Urban employment and services benefit from the economies of agglomeration— from cost savings and other advantages that accrue to firms when they locate near others in the same industry, or simply near other economic activities to share markets, services, infrastructure, labor, and information. The productivity advantage means that urban investment has strong multiplier effects in stimulating other high-value activities. The benefits extend to rural areas, which need access to urban markets to expand and diversify both farm and nonfarm production.
As a rule, larger urban areas are the most productive since they allow for greater specialization in labor use, better matching of skills and jobs, and a wider array of consumption choices for workers and ancillary services for producers. As long as this greater productivity outweighs higher costs for land, labor, housing, and other necessities, the city can thrive.
Once the diseconomies become too great, larger cities may lose their edge in creating jobs or improving the welfare of residents, unless they can shed some activities (those that are more mature and standardized) to smaller cities to make room for others (more innovative and higher value industry and services) and change land uses.
For cities to fulfill their potential as engines of national economic growth, they need to ensure that the labor market is not only deep but well integrated and inclusive—with accessible workplaces and residences. A city can improve its investment climate. However, cities in general can only improve the national investment climate if their overall legal and regulatory framework complements the national framework to minimize risks, uncertainties, and transaction costs to investors. This is especially important for small and informal sector enterprises, which provide most urban employment, rely more heavily on publicly provided infrastructure and information, and are particularly vulnerable to institutional and policy failures.