Abstract
AbstractThis paper examines the short and long‐term effects of urbanisation, via favourable urban development policies, on income distribution and social welfare for a developing country, in which the urban manufacturing sector is characterised by imperfect competition and free entry. Urbanisation shifts rural workers to the highly productive urban sector, while causing production in urban firms to expand because of scale economies. However, urbanisation may worsen wage inequality between skilled and unskilled labour in the short term. In the long term, urbanisation can attract new firms to the urban sector and favourable urban development policies may result in excessive entry of firms, which can amplify wage inequality in the economy. This entry‐amplifying effect is confirmed empirically, especially for low and lower‐middle‐income countries. If the entry effect is not considered, the impact of urbanisation on wage inequality could be understated by 13% for low and lower‐middle‐income countries.
Highlights
Urbanization refers to a population influx from rural to urban areas to seek better opportunities, an unavoidable trend in both developed and developing economies
For the developing economy, the second-best coordinated policy set is (i) free mobility of labor domestically by letting α equal 1 in equation 32 to remove the barrier of rural–urban migration, (ii) perfect mobility of capital internationally until the domestic rental rate is equal to the world rate in equation 34, and (iii) a production subsidy given to urban firms to correct the product market distortion adjusted by urban unemployment
The coefficient estimate of the interaction term θ2 is 0.0008 and statistically significant at 1%. This result indicates that the effect of urbanization on income inequality is stronger in countries with a higher firm entry cost
Summary
Urbanization refers to a population influx from rural to urban areas to seek better opportunities, an unavoidable trend in both developed and developing economies. Chang, Kaltanic, Loayza (2009) claimed that in the urban sector, a reduction of tariffs improves production efficiency but worsens unemployment in a Harris–Todaro model that has labor as the only production input These studies all assumed perfect competition in the urban sector, but in reality, imperfect competition prevails in the urban manufacturing sector in both developed and developing countries. This paper demonstrates empirically that the implementation of favorable urban development policies may widen the income inequality gap via the channel of firm dynamics. It differs from, and is complementary to, the past literature examining the relationship between urbanization and income inequality, which has had mixed results. The results show that income inequality can be underestimated substantially by 17.5% if the positive indirect effect of firm dynamics is not taken into account
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