CHAPTER 1: TOWN AND URBAN GROWTH

The definition of town can be from different perspectives but overall it has the same

concept. Town is a place where it is the focus of inhabitants and economic activities.

Some researchers have defined town based on the physical aspects only, while others

have defined it based on society’s characteristics. Most of the time, town can be defined

based on the size of its inhabitants. For example, in Malaysia a settlement with a

minimum of 10,000 people can be considered as a town. The basis of town definition is

crucial as it can influence the definition of township and town growth nationwide.

However, the minimum total of inhabitants is only a general guideline in determining

whether the settlement is a town. In reality, it is often that the term town is defined with

the help of other criteria such as population density, percentage of residents not working

in the agricultural sector of at least 75%, amenities provided, legal administration and

business administration.

Compared to the context of rural area, town is the centre of distribution of specialised

human resources in non-agricultural economic activities. However, the town growth

process depends on the trade with rural areas where their economy is mainly on

agricultural output. Excess of agricultural output from the rural areas is important in

maintaining a two-way relationship and as a catalyst for town growth.

Town Concept

According to W. Lean and B. Goodall in their book “Aspects of Land Economics”, town

concept is referred from the aspects of physical, demography, human life and social

characteristics, elements of concentration of work place and economic activities carried

out. Physical factors here means the physical environment such as river, valley, hill and

others as well as minerals in it. History shows that river played an important role in the

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civilisation of a race and a country’s development. World major towns in the past had a

close relation to the river such as the Ganges River in India, Nile River in Egypt and

Thames River in London.

In his writing “A Bibliography of the Urban Community”, Louis Wirth defined town as a

settlement that is relatively large, crowded and permanent where people from different

backgrounds live.

As an area becomes the focus point of many, the number of its population will rise and

various economic activities will happen. The existence of this settlement will turn into a

town, which is more permanent compared to a rural area. Rural areas are less permanent

due to the inclination of its inhabitants to move to a better area. The town will be

enriched with various customs, cultures and lifestyles due to its residents of many races

and will thus create a variety of economic activities and different levels of income.

In a research by Phillips M. Houser – “The Study of Urbanisation”, a town is defined as a

grouping of a certain size of population within an area. A town definition is focused on

concentration and collection of inhabitants at a specific rate which varies from one town

to another.

The minimum point of measurement for the population density is different from one

country to another. For instance in Denmark, a settlement with a population of more than

250 people is considered as a town whereas in Japan is 30,000 people, France 2,000

people and Malaysia 10,000 people (Census Report 1970). The most important concept

emphasised here is that the town has a specific population and it will grow from time to

time.

From the economics perspective, town growth happens when a community from the

town’s society has shown an increase in the capacity to produce goods and services. This

means that the town’s society has reached a level in development where agricultural land

usage has shifted to industrial and commercial usage.

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In truth, from the beginning, town concept depends wholly on economic power. For

example, the effectiveness use of earth natural resources cannot be separated from the

inhabitants’ concentration and wealth. With the existence of specialised human resources,

a town can be progressive and its productivity will increase.

Furthermore, town growth also depends on trade specialisation in the town and rural

areas. It covers all sectors from agriculture to industrial and so on. This trade requires

excess in output of goods so that exchange of goods is possible.

With these resources of economic power, the town growth will progress and the output of

goods will increase if it is undertaken correctly and properly.

In conclusion, it is clear that town growth is changes in the number of people living in a

town whereas urbanisation is the ratio or percentage of a country’s total population that

lives in urban areas.

History of Early Cities

Cities have long existed since the Neolithic revolution around 8000 B.C. Most of the

earliest human settlement started at river valleys in Central Asia. After at first being

active in hunting activities only, man now has started to dabble in breeding and

agriculture. This newly developed lifestyle is known as Neolithic Revolution that shows

early characteristics of human civilization such as grains production, animals breeding,

invention of the ploughing tools, and invention of wheel for movement purpose.

With these developments, there was an increase in food production and thus villages

developed into towns and small cities. The most important factor during that period was

the surplus of food production. The surplus occured after there was a specialisation

factor, which then became an important factor to design various sectors in town

economy. The surplus had its implication where it freed some people from agricultural

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work. This also means that there was an increase in production of non-agricultural goods,

which became the basis of city life.

This rapid and intensive development had created large cities with elements of social

class. It is estimated that these cities had a population of between 20,000 and 30,000

people. The next city development involved modernisation in agriculture. This

Agricultural Revolution recreated the city into a huge central market due to an increase of

food production.

The Modern Age showed the starting of the capitalist system in trade creating large

powerful colonies such as London, Paris and Amsterdam. During that period, the

development of science and technology also helped in the growth of cities.

The Industrial revolution and society revolution, which happened in France, Germany,

England and America had encouraged rapid urbanisation process due to the following

factors:

1. Industrial advancement such as, the discovery of steam engine, hydro and wind

power, use of fuel to move machineries and the process of changing land use from

agriculture to industrial and trading.

2. Agricultural advancement such as technological advancement and the discovery

of trade and service technique in obtaining food supply from rural areas.

3. Changes in society where city life was desired and this was followed with

migration to Conurbations and Megalopolis.

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Factors encouraging Urban Growth

Urban growth happens due to technological development, migration of residents, and the

development in economic activities from surplus production due to specialisation.

In general, urban growth in this country is influenced by factors below:

1. Migration and development of various economic activities

2. The history of how a city emerge and its development

3. Location factor that determines the growth pattern of a city suitable to be turned

into a city or a business area

4. Organisational, institutional and business facilities such as shopping complexes

5. Beneficial natural resources in an area

6. Good and suitable climatic factor; and

7. Good and strategic communication system that will speed up the city’s

development and growth

Urbanisation Concept

Town exist through a process called urbanisation. It is a changing process in different

aspects such as people, settlement, lifestyles, jobs and economic activities, human

thinking and others, which can create a town.

However, an urbanisation process is also influenced by other factors, such as agricultural

products, mining activities, strategic location, and political stability.

Kingsley Davis (1972) an expert in population studies defined urbanisation as a process

of people concentrating in an area considered as a town. It can be measured by comparing

the percentage of people living in the urban areas with the rural areas in a region, country

or other area units. Through this, the degree of urbanisation in area can be determined.

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R. M Hanson and C. F Schnore in their book entitled “The Study of Urbanisation” stated

that town development or urbanisation depends upon 4 items which are size and total

population, human knowledge of controlling the environment, technology development

and social development.

Urbanisation can also be defined as a process where the shape of society changes from

rural (informal) to town (formal). This is the difference between the rural society and the

town society.

Based on research in population, the major characteristics of an urbanisation process is

the large-scale movement of people from the rural areas to the cities. This process has

resulted in the followings:

1. Change of job ( from rural to city)

2. Change in lifestyle, way of thinking and so on

3. Change of land use from agricultural land, forest or neglected land to housing,

commercial and office buildings, school, hospital, roads and others

4. Change of distribution of population to a higher density

5. Change in society heading towards a more modern one

History of Urbanisation

According to western researchers, urbanisation process was slow prior to 1800. During

that period, cities were moderate centres of administration and business. Facilities such as

modern transportation that can create large cities were non-existent and well-known cities

did not have a population as large as today.

After 1800, rapid urbanisation process happened in Europe and America, as there was a

surplus in agricultural products, better transportation system, political stability and the

emergence of high technology industry. Therefore, there was a greater increase of people

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living in the cities than the increase of people in the world as a whole. It was found that

between 1800 and 1960, the world population has increased 3 times but the city

population with a total of more than 20,000 has increased 40 times while a city that has a

population between 20,000 and 100,000 has increased 90 times. Simultaneously, a city

with a population of more than a 100,000 has increased 60 times.

Urbanisation in Malaysia can be observed from the historical context of the Malaysian

Government before the year 1800. There were a few small towns in Malaysia located at

the mouth of the rivers, which was the King’s central administration. For example,

Malacca was a famous city back then and it was a major trade centre. From there

onwards, Malacca has gone through an urbanisation process and is still going through the

development progress to this present day.

Factors Encouraging Malaysia’s Urbanisation Process

Urbanisation process in Malaysia and other South-Eastern Asian countries are influenced

more by political and social factors compared to economic factors.

Factors that influence the urbanisation process in Malaysia are as follows:

1. Production Activities Based on Local Resources

Products made of newly found mineral and plants such as tin ore and rubber were

produced in a large-scale. These large-scale outputs have created a need to have a

central place for collection, storage and management purpose as well as for

workers residence. Upon the establishment of these centres, a town would emerge

nearby its output area. Examples of towns in Malaysia that have emerged through

this way are Kuala Lumpur, Taiping, Ipoh and Seremban. However, these towns

are located in the inland areas and therefore a port was required in order to market

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the tin ore and rubber products. This need has thus created towns by the sea such

as Port Weld and Port Klang.

2. Migration of People from Rural Areas to Town Areas

Migration of people from rural areas to town areas has started from the period of

the first ten years after the World War 2. The main reason for the migration was

the significant poverty in the rural areas due to scarcity of land and

overpopulation. Furthermore, the unproductive agricultural activities were not

enough to support a large population and this has resulted in unemployment.

Since then, people from the rural areas are drawn to the cities because of the job

opportunities from both the private and government sectors and the facilities in

the city that do not exist in the rural areas. The migration has caused a more rapid

urbanisation process and the movement of the Bumiputera community to the city

has also contributed to the high percentage of population growth in the city.

3. Function Centralisation and Economic Development

Urbanisation can also be linked to the centralisation of economic investment for

the development of the major cities. These readily advanced areas have huge

budget allocation in the country’s development such as amenities and facilities,

social function, culture and trade. The industrial growth in the major cities after

the 1960’s has also caused the centralisation of other functions, followed by the

population increase in the cities that varies the country’s economy and source of

income, and also fulfilling the needs and request of local users on previously

imported products.

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4. Urbanisation of Underdeveloped Areas

The urbanisation process of underdeveloped areas did not happen rapidly due to

the centralisation of the industrial sector in major cities. At the end of the 1970’s,

tremendous efforts have been made through the New Economic Policy to develop

the underdeveloped areas. Among the ways used for social and economic

development is through the formation of new towns in regional development

areas and the development of small towns especially in rural areas with a high-

density population.

5. Natural Increase in City Population

The concentration of inhabitants in the cities is not only caused by migration of

people from rural areas to the cities. The natural increase of inhabitants living in

the cities also plays an important role and Malaysia’s high rate of natural increase

is due to high birth rate and the low death rate.

6. Other Factors

‘The concentration of inhabitants to an area considered as town’ is the basis of

definition for ‘Urbanisation’. Therefore, the extension of the city border areas can

also increase the percentage of inhabitants living in the area. For example, when

the Kuala Lumpur area was extended from 93 square kilometres to 243 square

kilometres through the formation of the Federal Territory in 1974, inhabitants

outside the city border is accounted for the population census for the new Kuala

Lumpur. Other than that, the relocation of inhabitants to new settlements during

the emergency between 1948 and 1963 has also influenced the urbanisation

process.

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Benefits of the Urbanisation Economy

The urbanisation process is linked to the population growth of an area. When the total

population increases, people will live in groups and communities that would allow each

group to be active in a particular field. For example, a group would be active in the

business field while the other groups will be active in administration, service or industrial

fields. This situation creates specialisation and thus encourages economic development of

an area. The benefits of the urbanisation economy are as follows:

1. Specialisation Benefits

Specialisation is an important characteristic in modern economies. Specialisation can

increase production of output, increase on the quality of products, lowering the

average cost of production and providing more job opportunities.

There are two types of specialisation, which are labour specialisation and

specialisation according to regional or area function.

a. Labour Specialisation

This type of specialisation is practised in the cities for example, in the industrial,

manufacturing, construction, service and other sectors that are linked to the

city’s economic activities. The benefits gained from labour specialisation are:

i. Increasing the productivity of labour

ii. Decreasing cost of production

iii. Time saving

iv. The use of machineries and tools that are more efficient

v. Increase of products from the output of goods and services

vi. Large-scale production

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b. Specialisation according to Regional/Area Function

This type of specialisation arises due to differences of factors of production

between areas. Specialisation also depends on the Government’s Planning and

Policy. For instance, Kuala Lumpur CBD has been designated for commercial

and administration activities; whilst town edge area for industrial activities. In

addition to town edge areas such as Cheras and Ampang, certain hilly areas

such as Damansara Heights, Kenny Hills and Ukay Heights have also been

identified as residential areas.

2. Economies of Scale

Town area is the focal point of inhabitants as it provides a wide market for goods and

services. Good infrastructure, a stable economic and political condition encourages

the output of goods at a large scale. Thus, producers can enjoy economies of scale.

These benefits can be divided into two:

a. Internal economic benefits

b. External economic benefits

a. Internal economic benefits

An industry that operates in a declining cost situation has a tendency to group

its output. This situation will increase the profits of the producer and thus the

following benefits are enjoyed:

i. Management economics

Cost per unit management will decrease as the output increases.

This is because the same manager will be instructed to carry out

administration although the quantity changes.

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ii. Technical economics

Usually large firms in the cities have advantages in technical

economics such as the use of machineries and tools in the

production process. These firms can also use larger and more

advanced machineries to increase output and thus able to

decrease cost of production.

iii. Marketing economics

Firms that produce goods at a large scale are going to enjoy

benefits from the marketing aspect. Purchases in bundles and the

use of high and sophisticated technology decreases cost of

production. Large-scale production can increase the producer’s

capital and this would further intensify the promotions or

advertisements of the goods produced.

iv. Financial economics

It involves the large and stable firms with facilities to obtain

loans at lower interest rate.

v. Research economics

Large firms that carry out research to improve their product’s

quality, production of new products will further decrease their

cost of production.

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b. External economic benefits

External economic benefits are from the development of the entire industry

and enjoyed by the firms. There are two types of external economics that can

be enjoyed by producers due to urbanisation of an area. These are settlement

economics and information economics.

External economics will increase with the size of development of a town.

Therefore, external economics is dependent upon the market size.

3. Urbanisation economics

There are several types of economic activities that can enjoy benefits as a result of

being in the same location. With the existence of a town, all facilities as stated below

are gathered for its inhabitants:

a. Various types of facilities such as transportation, health and medical,

shopping centres, entertainment, cultural and institution of learning.

b. An increase of job opportunities in various sectors such as small

businesses, restaurants and hotels, tourism, construction and

manufacturing; and financial services, insurance and real estate.

c. Increase in supply of goods and services in the market.

d. Increase of technological design and innovation; and

e. Increase use of management techniques and efficient financing.

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4. Supply of factors of production

A town offers an attractive location for economic activities because all supply factors

can be generally utilised. The benefits are more obvious for labour, entrepreneurship,

capital and land.

Urbanisation Problems

Rapid and uncontrolled urbanisation process will cause a few problems as follows:

1. Concentrated and uncontrolled urbanisation

In general, rapid urbanisation process is mostly focused in the large cities only.

Concentrated urbanisation can create problems such as unbalanced development

between large cities and the continuing underdeveloped areas (Wan Daud,

2002). Inhabitants will continue to converge to the big cities and forced

allocation of social development to be concentrated to those cities only.

2. Migration of people from rural areas to the city

This problem exists in two ways:

a. From the economic aspect, migration of the educated and active young

people from the rural areas causes the agricultural sector from rural areas

to lose skilled and able labour. The decrease in the number of young

people in the rural areas can pose a threat to the rural area’s agricultural

industry.

b. A more threatening problem is the presence of rural inhabitants that is

unprepared with the city’s economic and social pattern and system.

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3. Poverty

A problem of poverty exists due to unemployment and the inhabitants’ low

source of income.

4. Problems in providing basic amenities for the inhabitants

From the social aspect, the government is forced to spend a huge financial

allocation to provide various basic amenities such as services, education,

communication and others. The huge financial allocation to provide these

amenities is a burden that can create liabilities to the government.

5. Housing problems

The low-income earners will face housing problems in the urban areas. With

their limited income, they will find that the houses are unaffordable. This root

problem is difficult to overcome and when this happens, the low-income earners

will opt to live as squatters.

6. Problem in separating the places of residence according to race and socio-

economic status

Poverty will become more complicated if there are city inhabitants who group

themselves according to their races. Separation pattern for places of residence

according to each group’s background would lead to communication tension,

prejudice and threats from illegal gangs.

c. Pollution of the physical environment

Pollution of the physical environment happens due to burning of energy

resources such as oil, coal and waste which has reached a dangerous stage.

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The high content of carbon monoxide together with dirt, smoke and other

particles in the air in the city area is enough to threaten humans’ health.

Indirectly, the increase of industrial area that has changed the land use from

agriculture to industrial has contributed to the pollution. Covered area,

whether it is concrete or tar has increased the rate of water flow, as water

cannot absorb into the earth and thus flash flood will happen.

d. Other problems

Another problem that can arise due to rapid urbanisation process is traffic

congestion. Most of the transportation problem is caused by traffic congestion

at major roads in the city. This usually happens when the road could not

support the existing amount of vehicles.

The next problem that could probably happen would be insufficient supply of electricity.

There are also several short-term programmes to overcome the problems stated above.

Examples are:

1. To develop squatters and crowded settlement areas, including giving advice and

training to the inhabitants in order to eradicate poverty gradually.

2. Prioritising home loan facilities from the public and private sector and also giving

first priority to low cost housing projects to overcome housing problems for the

low income earners.

3. Straightening and widening of roads to overcome traffic congestion problem.

4. Make an effort to maintain a balanced ecology.

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Long-term programmes to control urbanisation process are:

1. To develop new and old cities such as areas at the edge of a large city,

underdeveloped rural areas and regional development areas that can act as the

centre for economic growth.

2. To build more amenities in the underdeveloped rural areas, that can allow the

inhabitants to have a better life and to facilitate their acceptance towards

development.

Theories of Urban and Regional Growth

The theories of urban and regional growth can be considered from the aspect of demand.

Based on the aspect of demand, a number of urban and regional growth models have been

proposed by western economics researchers. Some of the proposed models are as

follows:

1. Central Place Theory (Walter Christaller)

2. Rank-size Rule (Zipf)

3. Urban Base Theory

4. Money Flow Theory

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Central Place Theory (Walter Christaller)

Walter Christaller proposed this theory in the year 1933 based on research done in the

south of Germany. This theory explains the relevance of the market area to the size of a

town’s population and the distribution of settlements. In his opinion, there is a unity in

distribution and pattern of settlement based on the degree of importance of the

centralisation, pictured by its functional characteristics. According to Christaller, central

place is defined as a settlement that provides services such as trading, education, cultural,

health, security and government’s services.

Other than physical space, central concept also covers aspects of economic system,

activity and size of population. Physical space is important in understanding the

distribution, location, arrangement and distance of central place in relation with the

economic system. This concept claims that the larger the size of the city, the greater the

degree of centralisation and thus the city will become more important in a settlement.

Based on the concept, the idea of urban hierarchy is introduced according to the town’s

level of specialisation. The difference of settlements’ specialisation shows different

degree of centralisation of a town that can be measured through different ways such as

population, numbers of function/specialisation, space, various types of goods and

services offered, size of spheres of influence and others.

ASSUMPTIONS IN CENTRAL PLACE THEORY

1. The land topography is a uniform plane. This would create a simple transportation

system in all directions where cost of transportation is compatible with the

distance.

2. Distribution of inhabitants and purchasing power are uniform in all areas where

consumers have the same income.

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3. Market areas for all types of goods and services take the form of a hexagon. The

form of a hexagon was chosen to avoid certain areas not being served and other

areas being served overlapping hinterlands. Market areas main function is to

supply goods and services plus administrative functions to rural areas.

4. The services provided depend on the status or hierarchy of a town. For example, a

medical centre is provided to a high grade town centre while a low grade town

centre is provided with a lower grade medical facility such as a local clinic.

5. Users will head towards the nearest centre that offers the function needed,

therefore long distance travelling is minimised.

Two important concepts that are emphasised in this theory are:

1. The threshold of inhabitants

The threshold of inhabitants is the minimum number of inhabitants needed to

support the existence of a settlement function. The threshold of inhabitants of a

town is largely influenced by the dispersion of purchasing power and its

inhabitants. The threshold of inhabitants is different between different types of

goods and services. For example, a shop is only necessary when the population is

in the region of 300 people while a clinic needs 1,200 people. A school is only

provided when there are around 2,500 inhabitants. These figures are the minimum

market threshold.

This concept is important in settlement research especially from the aspect of

providing basic amenities. This can be shown in the figure below:

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Figure 1.1: The threshold of inhabitants

With reference to figure 1.1, the radius is the potential maximum radius size for

that market area. A to C is the distance of goods.

a. Purchasing Goods Distance

The purchasing goods distance is the market of a service. The distance of the

market goods is related with the travelling distance, which is the travelling

distance back and forth depending on the geographic situation that involves

transportation cost and travelling period.

A :border of market area where its radius is equal to distance of goods

CSize of market area is determined by minimum demand

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Figure 1.2: The Relation between Demand for Goods and Distance

(1 type of good and 1 supplier)

The distance from A to C is the distance of goods where users are willing to travel in

obtaining the goods. The distance friction from the cost of transportation will lower the

demand for goods due to the increase of distance from the central place. For example,

when a user is at C, he has to purchase the least amount of goods compared to A because

he has to settle a high cost of transportation.

The layout of centralised area according to Christaller’s theory is as follows:

a. The formation of a specialised area is according to hierarchy where the

arrangement is from the towns with the highest level to the lowest level of

specialisation. It starts with the District Centre, County Seat, Township Centre

and Market Hamlet. Please refer to Figure 1.3 for a better picture.

b. The market areas of goods and services are hexagonally shaped.

Quantity of goods

A C Distance of goods/ distance from supplier (price + transportation costs)

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c. For each group of six towns there would be a larger city with more specialised

functions that would also be located an equal distance from other cities and each

has hexagon shaped market area. The lowest ranked centres are 7 km, followed by

the second lowest (Township Centre) that is 7km x √3 = 12km, next is Country

Seat at 12km x √3 = 21km and the biggest is the District Centre at 21km x √3 =

36km

The size of the area and the total population is three times according to hierarchy.

Hence, the trade factor has a pattern referred to as K = 3 hierarchy. The traffic factor has

a K = 4 hierarchy. This refers to the traffic network for a central market area with a

multiplier of 4. Administration factor has a pattern of K=7. This means that a central area

with a higher status has more administration compared to lower status area based on this

multiplier K=7.

Therefore, it can be observed that central place theory has two potential roles: first, as a

guideline to understand the regional space structure and second, as a model for future

planning. One main argument that supports the use of this theory in regional planning is

due to the central hierarchy system that encourages development. Thus, social benefits

from an economic field can be gained. Although, there are problems of using this

structure theory, the ideas contained in this theory is quite fascinating to plan the regional

pattern of an area.

Some of the weaknesses of the Central Place Theory by Walter Christaller are:

a. The assumption of a uniform plane does not exist and Christaller ignored

variations in topography.

b. The influence of the manufacturing industry especially in developed countries is

discounted. When the industry is focused on a certain product, the pattern of

settlement arrangement would also change.

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c. Government’s development policy for an area will also change the arrangement

pattern of function for Central Place.

d. Discount of changes in transportation system and trading between cities and its

effect upon the size of towns of a large in-migration of labour

Although this theory has received a lot of criticism, the Central Place Theory still plays

an important role as stated below:

a. Laying the foundation in understanding the arrangement of town settlements

(please refer to Figure 1.4)

b. The use of centralised settlement distribution of various sizes is important in

regional planning. If there are certain situation that can influence the known

distribution, a solution can be done from the aspect of the town size that can be

created, the amount, distance between one central area to another and the

functions that can be offered (based on the economic background and residents

distribution)

c. The residents limit concept and the distance of purchasing goods are most useful

from the aspect of planning and determining the type of highest goods that can be

offered in a city centre.

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Figure 1.3: Christaller’s Central Place Theory

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Figure 1.4: Central Place Dispersion (Grade 1 & Grade 2) in Peninsular Malaysia

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Rank Size Rule

The rank size rule explains that the cities distribution of a country tends to be a

continuous arithmetic from the biggest size to the smallest.

The cities in a country can be graded from the largest to the smallest size based on the

size of the settlers. Therefore, the largest city can be classified its rank as number 1, the

second largest number 2, and the number continues to the smallest city in that country.

Zipf (1949) explains the relation between the size of the urban settlers with its rank by

using a mathematical equation.

Assume ‘R’ is equal to the size of settlers in the largest city which is Level 1 divided with

‘R’. In other words, the studied urban settlement can be levelled as Rank 1 for the largest

city, ½ for second largest city, 1/3 for the third largest, 1/4 for the fourth and then 1/n for

the smallest city in that country.

In the mathematical equation:

Pr = Pi / Rb

Where Pr is Level ‘R’ urban settlers that needs to be counted

Pi is Settlers from the largest city (Level 1)

R is the known level for ‘R’ city

b is fixed value and often ignored in the calculation as P

value is mostly not explained.

This equation is often stated with different symbols but has the same meaning.

If the largest city, level 1 has a 1,000,000 population therefore the settlers for R city (for

example level 10) is equal to 1,000,000 / 10 which is 100,000 people. If the urban settlers

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for each level is counted, based on the population of the largest city which is level 1,

therefore the city’s size is as though having a systematic sequence from the largest to the

smallest.

Table 1.1: Rank-size of 12 Principal Cities in Peninsular Malaysia, 2000

City Ranks

CR

Name of City Real Population Expected Population

Pr = Pi / Rb

1. Kuala Lumpur 1,297,526 1,297,526

2. Ipoh 566,211 648,763

3. Klang 563,173 432,509

4. Petaling Jaya 438,084 324,382

5. Johor Bahru 384,613 259,505

6. Shah Alam 319,612 216,254

7. Kuantan 283,041 185,361

8. Kuala Terengganu 250,528 162,191

9. Seremban 246,441 144,170

10. Kota Bharu 233,673 129,753

11. Taiping 183,320 117,957

12. George Town 180,573 108,127

Source: www.citypopulation.de, Thomas Binkoff, 2003

THE IMPORTANCE OF CITY DISTRIBUTION BASED ON ITS RANK-SIZE

The distribution of a city based on its size is an important study to determine the overall

settlement system. Some of the important contributions of this study are:

1. Rank-size shows the number and frequency of cities of various sizes in a country.

It is useful to observe the cities’ importance from the aspect of size and function.

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2. It makes us able to observe the wider perspective of all cities in a country.

3. Comparison on the distribution of cities in a country with another country can be

done. Thus, it is useful in measuring the balance of cities distribution.

4. It can prove whether the cities are uniformly arranged in a smooth hierarchy as

claimed by Zipf.

In situations when other factors such as history, demography, natural resources and

government policy do not influence much on the development of urban settlements, the

distribution which is of log-frequency character depicts a more balanced social and

economic development between different areas in a country.

The truth is that rank size principle is only effective in helping researchers explain the

cities distribution of a large country. For a small country with an economic system that is

hard to explain, this rank-size principle, may not assist much in understanding the

problems in the distribution of cities.

For small countries like Malaysia that do not have a large population, it is difficult to

determine the most suitable distribution pattern for the cities.

Overall, the Rank-Size Principle is still useful at least to provide a guide in outlining the

urbanisation policy and strategy of a country

Urban Base Theory

Unlike the central place theory which was concerned with the distribution of products

from an urban centre to its hinterland, the urban base theory involves a consideration of

demand from anywhere outside the boundaries of the settlement. Urban growth will thus

28

depend upon the urban area’s ability to export goods and services to pay for its import

needs.

The urban base theory divides the urban area into two activities:

1. ‘Basic’ activity which involves the production of goods and services for export

2. ‘Non-basic’ activity which involves the output of products for distribution solely

to the urban area itself.

Based on this theory, the urban growth depends upon basic industry where it will

encourage development in non-basic activity and increase the overall urban economic

standard. In short, the theory states that non-basic industry will be dependent upon the

basic sector. The theory assumes that once the underlying economic, technological and

social structure of a country has stabilised, the ratio between basic and non basic

activities of an urban area and the ratios between all activities and the total population

remain constant. Furthermore, it is assumed that the open market principle is practised in

the urban area where there is no restriction in trade.

According to the theory, the larger the ratio between basic and non-basic activities, the

higher will be the rate of urban growth. As stated before, non-basic industries will be

dependent upon the basic sector where employees in the later activity provide much of

the demand for the products of the former. This theory also suggests that if an urban area

loses substantial employment in the basic sector, the employment in the non-basic sector

will also decrease.

If there is an injection of basic employment into the town, eventually non-basic

employment will have to increase. Local demand for goods and services will also

increase and this will create temporary imbalance between the local demand and ability

of non-basic sector to meet the demand. This temporary imbalance resulting from an

29

initial increase in basic employment will be eliminated through an upward adjustment in

both non-basic employment and total population as showed in Table 1.2.

Criticisms against the urban base theory are as follows:

1. This theory assumes that the underlying economic, technological and social

structure of a country is stable but in reality, it often changes especially changes

in technology.

2. There is unlikely to be a constant basic - non- basic ratio for an urban area with

other urban areas. The ratio will change when there are changes on the factors that

were assumed stable.

3. The theory only suggests what might happen if there is a change in the basic

activity but gives no indication of what future changes that may be anticipated in

an urban area.

4. The theory ignores the importance and effects of imports in urban growth

5. The theory states that a non-basic activity is dependent upon a basic activity but in

reality, the reverse is often true where there will be no basic activity without

excess factors from a non-basic activity.

6. By focusing on exports, the theory has ignored other variables such as

autonomous investment that can influence urban growth.

Nevertheless, the urban base theory is still important for the following purposes:

1. To provide a guideline in forecasting population growth in an urban area.

30

2. To determine the inter-relationship between economic sectors in a region.

3. To determine the strength of principal economies of an urban area, in order to

anticipate future development.

4. To provide guidelines in determining sector of employment for urban areas that

needs to be developed.

5. To measure the rate of unemployment and underutilised labour; and

6. To determine the type of basic amenities, services and other facilities that can be

provided.

Table 1.2 : Balance between Basic and Non-basic ctivities

Level І

Number Initial equilibrium ratio

to basic employment

Basic employees 10,000 1.0

Non-basic employees 18,750 1.5

Total employees 25,000 2.5

Total population 50,000 5.0

Level П

Number Disequilibrium ratio

to basic employment

Basic employees 12,500 1.0

Non-basic employees 15,000 1.2

Total employees 27,500 2.2

Total population 55,000 4.4

31

Level Ш

Number Possible equilibrium ratio

to basic employment

Basic employees 12,500 1.0

Non-basic employees 15,000 1.5

Total employees 31,250 2.5

Total population 62,500 5.0

Level П – shows that an injection has been given to the numbers of employees and

therefore the ratio to basic employment changes temporarily

Level Ш – shows that the ratio to basic employment has returned to the original

equilibrium

Money flow theory

J.M. Keynes introduced money flow theory in the year 1930. There are 4 role playing

sectors in the cash flow cycle which consists of households, firms, government and

overseas sectors. Figure 1.5 shows the income flow cycle as follows:

1. Consumers’ income is used for income tax payment, payment for goods and

services produced by the manufacturers as well as for savings.

2. Manufacturers’ income is used for tax payment imposed by the government,

payment for factors of production from households (consumers) and payment for

capital goods and imported raw materials.

3. Government’s income is used to pay civil servants’ wages and salaries and

government’s expenditures on goods and services produced in and out of the

country.

32

Savings made by the households or consumers and firms in financial institutions will be

borrowed and used by the producers for investment. Leakages and injections will happen

in the money flow. According to Keynes, these leakages consist of savings, government

taxes and imports whilst the injections comprise of investments, government’s

expenditures and exports.

In the open economic system model, savings made by the consumers and firms are the

leakages in the income flow and will cause the income flow to decrease. This is because

the savings made are not used immediately for investment (frozen savings). On the

contrary, investments made by the manufacturers are injections to income flow and

causes the income flow to increase. This is because the investments made are used to

increase the national production. Therefore, the larger the investment rate, the larger is

the income flow.

Tax imposed by the government is a leakage to this income flow. This is because the part

of consumers’ income used to pay the tax is not used by the consumers but will be

channelled to the government sector and this happens to the firm sector too. If the

government keeps the income they obtain from the taxes, the cash flow in the country

will decrease. However, government’s expenditure on goods and services is an injection

to this cash flow. Government’s expenditure on goods and services will increase firm

sector’s income. Besides that, the use of labour (civil servants) from the household sector

will increase income in this sector.

The action from household, firm and government sectors to import goods and services

from abroad is a leakage where it will cause cash to flow overseas. This is because there

is no income for factors of production in the country and there are expenses for imported

goods. On the contrary, export to overseas is an injection where the export of goods and

outgoing services will result in the inflow of money into the country for spending and the

balance to be saved.

33

Figure 1.5: Income (cash) Flow in a Four Sector Economy

34

SALARY AND WAGES, RENT, INCOME AND PROFIT

GOVERNMENT SECTOR

TAX TAX

PAYMENT FOR GOODS AND SERVICES

PAYMENT FOR PRODUCTION FACTORS

FIRM SECTORHOUSEHOLD SECTOR

IMPORT

OVERSEAS SECTOR

FINANCIAL BODIES

IMPORT IMPORT

EXPORT

FIRM FUND HOUSEHOLD FUND

ENTR

EPR

ENEU

R’S

INV

ESTM

ENT

USERS EXPENSES

SALARY AND WAGES, RENT, INCOME AND PROFIT

GOVERNMENT SECTOR

TAX TAX

PAYMENT FOR GOODS AND SERVICES

PAYMENT FOR FACTORS OF PRODUCTION

FIRM SECTORHOUSEHOLD SECTOR

IMPORT

OVERSEAS SECTOR

FINANCIAL BODIES

IMPORT IMPORT

EXPORT

FIRM SAVING HOUSEHOLD SAVING

ENTR

EPR

ENEU

R’S

INV

ESTM

ENT

USERS EXPENSES

The total allocation of money is based on the Marginal Propensity to Consume (MPC).

The process is continuous until the total money spent is small. The total income

generated is based on the concept of multiplier that is the multiplication of income flow

in the economy as a result of an injection.

Below is how the size of the multiplier is derived:

K = 11-MPC

= 11-0.8

= 1 or 10.2 MPS

= 5

When the change of investment that was earlier mentioned is said to be RM10 million,

MPC = 0.8, MPS = 0.2, therefore the change in output is

1 x change in investment1 - MPC

= 1 x 101 - 0.2

= RM50 million

From the above equation, the size of the multiplier in the economy is 5 times from the

investment. This means that the economic income increases 5 times from the initial

investment, thus, the change in investment as much as RM10 million previously will

generate an income flow as much as RM50 million. Here, the economic level that was at

RM1,000 million increases to RM1,050 million.

35

Thus, an investor is able to know the economic situation of a place or an area through the

multiplier value.

Based on Figure 1.5 above, it is clear that the high income in the city will cause an

increase in utilisation and thus encourage urban growth. When injection is made in the

cash inflow or the income into the country, export creates an income for the factors of

production. Multiplier will also cause the income to change at a higher rate from the

changes in those expenses. The formula to arrive at a multiplier is related both to MPC

and Marginal Propensity to Save (MPS) as follows

Multiplier Formula:

MPC is the changes in total consumption due to the changes in disposable income. MPS

is the change in total saving due to the changes in disposable income.

Although this theory relates to urban growth, it has its weaknesses from the aspect of

national economy as follows:

1. Insufficient data that make it difficult to predict when variable changes will occur.

2. Insufficient information on activities that is not payable by money where

originally these activities have to be considered in determining the income of a

city.

3. This theory also concludes that the higher the income, the higher is the

consumption and thus demand for goods in a city will also increase. However, if

the percentage change in income is equal to the percentage change in price of

goods, it will cause no difference in the purchasing power. If there is no increase

in the consumers’ expenditure, there would be no increase in the demand for

K = 1 or 11-MPC MPS

36

goods in a city and thus the city will develop slowly. This is also the case if

inflation happens.

Urban Growth from the Aspect of Supply

Urban growth from the aspect of demand can only happen in the short term, as it does not

consider the need for factors of production. Since the available factors of production are

limited, the subsequent long-term urban growth process would need an increase and

modification in factors of production in accordance with the current increase in demand.

There are two ways to upgrade the factors of production in an urban area. First, the

capability to attract resources within and outside the urban area. Second is the capability

to modify the output from production resources within the urban area or region itself.

This urban growth analysis can be further considered from the four factors of production;

labour, land, capital and entrepreneurship.

Labour

Labour is defined as the mental and physical capacity of workers to produce goods and

services other than the direct benefits gained from the employment. From the aspect of

economics, all labourers who receive wages in the form of money or goods for their

services are called labour. In general, there are three types of labour; skilled labour, half

skilled labour and unskilled labour.

An economics supply of labour is influenced by the size of inhabitants, ratio of employed

inhabitants, the total hours of each individual is willing to work, custom and beliefs

toward the job, labour mobility and others. In general, a large population would have a

large supply in labour. A country’s population rate of increase is dependent upon the rate

of birth, death and migration of inhabitants from rural areas.

37

The supply of labour is influenced by the rate of inhabitants that are willing to work. This

depends on the gender, age and the level of education of the inhabitants of a country.

The power in determining the labour supply for different jobs depends upon the number

of jobs available and the ability to enter or to get involved in a job and the amount of time

that they are willing to work. The supply curve of labour from an individual worker is of

a normal shape as below.

Figure 1.6 : Supply Curve of Labour

When wages increase, so does labour. Thus, the total supply will increase to a certain

level. If wages still increase, the supply curve of labour will curve backwards as

illustrated in figure 1.7 below.

Total labour’s working hours

Real wages

0

Pn

38

Figure 1.7 : Supply Curve of Labour that Curves Backward

Trade unions are labour associations that were formed to represent workers in a collective

negotiation in an industry. Trade unions have become the spokespersons for the workers

in fighting for their interest and welfare. Examples of active trade unions in Malaysia are

the Malaysian Trade Union Congress (MTUC). MTUC acts as a public relation and

spokesperson on behalf of its members. MTUC is dependent upon financial contribution

from each international labour trade society.

The main purposes of trade unions are as follows:

1. To increase wages and obtain more benefits

2. To ensure a better working environment such as shorter working hours,

comfortable working area, leave and others

3. To protect workers from unjust action such as dismissal of employment

0Total labour working hoursK1K

H1

H

PnReal wages

39

4. To discuss and negotiate economics and industrial policy

5. To participate in political organisations and to console the government to pass

bills that benefit workers

In conclusion, it can be stated that labour plays an important role in urban growth. At the

early stages, labours that are focused in an urban area originate from the inhabitants of

that area itself and from nearby areas. This is because labour supply is greatly needed in

the development of a pioneer city. When the city starts to develop, labours from rural

areas will migrate to the city.

Land

According to the National Land Code, land can be defined as all items that are attached to

the earth including plants and other natural resources whether it needs to use energy

periodically in its production or not.

Land is an important factor because it is a source of raw materials, vegetation for

agriculture, and site for development plus nature where it can further encourage the

process of urban growth. The finding of important raw materials such as minerals and

agricultural products for trade has pushed efforts to produce in a large scale. The need for

a central place to collect, store, manage and workers quarters has resulted in the

emergence of new cities nearby the production area.

In the 19th century, history has proven that urban growth is linked to high demand for

natural resources of an area. It can be observed, that the developed areas are places with

plenty of raw materials such as tin ore and petroleum or fertile soil suitable for

agriculture. In these areas, the number of inhabitants have increased, large cities have

emerged, railroads and highways were built and public amenities were provided.

40

The need to build a port has also resulted in new urban areas by the sea to emerge such as

Pelabuhan Kuala Sepetang (Port Weld), Port Klang and Teluk Intan. In addition, the

growth of a city population is indirectly linked to land factor and its use which naturally

creates higher need for housing, jobs and basic amenities. This will involve the process of

changing land use from agriculture, forest or neglected land to housing, commercial

buildings, offices, schools, hospital, roads and others. Therefore, it can be stated that the

change of agricultural land use to non-agricultural use is part of the urban growth

process.

Capital

In economics, the term capital means “tools to produce other goods”. Capital is surplus

goods such as factories producing raw materials, highways, railroads, factories,

machineries and others. Therefore, capital is a factor of production and helps to produce

other goods that can give satisfaction to consumers.

There are several types of capital:

1. Fixed capital

Fixed capital is a long-term production tool that is long life and does not change

form during production. In this category, we can include factors of production like

factories, machineries, highways and railroads, tractors and others that assist

further production.

2. Employment capital

Employment capital is a production tool that is only used once such as rubber,

clay and fuel. They change form entirely at different stages of production.

41

Employment capital needs to be replaced once it is all used which is different

from fixed capital that takes a long time to be replaced.

3. Social capital

Each community has large capital that is indirectly used in production. Schools,

hospitals, flower nursery and playgrounds are part of the country’s capital but are

not directly involved in the production of goods. This type of capital is important

to improve the standard of health, provides education and training and other

aspects to upgrade the standard of living. Indirectly, this type of capital will

increase the capacity to produce.

The relationship between capital and urban growth is crucial. Without capital, a city

cannot be developed or expanded properly. This is because capital is much needed at the

early stages of urban development.

Entrepreneurship

Lastly, an entrepreneur is needed to manage the three factors of production as explained

above to become one production unit. There must be a person to decide on:

1. What to produce (type and quantity of goods)

2. How to produce (method of producing)

3. Where to produce (factory location) and the risk involved in the decision-making.

The person who makes these decisions and undertakes its risk is called an entrepreneur.

An entrepreneur is a person who produces to seek profits. He will undertake on a

production that he believes has a satisfactory demand with prices that can give him

42

profits. He will decide on the location of the factory, hiring factors of production and

combining it in ratios that he thinks is effective. He is also ready to face risk of using his

savings by incurring all the expenses before his products hit the market. In conclusion, all

these four factors of production play an important role in the growth of urban economics.

Tutorial Questions

1. State the important concepts in the Central Place Theory (Christaller). How far does

the theory contributes in planning the structure of a settlement in a new developing

area that you know.

2. Explain the concept of ‘Urban Growth’. How far is the urban-regional growth

dependent upon the capacity to attract productive resources that is needed from

outside?

3. State an economics definition for urbanisation. Discuss the problems that may arise

due to rapid and uncontrollable urbanisation process that most developing countries

face.

4. Explain the factors that encourage urbanisation process in Malaysia and state the

economic benefits from the process.

5. Provide comments on two (2) from below:

a. Rank-size rule (Zipf)

b. Urban Base Theory

c. Money Flow Theory

43

CHAPTER 2: URBAN AND REGIONAL LAND USE MODEL

Introduction to Urban Land Use

From the aspect of physical planning, land use can be defined as a form or way how the

land is to be used. Therefore, land use is the land function or the activities carried out on

a piece of land and it can be classified into certain categories such as trade, commercial,

industrial and residential.

Urban and Regional Land Use Models

There are several theories that have been brought forward by economists and planners.

Among them is the earliest theory by Heinrich Von Thunen. He put forward the theory

where agricultural land use is different based on how far it is located from the market

centre. William Alonso has adapted this theory by suggesting the urban land use pattern

and Land Rent Value Principle. Another theory was put forward by David Ricardo who

emphasises that the land rent value is influenced by certain factors.

Von Thunen Land Use Model

In the year 1826, Johan Heinrich Von Thunen, a German economist came out with the

Agriculture Land Use theory. This theory is contained in his book, Der Isolierte Staat

(The Isolated State).

The theory’s main objective is to show the difference in land use with the increasing

distance from the market. Von Thunen tries to explain the location of different

agricultural land uses through economic principles with the rural land use pattern.

44

Basic Principles in Von Thunen’s Theory

In general, this theory has 2 basic principles. First, the intensity of a particular

agricultural output will decrease when its location gets farther from the market.

The farther is the farm from the market, the lesser is the intensity of its cultivation.

Therefore, intensive cultivation are carried out in areas that are located nearby the market

whereas an extensive agriculture system is carried out in areas far from the market.

Adaptation to the agriculture system is made to reduce transportation cost and cost of

production. This cost includes cost of transporting agriculture input from the field to the

market, cost of frequent supervision and tight care. For areas that are far from the market,

agriculture inputs including labour are reduced to save cost and maximise return and

products.

The second principle is that different types of land use follow the distance from the

market. Land use or types of plants are different with the increasing distance from the

market in order to cut cost of output and to increase the returns.

The assumptions proposed by Von Thunen are as follows:

1. A state has only one city centre in the middle.

2. The city centre has only one place to market agriculture goods.

3. The land area is uniform or similar from the aspect of soil fertility, climate and

geography.

4. There is only horse carriage as a form of transportation at the time.

45

5. Transportation cost is determined by the travelling distance.

6. All farmers in the area act as a human economy. This means that the farmers have

the attitude to maximise profits.

Economic Rent or Location Rent is an important concept in this theory.

Economic rent is the difference between the total revenue of a farmer for a particular

agriculture goods planted in a land area and the total production and transportation

cost of the particular agriculture goods. The revenue gained is based on the price of

the agriculture goods in the market.

It is found that transportation cost increases as the farther the agricultural activity is

from the market. The higher the transportation cost, the smaller is the difference

between revenue and the total cost. Thus, the location rent will become smaller.

The location rent of an area of land will decrease as it gets farther from the market.

For example, location ‘A’ has a revenue equal to the cost. Therefore, location ‘A’ has

location rent of zero for a land unit. Location rent is what a farmer would offer for a

land area.

46

Figure 2.1 : The Relationship between Location Rent and Distance from Market

1. Intensity model

As illustrated in figure 2.2 below, the Von Thunen model can also be explained in the

context of an intensity model.

Location Rent

0A Distance from Market

47

Figure 2.2 : Intensity Model

Based on the intensity model, location rent is different due to the distance from

the market for different intensity of output.

2. Location model for a number of crops related to the market.

This involves two types of crops, location rent and distance from the market as

illustrated in figure 2.3.

48

Intensive Extensive

Extensive

Intensive

km

Loca

tion

rent

Market

Market

Figure 2.3 : Location Model for a Number of Crops Related to the Market

In reality, the market price, durability, portability, rate of return and production

cost are always different between one agriculture product to another.

Therefore, the crop that can guarantee the highest location rent for a unit of land

will be cultivated.

Location rent is paid in the form of land price or land rent.

The location rent formula for a particular crop is:

SL = Hp - Hk – Htj

= H ( p – k – t)

Where:

SL : Location rent for a unit of land

H : the goods for a unit of land

49

Crop A Crop B

Crop A

Crop BLo

catio

n R

ent

P : the market price for a unit of commodity

K : the cost of production for a unit of commodity

T : transportation cost for a unit of commodity

j distance from the market

Pattern and Arrangement of Von Thunen Model of Land Use

Von Thunen depicts the suggested model’s pattern of arrangement as a circle.

This circle is then divided into six zones where there is one city centre in the

middle. (Figure 2.4)

50

Small town with its own production zone

Figure 2.4: Von Thunen Model

The zones are as follows:

1. Zone 1

This zone is the area closest to the city centre. Agriculture and economic

activities are focused on milk and vegetables production. The product is

not durable and the rent is the highest.

2. Zone 2

This zone is used for the production of forest resources. During Von

Thunen’s era, wood is important for fuel and building materials. As this

production creates transportation problem, it is important that production

be nearby the city.

51

Town centreFresh vegetables and milkSmall forestSix-year seasonal crop

Seven-year seasonal crop

Three field systemAnimal breeding

River

3. Zone 3, 4, 5

Activities carried out are in the form of agriculture too. Less intensive

agriculture is undertaken here and the agriculture products include

potatoes, dry grass and cereals that are cultivated alternately. The main

type of cereal is rye. The rental rate for this area is lower.

4. Zone 6

This area is for animal breeding. The rent is the lowest.

The Weakness of Von Thunen’s Theory

The weaknesses in the Von Thunen’s theory are as follows:

1. This model is only suitable in explaining the pattern of agriculture land use only.

It is very different from now, as land use displays a few important characteristics

such as the existence of a city centre and activities like commercial, trade and

services. In the suburbs, there are residential and industrial uses while in rural

areas there are intensive agriculture activities.

2. This model considers the distance aspect only and do not consider soil fertility

although it plays an important role in determining the suitable type of land use

and cultivation.

3. In his assumption, Von Thunen ignores technology advancement in the

transportation sector although in today’s reality it is one of the factors that

determines urban land use pattern.

4. Nowadays, there is no isolated state as explained by Von Thunen.

52

5. Von Thunen assumed that the land area is uniform from the aspect of fertility,

climate and topography. In reality, this is impossible as no place on earth has the

same topography.

6. The assumption that all farmers know the market price with the total revenue in

the future is inaccurate.

David Ricardo Land Use Model

Ricardo land use model is known as Rent Difference Theory. Through this theory,

Ricardo has denied Von Thunen’s opinion on constant soil fertility. According to

Ricardo, the rate of soil fertility is different and thus has influenced the agriculture land

use pattern. Hence, soil fertility is a major factor in determining different production cost

based on its economic function.

Assumption in Ricardo’s Theory

Among the assumptions that was put forward by Ricardo are as follows:

1. The market price of agricultural goods is higher than the cost. With this surplus

over production cost, profits from the agriculture produce are gained.

2. The land use pattern is based on the concept of marginal land. This concept refers

to land productivity where land is considered economical if it is intensively

utilised to create the surplus.

3. The land use pattern is based on the soil fertility itself where the type of activities

carried out will become more economical.

53

David Ricardo has created a formula to determine the land use pattern based on rental as

follows:

L = E (p - a) – EFK

Where:

L = Land rental

E = Production rate for each land unit

P =Market price for each commodity unit

a = Cost of production for each commodity unit

F = Cost of transportation for each commodity unit

K =Distance

With this formula, it is clear that the Ricardo Land Use Model is more focused on the rent

difference based on the supply and demand measured through the soil fertility.

Weakness of Ricardo Theory

Ricardo’s theory also has a number of weaknesses as follows :

The emphasis of this theory is on agricultural land use only. This theory does not give a

complete explanation on the urban land use.

Ricardo focuses more on the soil fertility without considering other factors of production

such as labour, capital and entrepreneurship and development of modern technology.

In reality, the market price is not always higher than the cost of production. Product

abundance, price fluctuation and other economic factors can affect the market price.

54

In conclusion, the theories brought forward by Ricardo and Von Thunen only emphasise

on agricultural land use pattern. Emphasis was also given on factors like soil fertility, rent

difference, influence of distance and cost of transportation. However, it is clear that the

given theories still fails to show other factors that influence the land use pattern such as

planning, government policy, technology advancement and change in current taste.

Urban Land Rent Value (William Alonso)

William Alonso in the year 1964 introduces this land use theory, which is a century after

the Von Thunen theory was introduced.

This theory was introduced based on the principle of the land rent where William Alonso

states that the land rent of an area is influenced by its distance from the central market

(city) and it will differ according to the land use in the particular area.

Basic Principles and Characteristics of W. Alonso Theory

This theory is based on the principle that land rent will decrease for areas that is getting

further from the city centre. This is the result of the rising cost of transportation needed to

get to the city centre despite the decreasing incomes received by the residents in that area.

Thus, it is W. Alonso’s opinion that the fall in rental rates will balance out the increasing

cost and the decreasing income.

As a result of the theory’s basic principle, a series of bid rents curve would emerge which

shows the steepness or the rent gradient. Different rent uses would have different rent

gradients. Here, Alonso has divided it into three types of land use which are commercial,

office and residential.

55

In figure 2.5, the horizontal axis shows the distance from the city centre while the vertical

axis shows the bid rent. Exhibit B shows that the land rent varies according to its land use

where the land rent for retail land is higher compared to land rent for office and

residential land use respectively.

a-a rent curve is a bid rent curve for retail land use. The rental rate is highest and has the

closest distance to the city centre. B-b curve shows the bid rent curve for office land use

while c-c curve is the bid rent for residential land use. Both bid rent curves have gradients

that gets steeper when the distance is further from the city centre.

For each land use mentioned, the bid rent is proportionally inversed with the distance

from the city centre. This is because the land rent will decrease when the distance of the

land increases from the city centre.

56

Exhibit A

Figure 2.5 : Land Rent by Alonso

57

Bid Rent

Distance from the City Centre

Bid Rent Curve

Exhibit B

Figure 2.5: Land Rent by Alonso

Exhibit A and B are bid rent curves that show the total resources that can be allocated to

own land closer to the market.

W. Alonso came up with a few assumptions in forming his theory. The assumptions are

as follows:

1. There is only a single market centre

58

b

Bid Rent

c

Commercial

Office

Residential

a b

c

Distance from City Centre

a

2. A uniform plain low land exist

3. Soil being of constant fertility

4. Perfect market; and

5. Goods located in city centre

W. Alonso’s model also has two approaches:

1. Total land use needed for each developer

2. Developer’s total revenue that is allocated for the purpose of purchasing land and

travelling cost needed due to the location of purchased land including cost of

service and purchasing of goods.

The individual capacity in competing and paying rent for the land partially depends on

the land size needed and the necessity to spend for other goods.

Critics on the Land Rent Theory can be summarised as follows:

1. The concept of a single city centre is not accurate because now many sub-centres

exist to support rapid growth of activities in the city centre area. For example, in

Malaysia the government has tried to spread these centralised activities to

surrounding areas to avoid the emergence of various problems such as the

increasing population that is getting denser due to process of migration that leads

to higher needs in other facilities such as residence facilities, transport facilities,

business centre and others.

59

2. The assumption that the topography is plain lowland that is uniform does not exist

in reality. Therefore, factors such as distance, physical and topography are also

important in determining the land use pattern and rent value in the city area.

3. The land rent does not always decrease as it gets further from the city centre. For

example, the Golden Triangle area in the Kuala Lumpur city centre has higher

land rent compared to the land rent of the city centre itself. The Golden Triangle

area has a high land rent because of the existence of exclusive buildings of

international status in the area. The materials used in the construction of the

buildings are also of high quality. In addition, other internal factors have also

attracted the interest of foreign investors to invest in this area.

4. In W. Alonso theory, the assumption is that inhabitants do not focus towards the

city centre. The opposite situation happens in Kuala Lumpur City, where it is the

inhabitants’ central focus. Migrations are focused here. This is due to the

attraction factor of easily obtaining a job and the social amenities and services

offered.

5. W. Alonso theory also ignores the industrial land use factor. Industrial activities

are ignored although the industrial revolution has already happened when the

theory was introduced. Due to modern advancement, various industries emerged

especially the light industries to increase the production of goods.

Determining the Urban and Regional Land Use Pattern

Besides the factors observed in the model analysis by Von Thunen, Ricardo and W.

Alonso, there are other factors that also influence the land use pattern of an urban area as

below:

a. Physical factor

60

b. Location

c. Accessibility

d. Demand and Supply

e. Grouping

f. Refusal

g. Government’s Policy and Planning

Physical factor especially topography will determine the positioning of a city whether it

is on top of a hill, at the hill’s terrace, on a plain, at the edge of a river estuary or by the

beach. From the aspect of climate, a city can be built in an area where it is too cold or too

hot. For example, a typhoon free area will have a different kind of building design.

Location factor plays an important role in determining the urban and regional land use

pattern. It is clear that the private sector, firms and local residents will try to obtain a

piece of land in the city and willing to bid prices if the land has a good location from the

aspect of communication and fulfils the total area of space needed. That location will

have a high land value because of its good potential.

Accessibility is another facility in order to communicate with the agents involved in the

city area, for example between the supplier, wholesaler, sundry shop owner and buyer. In

general, there are several types of relationship, which are relationship between

individuals, relationship from the information aspect and relationship from the aspect of

production factor. A site that has capabilities to offer these facilities will have a huge

profit where the value will increase and cost of production will decrease.

Agglomeration is the focus of all economic activities nearby the cities so that economies

of scale can be enjoyed. For an industrial area, this factor can cause distribution of social

class according to income level. Thus, this will attract other activities such as trading and

services sector to fulfil the demands from this social class.

61

Pushing aspect is found when there is an unsuitable economic activity and hence would

reject other activities in the same particular location. For example, palm oil factory is not

suitable to be placed next to a hospital area.

The demand and supply factor work alongside in determining the land use pattern.

Demand for an area is based on user incomes which are too dependent on location aspect,

accessibility, concentration and refusal. Therefore, users are willing to pay more to get

their ideal location. Here is when the demand for the location is said to be inelastic. Land

supply for a particular location at a particular time can be assumed to be less elastic due

to factors as follows; physical, communication, transportation and public services. A

suitable site from the accessibility aspect has a good potential and thus will have high

demand. The approach for land that has that quality will become the main principle in

determining the urban land use pattern. This result and reaction from demand and supply

are the main determinant for a particular site (land) in a location. Due to this

characteristic of shortage of land supply, a site is utilised to the best and highest level of

usage.

Lastly, planning is an important factor in determining urban and regional land use pattern

as a whole. Since economic factor shows supply of urban land is limited for a certain

purpose, negative planning factor will increase the problems in urban land market by

interfering in the open market system. This happens through planning influence as below:

1. In land division, where certain purposes are written in the development plan of an

area

2. In limiting change of land use to other uses; and

3. In limiting intensive usage level

The planning approach factor is the main determinant in forming the urban and regional

land use pattern.

62

Theories of Urban Structure

Rapid urban development since the early 20th century, either from the aspect of

population size or from the width of the bordered area will cause the layout and the land

use development to be disorganised and unmanageable. Control and planning problems

of land use will emerge and these have influenced economists, sociologists and planners

to undertake research in solving these problems for the purpose of an effective

management.

Their research focuses on the layout and urban land use structure in its relation to

economic activities and socio-economic traits of its residents. The researchers make an

effort to prove that uniformity exist from the aspect of land use arrangement of a city and

another city of the same size. This generalisation is useful for anticipating, managing and

planning purposes of urban land use development.

Attention is next given to opinions that were brought up on the urban land use structure.

Among it, are researches done by:

1. E.W Burgess (Concentric Zone Theory)

2. Hoyt (Sector Theory)

3. C.D Harris & E.L Ullmann (Multiple Nuclei Theory)

Concentric Zone Theory (E.W Burgess)

Concentric zone theory emerged from the work of E.W. Burgess on Chicago city in the

year 1900. He suggested that the urban land use structure of Chicago city has

characteristics of concentric circle. This pattern can also be observed in other large cities

in the United States of America at that time.

63

According to Burgess, Concentric circle can be distinguished into five zones, which are:

a. Central Business District (CBD)

b. Transitional Zone

c. Low Income Housing

d. High Income Housing

e. Commuter Zone

The diagrammatic representation and the explanation is shown in Figure 2.6 and Figure

2.7 respectively.

Legend:

1. Central Business District (CBD)2. Transitional Zone3. Low Income Housing4. High Income Housing5. Commuter Zone

Figure 2.6 : The Concentric Zone Theory

64

1. Central Business District (CBD)

This zone is the focal point of shops offices, high-rise buildings and traffic. A

small part of the land is used for residential. It is also allocated for hotels and

entertainment centre where this area becomes the central focus of residents during

the day and will subside in the evening. Therefore, the price and land rent of this

area is very high.

2. Transitional Zone

This zone places some business that needs ample space. There are a few hotels,

supermarkets, and public buildings with a small part of the land used for

residential areas. The population density is moderate. Therefore, the price and

land rent is also moderate.

3. Low Income Housing

Dwelling houses in this zone are usually shabby and may consist of low income

housing which are dilapidated and have been allocated for factory workers. The

residential areas are crowded with busy and narrow roads. The land rent in this

area is moderate and relatively cheap.

4. High Income Housing

This zone would be residential areas that are comfortable and complete with a

park, wide roads with trees planted by the roadside. Parts of the area which is not

developed are still agricultural areas that produce fruits, vegetables and milk. The

population density is moderate and the price and the land rent in this area is still at

a high level.

65

5. Commuter Zone

This area is the isolated residential township. It is connected to the city by roads.

The population is small and its density is moderate. Therefore, the price and the

land rent are moderate and low.

Increase of inhabitants, migration, economy and income cause each zone to encroach

into another zone outside it. The figure below will show the effect of an increase in

rent towards urban land use focal pattern.

Figure 2.7: Rent for Urban Land Use Concentric Zone Slope

a

b

Distance from City Centre (km)

Rent per sq. m.

0

c

66

Comments on Burgess Theory and the Development of Central Business District (CBD)

The development of CBD can be clearly seen in cities of America and the development

of CBD is moderate in European cities and old colonised cities in South America such as

Buenos Aires and Caracas. CBD can be found in countries where the majority is

Europeans such as Australia, South Africa and Rhodesia. CBD is not progressive in cities

of Asia, Africa and Europe due to several reasons:

1. The desire to preserve ancient buildings in the city centre will block efforts to

build sky scrapers, for example in Europe, Asia and Africa.

2. Shop houses institution will not only make the city centre a focal commercial

centre but also as the densest residential area in the city such as cities in Asia.

However, the CBD pattern is slowly being copied by countries such as Hong

Kong, Bangkok, and Singapore. In city of Kuala Lumpur, squatter areas have

been cleared and flats or condominiums have been built. The construction of high

office blocks in the city centre has been encouraged.

3. In most African or Asian cities, the land use structure is not really in the shape of

concentric circle. Since certain ethnic groups specialise in certain activities, the

Inhabitant Zone becomes a Functional Zone. For example, Chinese in the

Southeast Asia causes a Residential Zone to become a Trade Zone.

4. The land use for several areas in the city is heterogenic. Shops, offices, factories

and residential area may be located near to each other despite varying requirement

for the location and site. It is possible that there are a few locations suitable for

different activities and do not have to follow the Burgess model.

67

5. Concentric model does not take into account the following items:

Physical factors

Industrial use

Effect of radial route ways or highways towards the land value and its use

A star shaped land use pattern may exist, taking account of travelling time

factor.

Imperfect market; and

Planning control

However, Burgess still emphasised that these land use zones are not static in their

characteristics as this structure will change from time to time. Changes happen outwards

where the first zone will invade the next zone and so on. With the emergence of the

Burgess Model, more theories or other models on land use model have been proposed.

Sector Theory (H. Hoyt)

Homer Hoyt formulated the sector theory in the year 1939. This theory is a continuation

from the debate on the Burgess Concentric Zone Model. The sector theory is based on the

arrangement of residential land use where the urban growth is a continuation of the

growth of residential area and the result of high-income earners that moves along the

main road. Hoyt’s study is mainly on the surrounding cities in America. Hoyt explains

that the residential land use should be arranged in the shape of a sector with radius

patterns emitted from the city centre that are parallel with the main transportation roads.

Basis of Sector Theory

Hoyt’s theory is based on the difference of land value between zones that are located in

the city centre and the suburbs.

68

Hoyt’s study focused on the area of New York City, Chicago, Detroit, Washington and

Philadelphia. In Hoyt’s opinion, the land rental value of cities in America can show the

sector pattern where the tendency for the most expensive land rent are those located along

the transportation road and that the highest land value does not need to be located in the

city centre.

The characteristics of the sector theory are as follows:

1. The expansion of land use moves outwards from the city centre usually parallel

with the direction of the main transportation roads.

2. The arrangements of the main roads are radial where each road focus towards the

city centre and emits out toward the suburbs. This would create different rents and

in the end would create different land use too.

In this theory, there are a few fractions of different land use, which are known as sector

where:

a. Production and storage areas are located far from the areas of high-income earners.

b. Areas of low-income earners are located next to the production and storage areas.

c. Medium-income areas are located between the high-income and low-income areas.

d. There are network of highways exiting the sector area.

e. A railway connection crosses the sector area.

Figure 2.8 shows the different sectors in the Homer Hoyt’s model.

69

1. Central Business District

2. Manufacturing and Warehousing

3. Low Income Housing

4. Medium Income Housing

5. High Income Housing

Figure 2.8: Sector Model (Homer Hoyt)

70

The assumptions in the theory brought forward by Hoyt are as follows.

1. There are various group of society in the city

2. The city source of economics is industrial and trade

3. Individual ownership of assets

4. There is competition in land use

5. There is no focus on heavy industry

6. There is no land use due to heritage of historical city

7. The transportation road is not uniform but heading towards a specific direction in

the city.

In Hoyt’s model, there are several factors that result in different sectors to form:

a. Income factor

According to Homer Hoyt, there is a different stratum according to the people’s

income. For the high-income earners (prioritise comfort and able to afford it), they

will choose luxurious residential areas. Thus, the sector formed will extend out from

the city centre (sector 5).

For medium income earners, their housing are located between the high-income

housing and low cost housing (sector 4). In time, this group would be in the high-

income housing from their own effort.

For the low-income earners, they will occupy the area between the manufacturing and

warehousing area, the low cost housing area (sector 3). The shorter distance to work

can reduce their travelling expenses further.

71

b. Connection Factor

The city centre is connected to other cities through a network of roads and railways.

Thus, the city centre would function as the pulse of land use and urban growth.

Different land use occurs along these series of road based on the facilities provided.

c. Culture and Social Factor

This factor is more focused on the elite and high–income group. The focal influence

will cause the land price and rent of that area to be expensive. This is due to demand

and competition which snap up the areas with the required characteristics.

d. Physical Factor

Recreation area with a beautiful natural view that is also safe will become the focus

of high-income group.

Factors that encourage the growth of high cost residential area in the city can be

summarised as below:

i. The existence of a good transportation road

ii. The site speciality (no flood threats, beautiful view, clean air and far from

pollution)

iii. The focus of luxury housing around the homes of leaders and other elite groups

iv. The growth of commercial areas, financial institution and administration offices

that becomes an attraction, which encourages the development of luxury housing

v. The growth direction for high cost area will last for a certain period.

72

The Criticism on Sector Theory

Since Hoyt model was developed based on observation done on several cities in the

world, not many researchers have make an effort to test it. However, Walter Firey (1947)

did a study to observe the land use of Boston City, America. From the comparison made,

it was found that the Boston land use contradicts with the model formulated by Hoyt. The

difference on the physical factor of a city with another city, cannot be combined to make

one generalisation. The approach, performance and the cartography of the study is also

questioned by Firey and was considered insufficient to form a theory. To Firey, factors

such as social, history, sentiments and aesthetic value sometimes have more influence.

In 1964, Hoyt himself admitted that the high cost housing is not characteristically a full

circle instead it is in sectors at few urban areas. According to Hoyt, the high cost housing

is not changeable. The construction of express transportation road has caused new high

cost housing sector to expand outside its traditional area. Although Hoyt explained that

high cost housing expand towards the suburbs in the shape of sector, there is still a

tendency of layers of circular zones to exist based on the building’s age where the old

buildings are at the city centre and the new buildings at the suburbs as though it depicts

the pattern of concentric zone. Therefore, the sector model is only as a redevelopment

towards refining and completing the Burgess Model.

Multiple Nuclei Theory (Harris and Ullmann)

The Multiple Nuclei Theory was proposed by Chauncy D. Harris and Edward l. Ullmann

in the year 1945. In this theory, the development of land use structure does not focus on

certain areas only as other central point can grow and has its own attraction. These city

centres are known as ‘nuclei’ and are able to plan a different land use with other cities.

According to Ullmann, the growth of multiple nuclei in a large city is motivated by a few

factors as follows:

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1. The need for facilities or attractions by an economic activity at certain sites in the

city. For example, an industrial area is very suitable to be placed nearby ports,

railway tracks, highways or ample water supply.

2. The grouping of economic activities that will bring agglomeration benefits. For

instance, general stores will benefit if located in the middle of the city whilst

financial institutions and private office administration tend to locate together.

3. Incompatible land use at an isolated area.

4. The site cost factor plays an important role in determining the dispersion of an

economic activity in the city.

5. Historical result that can influence the urban land use. For example, certain cities

with older areas have become the traditional trade focal point in the city.

The characteristics of this theory are as follows:

a. A city will grow from one nucleus. When the city grows, then new city centres

will grow.

b. A few cities expand from more than one central point and later joined to become a

big city. For example, London and Westminster are two separate central points,

which have different specialisation.

c. There are a few groups of land use type that can expand around the nucleus of big

cities; and

d. Other city centres may grow due to certain needs by the city society.

74

The Multiple Nuclei Theory does not suggest a general model that can be used in

understanding the land use structure such as in figure 2.7. One of the critics for this

theory is that it cannot explain other situations such as the existence of concentric zone as

mentioned by Burgess and Hoyt, where in reality concentric and sector zones do exist.

Division of Zones:

1. Central Business district2. Wholesale and Light Manufacturing3. Low Income Residential 4. Middle Income Residential5. High Income Residential 6. Heavy Manufacturing7. Outlying Business District8. Residential Suburb9. Industrial Suburb

Figure 2.9: Multiple Nuclei Model (Harris & Ullmann)

75

The other weakness of this theory is the relation between the land uses and the main

transportation system rule pattern. The Multiple Nuclei Theory does not focus directly on

the role played by roads in influencing the growth of multiple nuclei in a city as

explained in the Sector Theory.

Land Use Development in Developing Countries

Although there is no suitable model that can explain the urban land use structure for all

countries, nevertheless, opinions suggesting the existence of land use structure according

to certain zones in the Western cities can be generally accepted.

Not many studies have been done on land use structure in the developing countries.

However, not so long ago, T.G. McGee has made a generalisation on South East Asian

urban land use structure. According to him, the existence of dualism economy in South

East Asian countries has created developed and underdeveloped sectors in these

countries.

Part of this scenario is reflected in the urban land use structure. A developed sector is

characterised by a commercial area similar to Western commercial area with large capital

and more formal arrangements while the underdeveloped sector is self reliant and

informal.

In certain parts of the city commercial areas, there are markets and bazaars besides

emporiums and supermarkets to place poor self-relying economic activities. Outside this

area, are poor housing areas especially those that consist of squatter and crowded areas.

As for the suburbs, it consist of high-income housing area especially those on higher

grounds.

The edge of a housing estate and industrial area reflects the efforts made to apply the

Western planning ideas. However, the land use structure is disorganised and far from the

76

accepted western standards due to obvious poverty problems. Studies of other areas in

developing countries such as Taipei, Calcutta, Cairo and Istanbul also proved the

significant difference in land use pattern between a developed and a developing country.

This proves that the Western land use model has to be modified before it can be applied

to the developing countries.

It is clear therefore, that certain land use structure exists in cities. However, there is a

difference in the shape and pattern between a developed and a developing country. The

difference on development of land use structure is because of dissimilarities in factors

such as the historical background, culture, level of development, inhabitants and others.

The knowledge on land use pattern is useful for the purpose of social and urban

economics planning specifically in formulating the urban development plan.

The Land Use Structure in City of Kuala Lumpur

Since the early 19th century, the Sumatrans have lived in villages around the confluence

of the Klang and Gombak Rivers. The first group of people to come on a large scale to

Kuala Lumpur in 1857 was led by Raja Abdullah and 87 Chinese miners to explore and

open tin mines. This group landed at a muddy pier at the confluence of Klang and

Gombak Rivers and succeeded in finding tin ore in Ampang. The discovery of tin ore has

quickened the economic growth and numbers of inhabitants. A small village has

developed into a town. In the year 1880, Kuala Lumpur became the capital of Selangor

with 2000 inhabitants only.

On 1st February 1972, Kuala Lumpur was awarded city status and was placed under the

Prime Minister’s Department (Federal Territory Development Division). The Mayor of

Kuala Lumpur holds the administration of Federal Territory and as the local enforcer, his

role is focussed on service provision and development besides concentrating efforts in

developing Kuala Lumpur City as Malaysia’s capital.

77

As the nation’s capital, Kuala Lumpur would be the source of the country’s life with

various activities, covering politics, administration, religious, trade, finance, culture,

sports and education. Today, Kuala Lumpur has a population of 1.7 million people and is

a dynamic capital that is on par with other nation’s capital in the world.

Main Development Areas in Kuala Lumpur

In general, Kuala Lumpur can be divided into four (4) main zones:

(See figure 2.8)

Zone A - Main Planning Area

Zone B - Area of New Developing Towns (Bandar Tun Razak, Wangsa Maju, Bukit

Jalil and Damansara)

Zone C - Existing Development Area (Jinjang, Sentul, Setapak, Dato’ Keramat,

Maluri, Bukit Anggerik, Seputeh, Bukit Indah, Penchala and Edinburgh)

Zone D - Industrial area

78

Figure 2.10 : Kuala Lumpur and Main Development Areas

79

Main Road

Zone ACentral Planning Area

Zone CExisting Developing Area

Zone B New Growth Area

Kuala Lumpur Development Strategy

Several future alternative-development strategies has been developed and tested before it

is applied into the concept contained in the Kuala Lumpur Structure Plan. These

strategies try to visualise the implication that allows development trend that is centralised

and distributed.

Decisions made on the strategy of development of Kuala Lumpur are based on a number

of factors as follows:

1. The potential in achieving the objective and target of Structure Plan;

2. To allow a balanced development in Kuala Lumpur City without an interest in

congested private investment in the city;

3. To take into account of current development trend and the objective in

rearranging and redistributing development in Kuala Lumpur City;

4. To provide an approach that is most pragmatic towards the hierarchy of centres

development and the execution of the concepts contained in the Structure Plan;

5. Enhance the working, living and business environment of the City Centre;

6. Designate and develop International Zones;

7. Designate and implement Comprehensive Development Areas (CDAs);

8. Encourage and facilitate the development of Malay Reservation Areas, traditional

kampungs and new villages;

9. Initiate and implement the redevelopment of blighted areas;

80

10. Ensure complete and integrated city linkages;

11. Provide priority and incentives to development in areas around transit terminals;

12. Ensure the functional distribution of centres and facilities;

13. Consolidate the development and enhance the environment of stable areas; and

14. Consolidate the development and enhance the environment of major entry points.

These strategies and their underlying principles are described in greater detail below.

(refer to figure 2.11 and figure 2.12)

81

Figure 2.11 : Kuala Lumpur Development Strategies Plan 1

Source : Draft Kuala Lumpur Structure Plan 2020 (2003)

82

Figure 2.12 : Kuala Lumpur Development Strategies Plan 2

Source : Draft Kuala Lumpur Structure Plan 2020 (2003)

83

This chosen strategy estimated that the Planning Unit 1, which is the Central Planning

Area as Zone 1 (City Centre) due to the surplus number of controlled labor (375,000) and

the population (360,000), compared to other planning units.

Planning Unit 5 (Wangsa Maju), Planning Unit 6 (Bandar Tun Razak), Planning Unit 12

(Bukit Jalil) and Planning Unit 13 (Damansara) are grouped into zone 3 which are

Existing Developing Area and Zone 4 that is Specialised Planning Unit.

The niches of the chosen strategy are as follows:

a. The ability to develop and prioritise development for Wangsa Maju and Bandar

Tun Razak where a huge part of it are government’s land

b. The ability to spread out some of the activities in the city centre and to reduce

commuting to the Central Planning Area

c. The ability to encourage a more balanced development in the Federal Territory.

Development centres are created at area outside the city centre.

d. It would be the city centre hierarchy where the new developing area will function

as a residential and labour zone. This would create a better environment and

structure for Kuala Lumpur.

84

Table 2.1: Federal Territory: The Distribution of Land Use and Population According

to the Planning Unit

ZONE LAND USE

Area (ha)

% POPULATION %

Zone 1

City centre (CPA) 370,000 35.8 128,721 16.4

Zone 2

New Developing Area

1. Planning Unit 5

Wangsa Maju

2. Planning Unit 9

Bandar Tun Razak

3. Planning Unit 12

Bukit Jalil

4. Planning Unit 13

Damansara

306,000

72,000

72,000

72,000

90,000

29.7

7.0

7.0

7.0

8.7

510,000

120,000

140,000

120,000

130,000

23.2

5.5

6.4

5.5

5.8

Zone 3

Existing Developing Area

1. Planning Unit 2

Jinjang

2. Planning Unit 3

Sentul

3. Planning Unit 4

Setapak

4. Planning Unit 6

Dato’ Keramat

5. Planning Unit 7

Maluri

6. Planning Unit 8

Bukit Anggerik

316,000

33,000

49,000

27,000

17,000

25,000

24,000

30.6

3.2

4.8

2.6

1.6

2.4

2.3

1,255,000

185,000

140,000

160,000

50,000

100,000

100,000

57.0

8.4

6.4

7.3

2.3

4.5

4.5

85

7. Planning Unit 10

Seputeh

8. Planning Unit 11

Bukit Indah

9. Planning Unit 14

Penchala

10. Planning Unit 15

Edinburgh

36,000

42,000

44,000

19,000

3.5

4.1

4.3

1.8

150,000

180,000

120,000

70,000

6.8

8.2

5.4

3.2

Zone 4

Specialized Planning Unit

KEMENTAH

Kelab Golf Di Raja Selangor

Universiti Malaya

Kem Sungai Besi

Chan Sow Lin

40,000

10,000

700

5,000

9,700

15,000

3.9

0.9

0.1

0.5

0.9

1.5

75,000

14,000

1,000

5,000

45,000

10,000

3.4

0.6

0.1

0.2

-

-

TOTAL 1,032,400 100 2,200,000 100

Adapted from: Kuala Lumpur Draft Structure Plan (1990 & 2003)

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Table 2.2: Residential, Commercial and Industrial Land Use change, 1984-2000

Growth CentreResidential (ha) Commercial (ha) Industrial (ha)

1984 2000 1984 2000 1984 2000

KUALA LUMPUR 3822.03 5489.56 504.36 1091.71 474.63 553.05

Central Planning

Area (CPA)

Percentage Change

1984-2000

390.58 287.60

(26.37%)

254.88 318.99

25.15%

4.12 0.93

(77.43%)

Designated New Growth Centres

Wangsa Maju 108.58 314.59

189.73%

5.22 64.64

1138.31%

18.57 30.66

65.11%

Bukit Jalil 2.75 51.76

1782.18%

0.00 9.04

0.00%

9.25 33.09

257.73%

Damansara 640.56 774.56

17.3%

12.74 49.60

74.31%

0.00 0.00

0.00%

Bandar Tun Razak 289.69 410.67

41.76%

19.18 62.25

224.56%

10.73 26.52

147.56%

Other Growth Areas

Jinjang 252.65 428.77

69.71%

32.27 80.63

149.86%

106.57 134.94

26.62%

Sentul 276.93 492.28

77.76%

17.63 124.50

606.18%

62.10 112.34

71.43%

Setapak 366.86 458.06

24.86%

15.79 53.20

236.92%

37.33 7.91

(78.81%)

Datuk Keramat 248.87 306.49

23.15%

11.83 41.81

253.42%

0.00 0.00

0.00%

Maluri 97.59 141.15

30.86%

13.14 34.01

158.83%

9.46 8.68

(8.25%)

Bukit Anggerik 56.97 127.46

123.73%

8.50 21.08

148%

11.29 21.69

92.12%

Seputeh 268.1 397.74

48.36%

39.80 70.50

77.14%

37.86 32.49

(14.18%)

Bukit Indah 305.78 677.90 31.00 99.79 99.46 57.77

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121.70% 221.90% (41.92%)

Penchala 147.00 281.11

91.23%

12.8 27.65

116.01%

1.97 2.76

40.10%

Bukit Maluri 189.28 197.11

4.14%

11.88 20.08

69.02%

22.64 25.90

14.40%

Adapted from: Kuala Lumpur Draft Structure Plan, 2020 (2003)

Based on the theories by Hoyt and Harris and Ullmann, it is clear that certain principles

in the theories are applicable to the current structure of Kuala Lumpur City. The most

important principle of these theories is the development and growth toward the suburbs

(as shown in Table 2.1 and Table 2.2). Both theories also explain the residential aspect

and here the Multiple Nuclei Theory is more appropriate to Kuala Lumpur City because it

takes into account other land use in detail. This theory is more prepared to adapt itself to

changes in the present structure of urban land use of Kuala Lumpur.

Factors Determining rental value in Kuala Lumpur City

W. Alonso in the Land Rent Theory put forward that the principles of rental value will

decrease when it gets further from the city centre. (Refer to Figure 2.3)

However, from the observation on the Kuala Lumpur land use structure, it is found that

the land rent value does not have the same pattern as the theory suggested (See Table

2.3). This is due to several influencing factors on the Kuala Lumpur property rental value

which are as follows:

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1. Supply and Demand Factor

This is the core factor influencing rental value in this city. The Property Market

Report 2005, for example has shown that an encouraging increase on the office

rental value in the city centre and the Golden Triangle area with rental exceeding

RM50.50 per square metre per month. Its occupancy rate too has also increased.

Table 2.3: Rental Value (per month) According to Type of Land Use in Kuala

Lumpur

a. TRADE (SHOP HOUSES)

i. Central Town Prime Area

- Jalan Tuanku Abdul Rahman = RM 138.89 p.s.m

ii. Central Town Secondary Area

- Lorong Haji Taib = RM 58.33 p.s.m

iii. Suburban Prime Area

- Desa Sri Hartamas = RM 70.55 p.s.m

iv. Suburban Secondary Area

- Taman Midah = RM 25.93 p.s.m

b. COMMERCIAL COMPLEX

i. Central Town Prime Area -Suria KLCC = RM 323.00 p.s.m

ii. - Kota Raya = RM 267.00 p.s.m

iii. Central Town Secondary Area -Ampang Park = RM 201.00 p.s.m

iv. - Plaza Imbi = RM 111.00 p.s.m

v. Suburban Prime Area -Mid Valley = RM 576.00 p.s.m

vi. Suburban Secondary Area -Cheras Leisure Mall= RM 205.00 p.s.m

v. Golden Triangle Area -Lot 10 = RM 377.00 p.s.m

-Star Hill = RM 387.00 p.s.m

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-Bukit Bintang Plaza= RM 290.00 p.s.m

c. OFFICE

i. Central Town Prime Area -Multi-Purpose Tower = RM 43.05 p.s.m

ii. Central Town Secondary Area-Amoda = RM 46.28 p.s.m

iii. Suburban Prime Area -PNB Damansara = RM 32.29 p.s.m

iv. Suburban Secondary Area -Wisma Damansara = RM 34.44 p.s.m

v. Golden Triangle Area -AmBank Group = RM 52.74 p.s.m

-UBN Tower = RM 62.43 p.s.m

-IMC Tower = RM 78.58 p.s.m

d. RESIDENTIAL

i. Kuala Lumpur District

-Single-storey terrace = RM 1,450/mth

-Double-storey terrace = RM 2,400/mth

ii. Ampang District - Taman Maluri

-Single-storey terrace = RM 800/mth

-Double-storey terrace = RM 1,200/mth

iii. Petaling District - Setapak

-Single-storey terrace = RM 700/mth

-Double-storey terrace = RM 1,200/mth

Source: Property Market Report Jan-June 2009

The increasing demand and high occupancy rate for both the city centre and the

Golden Triangle area has caused office spaces outside the city centre area to

experience higher rental value.

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The supply of office spaces is slow in responding to its demand. This would cause

the rental value to increase. Thus, the office space rental value in the Golden

Triangle area is higher than the city centre as the demand is higher in the former.

2. Economic Factor

A stable economy has encouraged investment to enter into the main areas of

Kuala Lumpur. This was followed by the increase of purchasing power due to

rapid economic growth for the past 7 years and the important recovery from

unemployment situation in the country.

The increase in the rental level in the commercial sector is an obvious proof of the

stable economic situation. Commercial property can be divided into Pre-War type

buildings and Commercial Complexes (shopping centres). An obvious rental

value pattern for the Commercial Complexes is where the Secondary City Centre

area experiences a higher value compared to the city centre area because investors

are more interested to invest in the secondary areas following an encouraging

economic development in those areas.

3. Type of Buildings

The design, structure and the shape of the buildings also influence the rental value

for Kuala Lumpur city. Careful considerations are given by a building owner to

these factors for the purpose of attracting customers or investors to his property.

Indirectly, these aspects would influence the rental value.

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Pre-War buildings in the city centre such as in Jalan Tuanku Abdul Rahman and

China Town have a much lower rental value compared to commercial complex

buildings outside the city centre ( for example in Ampang Park in the Secondary

Suburban area). This is because the Pre-war buildings do not have the attraction

and have less space to display goods.

4. Modern Facilities

All the facilities provided either basic amenities or modern facilities in an area

also influence the Kuala Lumpur rental value. These facilities include open car

parking area, controlled car parking area and other ancillary facilities.

5. Surrounding Development

Surrounding development can also influence the existing rental value pattern. For

example, the Sogo Pernas Complex and Marcoland along Jalan Tuanku Abdul

Rahman have brought new interest on the Pre-War and the 4-5 storeys shop

houses.

Retail space for the Mall Shopping Complex (located in the Secondary City

Centre) also has a high rental value compared to the city centre and the Golden

Triangle Area. This is due to its surrounding development comprising of

international hotels and luxury condominiums.

TUTORIAL QUESTIONS

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1. Briefly explain the land use model suggested by Von Thunen. How far does it explain

the land use pattern for any particular urban area that you know?

2. With reference to Kuala Lumpur city or any other large cities that you have studied,

explain and give comments on the characteristics and structure of:

a. Central Business District (CBD)

b. Industrial area

c. Residential area

3. Provide an assessment on the classic land use model that was put forward by E.W.

Burgess. How far does the model fulfil the real urban land use structure in Malaysia?

4. There is a close relation between land use, location and the land value. Discuss the

basic principles and theory behind this relationship.

5. With reference to a city that you have studied, give comments on its urban land use

pattern and state the main factors that influence the land use pattern.

6. Elaborate the factors influencing the land rent in Kuala Lumpur city and differentiate

the rental pattern with Land Rent Theory by W. Alonso.

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CHAPTER 3: REGIONAL ECONOMICS

Regional economics is a relatively new branch in economics. Lack of attention was given

to it in the early stages, as it is easier to see a country’s economy than regional. No

attention was given to regional economics in the traditional economics because the space

factor was not considered a factor that influences the economy. However, other factors

like time factor is considered a critical dimension. Awareness on the importance of space

factor has been emphasised earlier by other fields such as geography, sociology and

demography. Only when problems or weaknesses arise from the traditional economics,

the realisation on the importance of space factor emerges. From here, the regional

economics studies arises dealing with matters related to existing settlement and regions.

The following factors also contribute to the development of regional economics studies,

which are:

Increasing implications of regional policy

The development of new techniques in economic analysis; and

The awareness that there is a direct connection between regions in regional

planning.

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Concept and Definition of a Region

A region has a definition originally used in certain branches of discipline including

geography, political science and economy. A renowned Oxford Geography expert, A.J.

Herbertson uses the analysis approache to divide the world into natural regions based on

four criteria, which are land surface, climate, vegetation and population density.

According to political scientists, a regional concept is a superior achievement of a

political unit. This group refers to the division of government power such as the central

government and state government. They interpret a regional concept in terms of a

political unit based on similar characteristics found in the unitary system.

Economists regard region as a country’s economic sub-system. This approach is often

used in empirical studies. Most economists interpret region based on the government’s

objective and on existing definition especially from the aspect of political unit and

administrative unit.

Overall, the concept and definition of regions can be divided into three specific

approaches:

1. Uniform region

2. Nodal region

3. Planning region

Uniform region

Uniform region or homogenous region is based on the opinion that each space unit in a

country or geography area can be connected with one another to form a region if this

space unit shows uniform characteristics.

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Richardson, a Regional Economics expert (1969) said that the uniform characteristics

might consist of economic factors (such as similarities in production structure or usage

pattern), geographic factors (similarities in topography or climate), social factors and

political factors. All of these are considered as homogeneous variables.

Nodal region

Nodal region is a region that has different units or areas (heterogeneous). For example

from the aspect of dispersion pattern and the population division that brings to the

formation of cities, towns and metropolitan cities according to the settlement hierarchy.

These areas are closely connected to each other through the economic function and need.

The concept of nodal region consists of two areas, central area and the suburbs. The

central area is important from the aspect of economic, social and political activities while

the suburbs usually depend on the central area.

Planning region

This region can be defined as an area where economic decisions are executed and this

gives unification for that area. Related areas with certain problems are united to execute

certain development strategy.

Regional Concepts Suitable in Malaysia

1. Classification Based on Uniformity Concept

Based on Malaysia’s history, the uniformity concept has been applied by the English

where the states in Malaysia were divided into three areas: Allied Malayan States,

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Unallied Malayan States and the Straits. This division is considered from the angle of

politics and history.

According to the First and Second Malaysia Plans, the planning and execution of

regional development programme is undertaken by states where each state has its own

political unit and divided to its own administration. It is divided into 14 states, which

are Selangor, Perak, Kedah, Perlis, Pulau Pinang, Kelantan, Terengganu, Pahang,

Johor, Melaka, Negeri Sembilan, Sabah, Sarawak and Federal Territory.

This regional concept changes with time and economic conditions. In the Third

Malaysia Plan, regional development was introduced to reduce the economics gap

between regions. However, a more intensive approach was introduced in the Fifth

Malaysia Plan in terms of the development of states that have less resources and

having growth problems.

Consequently, Malaysia was divided into six regions, which consists of the Northern

Region, Central, Southern, Eastern, Sabah and Sarawak (Figure 3.1). For the

Northern Region, the selection of states is based on economic activities and resources

where most of it is from agriculture. This can be observed from the Goss Domestic

Product (GDP) where the Northern region has the highest agricultural produce

compared to other regions. For the Central region, the affiliated states under it

focused on the industrial and manufacturing sectors while the Eastern region has

natural resources industry. The Southern region has the same socio economic

characteristics as other states in Peninsular Malaysia and its development rate and the

resource-channelling pattern, is influenced substantially by its location nearby to

Singapore. The Sabah and Sarawak region is considered as a separate region based on

its size, location and its own socio-economic characteristics.

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98

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Nor

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n re

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Cen

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regi

onE

ast r

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nSo

uth

regi

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raw

ak r

egio

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bah

regi

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Overall, Peninsular Malaysia can be divided into 3 regions based on the achievement

and the stages of its economic development; which are the underdeveloped region

(Kelantan, Terengganu, Kedah and Perlis), moderate region (Malacca, Pahang and

Negeri Sembilan) and developed region (Selangor, Perak, Pulau Pinang and Johor).

2. Classification Based on Nodal Concept

Based on this concept, a region can be divided into a central node acting as a

growth centre and suburb areas. It started in the Fourth Malaysia Plan where

Malaysia was divided into six regions and each region has a growth centre as

below:

a. Northern region

Consists of Perlis, Kedah, Pulau Pinang and Perak where George Town acts as

the centre for growth.

b. Eastern region

Consists of Pahang, Kelantan and Terengganu where its centre for growth is

Kuantan.

c. Central region

Consists of Selangor, Federal Territory, Negeri Sembilan and Malacca where

the centre for growth is Kuala Lumpur.

d. Southern region

Consists of Johor where its centre for growth is Johor Bahru.

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e. Sabah region with Kota Kinabalu as its centre for growth.

f. Sarawak region growth with Kuching as its centre for growth.

It is found that each of those regions consists of a group of neighbouring states or a single

state only and its activities with at least one large town acting as its centre for growth.

3. Classification Based on Planning Concept

In Malaysia, the concept of planning regions has been classified according to the

criteria of the potential of natural resources in the area, growth stages, poverty,

income distribution and unemployment. The awareness on the necessity of

planning regions started in the year 1961 with the emergence of MUDA planning

region and to date there are several planning regions in Malaysia such as the

North Western Selangor, Klang Valley and Kuala Lumpur Territory.

The benefit of this concept is its changing capabilities due to the usage of both

concepts of uniform region and functional region. When a region has been

identified and its border determined, it is much easier to obtain data and execute

its development policy. Integration between sectors can also be easily formulated

in determining the relation of a sector’s development with another sector. It is also

found that it is easier to evaluate the regional planning development process.

Problems of Imbalanced Regional Development

In general, there are several forms of regional problems as follows:

1. Problems faced in the agricultural region where it is too underdeveloped and not

directly involved in the industrial activities. The region has a low standard of

100

living and is not provided with basic amenities that are found in other regions in

that country.

2. Problems faced in industrial region where they suffer from economic downturn

and as a result have a high unemployment rate.

3. Problems faced in congested region where its future development involves high

social cost. Consequently, the region needs a huge public investment in its

infrastructure development.

Imbalanced Regional Development in Malaysia.

Problems of imbalanced regional economics are the root of the problem of development

for many developing countries. Therefore, various strategies have been carried out to

tackle the imbalance between a poor region and a rich region.

In Malaysia, the issue in rural development and the imbalance problem has long existed.

Realising the existence of these problems, a regional development plan has been

introduced to reduce the economic development gap between the regions.

There are a number of factors leading to imbalanced regional development:

1. Natural Resources

Each region has different natural resources and this causes the development of

each region to be non-simultaneous and unbalanced. For example, in the case of

the central region; it was developed early with the discovery of tin ore in the area.

This discovery attracted many people to migrate and to work on the industry.

Thus, the central region developed earlier compared to other regions.

101

2. Politics

Politics also plays an important role in development. The opposition party for

example, has dominated the Eastern region and therefore it has less allocation for

development by the government. A region with political instability also will affect

its development.

3. Economic factors

Economic factors can cause imbalance. It is clear that each region has different

economic base. For example, the economic activity of the eastern region is based

on resources from the sea; south, agriculture; and central resembles more to trade

and industry. This difference is caused by factors related to history, geography,

natural resources and government policy. It cannot be denied that regions

practising agriculture-based economics are less developed compared to regions

that practices industrial and export oriented economies.

4. Migration factors

Migration can be defined as human or capital transfer from one place to another.

Migration can happen within an area or from an area to another area. The

migration motivating factors are:

a. High population increase that happens naturally that will cause limited

ownership of land and shortage of return from goods.

b. A decline in natural resources that cannot be renewed such as mining.

c. The prospect of getting a job is more secure in a more developed region.

d. More job opportunities and high wage jobs in a developed region.

102

e. High relative cost of living in the originating region because of low wages.

f. The provision of social facilities in a more developed region such as

entertainment, education, residential and infrastructure.

Migration can cause the following problems:

a. The arrivals of new inhabitants will cause a population surplus and if it continues,

will cause the decrease of average individual income per capita. This situation

happens when labour supply exceeds the demand for produced goods. Therefore,

unemployment in the region will occur.

b. The region that was left behind also has to face a number of problems as follows.

i. Shortage of skilled labour occurs, where most of them have moved to a more

secure region. Only the less productive labour remains to continue the

activities in the region.

ii. Abandoned land areas emerge and natural resources are not utilised. Interest is

given to the main sectors such as trade and manufacturing but the rate of

involvement is low.

iii. Problems in age structure of population in the region may occur, where the

people living in that region consist of the elderly and the below 15 age group.

Those within that age group are non-productive. Hence, the region will not be

that productive.

5. Income factor

103

Economists measure a region’s income through the region’s income account

where the level of achievement in the Gross National Product (GNP) can be

determined.

The Gross National Product (GNP) method is only suitable at the national stage as

there are problems at the regional stage as below:

a. There is a leakage such as income of a region spent in another region.

b. The production of goods produced for individual use such as farming

especially in less developed region. In a developed region, most of its

production will re-enter into the market.

c. The labour participation in a developed region is high where the percentage of

18 year olds that can enter the labour market is high. Furthermore, migration

happens continually and hence that region is total income is different from a

less developed region. Most of the productive labour groups have moved to a

more developed area.

d. Economic resource difference where the less developed region practices

agriculture-based economy where its income is constantly influenced by

external factors such as weather, geography and others.

6. Unemployment factor

One of the problems faced by some regions is unemployment. Types of

unemployment that usually happens are as follows.

a. Seasonal Unemployment

104

This type of unemployment is seasonal such as a region where fishing is

the main activity. During the rainy season, the fishermen are not able to

carry on with their activities as usual. This also applies to regions focusing

on agricultural activities where jobs can also be disrupted during drought

season. While waiting for the season to pass, many labourers are

unemployed.

b. Cyclical Unemployment

This is caused by the change in regional economics such as a change from

agriculture based economy to industrial based economy.

c. Frictional Unemployment

This usually happens when workers change jobs to a better paying one.

d. Structural Unemployment

This type of unemployment is caused by a mismatch of the skills of

workers out of work and the skills required for existing job opportunities.

For example when an electronics factory closes due to economic

downturn, the factory workers cannot change to other jobs, as their skills

are not suitable to available jobs.

e. Demand Deficiency Unemployment

Unemployment happens when there is a surplus of supply in a developed

region. This surplus will cause price of goods to fall and will thus increase

the cost of production. Therefore, entrepreneurs have to reduce the number

of their workers to reduce that cost hence the workers will become

unemployed.

105

Unemployment usually happens in a developed region because the total

number of workers, Malaysian or foreigners that enters the labour market is

high. However, seasonal unemployment usually happens in an

underdeveloped region because its economy is based on agriculture, which is

always influenced by climatic conditions.

7. Inflation factor

Inflation is a phenomenon where the general price level continues to increase.

According to quantity of money theory, the general price level will increase if the

money supply in the economy increases. The formula for this theory is:

MV = PT

Where, M - Supply

V - Velocity

P - General price level

T - Money exchange or total transaction

According to this theory, if the economy is at full employment, T and V will be

constant. If M increases, therefore P will increase directly at the same rate.

Inflation can be divided into several types:

a. Demand-Pull Inflation

This type of inflation occurs due to “too much money chasing too few goods.”

In other words, demand exceeds supply. It usually happens in a developed

region because of high individual disposable income. In a less developed

region, inflation rarely happens as full employment is rarely achieved.

106

b. Cost-Push Inflation

This type of inflation occurs when there is an increase in the general price

level resulting from an increase in the cost of production, such as an increase

in wages, raw materials or entrepreneurs trying to obtain more profit.

Wage-push inflation happens when the level of employment is full and no

labour is unemployed. This situation will increase the wage rate and when

wages increase; entrepreneurs will increase the price of goods to support the

increase of wages.

Profit-push inflation occurs when oligopoly and monopoly try to increase their

profits by increasing the price level of their produced good. It is usually seen

when an entrepreneur does his business in separate regions.

c. Imported Inflation

For regions that import goods from other regions, the cost of production for

that region will also increase when there is a price increase in the exporting

region. In order to fix the profit level, the price of production has to be

increased.

8. Accessibility

This factor is important in determining whether the region is developed or

underdeveloped. It can be observed to happen in a fast developing region such as

the central region. Investors can bring in factors of production and bring out the

produced goods easily compared to other regions that are not easily accessible

such as Sarawak. Although it is rich in natural goods, but due to inaccessibility

this region is less attractive to investors.

107

Due to this imbalance between regions, certain parties especially the government

has to take necessary steps to overcome this problem. Regional policies that can

be used to overcome this imbalance are policies to enhance the richness of an area

and the wealth of its people.

Regional Policy

In most countries, regional policy is the result based on the interaction of politic, social

and economic factors. Political factors emphasise on the effect of regional imbalance on

the community consolidation such as in the United Kingdom, Belgium and Malaysia (13th

May 1969 incident).

Social factors also emphasise the effect of poverty on underdeveloped region. Therefore,

social or community needs has to be given attention; the quality of the region’s

environment has to be taken care of and pollution problems has to be overcome.

From the aspect of economics, a region cannot depend on the power of free market to

determine the result of a location. Thus, the country’s economic growth needs a policy to

ensure that natural resources can be exploited to its maximum.

Regional Policy Objectives

The main purpose of a regional policy is to overcome problems of unbalanced regional

development. In other words, this purpose is related to social, environment, economics

and political issues. In line with its purpose, a regional policy has a number of specific

objectives:

1. To reduce the rate of unemployment

2. To reduce the concentration of a region

108

3. To reduce the pressure from demand between regions to avoid inflation

4. To balance man and environment

5. To balance the distribution of income, jobs, ownership and wealth domination

6. To maintain and further strengthen the identity and culture of everyone’s region

7. To increase the usage of resources in less developed region that has many natural

resources.

Strategy

In the execution of a regional policy, the Government needs two strategies that have

relation with the New Economic Policy, which are:

1. To Eradicate Poverty

New regions are created and existing regions are developed to increase the

society’s standard of living. With the existence of new regions, new job

opportunities are created and an increase in activities carried out by the local

people.

2. Rearranging Society by Disassociating Race Identification According to

Economic Functions

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The rearrangement of society is also an attempted strategy by the government. By

forming new regions, the government gives an opportunity to other races to go

into other sectors such as trade and industry. For example, the existence of new

factories and new commercial spaces are able to provide opportunities to

Bumiputeras to be involved in trade. When other races are involved in various

industries, in time it can eradicate race identification according to economic

functions, which happens since the colonized era.

In general, a regional policy is based on a regional development plan. This plan is based

on more specific objectives and strategies. Through the regional plan, the government has

tried to achieve the stated regional policy objectives.

Regional Development Plan

Regional development plan is an important strategy to achieve the New Economic Policy.

Regional development planning started in the Second Malaysia Plan which serves as the

New Economic Policy blueprint. Some of the Boards of Regional Development that have

been established in the Peninsular Malaysia are shown in figure 3.2 and subsequently

explained as follows.

110

Figure 3.2: Location of Regional Development Boards in Peninsular Malaysia and the

Areas Covered by Central Planning Studies

111

Kedah –Perlis Study

KESEDAR(2.9 million acres)

Penang Study

Kelantan StudyTHAILAND

Jengka Triangle(300,000 acres)

East Negeri Sembilan Study

Klang Valley Study

Perak utara Study

Seberang Perak Study

Terengganu Study

Kuantan Study

Malacca Study

West Johor Study

South Johor Study

KETENGAH(1.09 million acres)

DARA(2.5 million acres)

KEJORA(750,000 acres)

1. Central Terengganu Development Board (KETENGAH)

KETENGAH which was established on 6th April 1973 covers a huge portion of

district of Kemaman, Dungun and Hulu Terengganu. KETENGAH covers an area

of 443,945 hectare with a total population of 71,291 people.

2. South Eastern Johor Development Board (KEJORA)

KEJORA which was established on 1st June 1972 covers the district of Tanjung

Pengerang and the middle area of south eastern Johor . KEJORA’s total area is

300,000 hectares with a total population of 53,667 people.

3. Southern Kelantan Development Board (KESEDAR)

KESEDAR which was established on 1st May 1972 covers a combination of four

districts namely Gua Musang, Kuala Krai, Jeli and Tanah Merah. KESEDAR’s

total area is 1,237,667 hectare with a total population of 195,597 people.

4. Kedah Regional Development Board (KEDA)

KEDA which was established on 28th May 1981 combines several areas such as

Langkawi, Kubang Pasu, Padang Terap and a few other areas. KEDA’s total area

is 243,094 hectares with a total population of 195,597 people.

5. Jengka Regional Development Board (JENGKA)

JENGKA which was established on 1st August 1983 concentrates on the middle

area of Pahang. The JENGKA’s total area is 196,728 hectares with a total

population of 156,928 people.

112

6. South Eastern Pahang Development Board (DARA)

DARA was established on 1st September 1971. It covers several districts such as

Rompin, and part of it is from Pekan and Temerloh. DARA’s total area is

1,000,000 hectares with a total population of 142,269 people.

7. Penang Regional Development Board (PERDA)

PERDA which was established on 1st June 1983 comprises the whole of Penang

Island besides George Town and Butterworth. PERDA’s total area is 60,000 -

70,000 hectares with a total population of 293,141 people.

8. Iskandar Development Region (IDR)

Iskandar Development Region (IDR) (Malay: Wilayah Pembangunan Iskandar

subsequently changed to Iskandar Malaysia) is the new main southern

development corridor in Johor, Malaysia. The IDR was established on 20th July

2006. It was also known as South Johor Economic Region. It is named after

Sultan Iskandar of Johor.

It is against this backdrop that in July 2005, the Government of Malaysia had

appointed an investment company, Khazanah to conduct a feasibility study for the

development of a special economic zone in South Johor in what was then referred

to as the Southern Belt Economic Zone (SBEZ).

In October 2005, Khazanah presented a Conceptual Outline Plan for the proposed

South Johor Economic Region (SJER) to the National SJER Planning Committee

(NSPC) and concluded that there was a strong economic, social and

developmental rationale for the proposed development of SJER. The NSPC was

chaired together by the Prime Minister of Malaysia, Abdullah Ahmad Badawi and

Chief Minister of Johor, Abdul Ghani Othman. Khazanah acts as the secretariat

for the committee. The NSPC further instructed Khazanah to develop a detailed

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and comprehensive Master Plan for the development of SJER that aims to address

socio-economic development in a holistic and sustainable fashion.

In March 2006, the Ninth Malaysia Plan covering the period 2006 to 2010 was

launched by the Prime Minister. It identified the newly named Iskandar

Development Region (IDR) as one of the catalyst and high-impact developments

under the Plan. This was further reinforced when in November 2006, the Prime

Minister, Chief Minister of Johor and Khazanah announced further details of IDR

on the following Comprehensive Development Plan (CDP):

The Iskandar Development Region is administered by Iskandar Development

Authority.

9. Northern Corridor Economic Region (NCER)

Northern Corridor Economic Region (NCER) (Malay: Wilayah Ekonomi Koridor

Utara or Korridor Utara) is a new economic development corridor in Malaysia.

This programme is a Government initiative to accelerate economic growth and

elevate income levels in the north of Peninsular Malaysia - encompassing the

states of Perlis, Kedah, Pulau Pinang and the north of Perak. The NCER initiative

will span from 2007 to the end of the 12th Malaysia Plan period, i.e. 2025. The

NCER was launched on 30 July 2007 in Alor Star, Kedah and on 31 July 2007 in

Butterworth, Penang.

The vision of the NCER is to be a world-class economic region by 2025, where it

is amongst the world’s best in a number of its key economic sectors, such as E&E

(Electrical and Electronics cluster), agriculture, tourism and biotechnology.

Through the provision of a conducive business environment, the NCER will be a

destination of choice for foreign and domestic businesses to invest in, while its

emphasis on social development, community infrastructure and environmental

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integrity will make it a place where both Malaysians and foreigners would choose

to work, learn, visit and live.

The mission of the NCER development programme is therefore to help the

Region achieve this vision, through identifying commercially-viable opportunities

and implementing strategic initiatives approved by the Government of Malaysia.

10. East Coast Economic Region (ECER)

East Coast Economic Region (ECER) (Malay: Wilayah Ekonomi Pantai Timur or

Korridor Pantai Timur) is a new economic development corridor in Malaysia. It

covers the states of Kelantan, Terengganu, Pahang and the north of Mersing

district of Johor. The ECER initiative will span for 12 years starting from 2007.

The master planner for ECER is Malaysia-owned oil and gas company,

PETRONAS.

The ECER was launched in Kuala Terengganu and Kota Bahru on October 30,

2007 and in Kuantan the next day. During the launch of the project, a RM 6

billion allocation was announced for the opening phase of the project,

strengthening the Malaysian government's commitment to the project.

After this Economic Region, almost all areas in Peninsular Malaysia had become

Economic Regions, only Northern Johor, Southern Perak and Southern Negeri

Sembilan not included. Klang Valley include Kuala Lumpur, Selangor and

Northern Negeri Sembilan, and Melaka originally is an Economic Region. This

shows that the Government has initiatives to develop the whole of Peninsular

Malaysia by Economic Regions.

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11. Sabah Development Corridor (SDC)

The Sabah Development Corridor or SDC (Malay: Koridor Pembangunan Sabah

or Koridor Sabah) is a new development corridor in Sabah, Malaysia. The SDC

was launched on 29th January 2008.

The project is expected to take 18 years with total investment of up to RM 105

billion.On average, it starts from the year of 2009, RM5.83 billion will be

allocated each year for development. 900,000 jobs are expected to be created with

this project along with a waterfront city, tourism sub project and a Sabah Railway

terminal. The project kick-started with the Government announcing an extra

allocation of RM 5 billion under the Ninth Malaysia Plan to improve

infrastructure and lower the cost of doing business in the state.

12. Sarawak Corridor of Renewable Energy (SCORE)

The Sarawak Corridor of Renewable Energy or SCORE is a new development

corridor in central Sarawak state, Malaysia. SCORE was launched on 11th

February 2008. It is one of the five regional development corridors being

developed throughout the country.

SCORE is a major initiative undertaken to develop the Central Region and

transform Sarawak into a developed State by the year 2020.

It aims to achieve the goals of accelerating the State's economic growth and

development, as well as improving the quality of life for the people of Sarawak.

An alternative development strategy is needed in Malaysia since development has been

highly concentrated in cities such as Kuala Lumpur and Petaling Jaya. One of the

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methods is to develop regions that have potential but is underdeveloped to prevent people

from migrating out of the region.

The purpose of a regional development strategy is to strengthen the integration between

regions of a state in Malaysia. This can be achieved through eradication of unbalanced

economy and structure between regions of a state. This will identify and develop a

region’s strength from the aspect of agriculture and industrial development especially for

less developed states. The attempted objective is to balance the distribution of income

and also medical facilities, education, services, recreation, housing and most importantly

the social development opportunities and citizen’s economy in accordance with the

national objective.

Regional Development Strategy

In order to achieve regional development objective, four strategies were introduced,

which are:

1. Development of Resources and New Land

This is a strategy to place the development of agriculture, industrial and services

at less developed areas and underdeveloped states. Three natural resources

become the target of regional development activities that consist of:

a. Fertile land for agriculture

b. Forest for timber and related goods; and

c. Minerals for mining and initiating industrial activities.

These three mentioned resources can be largely found in Pahang, Johor, Kelantan

and Terengganu.

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2. In-situ Rural Development

The opening of new lands and central development cannot support the poor and it

is difficult for villagers to leave their place of birth and the area, which is

compatible with them. Therefore, in-situ development was planned to redevelop

and bring changes to existing areas and villages.

3. Industrial Placement Distribution

This strategy attempts to bring industrial activities to new areas in less developed

states. The strategy is formed based on three factors, which are:

a. The importance of industrial activities in regional development.

b. It is easier to influence or to get involved in determining the industrial

location from agriculture.

c. The government’s objective through the New Economic Policy is to

encourage the Malays, who mostly live in less developed parts of the country

to play their role in modern economic activities especially industrial activities.

4. The Formation of New Development Centre and Rural Urbanisation

The programmes that are included in this strategy are construction of cities,

traditional village development and construction of public amenities and

recreation. Development for new central development leans against the

development of Kuala Lumpur and Pulau Pinang with its capability to develop on

its own.

The strategy of urbanising rural areas is related with rural industrialisation,

distribution of industries and the formation of new central development. The

purpose of urbanisation is to bring the city’s environment, facilities and services

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to the agricultural area and rural areas. The main objective of rural urbanisation is

to rearrange the living structure of rural society and free them from traditional

living, which is full of poverty.

Agencies Involved in Regional Development

In making this regional development programme a success and hence achieving the

objectives of Regional Policy., various agencies are directly involved:

These government agencies can be divided into three categories, which are:

1. Socioeconomics

a. Pihak Berkuasa Kemajuan Pekebun-pekebun Kecil Getah (RISDA)

b. Lembaga Kemajuan Tanah Persekutuan (FELCRA)

c. Perbadanan Kemajuan Getah Malaysia (MARDEC)

d. Lembaga Pemasaran Pertanian Pesekutuan (FAMA)

e. Institut Penyelidikan Perhutanan Malaysia (FRIM)

f. Institut Penyelidikan Kalapa Sawit Malaysia (PORIM)

g. Institut Penyelidikan Getah Malaysia (RRIM)

h. Perbadanan Kemajuan Kraftangan Malaysia (PKKM)

i. Batik Malaysia Limited

j. Animal Services Department

k. Department of Education, and others

2. Trade and Industry

a. Petroleum Malaysia Berhad (PETRONAS)

b. Heavy Industry Corporation Malaysia (HICOM)

c. Insititut Piawaian dan Penyelidikan Industri Malaysia (SIRIM); and others

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3. Tourism

a. Tourism Development Corporation Malaysia (TDC)

b. Malaysian Airline System (MAS)

Methods of Measuring the Development Imbalance between Regions

A number of methods can be used to measure the difference in regional development:

1. Conservative Method to Measure Economic Development

This method usually does not take into account the regional macroeconomics

situation but emphasised more on microeconomics.

2. The utilisation of certain indicators such as:

a. The regional income per capita

b. The increase in income per capita over a period

c. The population growth rate

d. The migration rate

e. The total population in an urban area

f. The percentage growth of labour force

g. Industrial structure

h. Rate of unemployment

i. Level of education, medical facilities and others

3. The utilisation of indirect mediums towards differences in regional economic

development such as population percentage, housing percentage, power supply and

others due to the absence of direct statistics.

4. Statistical technique in regional data analysis

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a. Regional Income Measurement

b. Difference in incomes between states become a good indicator for the differences

in the rate of economic development between states. This method divides the

country’s income data according to sectors.

c. Regional Income Analysis

d. It compares the regional income with the country’s income.

e. Coefficient of Variation for each year is gathered to measure the difference

between regional income and the country’s income per capita.

f. The regional income data analysis is used to construct a graph to show a visual

picture on the meeting or deviation from the ideal line (equilibrium) in regional

development

5. Location Quotient (L.Q.)

This method is used to compare the receipt and the distribution of certain

activities of a region (population, industry production, agricultural production and

others) compared to the country’s total overall.

The formula used is as below:

% of state population = % of state total area

Country’s population Country’s total area

The figure obtained from the L.Q. will be used to form a curve called the ‘Lorenz

Curve’.

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TUTORIAL QUESTIONS

1. Explain the approach used by economist in explaining region. How far is the concept

of regional planning suitable in the regional classification in Malaysia?

2. How far are the concepts of uniform region and nodal region suitably used in this

country’s regional classification?

3. Explain the problems that arise due to regional development imbalance in Malaysia

and the regional policy that is needed in addressing the problem.

4. Explain the main objectives of regional policy.

5. Discuss the regional development strategies executed in the country during the

National Economic Policy period (1970-1990).

6. “Regional policy is expected to increase the efficiency of economic activities in

Malaysia”. Discuss this statement using various methods of measuring the

achievement of regional policy.

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CHAPTER 4: THE ECONOMICS OF PUBLIC AND PRIVATE SECTORS

Introduction to Public and Private Sectors

According to Arthur Seldon & F.G. Pennance in “Dictionary of Economics”, private

sector is a combination of economic elements and is neither a body nor a central agency

or Local Government. Therefore, it covers companies sector or individuals sector.

However, according to Alan Gilpin in “Dictionary of Economic Terms”, private sector is

a part of the economic system that is independent from government control. Private

sector is widely involved in productive activities carried out by private organisations.

This includes a wide organisational coverage from small firms to huge organisations

which are managed and controlled by private individuals who wish to maintain the

income and profits by selling goods and offering services to the general public.

On the other hand, public sector is defined as a part of national economic activities that

comprises of Central Government, State Government, Local Authorities and other public

organisations. Both these sectors play important roles in the development of a country.

The main difference between both sectors is in their objectives. The main motive of the

public sector is economic development and welfare of society without calculating the

profits. For the private sector, priority is on sufficient profits through services offered.

The objective of private trade sector is to offer quality, fast, cheap and profitable service

with social aspects and society’s welfare less focused upon.

It can be assumed that the number of staffs that serve the public sector is much larger

compared to the private sector which keeps only productive workers. The number of

workers in the private sector is kept to the minimum to save cost and others.

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In terms of range of services offered, it can be said that in the private sector this would

depend on customers’ requirements whereas in the public sector services are offered

according to certain standards. Schedule 4.1 shows the difference from various aspects

between these both sectors.

Table 4.1: Differences between Public Sector and Private Sector

PUBLIC SECTOR PRIVATE SECTOR

Objective

Without taking into account of profit,

emphasises the importance of social

welfare.

Efforts made to gain maximum profits.

Scope of Work

Has a wide scope especially in the

provision of hard to find goods through the

pricing system. For example:

a. Commodity such as public service,

police force, army and others.

b. Basic amenities for the people such

as infrastructure, highways and

others.

It includes commercial goods that can

generate profits.

Form of Organisation

Under the direct surveillance of the Federal

or State Authorities.

Under the surveillance of corporate parties

such as the Director of the Company, the

Board of Directors and shareholders.

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User

The society is able to use the service sector

provided.

Only for certain people with interests in the

sector.

Labour Force

The use of labour force may not necessarily

takes into account of optimum production.

Labour force is used efficiently to gain

optimum production of goods.

Working Hours

Working hours is fixed by the Authorities Working hours is not fixed and unlimited.

Investment

Investments made are more for the comfort

of the public without only considering the

profits from the production of goods.

Investments made emphasise more on the

profits and the produced goods in terms of

their value in monetary terms.

Bureaucracy

More complex and effective but more time

consuming for matters linked to the service

provided.

Transactions are made much simpler and

are not time consuming because of the

competition for the best service provider.

Level of Expertise

Level of expertise may be less because of

administrative constraints

The level of expertise in a field is much

higher and efficient with the capabilities of

the experts provided unlimited.

Use of Tools

The tools used are limited by cost and The tools used are modified to the latest

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dependent on the authorities. development so that they are more

effective, modern and sophisticated.

The Role of Private Sector

The role of the private sector is to complement the public sector’s efforts in the country’s

economic development and structural change. A more challenging responsibility has been

given to the private sector in the country’s effort to achieve continuous economic growth

and to further strengthen the industrial base.

The roles played by the private sector in assisting the country’s development are as

follows:

1. To put the country’s economic growth into motion

2. To increase investment

3. To achieve the New Economic Policy’s objective and the country’s vision

4. To quicken the industrialisation process

Malaysia Corporatisation Policy

The government in February 1983 introduced Malaysia Corporatisation Policy and as a

sequence from this policy is the launch of Privatisation Policy within the same year, that

is in May 1983. As a result, both of these policies are based on the concept of co-

operation between the government and the private sector so that more contribution can be

made towards the country’s development.

Based on this concept, Malaysia is considered as a company where both public and

private sectors nurture close co-operation and becomes equal owners. The importance of

this concept can be felt when co-operation between both parties is stepped up.

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Therefore, Malaysia corporatisation is an action plan for the economic development and

privatisation is part of the strategy. In summary, privatisation involves the transfer of

government’s interest, investment and responsibility in supplying goods, services and the

management of public sector to the private sector.

Objectives of Privatisation

In implementing the privatisation policy, a number of desired objectives or goals are to

be achieved:

1. To Create Public and Private Parties Co-operation

Established co-operation between both parties is for the sake of the country’s

development where its benefits are enjoyed among the people. It is known that the

government has many heavy responsibilities in the country’s development. This co-

operation will encourage more information sharing and the understanding of

procedures and vision of both parties.

2. To Reduce Government’s Service Work Load

Privatisation is intended to reduce the government administrative load in preparing

and maintaining a huge part of the service network. The provided policy is to

handover management in the form of trade to the private sector to allow the

government to focus fully in the up keeping of the law and legislation and gives

support in achieving the growth and objective of distribution of wealth.

3. Assistance in Achieving the New Economic Policy’s Objective

By increasing the private sector’s growth prospect, especially the corporate sector,

privatisation will provide opportunities in achieving the New Economic Policy’s

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objective and thus the National Development Policy related with the reformation in

economic thinking.

4. To Encourage Economic Growth

An important factor behind privatisation is to achieve the highest economic growth

rate. Privatisation will provide opportunities to the private sector in playing its role in

the development of the country since the private sector is more business oriented.

Therefore, it is hoped that the profits gain will contribute to a continuous economic

growth. That gain will also entails revenues to the government in the form of

corporate tax where it can finance projects under the socio-economic development

plan.

5. To Increase the Work Efficiency and Production

Privatisation can increase the quality of service provided because the private sector is

profit motivated is not influenced by the public service bureaucratic rules and

regulations. Each company that produces goods or provides services has to compete

with other companies that produce the same goods or provides the same services.

This will create high quality of service at a low or competitive price level.

6. Efficient Resource Allocation

A more tight competition between companies created by privatisation can exploit the

country’s scarce resources through open market to activities that can bring maximum

return.

7. To Reduce the Size and Existence of Public Sector

Withdrawal in stages by the government in the production of certain goods and

services through privatisation will reduce the size of the public sector. This will result

in an increase in economic activities that is spearheaded by the private sector.

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8. To Increase National Production

The source of revenue is an important element for a country especially in

implementing the country’s development policy. Before the existence of

corporatisation, the government plays an important role in the distribution of the

services to the people. However, the services provided by the government are less

efficient and productive. Therefore, the existence of corporatisation policy ensures

provision of better services to serve the people. Hence, the national income will

optimally increase.

Forms of Privatisation

There are several forms of privatisation as follows:

1. Privatisation through Build, Operate and Transfer (BOT)

BOT is a form of privatisation where it involves the giving of power or contracts by

franchising to the private party. The contracts awarded and the power given to the

private party involve building works, maintenance an operation. An example of

privatisation through the BOT method is the construction of highways where the

government will award the contract to the private party to carry out the construction

work, maintenance and operation including toll collection.

The BOT method is for a certain period set by the government to the private party.

2. Overall privatisation

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This method is carried out through a complete hand over (100%) to the private sector

in carrying out the management of a project. This means that all ownership, power

and management of the industry will transfer to the private sector after it is privatised.

An example of this method that has been executed is Telekom Malaysia Limited,

Tenaga Nasional Limited, Pos Malaysia and Selangor Water Supply Company.

3. Partial Privatisation

This method of privatisation is carried out by giving partial sale of the equity assets

owned by the government to the private party. The purpose of this partial

privatisation is to reduce the government’s burden from the financial management

aspect and provides best service to the users besides increasing the country’s

economic growth.

Examples of this type of privatisation are Urban Development Authority (UDA)

Holdings, Muda Agricultural Development Authority (MADA) and the Pilgrimage

Board. Partial privatisation of these bodies is to increase the quality of the respective

services.

4. Selective Privatisation

This method involves the privatisation of certain division in selected government

departments/bodies. Privatisation of garbage collection to certain contractors by local

authorities is a case in point.

5. Lease

This method involves privatising a service within a certain period. This is done

through leasing certain facilities and services where people have to pay for the use of

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the facilities. One example is for authorities to lease out parking lots to private parties

for a certain period. This form of privatisation does not involve changes in ownership

from the government to the private bodies. However, at the end of the lease, the

leaseholder may want to buy those facilities.

6. Management Contract

This method involves the giving out of contracts to private parties to manage

government entities. A sum of money will be paid as management fees to the

managing bodies. This will involve transfer of management responsibilities and may

also include the transfer of staffs. However, it does not involve transfer of assets to

the parties that was given the contract.

An example is the privatisation of the management of Wisma Persekutuan office

buildings of the entire country.

Privatisation in Real Estate Development

At present, the country’s real estate development projects are expanding progressively

and rapidly. This progress will make Malaysia a developed industrial nation in line with

its vision 2020 that is jointly upheld by the government and private sectors. Joint efforts

between the public and private sectors are essential since reliance on either the semi-

government bodies or government agency alone is inadequate to solve problems that may

arise.

The country’s privatisation policy, which was introduced in the year 1984, has played a

major role in the formation of the country’s economic charts and polarisation. The

improvement in the economic performance can be further enhanced through the

continuous increase in the foreign investment in the real estate industry in the country. A

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current example is the serious focus of private developers in increasing the construction

of low cost housing.

As a result, Bumiputera’s participation in the real estate industry increases and this will

indirectly increase the status of the Bumiputera group.

Another benefit from this development is that the government gains profit from tax

revenues and this will reduce its financial burden. The government’s budget allocation

especially in funding real estate projects will also be reduced.

However, a housing project carried out by the private party may face some problems in

its development process due to a number of factors as listed below:

1. Original Owner’s Perception

The original owner or the landowner refuses to give or share their land that is meant

to be developed by the private bodies.

2. Environmental Impact

Some projects that are developed by the private party are sometimes too intensive and

may disregard guidelines on the protection of the environment.

3. Imbalance Allocation

Most developers carry out residential projects of high commercial value. As a result

only the elite groups are able to enjoy the developed facilities.

4. Developers Main Priority of High Return

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Most projects that are carried out tend to gain high profits. Therefore, the prices

offered are too high.

5. Price Increase that is Not Uniform

Developers may exploit the fluctuation in residential market price by increasing the

house price by 35% to overcome huge losses incurred in the low-cost housing

projects.

6. Not Following the Planning Procedure

Due to the rapid development, some developers are eager to construct building

projects that may violate the planning procedures and regulations. Limited urban

lands supposedly for two-storey buildings were replaced by the construction of high-

rise buildings.

7. The Focus on Large Cities and City Centres

Site projects are more focused in the city centres and large cities and this will result in

an unbalanced physical development for settlements between the city centre and

suburbs.

A number of suggestions to reduce the above problems are as follows:

a. Giving accurate and detailed information

b. Detailed planning before the execution of the project

c. The control of price increase

d. Agreement between the Planning and Housing Department

e. Encouragements to provide loans and funding for project development; and

f. Government providing conditional tax reductions.

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Decision Making Process and Techniques in the Private Sector

The decision making process is a tough and complicated process. This is because the

process involves various aspects that need to be scrutinised, observed and studied before

a rational decision can be made. This process needs a prediction on the future market and

economic situation. Therefore, the private sector should be responsible and prepared to

accept the risk from the execution of the decision made.

The present day society can enjoy rapid development from the aspects of economy,

social, culture and specifically real estate development. The rapid development of real

estate has caused difficulties for the developers, owners and investors to make decision in

a real estate development project. This is because an active development and construction

sector will indirectly cause the rise of many competitors among the investors, buyers,

demand and supply and hence, the risks become more varied in the real estate

development. To overcome these problems, the private sector has focused its attention

towards in depth research and analysis on their projects before a decision is made.

Feasibility Study

Feasibility study is the preliminary step in the development process. It is an analytical

method and the viability aspect of a project is considered from various perspectives,

which are physical, economic, market, design and analysis. The contents of the study are

as follows:

1. Objectives

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The objectives of a feasibility study comprises of a strategic objective, priorities on

the alternatives being studied and the decision procedure.

2. Physical Analysis

Physical analysis includes a study on the location and site for development such as:

a. Information on the subject site

b. Provision of basic amenities such as water supply, electricity, sewage, drainage

and public transportation.

c. Planning requirements that are related to zoning, density and plot ratio. From

there, the subject site has to be inspected to determine whether it is in accordance

with the planned use.

d. Surrounding development and other facilities available.

3. Economic Analysis

A complete economic analysis will provide information on the following matters:

a. Population trend: The data can be obtained from the Department of Statistics

on the past total population trend, current population size and its main

characteristics.

b. Job trend: This analysis needs data related to activity rate, job rate and its

allocation according to types of industry and jobs. These data are useful in giving

a general picture, stability, income level and the implication of demand in the

subject studied area.

c. Income trend: For example, certain household income

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d. Economic resources of the study area: the feasibility study from the

economic perspective will provide a picture on the potential market size, its

characteristics and views on its possible growth.

4. Market Analysis

Market study is a macro analysis that involves forecasting and analysis on the

market focus. Market analysis is orientated on demand and focus on important

aspects in analysing rent rate, current and future economic situation of an area,

potential for improvement, recovery and change of development units. This study

also takes into account aspects of supply such as changes in the number of units in

real estate development. The determination of supply is important and is always

carried out by the Planning Agency, Housing Department and Local Government

and consultants. The market study focuses on two main topics, which are:

a. Supply Analysis

Real estate supply is influenced by sites that become competitive, land cost,

project rivalry, tearing down of buildings, building permits, presence of

building plans for similar projects, building costs and financing facilities.

b. Demand Analysis

The demand in real estate can be determined from sales and lease data,

vacancy rate and return, consumers’ taste, and real estate prices. Attention has

to be given on the necessity towards demand for expansion and replacement;

and whether there is a demand for extra facilities over and above the existing

facilities.

The market study is an analysis of data with various patterns and forms. These

data are usually stated in relatively smaller and uniform units to measure the

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effective changes in a wider category. For example, data on jobs will be defined

by types of industries (base or non-base) or by previous records and projection on

the average level of jobs in a studied area at a state or national level. A market

study is not only an economic projection or an analysis on the ratio of various

economic variables but it also uses the judgment and art of planning and

forecasting the population increase and the development of economic activities.

The market study will give answers on the decision that should be made in the

effort to achieve an organised development.

5. Financial Analysis

The last aspect in the feasibility study is the analysis of project financial situation

and the existing risk level. The estimation is based on surveys related to the

previous physical, economics, and market and design feasibilities.

In addition, the process involved in this study is the aspect of financial calculation

involving the following elements.

a. Gross development value

b. Cost of Construction

c. Professional fees

d. Loan interest

e. Developer’s profit

f. Return on investment

All the elements are crucial to a private developer to determine whether there is a

financial justification for a development project. The elements are considered in a

development appraisal.

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Development Appraisal

Real estate development can be defined as activities carried out on the real estate to

increase its value. These activities include construction, renovation and division of land

ownership and repairs carried out on the real estate. Real estate development is the key to

other real estate industry and indirectly creates demand in other industries.

Real estate development schemes may consist of one of the following items:

1. Development of a new building on a cleared site

2. The redevelopment of a site that involves changes and replacement of older buildings

with newer ones

3. Renovations or upgrading works on existing buildings; and

4. Combination of all the above

Activities in real estate development are the result of decisions made by the real estate

owners. The owners act as a leader in the development team and make managerial

decisions and supervise the activities of consultants involved in the development.

Main Objectives of Development Appraisal

The main objectives of development appraisal or valuation are:

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a. To study the viability of a project by taking into account other factors such as

demand, market and finance.

b. To calculate the maximum value of a development site for the purpose of sale in the

open market. The maximum development value is later compared with the asking

price to see whether it is profitable for the developer to purchase it.

c. To calculate the expected profits by the developer from the development where the

site belongs to the developer.

d. To calculate the ceiling cost for the construction after the land is acquired so that all

costs are known and the minimum profit to the developer can be determined.

Residual Method

The residual method is a method usually used in valuing land for development or land

that has potential for development. This method is based on the estimated total income or

the gross development value that can be obtained from the proposed development. After

deducting cost of development and developer’s profit, the residual from the gross

development value is considered as the market value which is delayed for the

construction period to arrive at the current market value. Therefore:

Gross development value – Development cost – Developer’s profit

= Residual value of development land

Development costs are the expenses spent in carrying out a development project as

follows:

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1. Preliminary cost, that is the cost to obtain planning permission, change of condition in

the land title, land surveying cost, cost of obtaining ownership and other related costs.

2. Site preparation cost that includes site clearance and site levelling cost so that

development can be carried out.

3. Infrastructure costs which include road construction, sewerage and drainage works.

4. Construction cost which is the actual cost for building the units in the development.

5. Management cost which includes advertising and promotion cost.

6. Professional fees, which are the payment made to the professionals involved.

7. Cost of loan.

8. Contingency, that is a sum allocated for unexpected costs.

Gross Development Value is the value of a completed development. For example in the

case of a housing development, the gross development value is the total selling price for

all units in the development.

Developer’s Profit is an estimation of the return on the invested capital. Usually the

estimated percentage as the developer’s minimum profit margin is 15% - 25% of the

Gross Development Value or 20% - 30% of the invested capital.

Table 4.2 is an example of calculation using Residual Method in valuing a development

site.

140

Table 4.2 : An Example of Residual Method Calculation

The valuation of development site for:

1) Shops with a gross floor area of 13,000 square feet. Net lettable area (NLA) is

8,000 square feet. The current net market rent is RM 50 per square foot per

annum and the construction cost is RM 105 per square foot.

2) Apartments

i. 50 units (2 bedrooms) with a floor area of 1,300 square feet.

ii. 50 units (3 bedrooms) with a floor area of 1,700 square feet.

iii. The selling price is RM 110,000 per unit for a 2-bedroom apartment and

RM 140,000 for a 3-bedroom apartment.

iv. Cost of construction is RM 45 per square foot.

3) Preliminary work : RM 40,000

4) Promotion : RM 200,000

5) Fixed interest rate @10%

Gross Development Value (GDV)

a) Shops NLA s.f. RM 8,000.00

Net market rent

p.s.f.. RM 50.00

RM 400,000.00

YP in perp @ 6.50% 15.384615 RM 6,153,846.15

141

No. Description Units Price / Unit Total

(RM) (RM)

b) Apartments

2-bedroom 50 110,000.00

5,500,000.00

3-bedroom 50 140,000.00

7,000,000.00 12,500,000.00

GDV 18,653,846.15

Gross Development Cost

RM

a) Shops

13,000 s.f (gross) @ RM

105.00 p.s.f.

1,365,000.0

0

b) Apartments

i)

1,30

0 s.f @ 50 units@RM

4

5 p.s.f.

2,925,000.0

0

ii)

1,700 s.f @ 50 units@RM

4

5 p.s.f.

3,825,000.0

0

c) Preliminary Works 40,000.00

Cost of

Construction

8,155,000.0

0

d)

Professional Fees

@ 12%

from cost of

construction 978,600.00  

Total 9,133,600.00

e) Finance Cost @ 10% p.a. for 2.5 yrs

142

((1+0.1)^2.5)-1) X (9,133,600 X 0.5)

1,228,737.3

0

f) Promotion 200,000.00    

Total Building Cost 10,562,337.30

g) Contingency @ 5% of Total Building Cost 528,116.9

h)

Legal / Agent fees

@ 4% of GDV 746,153.8

i)

Developer's profit

@ 25% of GDV 4,663,461.5   5,937,732.25

GDC 16,500,069.55

Residual value = 2,153,776.60

Gross Development Value - Gross Development Cost

Land Acquisition

Cost:

Assuming land value is

X

Land Acquisition Cost

@ 2% of X 0.02X

Land acquisition cost is

1.02 x 2.5 years

@ 10% 0.274X

0.294X

143

Therefore,

X = 2,153,776.70 - 0.294X

1,294X = 2,153,776.70

X = 1,664,433.31

Residual Value = RM 1,664,433.31

Say RM 1,660,000

There are opinions stating that the residual value needs to be present valued since the

development value can only be realised after the ongoing development is completed.

From the above example, it can be observed that the site value is RM 1,660,000 after the

development is carried out. From this appraisal, the developer can make a decision

whether to develop the land or not. If the value achieves the expected target or higher, it

is certain that the development will be carried out but if the value is too low, the

development will be postponed. Here, a careful decision has to be made as each decision

has its risks.

Viability Study

Viability study involves a comparison between cost and return of a development project.

The purpose of a viability study is to determine the viability of a development project and

the profit potential (or loss).

144

The conventional viability study method is derived from the residual method, where:

Gross Development Value – Development Costs- Site Cost

= Developer’s Profit

In measuring the viability of a development project, there are a number of approaches as

follows:

1. Capital Profit (Developer’s profit or Goss profit)

Measurement is based on the overall total return of a development project.

2. Development Return

Measurement is based on the potential income from the development project as a

percentage of the total building cost.

3. Developer’s Return

Measurement is based on the developer’s profit as a percentage of the development

cost or gross development value.

Based on Table 4.3 below, it is assumed that the developer has purchased the subject

project site or has been offered a doubtful price. In this situation, the developer wants

to know whether he can gain profit from the proposed development and whether it is

viable.

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By using the conventional viability study, the developer can calculate the

development’s return and determine the project’s viability.

Table 4.3 : Example of Development’s Return Calculation

RM RM

Gross Development Value

18,653,846.00

Development Costs

a) Building Costs

8,155,000.00

b) Professional Fees

978,000.00

Building Finance

1,228,737.00

Promotion

200,600.00

Contingency

528,117.00

Legal / Agent Fees

746,153.80

Land Acquisition Cost:

i) Site cost

1,664,433.31

ii) Legal cost, duty stamp

and others @ 2%

33,288.67

iii) Land Acquisition

Financing

146

456,786.88 2,154,508.86 13,991,116.66

4,662,729.34

Gross Profit as % on GDV 24.996%

(Developer's Profit)

Gross Profit as % on Development Cost 33.326%

(Developer's Return)

The above gross profit is receivable within 2.5 years. There are opinions which state

that the Gross Profit should be present

valued.

Gross Profit 4,662,729.34

PV for 2.5 years @ 10% 0.788

3,674,163.63

Risk and Uncertainties in Real Estate Development

Investment in real estate development is the exchange of current capital value

(purchasing power) for future benefit. This benefit may be in the form of income or

appreciation in capital value or both. Investors that are involved in real estate

development should take into account what had happened in the past to predict what will

happen in the future.

Risk is defined as a form of measuring the degree of identified loss resulting from a

decision made. Risk is accountable when the probability or a value is placed on a few

hopeful alternatives.

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Uncertainties can be defined as something that is unknown that can happen when a

decision is made. It is used to explain situations where the chances of occurrence of

something cannot be measured and hence no probability can be given to any hopeful

alternatives.

Weaknesses of Applying Residual Method in Development Appraisal and the Solutions

Some of the weaknesses in using the Residual Method are as follows:

1. Determined or given average cost for the length of development period is

unrealistic. This does not depict the real situation because in reality, the real cost

is not fixed and may change according to factors such as inflation and others.

This problem can be solved through the Cash Flow Analysis Approach where all

development costs especially building costs are divided into monthly, quarterly or

annually. The cash flows give a detailed calculation on the total cost of a

development scheme through a more accurate appraisal. The cash flows will

allow the incidence of short term financing to be spread through out the

development period. Costs in residual method are used as basic data for the cash

flow. The use of computers will give a more accurate and concise calculation.

2. Residual method is extremely sensitive toward relatively small changes in each

input. From the example given, if building costs increase by only 2%, the residual

value will decrease by as much as 10% (from RM1,664,433.31 to

RM1,496,265,46). If there are changes in building costs by as much as 2% from

the original costs resulting from say an increase in building costs for an apartment

by RM107.70 and an increase in building costs for a shop by RM45.90 p.s.f., the

site value will decrease.

148

This situation is one of the risks faced by a developer in a development project.

Therefore, it is important that an input is measured as accurately as possible by

using information that has been properly studied and suitable with current time.

This weakness can be fixed by using the Sensitivity Analysis Approach. In this

analysis, possible changes in the future need to be listed down and studied based

on the variables found in a project such as promotion, building costs, loan interest

and others.

Sensitivity Analysis is used in determining effects from changes or mistakes in

variables of a project on its result or value. It is formulated to answer questions

such as the effect on the Net Present Value or the rate of return if the gross return

increases for example by 10% or the vacancy rate (spaces that is unable to be

rented out) is 8% and not 4% or the effect caused by the difference in inflation

rate.

The analysis that is systematically tested will show which variable can cause a

huge change or needed attention to reduce risk. This analysis is able to decide on

which variable that needs more attention when making an investment.

3. All inputs in the residual method of valuation are fixed estimations. This approach

does not take into account possible changes such as increase of building costs

during construction or inflation during sales. These problems are not easily solved

but the increase of computer usage can overcome these problems through

Probability Analysis and Monte Carlo Simulation.

Probability Analysis and Monte Carlo Simulation

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A simulation model is a model where the characteristics of a complex system are

represented by a symbolic model. The symbolic model parameters are studied by

simulating input data through random figures generated in the computer programme

through the Monte Carlo process.

This model is very flexible because all the characteristics of the problems are in fact

studied by simulating the symbolic model for the problem. In general, a simulation can be

defined as a quantitative method of studying the characteristics of a business system or

the economy within a certain period.

To experiment a model through the simulation method, a large size of input data is

needed. The data input used in the simulation process are not explicit data but data that is

generated from a quantitative process. The method that is usually used is the Monte Carlo

method, which is based on the spread of random variable functions.

In a simulation analysis, the parameter value for each input or variable is needed. This

parameter value can be determined through research, previous saved records and the

valuer’s own experience.

This analysis involves 3 stages, which are:

1. At the first stage, the parameter value for each variable will be calculated together

with the probability of occurrence for each value contained in that parameter value.

For example, these parameters may include rental, vacancy rate, building costs,

developer’s profit and others. This can be observed from Table 4.4 below that takes

into account possible alternatives for the rental value and their respective probability

of occurrence.

Table 4.4 : Possible Alternatives for the Rental Value and their Respective Probability of

Occurrence

Possible Value (RM) Probability Random numbers

45 0.15 1-15

150

48 0.4 16-55

58 0.3 56-85

60 0.1 86-95

62 0.05 96-100

2. At the second stage, each variable will be given a value from the existing spread of

value by referring to a random number related to the respective probabilities. Here, a

value within a variable that has a 0.15 probability means that there is a 15 out of 100

chance for it to happen.

Next, a number between 1 – 100 will be chosen randomly and this number will

determine which value between the parameter values will be matched with those

parameters. For example, based on the above rental values, if number 22 is chosen

randomly, it is situated within the number group of 16 – 55. As a result, and it will

give a rental value of RM48 p.s.f.. If other random number is chosen, other

determinants for the first valuation can be determined.

3. At the third stage, values obtained from the determinants in the parameter value will

be inserted into the computer programme package (for example; Crystal Ball Version

7.2 and ICL 1900 series Package Prosper 2). This process will be done repeatedly

where each round will give a residual value for each of the valuation. Sometimes, the

combination from each variable will produce the same answer. For a more accurate

and satisfactory simulation, this procedure needs to be repeated 300 times or a

minimum of 100 times.

This simulation process will produce 300 site values that depict a more accurate real

value for that site. From the analysis that has been undertaken, the average value of the

site and its standard deviation can form the basis in estimating the site value.

By using the average value and its standard deviation, the following formula is

formulated to obtain a normal distribution that shows the probability of occurrence of a

parameter input.

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Z = X-M

S

where Z shows standard deviation between the real site value and the average site value.

M = Average Site Value

S = Standard Deviation

X = Raw Score (Site Value)

As a conclusion, the application of this simulation and probability approach can improve

decision-making techniques. However, these approaches are difficult to apply unless the

user has research resources or good records on the parameter values or inputs that will be

used. In addition, the user needs a complete knowledge on the computerised probability

and simulation. The simulation process also needs extra scrutiny towards matters that can

possibly happen in the future.

Investment Appraisal

When an investor is investing his/her money in an investment, a number of factors must

be studied, which are:

1. Capital stability

Capital stability means that the investment can guarantee that the invested capital will

not be lost or depreciate its value due to inflation. This can be linked with the future

such as unstable political situation, changes in government policy and others.

2. Return Prospect

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This relates to whether the investment secures a stable and safe flow of income. A

decision is made based on the expected rate of return and a comparison with other

investments.

3. The Possibility of an Increase in Income and Capital Growth

This can be studied from the percentage increase in income from the investment.

When there is an increase in the flow of income, this means that there is a capital

growth in the investment.

4. Liquidity and Marketability Elements

The ability to convert back the investment into money according to the economic

situation of a country is difficult especially in the real estate sector. This liquidity

characteristic is important for an investor to gain back his capital in the form of

money.

Factors that can cause an investment decision to become more complex are government

policy, changes in economic policy, inflation rate, high base lending rate and unstable

building costs. Therefore, investors have to undertake an in-depth study before making a

decision on the investment to ensure that the capital invested can provide a maximum

return.

Normally, in an investment, the developer or investor has a number of alternative

investments with different levels of return. The investor needs to be skilled in several

techniques prior to choosing a suitable alternative that will generate a profitable return.

Several appraisal techniques that can be applied in an investment appraisal are as follows:

Payback Method

153

This method is usually used in assessing investment in small projects. The payback

method is defined as the period taken in gaining net profit after deducting taxes in order

to recoup back the full capital used. In general, a shorter period that is used to recoup the

capital used for a project will attract the interest of a private party to invest in the project.

It is simply used to select those projects whose profits are large enough to repay the

amount invested within a chosen number of years.

An example of a cash flow for the purpose of applying the payback method is provided in

Table 4.4 below.

Table 4.5 : An Example of a Cash Flow for the Purpose of Applying the Payback

Method

Project A Year Project B

- RM500,000 0 -RM500,000

RM100,000 1 RM100,000

RM100,000 2 RM125,000

RM150,000 3 RM100,000

RM150,000 4 RM75,000

RM100,000 5 RM75,000

RM10,000 6 RM25,000

RM10,000 7 RM25,000

RM10,000 8 RM20,000

From the given example, between Project A and B, it is found that Project A recoups

back the capital used within the period of 4 years. On the other hand, Project B recoups

back all its capital that was invested in the 6th year.

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Based on this method, it is found that Project A is a better investment for the private

party.

Strengths

1. This method is easily applied because it does not require many and difficult

calculations.

2. Elements of risk are considered. For example, the method allows the estimation of

how soon the capital expenditure that was forked out can be paid back. The earlier an

investor recovers his capital, the smaller is the risk of making a loss.

Weaknesses

1. This method fails to interpret long-term profit. This is because the decision made is

based on the swiftness in regaining back the expenses.

2. Does not consider cash flow; which are the cash inflow and outflow.

3. The cash flow after recouping the invested capital expenditure is not considered,

whether it is an income or a small or large return.

4. This method does not consider current monetary value where future income needs to

be present valued to determine the current present value.

5. No allowance is made for taxation, for example, corporate tax and capital allowance.

6. Ignore the profit streams after the payback period is over.

155

7. A problem of risk such as project with shorter payback period means it is riskier.

Highest Profit Method

This method takes into account the highest year net profit for the whole duration of the

investment. This highest profit is accounted as the percentage of return on the investment

capital.

An example of a cash flow for the purpose of applying the highest profit method is

provided in Table 4.5 below.

Table 4.6 : An Example of a Cash Flow for the Purpose of Applying the Highest Profit

Method

Year Project A Project B

0 - RM100,000 -RM100,000

1 RM20,000 RM50,000

2 RM40,000 RM50,000

3 RM60,000 RM50,000

4 RM40,000 RM50,000

5 RM20,000 RM50,000

The above example shows that the highest cash flow profit for Project A is in the 3rd year

which is at 60% (60,000 / 100,000) where as Project Y shows an equal return each year at

50% (50,000 / 100,000). When compared, based on the decision criteria, Project A is

more suitable. The assumption behind this method is that the highest return is the average

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return for a project. This assumption is more accurate if the projects compared have the

same life duration and cash flow. Normally, the life duration and the cash flow for each

project are different. However, when Project A and B are closely examined, Project B is

better than Project A from in terms of profit. The profit for Project B is higher than

Project A for each year except in the 3rd year.

Average Profit Method

This is based on average profits over the whole project’s life. Such average profit is

expressed as a rate of return on initial investment after allowing for tax and capital

allowance.

An example of a cash flow for the purpose of applying the average profit method is

provided in Table 4.7 below.

Table 4.7 : An Example of a Cash Flow for the Purpose of Applying the Average Profit

Method

Project A & B with a capital outlay of RM100 each.

Year 0 1 2 3 4 5 Total Profit Average Profit % Return

A -100 20 30 40 50 60 200 40 40

B -100 60 50 30 30 20 190 38 38

From the above example, Project A is chosen since it gives the higher rate of return

The criticisms of this method are as follows.

1. The method is misleading as no consideration is given on the length of the project.

157

2. It does not take into account of profits that can be reinvested. For example, Project B

still makes higher profits in early years despite having lower average profits. The

surplus can be reinvested at the end of the period and may offset its disadvantage.

Discounted Cash Flow

Discounted cash flow provides assistance in investment valuation that produces a cash

flow. The application of this method is based on the principle that the present value of an

interest is more valuable than its future value. This discounting technique allows the

investors to make a more accurate decision whether to accept or decline projects that

have different time period, income or cost. In general, the cash flow has two standard

results which are the Net Present Value (NPV) and the Internal Rate of Return (IRR).

1. Net Present Value (NPV)

NPV is the future net profit that is obtained from the investment and discounted at a

certain discount rate to arrive at its present value. The total discounted profit is

obtained and the initial cost of investment is deducted from that total and the balance

is known as the Net Present Value. A positive NPV indicates that investment rate of

return is higher than the target rate. Target rate is the minimum rate required by the

investor so that investment is profitable after taking into consideration the risk

involved and other related factors.

The target rate should be compared with cost of capital. From that basis, a positive or

negative NPV will be derived from the analysis. The result from this analysis can

determine the investment to be chosen.

158

Based on the following example as shown in Table 4.8, a capital of RM100,000 is

invested into Project A that has a duration of 5 years. The flow of income with a 10%

discount rate is stated below.

Table 4.8 : An Example of a Cash Flow for the Purpose of Applying the Discounted

Cash Flow Method

YEAR NET CASH

FLOW

PV @ 10% PROJECT PV

0 - RM100,000 1 -RM100,000

1 RM28,000 0.9091 RM25,454,54

2 RM28,000 0.8264 RM23,140.49

3 RM28,000 0.7513 RM21,036.81

4 RM28,000 0.6830 RM19,124.37

5 RM28,000 0.6209 RM17,385.79

RM6,142.02

The investment produces a return of 10% and a positive NPV of RM6,142.02. In the

absence of other options, this investment is acceptable.

The NPV method is a useful assistance in overcoming most investment problems but

nevertheless, this method has a specific weakness. The gained return is stated in two

parts, which are rate of return and the total cash that represents extra return. Both

parts are stated in different units causing difficulties for comparison in some

investments.

159

2. Internal Rate of Return (IRR)

The Internal Rate of Return method is almost similar to the NPV method but the

result of the calculation is shown in percentage form. IRR is the rate of return

where all future cash flow has to be discounted so that its NPV becomes 0 (zero).

The investment decision criteria according to IRR method is that it must exceed

the discount rate used for the investment.

The Internal Rate of Return can be obtained through trial and error by using a number

of trial discount rates until the rate used can produce an NPV equal to 0 (zero).

However, this method is quite complicated. The IRR calculation can also be obtained

through a graphical interpolation method.

Assume that a cash flow of an investment is as stated in Table 4.9 below.

Table 4.9 : A Cash Flow for the purpose of using IRR method

YEAR CASH FLOW PV @

12%

PROJECTED PV

@ 12%

PV @

13%

PROJECTED PV

@ 13%

0 - RM100,000 1 - RM100,000 1 - RM100,000

1 RM28,000 0.8928 RM24,998.40 0.8849 RM24,777.20

2 RM28,000 0.7971 RM22,318.80 0.7831 RM21,926.80

3 RM28,000 0.7117 RM19,927.60 0.6930 RM19,404.00

4 RM28,000 0.6355 RM17,794.00 0.6133 RM17,172.40

5 RM28,000 0.5674 RM15,887.20 0.5427 RM15,195.60

RM926.00 (RM1,524.00)

From the cash flow, a graph can be obtained as shown in Figure 4.1 below:

160

Figure 4.1 : Using a Graph to Determine IRR

From the graph, it can be determined that the IRR for the cash flow is 12.3779% .

However, the graph drawing is time consuming without the guarantee of full accuracy.

Although it can be observed that the graph has a gentle sloping curve, a straight line is

assumed to be located between two trial rates that are close to each other. Using this

method, the IRR can be estimated at a degree of average accuracy. This process is called

Linear Interpolation.

Through Interpolation method, the IRR can be determined as follows:

IRR = R1 + (R2 - R1) [(NPV@R1) / (NPV@R1 + NPV@R2)]

= 12 + (13 – 12) {(926.00 / (926.00 + 1,524.00)]

= 12 + (1) (926 / 2,450)

= 12 + 0.3779

= 12.3779%

NPV

(RM

) Trial rates (%)

12%

Actual NPV

Interpolation to 12.3779

13%

161

Here, the Internal Rate of Return that can be obtained form the investment is 12.3779%

However, the IRR method has the following weaknesses:

a. This method assumes that a cash flow is promptly received at a pre-determined time

without giving attention to elements of risks and uncertainties.

b. When the NPV and IRR are compared, difficulties may arise as they are expressed in

different units.

Incremental Cash Flow Analysis

When there is a situation where an investor is faced with problems of choice amongst

competing alternative investments or mutually exclusive projects, this analysis is

required. In such circumstances, the decision is to choose the ‘best’ amongst a number of

alternative investments and not simply to accept or reject a particular investment.

Subsequently, it is to be decided whether that ‘best alternative’ is a worthwhile

investment to be selected.

The use of Incremental Cash flow Analysis is to solve the problem where NPV and IRR

methods of appraisal produce contradictory results as to which investment to choose.

An example of the cash flow from two projects producing conflicting results between

NPV method and IRR method is shown in Table 4.10 below.

162

Table 4.10 : An Example of the Cash Flow from Two Projects Producing Conflicting

Results Between NPV Method and IRR Method

Years Project A Project B A-B

0 -1,000 -500 -500

1 475 256 219

2 475 256 219

3 475 256 219

NPV @ 10% 181 137 44

IRR 20% 25% 15%

The conflict between the use of NPV method and IRR method is as follows:

Based on NPV - Project A should be chosen

Based on IRR - Project B should be chosen

The solution is to use Incremental Cash Flow Analysis that is, A-B to find incremental

IRR.

The decision by using the Incremental Cash Flow Analysis is to choose project A. Since

IRR on A-B (incremental) is 15% being greater than the firm’s marginal rate (opportunity

cost of capital rate) A is preferable than B.

The reason is that since A offers similar to B plus 15% rate of return on extra capital

invested of 500, it would be better to choose A.

The decision rule suggested by Lumby (1991) is as follows:-

1. If the incremental IRR is greater than the discount rate and:

163

less than both projects’ IRR , then accept the project with smallest IRR (or

highest NPV).

a. Greater than both projects’ IRR, then accept the project with highest IRR.

2. If the Incremental IRR is less than the discount rate and:

a. The IRR of one or both projects are higher than the discount rate, and then

accept the project with highest IRR.

b. If neither projects’ IRR is greater than the discount rate, reject both.

Sensitivity Analysis

David B Hertz introduced sensitivity analysis into the business field in1964. Sensitivity

analysis is an analysis to determine the variations of a variable due to a change in another

variable. For instance, an investor would like to know whether the value of a property is

sensitive to its rental. If the property value is sensitive to rental, the investor then should

be careful of their rental data for a slight discrepancy in rental data will result in a large

error in property value.

The Sensitivity Index

There are several variations of sensitivity analysis. One of the common measure of

sensitivity is to compare the percentage change in one variable and the percentage change

in another variable. For example, to determine whether property value is sensitive to

rentals, we compare the percentage change in value and the percentage change in rentals.

If the percentage change in property value is less than the percentage change in rentals, it

means that the property value is not sensitive to rentals. If his happens, we need not be

too concern if our rental data is slightly inaccurate.

164

base

base

base

base

Alternatively, if the percentage change in property value is more than the percentage

change in rentals, it means that property value is sensitive to rentals. In this case, we need

to exercise caution as a slight error in our rental data will lead to a large error in our

valuation. A convenient way to show whether the percentage change in one variable is

more or less than the percentage change in another variable is to express it as an index.

The sensitivity index is shown by the following formula:

S.I = % ∆ in variable A

% ∆ in variable B ……(1)

where,

% ∆ in variable A = A - A x 100

A

% ∆ in variable B = B - B x 100

B

Note:

i. -1.0 ≤ variable A is not sensitive to variable B if SI ≤1.0

ii. Variable A is sensitive to variable B if SI > 1.0

iii. Variable A is sensitive to variable B if SI < -1.0

165

basebase

Derivation of SI – A Simple Example

Rental of 2 storey shop houses in Taman Kayangan is RM1,500 per month. Rate of return

for shop houses is about 6% per annum. The shop houses are freehold and tenants are

responsible for maintenance.

You are required to value a shop house and determine whether the value is sensitive to

rentals (in this case rental is equivalent to net income)

Value of a shop house= Net income p.a. x Years Purchase @ 6%p.a.

= (1500 X 12) x 1/0.06

= RM300,000

To determine whether the shop house value is sensitive to rentals, you first have to vary

rentals. This is shown in Table 4.11 where rental varies between RM1,200 to RM1,800

per month. Note that you only change rentals while rate of return remains constant at 6%

per annum.

Table 4.11 : Changes in Rentals vs. Changes in Value

Net Income per month

(RM)

Value

(RM)

1,200

1,300

1,400

1,500

1,600

1,700

1,800

240,000

260,000

280,000

300,000

320,000

340,000

360,000

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value-rental

base base

value-rental

value-rental

SI = % ∆ in value

% ∆ in rental

where,

% ∆ in value = 300,000 – 280,000 x 100

300,000

= 6.67

% ∆ in rental = Rental - Rental x 100

Rental

= 1,500 – 1,400 x 100

1,500

= 6.67

Therefore,

SI = 6.67

6.67

= 1.0

The SI equals 1.0 means that changes in rental result in an equal change in

value. This means that in this example, value is not sensitive to rental. Note that it is not

necessary to calculate the sensitivity index based on a variation of rental from 1,500 to

1,400. One could very well calculate the sensitivity index base on any rental variations

for example, from 1,500 to 1,800 or 1,500 to 1,200. The only requirement is that the

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calculation must start from the base rental that is 1,500. Regardless of the variations of

rentals (from base rental), the sensitivity index remains constant at 1.0.

Decision Techniques in the Public Sector

The main objective of investment by the Public Sector is to maximise social welfare and

to provide facilities to the public. The approach in appraising investment projects are

different and depends on the methods used. Some of the methods used in appraising

public projects are Cost-Benefit Analysis, Planning Balance Sheet and Goal Achievement

Matrix. If compared to the private investment valuation technique, the public sector

techniques are different because:

1. The market mechanism that is generally received by the public as the basic method in

allocating resources (in a free market economy) cannot be carried out in the public

sector because each individual in the society has to be considered and involved in the

decision made.

2. Cost and interest elements involve the calculation of visible and invisible matters.

The private sector usually does not consider invisible matters and focus on the profits

and revenues only.

3. Most public projects involve large capital and public resources where private sectors

do not want to be involved. For example, highways, airports, and pollution control

system projects and others that require the economisation of those resources.

Cost-Benefit Analysis

The cost-benefit analysis is an economic analysis that can assist in selecting a project by

scrutinising aspects related to cost and benefit related to the project. It is a practical way

168

in appraising the project’s welfare because the analysis considers a wide and far-sighted

perspective (including external and side effects) on the society, industry and region or

country.

For example:

1. In the redevelopment of cities , the advantage to the locals is that they can experience

a more comfortable living place and can enjoy the benefits of development and public

facilities.

2. The benefits of city redevelopment to the traders are that they have a more organised

trading space and can attract more customers. In addition, the Government can create

more jobs for the people and optimise the usage of utilities.

Procedures in Executing Cost-Benefit Analysis

Several aspects that have to be considered in the use of Cost-benefit analysis as a method

in decision-making are as follows:

1. What are the costs and benefits that need to be valued?

2. How to measure those costs and benefits?

3. What are the discount rate that needs to be used in valuing the future costs and

benefits and the next course of action?

4. What is the project’s viability?

169

a. The cost and benefit that needs to be valued

The decision maker has to determine the cost and benefit that have to be considered.

This is because this technique involves social cost, cost of interest and utility function

of each individual that forms each investment unit output. Therefore, the calculation

of cost and benefit is based on the following items:

i. Some of the items are calculated in the same way as the private sector financial

valuation.

ii. Some of the items which are not taken into account in the above valuation is

considered in the cost and benefit analysis. For example, the side effects such as

pollution, and value of invisible items that needs to be changed into monetary

values. As this investment project is undertaken for the public, priority is given

to its effect on the society.

iii. Some items are exempted or amended. For example, labour cost that is

unemployed is not considered for public projects because it does not involve

social cost.

iv. All cost of the inputs and benefits from the output of the project are listed down.

b. Method of measuring cost and benefit

Cost benefit analysis requires practice in comparison valuation where the financial

valuation is based on the market price that refers to the buyers’ or sellers’ needs.

When the price can be clearly used to exchange items freely, the market price can be

used in public investment projects.

However, when the market price is not clearly stated, it cannot be used freely and is

called shadow price or accounting price. In general, this shadow price shows the

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opportunity cost of the goods and services and it reflects the benefits foregone from

the consumption of the last item, which is a person’s willingness to pay for the last

item which is its real value. Shadow price depends on two main factors, which are

objective function and social and political factors.

c. The discount rate used

Any chosen projects will involve the flow of cost and benefit for a number of years to

come. The value of these benefits has to be discounted to get its present value. There

are three types of discount rate, which are:

i. Individual discount rate

ii. Social discount rate

iii. Market discount rate

Since the future usage value is low compared to current usage value, a social discount

rate is used. The use of social discount rate in cost benefit analysis considers the

overall interest of society and not only the individuals involved.

Social discount rate is based on the statement that the future generation will probably

achieve a higher standard of living compared to the current generation.

However, this social discount rate does not reflect the market rate. In the cost benefit

analysis, the discount rate used is lower than the market rate. In practice, the

government fixed a lower discount rate that is known as “test discount rate” and this

rate assists the decision makers in the public sector.

171

d. To value the viability of a project

A project that gives the highest net social benefit has to be chosen but this depends on

existing obstacles. Nevertheless, other potential projects that give a positive net social

benefit must also be considered in valuing the proposed project’s viability.

Below is the assessment methodology of cost benefit analysis according to the LMST

(Little and Mirrlees (1990) and Squire and van der Tak (1975)) principle.

Cost Benefit Analysis Valuation (LMST Principle)

The valuation approach involves three stages of analysis as follows:

1. Financial Valuation

This analysis is similar to the private sector’s analysis on return. It involves an

analysis on the viability of a project from various angles by using the project’s

input and output values at market price.

2. Economic Valuation

The purpose of an economic valuation is to identify, quantify and assess the costs

and benefits involved in the project. The use of market price becomes a problem

when that price is inefficient and produces a confusing result.

Shadow price or Accounting Price (AP) is used to overcome problems in local

market price. AP can be obtained based on the Market Price (MP) by making the

following modifications:

172

a. A base yardstick is determined to measure the shadow price or AP as it is

needed to measure the opportunity cost and real benefit of the project to the

economy. Thus, the base yardstick that is chosen can be in terms of limited

scarce resources or constraint to the country’s economic development such as

the level of foreign exchange.

b. Use international price in valuing a project’s cost and benefit. In the economic

analysis, the project’s contribution towards the national income is considered

as a criterion to value a public investment. Hence, in the terms of the chosen

base yardstick, the criteria used in valuing the project is the “project’s

contribution towards the national income measured in the form of a foreign

currency”.

c. To value the cost and benefit of the inputs and outputs, LMST principle

categorised goods into two categories, which are:

i. Traded goods (TGs)

ii. Non-traded goods (NTGs)

All TGs are valued according to world price by using the Conversion Factor

(CF) where:

Conversion Factor (CF) = Accounting Price (AP)

Market Price (MP)

Therefore, AP (Shadow price) = CF X MP

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d. The production of NTGs has an indirect effect on the country’s situation in

foreign exchange. There are two ways to value it:

i. NTG is divided into its cost component as follows:

TG1, NTG1, & L1 (Labour)

Next, TG1 is valued according to the above procedure and L1 is valued using

the opportunity cost of labour.

NTG1 is further subdivided into TG2, NTG2 and L2. Then NTG2 component

is valued. This process is continued until NTG = 0

ii. NTG account value is counted by multiplying NTG market value with suitable

conversion factor for the NTG. The country’s Planning Unit provides this

conversion factor.

iii. The principle used to value the labour cost is by estimating opportunity cost of

labour in the economy. Labour opportunity cost is the marginal product of

labour in the best alternative job. Labour wages in a developing country

exceeds their opportunity cost. Therefore, the value has to be adjusted using

the following formula:

Wage Conversion Factor (WCF)

= Opportunity Cost of Labour i.e. Accounting Price (AP)

Wages i.e. Market Price (MP)

e.All costs and benefits valued at world price (in local currency), is converted into

another exchangeable foreign currency (such as US dollar) by using the Official

Exchange Rate (OER).

174

f. Prepare a cash flow and use the investment criteria to value the project’s viability

by using the method of Net Present Value or Internal Rate of Return (IRR).

Project that produces a positive NPV and IRR >i (opportunity cost of capital), is

considered profitable if executed.

3. Project Social Analysis

Project Social Analysis covers important allocation aspects in a country as

follows:

a. Allocation between current income groups

b. Allocation between areas

c. Allocation between ethnic groups

d. Allocation between citizens and non-citizens

e. Allocation between generations

The allocation between current income groups is central to the project social

analysis and it merits elaboration as follows.

i. Allocation Between Income Groups

The increase in income from a project is valued differently by different

groups who gain benefits from the project. This depends on the elasticity of

the marginal utility of consumption of people in different income groups.

The allocation given is as follows:

d1 = (Ŷ)n

Yi

Where:

175

d1 is the value of the allocation given to the increment in each group’s

income of Yi relative to the average income Ŷ for a country.

n : Marginal elasticity of income (consumption)

di : Allocation of value depends on two items which are the group

income level i relative to the average income level per capita and Value n.

In principle, if the income level of a group relative to the average income is

low and the marginal elasticity of income is high, a high allocation of

benefits is given to this group and vice versa.

ii. Social Wage Rate

Economic Wage Rate (EWR) = M1 X AR1

This means that the Marginal Production of Labour in the original job is

valued at the accounting price multiply the accounting price ratio. Another

cost element that needs to be considered in the Social Wage Rate (SWR), as

in the example below:

Firstly, additional jobs utilisation is a benefit for new workers but is cost to

the government.

Secondly, additional utilisation is equal to the difference between new

worker’s wages (W1) with the value of production that has to be stopped

(M1) by the worker in his old job.

176

Therefore, Social Wage Rate (SWR) = Mi Arm + [(Wi-Mi) – (Wi – Mi) d/v] ARc

1 2 3

4

Where:

1 is EWR (opportunity cost of labour)

2 is additional cost in consumption to be borned by the government to

provide a job opportunity

3 is the benefit received by the workers as a result of the wage increment

after considering inter and intra-temporal allocation aspects (d, v)

4 to change point (4) into a base yardstick, it needs to be multiplied with

suitable changing factors (ARc)

If those workers come from the poor group (d / v < 1), the additional cost element

is negative. The Social Wage Rate (SWR) is less than the Economic Wage Rate

(EWR).

But if those workers come from the well to do group (d/v >1), the additional cost

is positive and SWR > EWR.

Social cost for the poor group is small although the economic cost is high.

iii. Social Discount Rate

Social Accounting Rate of Interest (SARI) is the social interest rate to

calculate the present value of the project’s social net profit.

SARI is needed to compare the Social Internal Rate of Return (SIRR). From

there, if the NPV(NSB) >0 and SIRR > SARI, the project is viable. In

practice, SARI is determined by the economic planning unit as a discount rate

177

that equates the project investment total value with the existing total financial

resource at the treasury.

Critiques Toward the Cost Benefit Analysis

The critiques toward the Cost Benefit Analysis are as follows.

1. Proposals such as urban and regional planning involve a wider group and

influence the whole society. Therefore, hidden cost and benefit needs to be

considered but it is difficult to measure. For example, not all conversion factors

can be obtained from the State Economic Planning Unit, thus there is a need to

find our own information. In determining the conversion factor, the crucial market

price is forced to face the problem of constant changing world price. Each world

currency exchange rates with the US Dollar will be stated. The process of

determining the exchange rate is related to the price theory. The local exchange

rate is the number of US Dollar for each Malaysian Ringgit. In the end, the

exchange rate in determining the market price may not reflect the shadow price.

2. Cost benefit analysis is only suitably used in one economic sector only. It does

not consider the practice in urban and regional planning that usually involves a

number of different types of investment made at the same time.

3. It is difficult to determine or classify an external factor whether it is an external

factor or not. This is because according to its principle, external factors cover

parties that gain profits or loss in terms of cost and benefit due to ongoing

development. The problem is to determine how far the element is considered a

loss or profit from the development.

4. A problem may arise in the calculation of cost and benefit. In doing a cost and

benefit calculation, care has to be taken to avoid double counting or insufficient

178

calculation. For example, the benefits that do not have a price sometimes can be

given a value that is possible to count but usually the value given is inaccurate.

5. The discount rate used varies and is not based on a solid basis. This creates

critiques towards the application of the discount rate.

6. Problems in placing a price on public goods also arise. This is because some of

the public goods are not marketable and does not have a price, for example, more

highways and transportation facilities to save time.

An example of the Cost and Benefit Analysis in an urban renewal project in terms of the

different benefits and costs to different parities is summarised in Table 4.12 below.

Table 4.12 : Examples of Cost Benefit Analysis Application in Urban Renewal Project

Parties Receiving Benefits

Government Facilities provision

Job opportunities to the citizens

A good impression to the tourist and others on aesthetic values

Residents Educational facilities and others

Avoidance of congestion

Clean and more comfortable environment for daily activities

A better place to live

Traders Transportation system and storage area

Vehicles and others

Shop lots for business

Safety to run business

Prospect of more profits

179

The Costs Involved

Government Financial cost for the project

Delay will cause a decline in trade

Development time may evade traffic movements and trading

activities

If fail, problems will arise from the public

Subjected parties’ refusal to carry out trade or live in those areas

Residents Noise, dirt and dust the during construction works

Transfer of residents

Emotional and sentimental values on old houses

Living routine is temporarily disrupted

Traders Disrupts daily trading

Related opportunity cost

Loss from price of land, goods and transportation

TUTORIAL QUESTIONS

1. Explain the main differences between the public sector and the private sector. Explain

the roles played by both sectors in the country’s economic development.

2. Malaysia Corporatisation Policy (1984) is an action plan for the country’s economic

development and privatisation is one of its strategies. State the objectives and forms

of privatisation in this country. Give comments on its achievement in the real estate

development sector.

3. State the main objectives in development appraisal. Explain how the probability

analysis and simulation can improve decision-making techniques in development

appraisal.

180

4. What are the main objectives of investment appraisal? Suggest the benefits of

alternative techniques in investment appraisal.

5. “Cost benefit analysis is an economic analysis that aims to evaluate projects based on

their benefits and cost”. Discuss.

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CHAPTER 5: FINANCIAL RESOURCES FOR PUBLIC AND PRIVATE SECTORS

In the development of a country that practices an open system like Malaysia, the

integrated role of the public and private sector is important. Through these both sectors,

the country’s development and advancement can be achieved. The public sector which

consists of the Central Government, State Government and the Local Authorities need to

outline a solid and careful development policy to execute the planned development. The

private sector which consists of private or individually owned firms and the corporate

sector from either local or overseas need to take necessary steps to execute the policies

outlined by the authorities. With the consolidation in job methods and policies between

both sectors, the development of the country can be achieved.

Both sectors need to have specific financial resources to finance the development

projects.

Federal Government Financial Resources

The Federal Government financial situation is expected to improve further and strengthen

in 2006, because of a more favourable economic outlook, particularly greater private

activities. The government’s fiscal policy will continue to stress on efficiency and

effectiveness in its financial management.

The total budget allocation for 2006 amounted to RM134,748 million and based on a

projected revenue growth of 9.2% or RM115,561 million, the Federal Government

financial position is expected to further improve, with the overall deficit decreasing to

RM18,443 million or 3.5% of the Gross Domestic Product (GDP) in 2006. In contrast,

the consolidated public sector fiscal situation is envisaged to show a large surplus of

RM53,184 million or 10% of the GDP. The situation is shown in Table 5.1 below.

182

Table 5.1: Consolidated Public Sector Financial Position (2004-2006)

2004

RM million

2005

RM million

2006

RM million

Current Account

Government Sector

Revenue

Operating Expenditure

NFPEs current surplus

Public Sector current balance

116,328

101,649

81,875

96,654

122,663

108,475

100,120

114,308

135,305

112,471

100712

123,546

Development Account

Development Expenditure

General Government

NFPEs

Overall balance

% on GDP

56,716

32,083

24,633

39,838

8.9

70,839

31,437

39,402

43,469

8.9

70,362

39,429

30,933

53,184

10.0

Source: Economic Report (2005/2006)

Federal Government Financial Resources

There are a number of important sources of revenue for the Federal Government as listed

below:

1. Direct taxes

2. Indirect taxes

3. Non-tax revenues

4. Receipt of non-revenues

5. Loan

183

An example of revenues from taxes and non-taxes is shown in Table 5.2 below.

Table 5.2: Federal Government Revenue (2004-2006)

Revenues 2004

Million

%

of

GDP

2005

Million

%

of

GDP

2006

Million

%

of

GDP

i. Direct Taxes

ii. Indirect Taxes

A. Total Tax

Revenues

B. Total Non-Tax

Revenues

C. Total Revenues

RM48,703

RM23,347

RM72,050

RM27,347

RM99,397 22.1

RM48,345

RM26,990

RM75,335

RM30,521

RM105,586 21.7

RM52,008

RM28,417

RM80,425

RM35,136

RM115,561 21.8

Source: Economic Report (2005/2006)

Direct Taxes

Direct taxes consist of:

1. Income tax

This tax is imposed on individuals and partnerships. This tax is also received from

companies. Petroleum income tax is also included under this category. For company

taxes, the petroleum companies’ income tax is not included.

2. Share transfer tax

This tax is imposed on transferred shares. It was introduced in the 1985 budget.

184

3. Petroleum Royalty

Petroleum Royalty is received by the Federal Government from oil rig companies and

oil production companies.

4. Gas Royalty

This royalty is received from projects related to natural liquid gas production and

projects in Bintulu, Sarawak.

5. Estate Duty

This duty is imposed on the dead willed estate. This duty is only imposed when the

ownership of the estate is transferred.

6. Real Property Gains Tax

This tax is imposed on capital gains obtained from sale of property. For private

individuals, this tax is only imposed for gains from disposal made within five years

from the date of purchase.

Indirect Taxes

Indirect Taxes can be divided into:

1. Import duty

185

This tax is the receipt from the country’s total import such as raw materials,

components, machineries and equipments, passenger vehicles, alcohol, cigarettes and

clothes. The increase in import rate on these goods causes the increase in excise duty

revenues, where the goods are produced in the country and subject to excise duty.

2. Road tax

This tax is imposed especially on individual passenger vehicles according to their

engine power in terms of centimetre cubic horsepower.

3. Service tax

Service tax is the receipt of tax imposed on the hotel industry, restaurants and tourism

industry.

4. Export duty

This duty is received from the export of rubber, tin ore, palm oil, timber and

petroleum. The increase in the price of rubber and other goods including the increase

of rubber export will also contribute to an increase of indirect tax to the Federal

Government.

5. Excise duty

This duty is received from duty imposed by Customs.

6. Stamp duty

This duty is imposed on transferred assets either in the form of land and buildings or

shares.

186

Non-tax revenues

Non-tax revenues consist of:

1. Collection from payment for licence and permit

2. Rental from government assets

3. Service payment such as assessment imposed on facilities provided within the Local

Council area like street lights and others

4. Income from investments

5. Collection from fines and confiscation

6. Petronas dividends and Bank Negara Malaysia profits

7. Receipt, expenditure returns from Government agencies and revenues from Federal

Territory.

Non-revenue receipts

Non-revenue receipts include the following:

a. Return from expenditures

b. Receipt from Government agencies

c. Revenues from the Federal Territory

Loans

Loans can be divided into three, which are:

187

1. Gross domestic loans

This loan consists of government guarantee letters, 21 year guarantee letter at 8.6%

interest rate and 15 year guarantee letter at 8% interest rate, treasury bills and

investment certificates.

2. Gross overseas loan

This loan consists of market loan, project loan and return payment of International

Monetary Fund (IMF) facilities.

3. Market loan

Two loans that can be obtained from the international finance market is Swiss Bank

loan with a 10 year maturity period and interest rate of 5.82%. The second loan is

Yen loan for 10 years with an interest rate of 28.1% from the total overseas loan

expected to be received from the project loan. These loans can come from two-way

sources and financial institutions such as the World Bank and Asia Development

Bank.

Federal Government Expenditure

Expenditure at the Federal Government level consists of:

1. Operating expenditure

Operating expenditure is the largest expenses in the Federal Government expenditure.

There is always an annual increase in the operating expenditure. This is because of

the need to increase the operating expenditure of government agencies. A case in

point is the need for civil servant salary review. The obvious increase in the operating

expenditure is from pensions and gratuities, management expenses of primary and

secondary schools and return payment (Refer Table 5.3).

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Table 5.3: Federal Government Operating Expenditure (RM millions)

Operating Expenditure

2004 2005 2006

Emolument 23,779 23,137 23,587

Debt Service Charges 10,920 13,300 12,726

Grants to state

government

2,895 3,089 2,651

Pensions and gratuities 6,060 6,227 6,633

Supplies and services 16,663 19,286 20,554

Subsidies 5,796 11,833 11,022

Grants to statutory bodies 6,653 8,212 8,611

Refunds and write-offs 5,023 322 357

Others 13,539 12,838 15,105

Total 91,298 98,244 101,246

% of GDP 20.3 20.1 19.1

Source: Economic Report (2005/2006)

a. Emolument

The schedule above shows the government has approved an emolument of

RM23,137 million in the year 2005 . The emolument expenses has increased by

as much as 1.9% to RM23,587 in 2006. Slightly more than half of the emolument

189

is for salaries of teachers, doctors and nurses whose term and conditions of

service have been improved with better incentives and higher allowances.

b. Debt Service Charges

Debt Service Charges is expected to be higher, totalling RM13,300 million in

2005 and RM12,726 in 2006 which are 13.5% and 12.6% of total operating

expenditure respectively. Of the total debt service charges, approximately 85% is

for domestic debt.

c. Supplies and services

For supplies and services, the second largest component, they have increased by

6.6% to RM20,554 million between 2005 and 2006, mainly for maintenance and

repairs, rentals as well as payments for professional services.

d. Pensions and gratuities expenditure

For the expenditure on pensions and gratuities, between 2004 and 2006 more than

RM 6 billion are spent every year.

e. Grants to state government

This category of expenditure shows an increase of 6.7% between 2004 and 2005

and a drop by 14.2% between 2005 and 2006. The expenditure is mainly on road

maintenance and constitutes the largest component in the grants from the Federal

Government to the State Governments.

f. Subsidies

190

From this portion of operating expenditure also, there are expenses allocated for

subsidies. Some subsidies expenses are paddy price support subsidies, textbooks

subsidies and petroleum subsidies. The bulk of the increased expenditure in 2006

is for payment of subsidies, which accounts for 86.9% of the increase in total

operating expenditure. This follows a sharp escalation in world crude oil prices.

The increase in retail prices of petroleum products by 10 sen and 20 sen for petrol

and diesel respectively has helped the government to reduce subsidies by

approximately RM1 billion. Despite the gradual price adjustment of petroleum

products at the retail level, total subsidy payments remain high at RM11,833

million in 2005 an increase of 104.2% from the figure in 2004.

2. Expenditure according to sector

Expenditure according to sector is summarised in Table 5.4.

This comprises of the followings.

a. Social Services Sector which consists of health, education, housing and others.

b. Economics Service Sector is divided into agricultural and rural development,

public services, commercial, industrial, transportation, communication and others.

c. Security Sector is given specific attention for the country’s safety. The sector’s

expenses are divided into defence and internal state security.

d. General Administration Sector covers expenses for departmental services,

overseas services and return profits.

191

Table 5.4 : Federal Territory Development Expenditure (according to Sector)

Development Expenses 2004

(RM million)

Changes

in

%

2005

Revised

Budget

(RM million)

Changes

in

%

Economic services of which:

a. Agriculture and rural

development

b. Trade and industry

c. Transport

11,851

2,881

1,201

6,630

-14.0

77.8

-65.2

-9.8

14,097

2,537

1,743

7,442

19.0

-11.9

45.1

12.2

Social services of which:

a. Education and

training

b. Health

c. Housing

10,260

4,316

2,352

1,593

-42.1

-57.7

-12.3

-17.4

8,422

3,424

1,204

1,729

-17.9

-20.7

-48.8

8.5

Security

General administration

4,133

2,620

-31.4

43.6

4,782

3,210

15.7

22.5

Total

% of GDP

28,864

6.4

-26.7 30,511

6.3

5.7

Source: Economic Report (2005/2006)

Local Government Financial Resources

192

Local Government in the Peninsular Malaysia context means government in the urban

area, rural or combination of both of these areas and under the jurisdiction of the

respective Local Government.

The first Local Government established in this country is Pulau Pinang by the British in

the year 1800 and followed by Malacca in the year 1848. The next Local Government

was established in 1907 for the Federation of Malay States and Non-Federation of Malay

States.

After gaining independence, the development on Local Government took place where the

Federal Constitution placed the Local Government under the State Government while the

Federal Government has the right to give advice in order to achieve a comprehensive

development for the whole country.

The main function of the Local Government is in general to give as much municipality

services. The District Councils are responsible for rural areas while the Municipal

Councils for urban areas. The Local Government in Malaysia practise decentralisation

concept where power is transferred from the Central Government to the urban units.

Detailed Local Government Financial Resources

The local government financial resources consists of the followings:

1. Loan

Loan is one of the Local Authorities financial resources. Section 41 of the Local

Government Act 1976 has given permission to Local Authorities to borrow money

from the State Government, Federal Government or even other parties such as banks

with condition that approval has been obtained from the State Government. One of

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the conditions that need to be complied by the Local Authorities before making a loan

is that the total loan must not exceed 5 times the annual value from the valuation list.

2. The Issue of Permits and Licences

The revenue from charge collection imposed on issued license and permit is an

important resource for the Local Authorities. This is because the Local Authorities

have the power to issue specific licenses and permits for businesses. The issue of

these licenses and permits will involve payment of certain fees and provide revenues

to the Local Authorities.

3. Rental Payments

Rental payments are one of the sources of Local Authorities’ incomes. The Local

Authorities rent out their buildings or properties such as food emporium, shops, stalls,

hawkers lots, markets and others.

4. Rates

Rates or its common name assessment is a sum of payment towards fixed properties

that is imposed annually. The method used in determining the payment for rates is

based on a percentage from the Annual Value or the estimated gross rent per annum

for the property. Rates are the largest financial resources of Local Authorities

compared to other resources.

5. Contribution

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Contribution meant here is a sum of money contributed by the Federal Government or

the State Government for the financing of a development project within the Local

Government jurisdiction.

6. Mortgage

The Local Authorities can obtain their financial resources from mortgage or

collateral. The Local Authorities can mortgage or pledge their properties as collateral

to a bank or financial institution to obtain money for the financing of a development

project.

7. Service Payment

Payment for services is another form of financial resources for the Local Authorities.

Usually, the Local Authorities will provide public facilities and impose a certain

charge for those services. For example, the Local Authorities provide garbage

collection service, waste soil collection and others. Therefore, charges will be

imposed on those who use those services.

8. Compound and Fines

Compound or fines are imposed on offences committed or in conflict with the local

legislation stated by the Local Authorities. Examples of offences are parking at the

wrong place, littering, unkept home compound area and others. Hence, compound or

fines are imposed to those who disobey the law set by the Local Authorities.

9. Profits from Investments

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Sometimes, the local Authorities allocated a certain amount of money in its annual

budget for investment purpose. This money would be invested into sources or

activities that can give profitable return. Profits from this investment are financial

resource for the Local Authorities to finance future projects such as shop houses and

high-rise buildings.

10. Special Aid Contribution

In certain situations, the State Government will provide a sum of money to Local

Authorities as Special Aid contribution in order to assist the Local Authorities in

solving their financial problems. However, this special aid contribution is normally

provided when the State Government finds that the Local Authorities’ financial

resource is insufficient compared to their expenses.

11. Annual Grants

The Local Authorities also obtain their financial resources from Annual Grants given

by the Federal Government. This yearly grant which was introduced in early 1978 is a

form of financial aid from the Federal Government to the Local Authorities.

However, the giving out of Annual Grants is based on a number of requirements set

by the Federal Government.

12. Contribution in Aid for Rates

The Local Authorities is able to obtain its financial resources through Contribution in

Aid for Rates. It comes from rates imposed on assets belonging to the Federal

Government, State Government or Semi Government Bodies situated in the area of

jurisdiction of a Local Authority. The tax rate imposed is known as Contribution in

Aid for Rates. The Federal Government’s assets that are involved in this Contribution

in Aid for Rates are schools, investment, railways and others.

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The summary of a Local Council financial resources is shown in Table 5.5 below.

Table 5.5 : Summary of a Local Council’s Financial Resources

Financial Resources Examples of Related Items

1. Licence Business Licence

Industrial Licence

Hawkers Licence

Advertisement Licence

2. Direct tax Rates

3. Permit Banner permit

Hawker’s permit

Rubbish dumping permit

4. Services and Payment for

Services

Fees for Planning Plan Approval

Fees for New Building Approval

Fees for Change of Building Use

5. Earnings from Sales Sale of Tender Documents/Quotations

Sale of Maps

Sale of Goods/Auctions

6. Rental Rented Stalls

Rented Markets

Rented Office spaces

Rented Hawkers’ Sites

7. Interest and Earnings from

Investment

Current Account Interest

Fixed Deposit Interest

8. Compounds and Fines Hawkers’ Compound

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Building Compound

Parking Compound

9. Contributions and Payment

for Loss

Contribution/Donation

Insurance Claim

Payment for Loss/Compensation

10. Return from Expenditure Return from Expenditure on

Infrastructure

Return from Expenditure on Restoration

and Repair

Return from Expenditure on Finishes

11. Receipts from Government Equity Grants

Development Grants

Contribution in Aid for Rates

Local Government Expenditure

Based on the obtained financial resources, below is the list of the Local Government

expenses.

1. Management expenses such as salary payment, building and equipment maintenance,

travelling, professional services expenses and others.

2. Development expenses inclusive of infrastructure expenses and others for the purpose

of development. Among the expenses made for the purpose of development are:

a. The provision of infrastructure such as the construction of bus stops and map

booths.

b. The provision of sewage service for the people and maintenance of plant and

sewage system.

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c. Maintenance inclusive of cost of road repairs that needed to be done. The

expenses are also for construction of new roads based on the plans of the Planning

Department.

Table 5.6 provides an example of the revenues and expenditures of a Local Council.

Table 5.6 : Shah Alam City Council Revenues and Expenditures

REVENUES

Tax Revenues

Non-tax Revenues

Receipt from non-revenues

Total Revenue

2003 (RM)

124,880,466

30,130,843

7,743,033

162,754,342

2004 (RM)

126,801,872

38,037,821

11,118,524

175,958,217

EXPENSES

Emolument

Services and Supply

Asset

Imposed Fixed Payment

Other expenses

Total Expenses

Income Surplus/(Deficit)

Less:

Loss on Sales of Shares

Income Surplus/(Deficit) before

adjustment

25,200,562

98,355,589

17,420,928

638,192

326,423

194,170,924

(31,416,581)

(15,314,400)

(46,730,982)

9,302,485

24,359,480

18,347,430

207,450

40,380

56,185,535

7,233,036

-

7,233,036

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Plus:

Previous year adjustments

Income Surplus/(Deficit) in the year

1,473,192

(45,257,790)

(136,872)

7,096,164

Sources: Shah Alam City Council Report (2003/2004)

Local Authorities Financial Resources Problems

Although the Local Authorities have a number of financial resources to finance its

development projects, there are still several problems that need to be faced in order to

obtain those resources. Among the problems are as follows:

1. Problems in Arrears and Tax Evasion

Although the main financial resource for Local Authorities is from the collection of

rates and others, most of these taxes are not paid. This will result in arrears in taxes

that can affect the Local Authorities financial resources.

2. Investment losses

Sometimes the investments made by the Local Authorities bring losses. For example,

investment in the construction of shop houses that is not rented out or transacted if

there is an economic downturn.

3. Insufficient Allocation From the Federal and State Government

Not all allocation or contribution by both parties can fulfil the required expenses of

Local Authorities’ project. Due to the insufficient contribution made, the Local

Authorities will face problems in meeting the expenses for the ongoing projects.

4. Doubts from the Banks and Financial Institutions.

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In certain situations, the banks and financial institutions are not fully confident with

the Local Authorities’ capabilities to execute a development project. They may have

the perception that Local Authorities always suffer losses in their development

projects. This perception can also affect the Local Authorities financial resources.

Private Development Projects Financial Resources

The private sector needs sufficient financial resources to finance a project. The type of

financial resources depends on the project duration whether the interest is kept as an

investment, or sold to interested institutions.

In general, financial resources for private projects can be divided into two categories,

which are equity funds or debt funds.

The form of funding is the same for private companies or others. The structure on the

equity or debt fund is shown in the following graph in Figure 5.1.

Indicators:

A: 100% equity base

C

A

0

Debt/equity fund (%)

Time

BD

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B: Debt fund begins until project completes

C: Project completes

D: Debt is finally cleared

Figure 5.1: Equity/Debt fund Structure

At the start of the project, the private party has obtained financial resources for the

ongoing project. This amount is the amount agreed between the developer and the private

institution as shown in the graph at point A.

When the project starts, the private party will start to use the fund to support funding

costs (point B) and this situation will continue until the construction completes (point C).

After “n” years, the developer will take some time to pay back the loan. This is proven

by the rising of the curve after “n” years even though the construction period and the

funding period are over. At “point D”, the return of investment has started and this

situation will enable the private party to start paying back the loan.

Equity Fund

Equity fund can represent a personal investment on the planned private project.

Sometimes the equity fund is known as “risky capital” because investors are assumed to

accept the risk (basis) if their business fails. However, they will also enjoy return and

interest if the project succeeds.

At the start of the project, equity fund is considered cheaper than external loans from

financial institution. This equity consists of the sale of ordinary shares and preference

shares.

To encourage participation from outsiders (other than ordinary shareholders), private

developers can invite banks and contractors to invest in both types of shares. This

instrument can be structured to gain the following benefits:

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1. Sufficient and fixed return can be gained by both parties namely the contractors and

financial institutions.

2. An “exit tool” can be provided where there is a possibility for investment liquidation

through sale in the open market or sale and leaseback by the owner when the project

completes.

3. To provide a share from the contract total amount to the contractors

This equity fund has a number of advantages. It facilitates the private sector in reducing

original cash expenses and thus reduce loans, reduce cost of funds, obtain contractors

commitment, and ensure that the job in the contract is completed according to the original

agreement.

Debt fund

Debt fund involves the resources from borrowings and then paid back at an interest rate.

The borrowed capital allows developers to maintain full ownership of that project. There

is a variety of credit options based on the credit characteristics.

Thus by understanding the different types of debt fund resources (commercial and

government loan) and their characteristics, the developers are able to increase their

chances of obtaining a loan at an optimum cost.

The sources of debt fund resources are debt security; commercial banks, merchant banks

and local and overseas financial institutions; insurance companies and also the

government.

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Debt Security

Normally, this type of security is in the form of loan stocks that is transferable, gives a

fixed interest rate, and thus gives the option to the investors to switch their investment

into equity.

Commercial Banks, Merchant Banks and Local and Overseas Financial Institutions

These banks and financial institutions are at the centre of the financial market and offers

different types of loans and credit facilities. The periods of the loans are as follows:

1. Long-term loan

There are several types of long-term loans , for example loans exceeding 10 years,

debentures and mortgages for 20-25 years for freeholds and long term leasehold

(95-120 years) and through sales and leaseback. The parties involved in offering

this type of loans consists of insurance companies, developer groups, property

sales unit, large property companies and other investors.

2. Medium-term loan

This loan is between 3 and 10 years.

3. Short-term loan

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This type of loan is between 1and 5 years. The source of this loan is Merchant

Banks.

Types of loans

Several types of loans are available to the private sector. They are as follows.

1. Bridging finance

In general, banks expect that private parties will mortgage their assets as collateral

to finance its development.

A financial institution or usually a group of banks under a syndicated loan

arrangement manages bridging finance.

Here, private parties will appoint a main manager (usually a Merchant Bank) to

pool certain funds by inviting other banks to participate and thereafter manage the

loan. This loan is a periodic loan with fixed instalments. Sometimes, overdraft

facilities offered can be reduced by redeeming ownership of sold units. In some

cases, to facilitate the initial problem of cash flow, half of the loan can be released

to the borrower at early stages of the development when situation permits.

The interest rate stated is the rate agreed on above the bank’s base lending rate.

Private parties should realise on the interest rate trend between banks (given by

the Merchant Bank) that contradicts with the commercial banks’ base lending rate

and then continue to choose a two-way strategy that gives both benefits.

2. End-financing

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This type of financing is easily obtained. For example, housing developers will try

to get the best deal from banks for their customers by arranging an end-financing

scheme.

Currently, the interest rate imposed on buyers is between 1.5% and 2.0% higher

that the banks’ base lending rate (between 6.75% and 10.0%). The loan duration

is 15 to 25 years. As collateral, banks need first fixed charge on the ownership,

loan agreement or deed of assignment.

Other Types of Financing

This can be in the form of joint ventures; turnkey contracts; issue of company shares;

debentures; overdrafts and leasing.

1. Joint ventures

For companies that have insufficient capital, they usually will search for

partners or joint ventures that have strong financial standing. By using

financial resources of the partnership, ongoing projects can be funded. Profits

from the projects are usually, divided equally or based on a percentage of

contribution between the partners. In Malaysia, private local companies often

practise this system with overseas companies.

Development can also be financed through joint ventures between:

a.Banks and developers

b. Two developers

c.Landowners and developers

d. Public bodies and developers

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Loose arrangements are simply an arrangement to cooperate in order to

achieve a common objective that takes the form of a single purpose vehicle, a

limited liability company established solely for carrying out the project and

which the joint venture partners have shares.

The advantages of joint ventures are:

i. To spread the risk among participating parties

ii. To enable the development of large projects

iii. To attract market knowledge and development expertise

iv. To secure sufficient development finance

The disadvantages of joint ventures are:

i. Control over the development project is dissipated

ii. Disposal of a particular interest in a partnership scheme is more difficult

iii. There may be double taxation

Before embarking into a joint venture, the parties will need to consider the

following:

i. Number of participants in the project

ii. Nature of the proposed scheme and the relative risks inherent in

development

iii. Time scale involved and the policy towards disposal or retention

iv. How the venture is to be financed and the desired mix of debt and equity

v. Responsibility for losses and limitation on liability

vi. Tax position of the respective parties

vii. Way in which profits are to be distributed

viii. Any relevant statutory legislation on joint ventures

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ix. Ability and ease of disposing of interest by the parties involved

x. Any special balance sheet requirements

2. Turnkey Contracts

The landowner will appoint a contractor fully responsible in completing the

project. This provides a single point responsibility so that in the event of a

building failure the contractor is solely responsible. The client’s interest is

safeguarded. The project will only be handed over to the client after the

project is completed. The fees imposed are according to the agreement made

before the project is executed. The nature of the contract tends to reduce

changes (variations) from the original design and disruption of the works is

less likely to occur, hence encouraging time and cost savings.

3. Sale of Company’s Shares

For large companies that have gained respect of many, company shares are issued

to the public. These companies normally gain profits from their business deals.

The money from the sale of the shares is used to finance their projects. The profits

obtained from their projects will be channelled to their shareholders in the form of

dividends or bonus. To date, many companies list their shares in the Bursa

Malaysia either on the Main Board or Second Board.

4. Debentures

Private developers can also obtain loans in the form of debentures that is

redeemable or non-redeemable, exchangeable or non-exchangeable, secured or

non-secured. This loan is for a certain period with interest payment at an annual

rate.

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5. Overdrafts (OD)

An overdraft is a credit agreement where banks allow the borrowers to manage

their current account into deficit to the approved amount.

An overdraft is a main short-term financial resource that is offered by the

commercial banks. The borrowers are free to mange it within the fixed overdraft

limit and repay as much as possible at anytime without any notice. Interest is

calculated on the daily loan balance and is usually paid every month or within an

agreed period.

6. Leasing

Leasing facilities provide an opportunity to use capital goods by paying a certain

amount of rents within a fixed period under a leasing contract.

There are two types of leasing, which are:

a. Direct leasing

Two parties are involved where a bank obtains the capital goods and lease

them to a company.

b. Leverage leasing

It is within a syndicated loan arrangement where a large amount of

financing is involved. Three parties are involved in this type of leasing

namely the company, equity participants and borrowers.

7. Forward sale and rental guarantees

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Two main options are available to a developer as follows:

a. Forward sales where the project is sold before any work has started.

b. Wait until construction has been completed and the buildings have been

fully let.

Most short-term financiers will look for a guarantee that there is an

arrangement with a long-term investor or a prospective owner-occupier to

“take out” their interest when the project is completed and often occupied.

8. Sales and leaseback

This arrangement involves a developer selling the freehold interest and the

investor taking back a long lease at a rent that equates to the initial yield reflected

in the selling price. The developer sublets the property at a higher rent paid to the

investor thus creating an immediate profit rent.

Insurance Company

In Malaysia, insurance companies are not actively involved in providing finance to

the private sector due to restrictive legislation that allows investment in approved

assets only. Therefore, their participation is limited to syndicated loans only.

Government

In a high risk construction industry, the types of support that are offered by the

Government are as follows:

210

1. Soft loan that is a loan with low interest rate and reasonably long repayment

period.

2. To determine that the foreign exchange rate is secure to avoid fluctuations in

foreign exchange.

3. To ensure a secure traffic flow such as toll collection that constitutes a part of

the financing resources; and

4. As a guarantor to borrowers (private sector) by imposing a tax rate that

supports the project.

Other Resources

Other financing resources in the private sector are institutions of Social Security,

Foreign Government and the World Bank.

Risks

The risks involved in the development of private projects consist of risks of rising interest

rate, fluctuations in foreign exchange, price increase, construction delay, and receiving

financing resource delay and changes in tax legislation.

Below are some of the problems faced by the private sector in obtaining financial

resources:

1. High interest on loan

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The bank and other financial institutions will impose an interest rate on the loan given

to the private sector. Although the current interest rate has gone down to 8% - 10%

and is much lower compared to the past, the private sector still feel that the rate is still

at a high level.

2. No Direct Government Aid

If the Local Authorities obtain government aid in its financial resources, the private

sector however does not have any direct aid from the government. This closes one of

the financial options for the private sector.

3. Government’s policy

Sometimes the policy determined by the government affects the financing resources.

For example, a high tax policy such as income tax, real property gains tax and stamp

duty causes the source of income or financial resources of the private sector to be

affected, and this will probably affect ongoing projects. This is because a large

amount of money is needed to pay the imposed tax rate.

4. Lack of Confidence on Shares Issued

Company shares that are sold to the public are one of the financial resources for the

private sector. However, sometimes the company’s profile causes the public to lose

confidence in the company. This will hinder the public from purchasing the shares

and thus will affect the company’s financial resources and the planned or ongoing

development projects.

A slow economy can seriously affect the private sector financial resources. Economic

depression will cause a poor return in investment, less opportunities to apply for a

loan, an increase in the cost of construction materials and others. All these can create

problems for the private sector in obtaining its financial resources.

212

5. Deprecation in Property Value

Land value also plays a role in the efforts made in loan application through mortgage

or collateral to the bank or other financial institutions. If the market value of

properties depreciates, the total amount that can be loaned by the bank to the private

sector will also decrease according to the total value of the mortgaged properties. This

situation will affect the private sector’s financial resources for their projects.

6. High Risk Assumptions

Before banks and other financial institutions give out loans, they need to know the

type of project planned out. If it is in their opinion or assumption that the project

carries a high risk to its developer, they will not give the loan or give a small amount

of loan. This is because they are worried that the loan may not be repaid. The

assumption and opinion of the bank will affect the private sector financial resources.

It is felt that there are several solutions to the problems faced by both these sectors.

For the Local Authorities, the proposed solutions for their problems are as follows:

a. To impose a strict action against those that have not paid their tax arrears and

those who try to evade the tax.

b. To ensure that only profitable investments are invested into and to prevent

investments that fail to consider other factors such as loan interest, economic

situation and others.

c. To urge the Federal Government and the State Government to provide sufficient

financial allocation.

213

d. To convince the bank on the future potential customers from the ongoing project

to facilitate the loan application.

e. To review drafted legislations that give negative effects to Local Authorities.

For the private sector, the proposed solutions for the problems are as follows:

a. To urge the Government to decrease the interest rate on loans.

b. To request that the Government provide financial assistance to the private

companies facing financial problems.

c. To look after the company’s image and performance when it is necessary to

convince the public to purchase the company’s shares.

d. To urge the Government to review the high tax rate to a lower level.

e. To convince the bank by giving an impression that the planned project is

profitable to facilitate obtaining the financial loans.

The suggestions could help overcome the problems faced by the Local Authorities and

private sector in obtaining their financial resources for their development projects.

TUTORIAL QUESTIONS

1. List down all the Federal Government or the State Government financial

resources. Explain how these financial resources are spent.

2. “The role of Financial Institutions in the developemt of central areas in Malaysia

is quite encouraging recently.” Discuss.

214

3. Explain the Local Government financial resources that you have studied and state

the problems faced in obtaining those resources.

4. Give comments on the types of equity financing and explain the speciality of this

form of financing.

5. What is meant by “debt financing”? State those financial resources and the

facilities offered by financial institutions in this country.

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CHAPTER 6: REAL ESTATE INVESTMENT AND MARKET

Investment is the giving up of a capital sum in the hope for a profitable return in the

future whether in the form of rent, interest, dividend, bonus, increase in value and others.

An investor would consider the security of capital and the return expected from the

investment. Other qualities that would be considered are liquidity of capital, security of

income from the aspect of stability in the purchasing power and the prospect of capital

appreciation.

In general, two main investment vehicles exist in the market. These investment vehicles

are:

1. Security (equity shares and fixed income securities)

2. Real estate or property

Security investment is the main investment vehicle that offers various types of shares and

stocks investment from fixed income securities such as stocks and debentures that are

low-risk to high-risk equity stocks.

Stocks and shares that are offered represent various sectors of the economy such as

manufacturing, agriculture, mining, finance, trade and real estate. Besides direct security

investment, investors can also invest in unit trust where a large amount of the investors’

fund is invested into main stocks and other investments.

Real Estate Investment

216

The availability of real estate investment is limited compared to other investments but the

capital and income are more secure. Moreover, real estate investment offers the prospect

of capital appreciation.

Real estate also has its own special characteristics that are not available in the other

alternative types of investment. These characteristics are:

1. The supply of land is limited.

2. Land is man’s basic need for any type of activity.

3. Real estate ownership brings pride and status to its owners.

4. Real estate is physically durable with low rate of depreciation.

5. The site on which the property sits cannot decay, be destroyed or stolen. On the

contrary, its value will appreciate through time and it can be a good hedge against

inflation.

6. A property is unique and different from other properties in terms of location,

design, area, structural condition and others.

7. In general, a real estate investment has a more stable performance compared to

other types of investment.

8. Large amount of capital is usually required in a real estate investment.

9. Generally, a real investment cannot be easily divided into smaller units. However,

smaller divisions of ownership can be made possible through the purchase of

investment units in Real Estate Investment Trusts as will be discussed later in this

chapter.

217

Real Estate Market

Real estate or property market is a collection of all real estate transactions in the country.

However, in general, it is an imperfect market compared to other investment markets due

to the following:

1. Property market does not have a central institution similar to the share market

such as the Bursa Malaysia and it does not exist physically.

2. Property market needs real estate experts such as agents and property consultants

for sale and purchase transactions and giving professional advice to reduce

imperfect knowledge.

3. Property market is complex due to the different objectives and intentions of

investors in different property transactions.

4. Transfers of ownership in property market are time consuming and costly

involving among others legal fees, stamp duty and real property gains tax. On the

contrary, transfers of ownership in general investment market does not take a long

time and are not costly.

5. The property market is unique and this would create some problems to the

investor. With the exception of property unit trusts, property cannot be bought in

smaller units. This is different from investment in stocks and shares.

Determining Property Value in the Perfect Market

218

Economists verify that the market price of a property reflects its economic value. The

economic value of land is determined by three factors, which are utility, scarcity and

proof of ownership. The open market value or the land value depends on the demand for

and supply of the land. The interaction between these two factors determines the property

market price.

Firstly, the concept of market value is explained here. Economists confirm that the

economic value of property is the same with its market value. Therefore, its economic

value is influenced by supply and demand and the value is not fixed. There will be

changes in value if there are changes in supply or demand.

The market value is the expected price by an individual in a particular market situation.

This value is sometimes defined as the most probable selling price. However, explanation

on the meaning of a definition must be based on certain assumptions as follows:

1. A market where competition exists that is there are more than one buyer and seller

dealing in the market

2. Perfect knowledge

3. Rational behaviour from both buyers and sellers

4. Normal selling market situation (not forced selling)

5. Open market situation

6. Normal financing situation

Therefore, the meaning of the concept of market value is the most probable selling price

that is agreed between a buyer and a seller in a normal market situation.

219

Complications Faced in the Perfect Market

The process of adjusting the market price to an equilibrium situation (where the demand

is equal to supply) has a number of complications. This would lead to the difficulty of

reaching market price in the property market. Factors that can cause an imperfect market

are:

1. Imperfect knowledge on the market where the seller and buyer do not realise the

price and quantity offered or the price that other buyers can afford to pay.

2. The influence of Government’s policy that is demand can be influenced by

government’s policy namely, actions or policies that can cause an increase in the

demand for property such as:

a. Subsidisation where the interest rate through tax policy are exempted from tax

b. Reduction in stamp duties and quit rent

c. Provision of housing loan facilities

Properties transacted in the market will reflect the changes in supply and demand

influenced by the Government’s policies.

3. Social factors, for example the land value of Malay reserve land is lower

compared to other areas, and this will influence the demand for property in this

area.

4. Market movements in response to changes in supply and demand: Real estate is

fixed economic goods. Its supply cannot be increased in the short term. As

indicated in Figure 6.1, there would be a price increase if there were any changes

in the demand for a particular type of property.

220

Price

Figure 6.1 : Price increase with demand increase

5. Legal restrictions such as ownership restrictions and transfer of ownership.

Real Estate Investment Trusts (REITs)

A REIT is a company that buys, develops, manages and sells real estate assets. REITs

allow participants to invest in a professionally managed portfolio of real estate properties.

It also qualifies as pass-through entities, enabling companies to distribute the majority of

income cash flows to investors without taxation at the corporate level (providing that

certain conditions are met). As pass-through entities, whose main function is to pass

profits on to investors, a REIT's business activities are generally restricted to generation

of property rental income. Another major advantage of REIT investment is its liquidity

(ease of liquidation of assets into cash), as compared to traditional private real estate

Supply Curve (Zero elasticity)

Quantity

221

ownership which are not very easy to liquidate. One reason for the liquid nature of REIT

investments is that its shares are primarily traded on major exchanges, making it easier to

buy and sell REIT assets/shares than to buy and sell properties in private markets.

Investing in REITs

Both foreign and domestic capital sources provide investment in the REIT market.

Thousands of individuals, as well as large institutional investors including pension funds,

endowment funds, insurance companies, bank trust departments and mutual funds own

REITs. The investment goals for REIT share ownership are much the same as investment

in other stocks. For example, in the investment, current income distributions and long-

term appreciation potential are considered.

The majority of REIT shares can be purchased on the major stock exchanges, and orders

can be placed through stockbrokers. Financial planners and investment advisors can help

to match an investor's objectives with individual REIT investment.

REITs also provide an annual report, prospectus and other financial information directly

to an investor. Recently, mutual funds have emerged specializing in REIT investment and

diversification.

Some of the key elements in evaluating a REIT include:

1. Management

As with any business, a key to successful performance lies with the expertise of

management. However difficult for the individual investor, a couple of indicators

used to assess a REITs’ value are its management's amount of experience as well

as the length of time the management team has worked together. If a REIT has

recently booked a new source of funds, it can be inferred that the institution

providing the capital feels comfortable with the strengths and strategies of the

REIT's management.

222

2. Capital Sources

Because REITs are, by definition, obligated to distribute 90% of their taxable

income to investors, they must rely upon external funding as their key source of

capital. Investors must consider a REITs potential for future success, assessing

whether individual REITs have the access to debt or equity capital sufficient to

fund their future growth plans. REITs that have the ability to properly leverage

themselves usually will deliver superior returns.

3. Earnings

Net income under generally accepted accounting principles assumes that the value

of assets diminishes predictably over time. However, real estate values tend to rise

and fall with current market conditions. Funds From Operations (FFO) was

adopted to address the problems with valuation and performance by excluding

historical depreciation costs from the net income figure.

FFO has become the industry’s wide performance standard for REIT operating

performance, but other factors should be considered when evaluating a REIT's

overall performance. For instance, if a REIT has a portfolio which includes older

properties, its higher capital expenditure needs make its FFO value misleading to

investors. Many professional REIT investors calculate cash flow after capital

items (known as Cash Available for Distribution or CAD) as another measure of a

REIT's performance. In addition, investors must also be familiar with the REIT

dividend payout ratio as a measure of sustainability of dividends.

Types of REITs

REITs fall into three broad categories:

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a. Equity REITs

Equity REITs invest in and own properties, thus responsible for the equity or

value of their real estate assets. Their revenues come principally from their

properties' rents.

b. Mortgage REITs

Mortgage REITs deal in investment and ownership of property mortgages. These

REITs loan money for mortgages to owners of real estate, or invest in (purchase)

existing mortgages or mortgage backed securities. Their revenues are generated

primarily by the interest that they earn on the mortgage loans.

c. Hybrid REITs

Hybrid REITs combine the investment strategies of Equity REITs and Mortgage

REITs by investing in both properties and mortgages.

Individual REITs are able to distinguish themselves by specialisation. REITs may focus

their investments geographically (by region, state, or metropolitan area), or in property

types (such as retail properties, industrial facilities, office buildings, apartments or

healthcare facilities). Certain REITs choose a broader focus, investing in a variety of

types of property and mortgage assets across a wider spectrum of locations.

Benefits of REITs

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In general, REITs and their performance have some common characteristics with small-

cap stocks and bond-like investments. However, REITs have advantages over stocks and

bonds in terms of dividends. The long-term performance of an individual REIT is

determined by the value of its real estate assets at any given time. One of the primary

incentives for REIT investment is the low correlation of its value to that of other financial

assets. Because of this, REITs possess low relative historical volatility and provide some

degree of inflation protection. In addition to the advantages of an investment which

avoids double taxation and requires no minimum investment, REITs offer investors

current income that is usually stable and often provides an attractive return. Another

factor attractive to the investor is that independent directors of the REIT, analysts,

auditors, and the business and financial media monitor a REIT’s performance on a

regular basis.

Planning Concept

It is important to understand the concept of town planning as it has some implications on

investments and real estate market.

Planning is a process executed for obtaining an optimum result or benefit. Town planning

is executed through development control of an area that ranges from physical, land use

and surroundings for its inhabitants and their needs. Other factors include economic

factors and management of resources. Planning plays an important role in determining

the success and the development process of a city or the property market. The

government is directly involved in executing this plan.

In coming up with a plan, firstly, the government would undertake a study and research

on an area that would be developed. A structure plan is prepared for developing that area

and suggestions will be made on the execution of work. Subsequently, the local plan will

be executed after considering various aspects, conditions and objections from all parties.

The execution of a local plan is the result of cooperation from various government

departments. All respective departments have specific tasks and responsibilities in

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executing the local plan. The Town and Country Planning Act 1976 is the act directly

involved in regulating the planning aspects on land use matters.

The Development Plan System

Planning involves the preparation of improvement scheme system, which is the planned

development system from the aspect of shape, content and procedure. The development

scheme is divided into two main phases, the Structure Plan and the Local Plan, which are

closely related to each other.

1. Structure Plan

It is a wide working outline for local plans. It covers policies that have been

identified by the government in developing the country, which provides a

comprehensive basis for the overall planning system. A structure plan is therefore,

an overall plan or policy statement and suggestion which concerns with the

development and land use of an area. These involve social, economics, physical

and environmental aspects of a local authority. It indicates to the State Authority

and the society on the Local Planning Authority’s development and land use plan

for the next 5 to 20 years.

In general, the themes contained in most Structure Plans include the following:

a. Equality principles

b. The situation of existing main cities

c. Development control (such as zoning, density and green belt area)

d. Status or standard of office development or shopping complex

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e. Compromising strategy

2. Local Plan

It is a map with written statements showing all the detailed plans of a Local

Planning Authority for the land development in the local authority area. For

example, the plan may contain the steps in improving the physical environment,

communication and traffic management. In the preparation of the local plan, the

structure plan provides the framework or guideline in the form of policy

statements.

The emphasis of the local plan is to provide an explanation of the objectives of

the Local Planning Authorities to the public on how their properties would be

affected by the planning activities and informing developers on opportunities that

can be gained. The planning components of the Local Plan can be explained in the

layout plan map.

The Implications of Development Plan on Investment and Real Estate Market

Development Plan Policy plays an important role in determining the success of an

investment and thus responsible towards the development of the property market. Each

plan that is successfully implemented would ensure the success of the government

towards improving the people’s standard of living in a country.

In summary, the implications of the structure plan theme are as follows:

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1. Equality principles can be used to solve problems in a declining economy and

controlling development in an established city centre. Here, positive

discrimination is used to:

a. Increase job opportunities

b. Facilitate planning permission if there is an investment

c. Provide initiatives and subsidies in creating job opportunities

2. Development Control Policy can control the growth of low-density development

in rural areas. The purpose for this control is to prevent the emergence of too

many new centres that will compete with existing city centres. This is to ensure

that future investments in established city centres can be retained.

3. The following development control in general affect the demand for properties.

a. Zoning

Urban planning needs a comprehensive layout of land use so that an

organised and systematic area can be created .Good land allocations through

zoning can bring changes in development of an area. Zoning is the division

of land into several areas according to its use. Land in an area can be

divided into agriculture, industrial, manufacturing, residential and

commercial land uses.

Division according to land use will directly affect the market of the land

depending on the zone to which the land is designated. For example, an

agricultural land that has later been zoned as an industrial area will

experience an increase in value to the level of value of existing industrial

area in the market.

b. Population Density Control

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The control of population density in a developing area intends to avoid over

supply of certain types of property in the area. This is imposed during the

construction of development projects where the planning authority limits the

number of houses that can be built in that area. If such a restriction is not

made, housing developers will build more houses to gain extra profits and

when this happens, an oversupply of houses will indirectly decrease its

value. This step to determine the limit of population density is one of the

best ways to control the price from declining sharply in the market.

c. Development Approval

For commercial buildings, the local planning authority can control the

supply by limiting development approvals. The purpose of this control is to

ensure that there would be no oversupply of retail and office spaces in the

market. If this is not done, developers may build high-rise commercial

buildings as they please. Oversupply of commercial spaces will indirectly

decrease the rental value if the supply of commercial spaces exceeds its

demand. The issue of supply and demand is initially studied before the land

use planning of an area is undertaken. This will depend on the prospect for

future development schemes. From another point of view, value will

increase if developers offer limited spaces. Through plot ratio, the supply of

commercial spaces can be controlled by the government.

The Negative Effects of Planning on Real Estate Investment

Planning may also bring negative effects on real estate investment. Planners should also

take into account of aspects of planning that can cause these outcomes. Some of the

planning that need to be considered carefully are as follows.

1. Malay Reserve Land

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In the beginning, this form of control was introduced to avoid land belonging to

the Malays to fall to foreign investors. However, it may bring negative effect on

the country’s development, as development may not take place due to lack of

capital and the attitude of some of the owners themselves of not wanting

development. The Malay Reserve Land will continue to be ignored if the

government does not take any positive action to promote development in that

area.

2. Express condition

In a land ownership title, an express condition may be stated by the government.

Originally, its purpose was to prevent real estate owners from undertaking

activities as they please on their land. The government as the original owner has

plans on the land and this may become an obstacle for any development for the

area. For example, a piece of land with development potential may have been

allocated for agriculture, and thus cannot be developed as there is an express

condition that prohibits development on the land. However, development can still

take place by application to change the condition but this can be a long process

and some are not approved. This is the reason behind the failure to develop due

the existence of strict express condition.

3. Temporary Occupation Land

Temporary occupation land is difficult to develop because development on the

land is not approved although there is development potential. The government

can acquire the land as and when it is needed. Therefore, no development can

take place although there are many interested investors to develop that area.

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Government Intervention in Real Estate Market

Listed below are actions by the government that can assist in the development of the

property sector.

Housing Sector

In the housing sector, the government can facilitate the processing of application for

conversion of land use from agriculture to residential use. In the execution of a

development, the government also has to be involved in the following matters:

1. To specify the population density rate in an area with the intention that all public

amenities are channelled properly and sufficiently into the area.

2. To determine the quota of ownership to people of low income bracket to ensure

that they are given opportunities to home ownership.

3. To ensure that the people will benefit from infrastructure facilities. The

government can only approve development that provides sufficient infrastructure.

4. To provide loan facilities to developers so that development can be undertaken by

them.

Retail Sector

The government introduces the following course of action to encourage more investment

in the retail sector.

1. To determine that each housing project has an allocated area for retail activities.

2. To have capital loan scheme for Bumiputera traders or purchasers of retail

properties.

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3. To provide encouragement and training to the traders to develop their

entrepreneurship skills and expand their business.

4. To offer a fair loan rate of interest so that they can compete with foreigners.

Office Sector

The government can provide assistance in improving investment in the office sector

through the following.

1. To restrict the development growth of office spaces for a certain period. This can

maintain the rental value and prevent excessive supply of office spaces.

2. To protect property value by opening up investment opportunities in business.

When the economy picks up, the investors are able to pay rent and eventually own

the property.

Industrial Sector

In the industrial sector, the government has introduced certain initiatives to encourage its

development. Among the initiatives are :

1. To award pioneer status where tax exemption is given to new industries in a

particular new field. This will encourage foreign investment and the transfer of

new technologies from overseas to the country.

2. To designate free trade zones such as the one in Shah Alam to encourage

investment in the industrial sector.

3. To provide all infrastructures in the industrial areas to attract the interest of

investors into these areas.

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4. To provide a well planned and complete highway system so that investors are able

to transport their goods for distribution easily.

5. To allocate industrial sites near the country’s entry and exit points in proximity to

ports or airports to facilitate the import and export of goods.

It is clear that planning brings benefits and smoothes the operation of the property

market. However, several aspects pertaining to imperfection of the property market and

land use planning need to be understood so that all forms of investment in the property

market can be undertaken smoothly. These need to be given serious consideration so that

the country’s economic development will continue to prosper in accordance with the

nation’s aspiration.

TUTORIAL QUESTIONS

1. State the difference between property market and stock market. What are the factors

that cause the imperfections of the property market?

2. “Planning has brought positive effects on the land value and the smoothness of

operation of the property market”. Discuss

3. Present a complete report on factors that influence the Current and Future Rental

Value for residential and commercial properties in this country.

4. With reference to relevant economic principles, discuss the need of Government

intervention in the development of the property sector especially in the housing

industry.

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