1. GEOGRAPHICAL ECONOMICS (SECOND PART) URBAN AND REGIONAL ECONOMICS José-Luis Roig

2. WHAT IS URBAN AND REGIONAL ECONOMICS Urban and regional economics adds geographical space to the economic analysis of utility-maximizing households and profit-maximizing firms. It lies at the intersection of economics and geography. Urban and regional economics recognizes that goods are produced at certain locations, traded at some locations and bought by individuals who live at one location and work at another location. Distance between different economic activities implies costs for transporting goods and moving people. Distance also defines communication and social interactions among consumers and workers.

3. Increasing Urbanization Rates More than half of the World’s population now lives in cities Source: UN World Urbanization Prospects, 2009 Revision, esa.un.org/unpd/wup

4. Urban Concentration in Europe Population density in 2005 by OECD TL3 region

5. Economic Concentration in Europe GDP per km2 in 2005 by OECD TL3 region

6. Employment in the wine industry (SIC 2084) Sectoral concentration explained by natural advantages

7. Employment in the computer software industry (SIC 7371, 7372, 7373, 7375) No natural advantages

8. Employment in the Computer Software Industry (SIC 7371, 7372, 7373, 7375) San Francisco

10. Employment in the Carpet Industry (SIC 2273)

12. Productivity increases with employment density Elasticity around 5%(U.S.),4.5%(Europe) Doubling density increases productivity by 5%(4.5%)

13. Agglomeration economies Firms can benefit from the concentration of other firms (A. Marshall): - Large labour market - Large market of intermediate input suppliers - Knowledge spillovers

14. Strong regional disparities of GDP per capita in EU - Blue Banana - Nordic Countries - Periphery - Large difference within some countries - Spatial contagion (spatial diffusion of development)

15. Accessibility and Transport Cost: The Market Potential M: Population, GDP,… GDP level provides a crude measure of economic size of a region. Some insight into the potential of attraction of new activity Besides its size, one expects the accessibility of a region from others to be another critical determinant of firms’ and workers’ locational decisions The market potential aims to capture the idea that being close to prosperous regions makes a region more attractive because it offers good access to several large markets

16. Strong core-periphery pattern

17. More spatial dispersion. Prosperous states scattered all over the country Regional disparities are much wider within the European Union than in the United States. Less strong core-periphery pattern

18. How to model the spatial economy We must start from at least one of three assumptions: i.Space is heterogeneous as in the neoclassical theory of international trade ii.There are externalities in production and/or consumption iii.Markets are imperfectly competitive

19. Theory of Industrial Location  What leads firms to locate where they do?  Can space confer monopoly power?  How do compete firms in space?

20. Theory of Industrial Location A. Location of the firm and transport costs B. Location and market areas: spatial monopoly C. Location and market areas: spatial competition

21. A. Location of the firm and transport costs The Weber location-production model (fixed coefficients technology) The Moses location-production model (factor substitutability)

22. The Weber Location-Production Model Transfer-oriented firm: transport cost is the dominant factor in the location decision  The firm chooses the location that minimizes total transport costs Two types of cost: - Procurement cost is the cost of transporting raw materials from the input source to the production facility - Distribution cost is the cost of transporting the firm’s output from the production facility to the market

23. Four assumptions: 1.Single transferable output. The firm produces a fixed quantity of a single product, which is transported from the production facility to a market M 2.Single transferable input. The firm may use several inputs, but only one input is transported from an input source, F, to the production facility. All other inputs are ubiquitous. 3.Fixed-factor proportions. The firm produces its fixed quantity with fixed amounts of each input. No factor substitution 4.Fixed prices. The firm is so small that it does not affect the prices of its input or its output  The only cost that varies across space is transport cost  The firm will choose that location that minimizes transport costs

24. Resource-oriented firm. Firm that has relatively high costs for transporting its input. Example: A firm produces baseball bats

26. 7 tons of beets needed for 1 ton of sugar

27. Market-oriented firm. Firm that has relatively high costs for transporting its output to the market Example: Bottling firm of beverages

29. 10 tns. of wheat needed for 100 tns. of beer

30. Transshipment points and port cities

31. Labor markets and location choices

32. Two inputs and one market: the Weber location triangle Example: car manufacturer uses steel and plastic Profit of the firm: Given the assumptions of fixed coefficients of inputs and fixed prices:  Single establishment – profit maximizer – price taker – perfect competition – 2 inputs single output  Critical factors m1 m2 m3; p1 p2 p3; M1 M2 M3; t1 t2 t3; K  Maximise profit by minimising total costs

33. The Moses location-production model - Now the firm can substitute in favour of the cheaper inputs - The distance from the factory to the market, d 3, is fixed - The firm chooses a location along the arc IJ

34. Budget constraints at the end points I and J

35. The envelope budget constraint

36. Location-production optimum

37. Effect of a road-building program that takes place in the area around M 1

38. B. Location and market areas: Spatial monopoly Spatial market areas: linear market with equal transport rates Space can confer monopoly power on firms The lower transport and production costs are, the larger the monopoly area

39. Spatial market areas: linear markets with different transport rates and production costs

40. C. Location and market areas: spatial competition The Hotelling location game Assumptions 1.Costless firm movement 2. Homogenous product 3. Consumers equally spaced along main street (i.e., sales are a + function of the market area) 4. Perfectly inelastic demand 5. Identical costs and transport rates

41. Welfare implications of the Hotelling result Gain Loss

42. Effect of price competition on the Hotelling result

43. A firm lowers its price assuming that its rival’s prices will not change. Rival firm lowers its price assuming that the original firm will not change its price again. Etc. Every firm is surprised when the other firm retaliates. Result: Price shading continues until the firms price at or (temporarily) below MC

44. ECONOMIES OF AGGLOMERATION

45.  Density generates costs Higher cost of land Greater congestion, higher commuting and transport costs  Population and economic activity are ever more concentrated in cities  There must be offsetting benefits Higher productivity for firms Higher wages for workers  Are these advantages due to agglomeration economies?  What are their scale and scope and causes?

46.  Why is it profitable for firms to concentrate employment? 1.Plant-level economies of scale  Plants produce more efficiently at a larger scale 2.Agglomeration economies  Plants produce more efficiently when close to other plants A.Urbanization economies when close to other plants in general B.Localization economies when close to other plants in the same industry

47. Economies of agglomeration are externalities A person who is making an economic decision, such as whether to produce more output, makes the decision on the basis of his own marginal costs and benefits, and ignores costs or benefits that affect others An example An industry in an urban area: demand, D and supply, S Made up of a large number of small, competitive firms Each of these firms has a lon-run average cost curve that has a minimum point at some level of output In the long run the output of the industry expands by adding more firms The long-run supply curve of the industry is the horizontal line S The market price is set equal to long-run average and marginal curve

48. Economy external to the firm but internal to the industry: The expansion of the industry output, through the addition of another firm, will lower the average costs for the other firms The price at which the firms in the industry will offer the good now drops to the lower average cost

49. MICRO-FOUNDATIONS OF AGGLOMERATION ECONOMIES Sharing. Matching. Learning.

50. 1. SHARING A.Sharing indivisible facilities  Simplest argument to justify the existence of a city  Example: ice hockey rink Expensive facility with substantial fixed costs Few individuals would hold a rink for themselves An ice hockey rink is a an indivisible facility that can be shared by many users  Factory towns

51. B. Sharing the gains form the wider variety of input suppliers that can be sustained by a larger final goods industry C. Sharing the gains from the narrower specialisation that can be sustained with larger production  Example: Dresses and Buttons  Some competing firms locate close to one another to share a firm that supplies an intermediate input (something one firm produces that a second firm uses as an input in its production process)  Buttons produced by one firm are used by a dressmaking firm

52.  Production of high-fashion dresses  Demand for dresses subject to the whims of fashion dressmaking firms must be small and nimble (ready to respond quickly to changes in fashion)  Varying demand for dresses causes varying demands for intermediate inputs (e.g., buttons)  Demand for buttons changes from month to month Important → not in the quantity demanded, but in the type of buttons demanded (e.g., one month square blue buttons with a smooth finish and the next month round pink buttons with a rough finish)  Production of dresses is subject to constant returns to scale

53.  Production of buttons  Subject to economies of scale. Use of indivisible inputs and specialized labour → Cost per button decreases as the quantity increases Scale economies large relative to button demand of individual dressmaker  Face time. A button for a high-fashion dress is not a standardized input. Requires interaction between dressmaker and button-maker Dressmaker must be located close to the button-maker  Modification cost. The dressmaker may incur a cost to modify the button to make a perfect match (e.g., to shave the edges of a square button to make it a hexagon)

54.  Average cost of buttons from the perspective of the dressmaker Point a → High cost for an isolated dressmaker Two reasons: - Low production of buttons - Button-maker produces only one type of button

55. Point f → Low cost for the each dressmaker in a cluster Two reasons: - Sufficient demand for buttons to exploit economies of scale - Larger demand for buttons allow specialization of button-makers

56.  Other example:  High-technology firms - Rapidly changing demand → Small innovative firms - Share suppliers of intermediate inputs (electronic components) - Not standardized inputs → Face time

57. Model of gains from diversity productive advantages of sharing a wider variety of differentiated intermediate inputs produced by a monopolistically competitive industry ↓ Aggregate returns to scale There are sectors In each sector, perfectly competitive firms produce goods for final consumption under constant returns to scale They use intermediate inputs, which are specific to each sector and enter into plants’ technology with a constant elasticity of substitution The higher the lower the elasticity of substitution

58. Intermediates produced in monopolistic competititon Production is explained by: Increasing returns is the marginal productivity of laboris a fixed cost Profit maximizing price Long-term equilibrium

59. Number of firms in equilibrium: Applying normalizations: An increase in final production by virtue of sharing a wider variety of intermediate suppliers requires a less than proportional increase in primary factors

60. Gains from specialization Consider a perfectly competitive industry in which firms produce a final good by combining a variety of tasks that enter into their technology with a constant elasticity of substitution The number of tasks is fixed Each atomistic worker is endowed with one unit of labour. Any worker allocating an amount of time l(h) to perform task h produces Parameter of productivityIntensity of the gains from specialization

61. Note that l(h) can be interpreted as a measure of specialization, since the more time that is allocated to task h the less time that is left for other tasks. L workers andtaskseach worker devotes of her unit labor endowment to each of thetasks she performs

62. D.Sharing risk: labour pooling  Firms are subject to demand shocks  In each time period the demand for some firms grows and the demand for some other firms decreases  Unsuccessful firms will be firing workers at the same time that successful firms are hiring them  An agglomeration of firms facilitates the transfer of workers from unsuccessful firms to successful ones  The process occurs at the level of the firm, not the industry

63.  A simple model  The total demand at the industry level is constant, but the demand for each firm varies from year to year  For each firm there are two possibilities equally likely: a. High demand b. Low demand

64.  Isolated firm  A firm can be isolated  The isolated firm doesn’t face any competition for labour within its town  Labour supply is perfectly inelastic, fixed at 12 workers High demand for the product of the firm ↓ High demand for labour Equilibrium at point b → wage= $16 Low demand for the product of the firm ↓ Low demand for labour Equilibrium at point h → wage= $4

65.  Firm in agglomeration  Firms in agglomeration face competition for labour (labour supply perfectly elastic, horizontal line)  For every successful firm hiring workers, there is an unsuccessful firm firing them  Total demand for labour in the agglomeration is constant A firm can hire as many workers as it wants at the market wage High demand for labour ↓ Firm hires 21 workers (point d) Low demand for labour ↓ Firm hires only 3 workers (point j)

66.  Spatial equilibrium  Wage uncertain at the isolated site high demand w=$16, low demand w=$4 The two outcomes are equally likely: Expected wage (isolated firm) = 0.5 · $16 + 0.5· $4 = $10  To make workers indifferent between isolated site and agglomeration → w(agglomeration) = $10

67.  Firm gains from agglomeration  Expected profits will be higher in the agglomeration  Let’s suppose a firm moves from isolated site to agglomeration and then experiences one year of high demand followed by a year of low demand Good news when demand is high (w=$10 instead of w=$16, and can hire 21 workers instead of 12 workers) Higher profit Bad news when demand is low (w= $10 instead of w=$4) Lower profit

68.  Which is larger, the good news or the bad news? –Good news dominate because a firm in the agglomeration responds to changes in the demand for its product –Expected profit in agglomeration > Expected profit in isolated site (0.5 · adf) + (0.5· gjf) > (0.5 · abc) + (0.5 + ghi) (0.5 · $147) + (0.5 · $3) > (0.5 · $48) + (0.5 + $48) $75 > $48

69. 2. MATCHING. A.Improving the quality of matches between employers and employees  Usual assumption → workers and firms are matched perfectly  Each firm can hire workers with the skills the firm requires  In real world workers and firms are not always perfectly matched  Mismatches require costly worker training  A large city can improve the matching of workers and firms in the real world

70.  A simple model  Assumptions  Each worker has a unique skill described by a position or “address” on a circle with a one-unit circumference  There are 4 workers and skills evenly spaced on the circle  The address of a worker is the distance between her skill position and the “north pole” of the circle  Each firm enters the market by picking a product to produce and an associated skill requirement. S=1/8 S=5/8  Training costs. Workers incurs the cost associated to mismatch

71.  Competition for workers. Each firm offers a wage to any worker who meets its skill requirement Each worker accepts the offer with the highest net wage net wage = wage offered by the firm - training costs  Each firm will hire two workers

72.  Equilibrium  Each firm is the single employer in the skill interval surrounding its skill requirement Equilibrium with 4 workers (skill types) and 2 firms Equilibrium mismatch is 1/8 (workers at 0 and 2/8 work in firm at 1/8, so each worker has a skills gap of 1/8) Each firm pays a gross wage equal to the value of output produced by a perfectly matched worker. Net wage = Gross wage – Skills gap·Unit training cost Net wage = $12 – 1/8 · $24 = $9

73.  Introducing agglomeration  We represent an increase in the size of the labour force by increasing the number of workers on the unit circle Now we have 6 workers (skill types) and 3 firms enter the market Each worker has a mismatch of 1/12 Workers incur lower training cost Net wage increases Net wage = $12 – 1/12 · $24 = $10

74.  An increase in the number of workers decreases mismatches and training costs  The presence of a large number of workers attracts firms that compete for workers, generating better skill matches and higher net wages  This is an incentive for workers to live in large numbers in cities, so the attraction between frims and workers is mutual

75. 3. LEARNING The Obligatory Marshall Quotation When an industry has thus chosen a locality for itself, it is likely to stay there long: so great are the advantages which people following the same skilled trade get from near neighbourhood to one another. The mysteries of the trade become no mysteries; but are as it were in the air, and children learn many of them unconsciously. Good work is rightly appreciated, inventions and improvements in machinery, in processes and the general organization of the business have their merits promptly discussed: if one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas. Alfred Marshall. 1890. Principles of Economics. London: Macmillan. Book IV, Ch. X, § 3: The advantages of localized industries; hereditary skill.

76. Cost and output for an industry Dynamic agglomeration economies

77.  Three Types of Externalities (Glaeser et al. 1992) 1. Marshall-Arrow-Romer Local knowledge spillovers between firms in the same industry Specialization and concentration promote growth Local monopoly helps growth by internalizing externalities 2. Porter Innovation in competitive industry clusters with many small firms Specialization and fragmentation promote city growth Local competition requires firms to innovate or die 3. Jacobs Local knowledge transfers across industries Diversification and fragmentation promote city growth “Cross-fertilization” of ideas across different lines of work

78.  Evidence not conclusive  Glaeser et al. (1992) find evidence of Jacobs externalities explain the employment growth of sector-city  Henderson et al (1995) find that new industries appear in diverse cities but mature industries grow in specialized cities.

79.  Nursery cities (Duranton and Puga, 2001)  Consider a firm that is looking for the ideal production process for a new product  By experimenting with different processes, the firm will find the ideal process  Once found the ideal process, the firm will switch to mass production and start earning a profit  Question is: where should the firm experiment, in a diverse city or a specialized city?

80.  Cost and Benefits of both options (model)  First option → experiment in a diverse city and then move to a specialized city after discovering the ideal process  An experiment entails producing a prototype of the firm’s new product with a particular production process  Suppose there are six processes in the diverse city  Once the prototype from the ideal process is finished, the firm will immediately recognize that it has discovered the ideal process  Assume that it takes on average three years  Once discovered the ideal, the entrepreneur will move to a specialized city and start making profits

81. Cost of each prototype = $4 (losses of the firm each year of the 3 year) Year 4 the firm moves to specialized city. Moving cost = $7 Assume firm operates 6 years Last 3 years the firm earns a gross profit = $12 Firm’s lifetime profit is Net profit = Gross profit – Prototype cost – Moving cost Net profit = $36 – $12 – $7 = $17

82.  Second option → search for the process in the specialized city Advantage → lower prototype cost Each specialized city has the specialized inputs for one production process Suppose, prototype cost = $3 · 3 years = $9 Disadvantage → Higher moving cost The search for the ideal process would require moves from one specialized city to another An average of three moves, moving costs = $7 · 3 years = $21 Net profit = $36 - $9 - $21 = $6  Profit is lower when experimenting in specialized cities  Different roles of diverse and specialized cities

83. Establishment relocations in France, 1993-1996

84. Benefits and costs of agglomeration: Urban Size Wage curve: wage as a function of the local labour force, w(N), is increasing in the size of the labour force reflecting agglomeration economies Cost of living curve: commuting, housing and other consumption goods Labour supply curve: indicates for any level of net wage, the amount of labour supplied in the area (here it is assumed perfect mobility)

85. DIVERSITY, SPECIALIZATION AND URBAN SIZE Cities of different size and productive specialization can be found in all the economies Specialized and diversified cities co-exist Medium size cities tend to be highly specialized in their production patterns, in terms of goods exported form the city All cities have a base of locally produced goods and services just for local consumption: housing, retail and personal services, business services, repairs and education and health services. (about 60% of total employment)

86. Two industries of similar size nationally (USA, 1987):  Traditional textile (excluding apparel)  High-tech instruments

87. Textiles Most metro areas have no employment None of metro areas > 1m even have 1% of employment in textile Most of specialized areas are medium-small

88. Instruments: Most metro areas have no employment Very large metro areas record small shares Some areas >1m. record shares that are almost 4% of local employment

90.  Functional specialization (Duranton & Puga, 2005)

91.  Technological progress in transport and telecommunication technologies have made it less costly for firms to separate their production facilities from their headquarter and management facilities  Such a separation is worthwhile only if the firms can locate their production facilities in environments with greater same sector specialisation and their headquarters in business centres where business service employment is abundant  This in turn gives a strong incentive for cities to shift from a main specialisation along a sectoral dimension to a main specialisation along a functional dimension, leading to the emergence of separate business centres and manufacturing cities  With greater benefits from proximity for headquarters and business services than for manufacturing, the shift from sectoral to functional specialisation also implies that business centres are few and large whereas manufacturing centres are more numerous and smaller in size

92.  Headquarters have a strong propensity to out-source business services  Headquarter location decisions are mostly driven by the existence of a large and diverse local supply of business services rather than by the presence of a large number of other headquarters  Headquarters have moved away from locations with relatively few other headquarters and business service producers towards locations with a greater presence of both, whereas headquarters already in locations with relatively many other headquarters and business service producers have tended to remain there

93.  Firms, in each sector, require both sector-specific inputs as well as business services for their headquarters  There are agglomeration economies in all sectors  Firms face a trade-off between spatial integration of both headquarters and production facilities and the spatial separation of these two functions  If firms decide to split, then both parts of the operation can fully benefit from the relevant agglomeration economies: Sector specific inputs for production Business services for headquarters  Spatial integration Firms manage the interaction between production facilities and headquarters more efficiently because of savings on communication costs But more expensive inputs due to crowding

94. 1.When communication costs high → split costly → low demand for labour from spatially disintegrated firms → firm will pay low wages 2.When communication costs low → separation efficient → cities specialized by function → each function benefit from specific agglomeration effects → headquarters will pay higher wages