flux. However, studies of migrants based mainly on cross-sectional surveys that may overrep- resent the more successful migrants generally show that rural migrants undergo a period of adjustment to city life during which their earnings are low, but sub- sequently achieve earnings levels that rival and sometimes exceed those of urban natives. Recommendations Given the partial nature of this review, it is impossible to formulate a list of specific research recommendations on the relationship between population and labor force growth and labor absorption. Space constraints have forced us to ignore many critical issues, such as the role of unions, discrimination, and occupational segre- gation in the demand for and supply of labor. We have also chosen to overlook issues relating to hours worked, retirement decisions, job attachment, work effort, and the nature of contracts. And finally, we have not discussed the technological advances that might raise the marginal productivity of labor in agriculture. Never- theless, our review has uncovered two central research themes that will doubtless play a large part of a future research agenda in this area. Cities and city-regions Our review has underscored the need to place urban de- mographic issues within an urban economic context. However, we have paid little attention to the economy and demography of the region immedi- ately surrounding cities and metropolitan regions what we might call the urban-regional economy. Greater attention to this subject in future demo- graphic research is important because these surrounding regions are inte- grally related to what is happening to cities and metropolitan regions. Globalization andinequality There has been much recent speculation about whether the globalization of economic relationships heightens urban in- equalities. Case studies of Brazil, Taiwan, and China provide some evi- dence of a growing dispersion of urban incomes in the 1990s. Although

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354 CITIES TRANSFORMED the sources of the trends are not clearly identifiable, such empirical find- ings are consistent with the view that urban labor markets are increasingly heterogeneous and volatile, in part because of their exposure to world mar- kets. An examination of the effects on urban populations of international economic shocks and crises shows that city dwellers can be disproportion- ately affected; the evidence from Indonesia is especially clear on this point. The spatial effects are not always focused on cities, however, and urban residents also draw considerable benefits from exposure to world markets. Nevertheless, as globalization proceeds, more research will be needed on both the costs and benefits to urban residents of their increased exposure to world markets.