What do we know about the causes of regional growth? Part 2: Demand models ECON 4480 State and Local Economies 1

Demand models The neoclassical model focused exclusively on supply-side characteristics such as capital, labor, and technical change. The model ignores completely the role of demand side of the economy. 2

Demand models This presentation introduces three demand- side models of regional growth: Export demand model, Cumulative causation model, and the External economies model. 3

Export Demand Models Models for export-related regional growth date back to the 1920s, with more development in the 1950s. Primarily focused on resource-rich regions in the northwest US. Capital and labor flowed into these regions to exploit the natural resource base. Transportation linkages with external markets developed, led by world demand for the natural resources. 4

Export Demand Models Central proposition: Initial growth stimulus for a number of regions can be traced to the exploitation of the region’s natural resources. Trade theory tells us that a region will specialize in the production and export of commodities that are relatively abundant. Capital and labor will flow into the region in order to exploit the abundant natural resource. The model sets out the determinants for both the demand and supply of a region’s exports. 5

Determinants of export demand The demand for a region’s exports (X d ) depends primarily on three items: The price of the region’s exports (P x ), The level of income in other regions (Y other ), and The price of substitute goods in external markets (P s ). Thus, the export demand equation: X d = f (P x,Y other,P s ) 6

Determinants of export supply The regional supply of exports (X s ) depends on: The price of the region’s exports (P x ), The region’s wage costs (W), The region’s raw material and input costs (C), and The state of technology (T). Thus, the export supply equation: X s = f (P x,W, C, T) 7

Export Demand Models When exports of the resource grow, the regional demand for inputs and factors of production rises. This causes wage rates and the rate of return to capital to rise in the region, creating incentives for the inflow of labor and capital. The region now grows faster than other regions. 8

Export Demand Models Exports produce a multiplier effect on regional output, and capital spending increases also. Labor inflow increases the demand for housing and retail goods and services. Suppliers to the exporting industries will grow, perhaps eventually developing additional markets and products. 9

Export Demand Models Over time, both supply and demand conditions may lose some steam: Rising regional production costs hurt competitiveness, and Customers may turn to suppliers in other regions. The region must improve competitiveness by increasing productivity and developing new products in order to access new markets. 10

Export Demand Model Summary The export demand model stresses the role of demand factors in regional growth without ignoring the supply side of the economy. The model has little to say about the role of internal growth factors such as entrepreneurship and local economic development policy. Big weakness: no explanation of the determinants of export demand. 11

2) Cumulative Causation Model Builds on the export base model and allows growth to become self-sustaining, or cumulative. Initial model by Nicholas Kaldor (1970). Elaboration and modifications by Dixon and Thirlwall (1975). 12

Cumulative Causation Model Kaldor- Regional growth depends on the ability to exploit economies of scale and gains from increased specialization. Economies of scale means being able to reduce production costs (per unit) by using larger scale of production, thereby increasing productivity. Specialization refers to producing fewer goods, but more efficiently. 13

Cumulative Causation Model Kaldor- Scale economies and specialization are much easier to achieve in regions that specialize in manufacturing than in land and resource-based industries (mining, agriculture). Manufacturing, or processing, based regions will grow faster than resource- based regions, and the process is self- reinforcing (cumulative). 14

Cumulative Causation Model Dixon and Thirlwall (1975) add a feature in which output growth feeds back on competitiveness. Growth spurs technical change and raises the capital/labor ratio. Consequently, labor productivity rises. Rising labor productivity improves competitiveness, pushing down export prices. Lower prices cause increased demand for the region’s exports. Higher exports feedback to regional output growth (diagram next slide). See Appendix for formal model. 15

Cumulative Causation Model 16 Regional Output Growth Growth of R&D, human capital Rate of technical progress Capital costs relative to labor costs Growth of the capital/labor ratio Growth of labor productivity Change in wages Change in price of substitutes Change in price of region’s exports Change in world income Growth of region’s exports Feedback loop

Cumulative Causation Model A simpler diagram: Productivity growth > Competitiveness > Higher exports > Higher output growth > more productivity growth, and so on. Result: cumulative growth. 17

Cumulative Causation Model Critical relationship: The connection from output growth (y) to productivity growth (q) is the important relationship, and is demonstrated by the Verdoorn Law: q = α + λy -1 α is autonomous productivity growth (the part that does not depend on output growth) λ is a constant known as the Verdoorn coefficient. This coefficient relates productivity growth to output growth, lagged one period. 18

Cumulative Causation Model Verdoorn’s argument: rapid output growth creates opportunities for greater specialization for both labor and industries. Greater specialization generates higher productivity. Criticism: The connection from output growth to productivity growth is very complex, and the Verdoorn Law oversimplifies the relationship. 19

Cumulative Causation Model Empirical evidence regarding the Verdoorn Law is sketchy and controversial. Some studies found evidence supporting the Verdoorn Law in the US and EU. A study of the EU estimates that the Verdoorn coefficient is about 0.5, indicating a very strong relationship. This means that a 1% increase in output growth will cause productivity to increase by 0.5%. 20

Tennessee Strong association between output growth and productivity growth. But which comes first? 21

Cumulative Causation Model Strengths and weaknesses of the model Three Weaknesses: Fails to specify the origin of regional specialization. How does a region initially acquire a specialization? Resource endowments? Assumes exports are the only source of regional growth. Productivity could increase due to increased regional trade or technical progress, not related to exports. Assumes a very complex relationship in a simple equation (Verdoorn Law), with debatable empirical support. 22

Cumulative Causation Model Strengths: Offers an explanation for how a region might achieve sustainable economic growth. Pulls together supply-side considerations (labor, capital, technical progress) with the demand side (export growth). 23

3) External Economies Model A third demand-oriented model is the External Economies model. ‘External economies’ refer to efficiencies gained that are ‘external’ to the firm. These efficiencies occur in the firm’s local environment. Two sources of external economies: Localization economies, and Agglomeration economies. 24

Localization Economies Localization economies result from the geographic concentration of plants in the same industry. Detroit Silicon Valley Country music Nearby plants can have input and output linkages with one another (forward and backward linkages). Close proximity minimizes transportation and assembly costs. 25

Localization Economies Three Factors that lead to clustering: 1) Individual plants can specialize more than they would if plants were widely dispersed. Specialization increases productivity, improves competitiveness. 2) Research and development is facilitated by the exchange of knowledge and ideas with nearby firms. Firms working together. Workers moving between firms. 26

Localization Economies Three Factors that lead to clustering: 3) Clustering of firms reduces risk for both workers and employers. Workers can change jobs without moving households; more willing to acquire industry-specific skills. Firms have lower training costs, lower costs of recruiting and retaining highly skilled workers. 27

Agglomeration Economies Geographic association of a large number of facilities and activities. May not be in the same industry. Facilities and activities may include: Urban transportation services. Cultural amenities and entertainment services. Specialized legal and financial services. Well-organized labor markets with large pools of workers with different types of skills. 28

External Economies Model Concentration of growth can create negative backwash effects: Growing regions attract capital at the expense of less developed regions. Growing regions attract skilled labor from other regions (Brain Drain). Rich regions tend to trade with other rich regions. Nearby poorer regions are passed by. Over time, poorer regions may be drawn into the growing economy. 29

External Economies Model Concentration of growth can create external diseconomies as well: Traffic congestion. Pollution. Higher wages and factor prices. Higher housing prices. External diseconomies may cause employers to seek other regions. 30

Summary These three models (export demand, cumulative causation, and external economies) give considerable attention to the demand side of the economy, an important element missing from the neoclassical supply-side model. 31

Summary The export demand (or export base) model shows how specializing in exports can generate a multiplier effect on local growth. Export demand takes into account both demand and supply (input costs, technology) considerations. However, little or no attention is given to internal factors that can cause growth such as the development of new firms and local policy. 32

Summary The cumulative causation model begins with export demand, but then links to productivity. Productivity growth is linked to output growth in Verdoorn’s law. The model explains how a region or state may achieve sustainable growth. But cumulative causation fails to explain how a region specializes and the other possible sources of productivity growth. 33

Summary The external economies model focuses on the economic environment external to a firm. The model points out the reasons for locating nearby other firms in terms of localization economies and agglomeration economies. According to this view, large growing regions will have increasing advantages over small regions simply due to the locally available inputs and expertise caused by size. 34

Appendix: Dixon-Thirlwall Model of Cumulative Growth Model consists of four equations. All variables are in growth rates (% per year): q = productivity growth rate y = output growth rate p = domestic rate of price growth (%) w = rate of growth of wages (proxy for production costs) P c = rate of growth of foreign prices Z = rate of growth of foreign income 35

Appendix: Dixon-Thirlwall Model of Cumulative Growth 1) q = α + λ y -1 (productivity growth equation) 2) p = w – q(domestic price growth equation) 3) x = -b o p + b 1 p c + b 2 z (export demand equation) 4) y = x(output growth equation) The terms λ, b o, b 1, and b 2 are parameters to be estimated. 36

Appendix: Dixon-Thirlwall Model of Cumulative Growth To solve for y, substitute equations 1, 2, and 3 into equation 4: y = -b o (w - α - λ y -1 ) + b 1 p c + b 2 z, or y = -b o (w - α ) + b 1 p c + b 2 z + b o λ y -1. Let A = -b o (w - α ) + b 1 p c + b 2 z and B= b o λ -1. Then y = A + B y -1 (equation 5) In other words, the current rate of growth of output depends on last year’s growth rate. 37

Appendix: Dixon-Thirlwall Model of Cumulative Growth Numeric example: Suppose parameters α=2, λ=0.5, and b o = b 1 = b 2 =1. And, variables P c =4, w=5, and z=2. Recall A = -b o (w - α ) + b 1 p c + b 2 z Then A = -1(5 - 2 ) + 1*4 + 1*2 = 3 Recall B = b o λ, then B = 1*0.5 = 0.5. So y = y -1 is the solution for the short-run rate of growth of output. What about the long-run? 38

Appendix: Dixon-Thirlwall Model of Cumulative Growth In the long-run, we assume that the growth rate of output remains constant from one year to the next. This means that y = y -1. Recall that y = A + B y -1 To solve for the long-run growth rate, substitute y for y -1 in y = A + B y -1, so that y = A + By. 39

Appendix: Dixon-Thirlwall Model of Cumulative Growth Solving, y = A / (1-B) in the long-run. Previously, A=3 and B=0.5. Consequently, long-run y = 3/(1-0.5) = 6 %. The long-run rate of growth of output is 6% per year. Equilibrium occurs when the actual output growth rate equals the long-run growth rate. 40

Appendix: Dixon-Thirlwall Model of Cumulative Growth The figure shows two functions: 1) the actual growth rate (in red, described by y=A+By -1 ) and the long-run growth rate (in blue, described by y=y -1 ). The two intersect at 6%, where the actual rate equals the long-run rate of growth. 41

Appendix: Dixon-Thirlwall Model of Cumulative Growth The actual rate will change when a variable changes. Example: suppose foreign income growth (z) rises from 2% to 3%. This will cause A to rise, shifting the red function up. The initial rise in exports cause a ripple effect on productivity, causing output to rise further. Eventually, output growth rises to 8% from 6%. 42

Appendix: Dixon-Thirlwall Model of Cumulative Growth Summary: the Dixon-Thirlwall shows how output growth and productivity growth can interact, resulting in higher cumulative growth. 43