Community Economics: Growth Theory

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Community Economics Growth Theory
Spatial implications of endogenous growth

Krugman explicitly incorporated space into the
new endogenous growth theory by asking a basic
question what are the economic forces at play
that result in the creation of megalopolises such
as New York City and Tokyo? He suggested that
many of the notions common to regional and urban
economics could be reconsidered in the new light
of endogenous growth theory. Krugman maintains
that without the new endogenous growth theory
there is no mechanism that moves the economy
beyond a series of smaller rural hamlets. The
agglomeration forces that drive rural hamlets to
become cities are assumed in prior theories.
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Community Economics Growth Theory
Spatial implications of endogenous growth

Centrifugal and centripetal forces in a spatial
world allows for a better understanding of a
system of places. Centripetal forces create
urban centers and describe the economic forces
that pull economic activity together. Krugman
offers three broad types of centripetal forces
including market-size external economies, natural
site advantages and pure external economies.
Centrifugal forces force or spread economic
activity away from the urban center. Krugman
again offers three broad types of centrifugal
forces dispersed natural resources,
market-mediated forces and non-market forces.
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Community Economics Growth Theory
Spatial implications of endogenous growth

Drawing on the ideas of the new endogenous
growth theory Krugman is keen to make a sharp
distinction between natural advantages and
acquired advantages that are self-reinforcing
through the market processes. He also makes a
distinction between technological (non-market)
and pecuniary (market) externalities. The
behavioral forces are that we allow monopoly
profits and these are increased via agglomeration
economies. Firms locating within the same
general area create the agglomeration economies.
In the same logic as Romer, these agglomeration
economies appear as the scale of firms increase
and they become self-reinforcing as more firms
tend to locate together.
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Community Economics Growth Theory
Spatial implications of endogenous growth

The inevitable results of Krugmans stylized
model are that economic activities tend to
cluster within the same location. If the economy
begins with a random scattering of hamlets,
centripetal forces will result in economic growth
being clustered in a small number of cities.
These cities, once they gain a growth advantage
will maintain that growth advantage until
centrifugal forces begin to come into play. The
implication of the Krugman model of this system
of cities on smaller communities is not pleasant.
In essences, the forces of economies of scale
play to the favor of large places many times at
the expense of smaller places.
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Community Economics Growth Theory
Policy implications and conclusions

It is important to remember that most of this
theory has a limited direct application to
community economic development because it is
macro in scope and conceptual. This discussion
sets the context for much of what we try to do in
communities. Much of the theoretical discussions
have tended to focus on developing economies and
the process of how an economy progresses from a
simplistic to a mature advanced economy. These
theories do provide insights into the growth
process when viewed from the local perspective.
What drives overall growth sets the tone of
discussion at the local level.
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Community Economics Growth Theory
Policy implications and conclusions

What we have learned from these theories and
their implications is significant. First and
foremost are the common themes that run through
all of these theories of economic growth.
Clearly defined institutional rules, perhaps the
most important of which are property rights, are
necessary for economic growth. Comparative
advantage is a key concept and a focus of
community economic development hinges on
identifying and acting on a communitys
comparative advantage. The visions of a
community must be realistically in line with the
communitys comparative advantage. Technological
progress including human capital is an important
engine of economic growth.
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Community Economics Growth Theory
Notions of Growth Poles/Centers

Growth center theory stresses the role of
propulsive sectors in shaping the economic growth
fortunes of communities. These propulsive
industries are comprised of technological
innovators (or lead firms) with growth
stimulating effects on both backward and forward
linked sectors through which positive growth
(spread) effects or negative (backwash) effects
are propagated. In short, growth center theory
suggests that there is a dynamic disequilibrium
where cost reducing and growth inducing actions
feed on themselves and pull other areas along.
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Community Economics Growth Theory
Notions of Growth Poles/Centers

The tendency for high technology to agglomerate
is due equally to traditional organizational
needs and agglomeration advantages and the
locational preferences of professional workers.
One agglomeration advantage is the mutual
relationship among firms and workers in that many
firms of all kinds and especially firms in the
same industry becomes an attractive location for
technical workers. They have a variety of
potential employers should they decide to leave
their current job. A second agglomeration
advantage is the contact networks of technical
workers. Firms rely on the heterogeneous
contacts and networks of individuals in order to
acquire information and technical knowledge from
other organizations.
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Community Economics Growth Theory
Notions of Growth Poles/Centers

As argued by Krugman (1991a 1991b), Barkley
et.al (1994 1996) and Henry et.al (1997) the
spread and backwash effects can occur through
several broad economic forces.i These include
investment, spending for goods and services,
migration, knowledge and technology and political
influence and government spending. Each of these
can be shown to have both spread and backwash
dimensions. i In Krugmans terminology
backwash effects are called centripetal and
spread effects are referred to as centrifugal.
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Community Economics Growth Theory
Notions of Growth Poles/Centers

The balance between countervailing spread and
backwash effects will vary from community to
community. What Henry et.al. (1997) conclude is
that perceived quality of life differences
between the urban core and the surrounding
hinterland will play a primary role. If the
urban center is perceived to be a better place to
live and conduct business relative to the
surrounding area, backwash is likely to be
present. Conversely, if the urban center is
perceived to be crime-ridden and run-down while
the surrounding hinterland is blessed with high
levels of natural amenities, strong spread
effects are likely to occur.
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Community Economics Growth Theory
Classical Location Theory

As we have seen in our paradigm of community
economic development understanding spatial and
geographic dimensions of the community and the
larger economic area in which the community is
located is fundamental to our understanding of
how the economy of the community functions.
Central to this understanding is the economics of
firm and market locations. In this chapter we
focus on the basic elements of location theory.
Location theory focuses on the attributes of
space such as the location of resources, the
location of production, the location of markets,
and the transportation system. These attributes
explain where economic activity occurs.
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Community Economics Growth Theory
Classical Location Theory

The most general problem facing the firm is a
situation where their consumers and suppliers are
scattered across a homogenous economic plane.
Here an economic plane is a featureless surface
that is not complicated by natural or
institutional barriers such as mountains, rivers
or valleys that create transportation
bottlenecks, and political boundaries. The firm
is faced with the locational choice that places
the firm somewhere on the economic plane in a
manner that maximizes profits. The firm does
this by minimizing the transportation costs of
shipping input supplies to the firm and
maximizing the potential market demand for their
good or service. In other words, profit
maximization
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Community Economics Growth Theory
Classical Location Theory

The profit maximization approach examines both
the total revenues and the total costs portion of
the profit equation Profits Total Revenues -
Total Costs The firm is faced with balancing two
factors the location of customers which drives
the revenue side of the profit maximizing
equation and the location of suppliers with
drives the costs side of the equation.
Typically, the firm believes one of these factors
is more important than the others, and they focus
on either maximized revenue or minimized costs
first.
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Community Economics Growth Theory
Classical Location Theory

To help see how the profit maximization problem
facing the firm plays out, lets formalize the
problem and examine two special cases costs
minimization and demand maximization. Assume
that a single firm produces one good using a
number of inputs shipped from different locations
and the output is shipped to a number of markets.
This firm produces a good that is also offered
for sale by large number of competing firms
hence the firm is in a market that can be
described as competitive.
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Community Economics Growth Theory
Classical Location Theory

In our spatial world, however, firms have some
flexibility in setting their own prices. In a
spatial world firms compete through effective
prices, where effective prices reflect not only
the costs of production but also transportation
costs. For example the effective price of a
gallon of milk is composed of two parts, the
price at the store plus the cost of traveling to
the store to make the purchase. Stores offering
milk for sale compete directly by paying
attention to the price at the store, but imbedded
in the price to the consumer is the cost of
traveling to the store. Which store will the
consumer select, the store with the lowest travel
cost which is likely the store closest to the
customer.
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Community Economics Growth Theory
Classical Location Theory

To formalize the firms problem define demand,
production and transportation costs we need to
define the following terms ? profit Pi
price charged at market i 1m Di(Pi) demand
for the firms product at market i 1m Si
spatial location of market i 1m t(s,si)
cost of transporting one unit of the good from
firm location s to market location si
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Community Economics Growth Theory
Classical Location Theory

f fixed costs facing the firm to produce the
good v constant marginal cost of producing one
unit of the good xi production inputs from
market i 1n d(s,si) cost of transporting
one unit of input xi from market location si to
firm location s q(xi) output level of the firm
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Community Economics Growth Theory
Classical Location Theory

In a spaceless or aspatial world, the firm
maximized profits expresses as
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Community Economics Growth Theory
Classical Location Theory

Now lets place our firm in a spatial world where
it must balance not only prices (Pi) at each of
the output markets, but also transportation costs
of shipping both inputs to the firm and output to
markets. The firm does this by selecting a
location (s) somewhere on our economic plane that
minimizes transportation costs. We can express
transportation costs as
Cost of shipping outputs
Cost of shipping inputs
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Community Economics Growth Theory
Classical Location Theory

Figure 3.1. Transportation on an economic plane
Webers problem
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Community Economics Growth Theory
Classical Location Theory

Simple cost minimization
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Community Economics Growth Theory
Classical Location Theory

In the cost minimization approach the firm has
not necessarily made its final decision when it
identifies the transportation cost minimizing
location s. If we lift the strict assumption of
a homogenous economic plane and allow for some
economic variations across locations the cost
minimizing firm is said to go through a two step
process. Here the first step centers on the
general location based on transportation costs.
The important thing to remember is that once
transportation costs are minimized the firm
attempts to minimize factor of production costs
may change the location from the minimum
transportation costs site. Suppose that the firm
makes the decision that it wants to be closer to
its input markets than its output markets. Once
this decision is made, it must pick a specific
location. This is the second step of the two-step
process.
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Community Economics Growth Theory
Classical Location Theory

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Community Economics Growth Theory
Classical Location Theory

It is in this second stage of the location
decision-making process that communities often
have some influence on firm location decisions.
Communities can offer high quality
infrastructure, skilled labor, building locations
and generally high quality of life
characteristics and not only offer low cost
alternatives for the firm but, more importantly,
offer a viable comparative advantage over other
locations. More discussion of policy options for
communities that follow from this theoretical
view of firm location.
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Community Economics Growth Theory
Classical Location Theory

The least cost approach to location selects the
site by assuming that the firm sells its total
output to a given point market (i.e., effectively
eliminating demand from the location decision).
The demand maximization approach, however,
reaches the location decision by explicitly
incorporating demand into the decision. The
demand maximization approach to location
decisions contends that each seller will select a
site to control as large a market area as
possible. The seller exercises some monopoly
control over that portion of the market area she
can supply at a lower price than rivals. Consumer
behavior and the location decisions of
competitors determine the size market the firm
controls.
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Community Economics Growth Theory
Classical Location Theory

In our spatial world we have a unique situation
where the market has characteristics of both
competitive markets and spatial monopolies. Over
the whole of the economic plane competition
determines the at store price of the good or
service. Thus all firms in essence charge the
same at store price. But consumers are looking
at what is called the effective price of the good
or service. The effective price is composed of
two parts, the at store price plus the cost of
transportation to the firm P t(s,si).
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Community Economics Growth Theory
Classical Location Theory

P t(s,si)
Effective demand
t(s,si)0
Q
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Community Economics Growth Theory
Classical Location Theory

The classic example of the demand maximization
problem has come to be known as the case of
Hotellings beach vendors. Imagine a beach that
is bordered on both ends by cliffs and a number
of beach goers evenly distributed across the
beach. On this beach are two refreshment vendors
selling identical products at identical prices.
From the perspective of the patrons they will
select the vendor that is physically closest to
them. The vendors are mobile and can locate
their shop at any location on the beach each
morning. Given this structure one can view the
Hotelling problem in a game theoretic framework
how will the two vendors react to each others
location decision with the objective of the game
to maximize the number of beach patrons buying
from this vender?
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Community Economics Growth Theory
Classical Location Theory

Is this the social optimal? NO Aggregate
transportation cost is maximized.
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Community Economics Growth Theory
Classical Location Theory

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Community Economics Growth Theory
Classical Location Theory

Löschian demand cone
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Community Economics Growth Theory
Classical Location Theory

Intro the supply side of the problem
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Community Economics Growth Theory
Classical Location Theory

The range of a good or service is the maximum
distance people will travel to purchase that good
or service at a particular location. Demand
threshold is the minimum market required to
support a particular good or service and still
yield a normal profit for the merchant.
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Community Economics Growth Theory
Central Place Theory

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Community Economics Growth Theory
Central Place Theory

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Community Economics Growth Theory
Central Place Theory

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Community Economics Growth Theory
Central Place Theory

Threshold Estimates for Wisconsin SIC Type of
Establishment Threshold 5812
Eating places 775 5813 Drinking places
1629 5940 Miscellaneous shopping goods stores
1914 5540 Gasoline service stations
2062 7230 Beauty shops 2150 7530 Automotive
repair shops 2167 8020 Offices and clinics of
dentists 2234 5410 Grocery stores
2573 8040 Offices of other health practitioners
3413 5710 Furniture and homefurnishings stores
4201 7990 Misc. amusement, recreation services
4365 7010 Hotels and motels 4519 7340
Services to buildings 4581
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Community Economics Growth Theory
Central Place Theory

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Community Economics Growth Theory
Central Place Theory

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Community Economics Growth Theory
Central Place Theory

One of the powers of central place theory is its
ability to help the community economist think
through how shocks, shifts or changes in the
economy will filter through the retail and
service markets. As we have seen repeatedly
communities do not function in isolation from
their surrounding communities. Any change in the
economics of one community will affect not only
its own place in the hierarchy but all
communities in the hierarchy. The community
practitioner needs to understand how shifts to
one community can affect all communities in the
system.
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Community Economics Growth Theory
Central Place Theory

One of the key assumptions of central place
theory is an even distribution of homogenous
people across the economic plane. Clearly this
assumption does not hold in the real world and
lifting the assumption greatly complicates our
notion of central places, but it does not destroy
it. People cluster together into cities and
villages fundamentally altering the shape of our
Löschian demand cones. Likewise, external
economies of size vary with each community's
social and economic characteristics. This
community influence is often expressed as
external economies or economies of agglomeration
that shift the firm's average cost curve. By
allowing for something other than a homogenous
economic plane the rather sterile view of central
places becomes much more reflective of the real
world. The idea of multi-purpose shopping trips,
business clustering such as shopping malls and
market segmentation such as entertainment
districts as opposed to office buildings begin to
make sense.
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Community Economics Growth Theory
Summary and critique of classical location theory

Classical location theory conceives the location
decision being made by a profit-maximizing firm
located on a homogenous economic plane. Firms
and customers have perfect information and can
fully process that information. In addition,
firms are perfectly mobile and able to enter and
exit spatial markets with no costs. The
approach, while abstract, provides a rigorous
framework to begin to think about space in a
community economics setting. As a deductive
theory of location it provides an excellent
foundation for more in-depth analysis.
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Community Economics Growth Theory
Summary and critique of classical location theory

Our current economy, however, is characterized by
large scale, mass production operations that are
part of complexly organized, multi-product and
multi-establishment businesses. With a
multi-product, multi-location, multi-divisional
firm, the questions of optimality are complicated
by optimality for the total firm or a particular
division total product line or a particular
product internal flows of inputs or markets
being served or the interest of management or
the owners. The firm's multiple objective
function includes objectives other than profit
maximization. These other objectives arise
partially from the interaction between the firm
and the communities (society).
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Community Economics Growth Theory
Summary and critique of classical location theory
The classical profit maximization approach yields
models with relatively low predictive powers,
thus preventing its ready adoption. There are
several reasons for this low predictive ability.
First, the model does not handle personal
preferences and psychic incomes/costs related to
location decisions. These personal considerations
cause the decision maker to maximize total (money
and psychic) satisfaction rather than just
monetary profit. Second, it assumes that the
individual making a location decision has perfect
knowledge about the future, which is, of course,
not possible. Differences in opinions about risk
and profit potential associated with various
locations leads to different location decisions.
A risk-averse owner or firm with limited
financial resources may choose a site with less
potential profit but less risk of loss.

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Community Economics Growth Theory
Summary and critique of classical location theory

Third, location decisions are typically made
infrequently during the career of a business
owner/manager. This infrequency, coupled with
imperfect knowledge, often yields site selection
criteria such as long-run sales growth with
reasonable profits or space for expansion. The
cost of acquiring additional information about
alternative sites deters the business from
further inquiry. The result is the selection of
a satisficing rather than a profit-maximizing
site.
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Community Economics Growth Theory
behavioral approach to location theory

The behavioral approach proposes a significant
relaxation of these assumptions. It allows for
personal goals other than profit maximization
inadequate and inappropriately used information
and uncertainty about current and future
conditions of markets, rivals, and inputs. The
approach uses game theory and the concept of
bounded rationality to analyze location
decisions. The behavioral approach attempts to
explain why the selection of certain sites
appears to be irrational.
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Community Economics Growth Theory
behavioral approach to location theory

Objective functions The behavioral approach
explicitly permits the decision-maker to seek
some objective other than profit maximization in
making location decisions. Uncertainty
Relaxing the assumption of complete geographical
and temporal knowledge by the firm permits
uncertainty in the location decision.
Information The behavioral approach argues
that the firm does not have full and complete
information even without uncertainty. Bounded
rationality says the human limitations of the
decision-maker within the firm prevent absorbing
all the information available.
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Community Economics Growth Theory
behavioral approach to location theory

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Community Economics Growth Theory
behavioral approach to location theory

The behavioral approach focuses community
economic development on the information and
objective functions. There is little the
community can do about uncertainty beyond
providing a stable public-private environment.
The community performs an information role by
helping the firm acquire and use information
through management counseling and assistance. The
community affects the objective function by
recognizing the importance of noneconomic factors
in the location decision.
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Community Economics Growth Theory
behavioral approach to location theory

The behavioral approach, however, is a deductive
theory of the location problem. As such, while
intuitively appealing, does not lend itself to
rigorous testing. As Scott (2000) argues a major
drawback to the behavioral approach is that it
focuses too much on sociological, psychological
and other soft variables often ignoring the
economic foundation of the classical profit
maximization approach.
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Community Economics Growth Theory
Institutional approach to location theory

Much of the location decision-making process
involves negotiations between businesses, owners
of the land, labor unions and local governments
for access to local infrastructure. The
institutional approach focuses on the rules that
set the parameters for negotiations and contract
law as well as the negotiating power of the firm.
Larger firms have greater negotiation leverage
then smaller firms. State level economic
development policies are often targeted towards
larger firms and firms have become accustom to
seeking incentives from state and local
governments.
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Community Economics Growth Theory
Institutional approach to location theory

Indeed, the new war between the states have
state economic development agencies effectively
bidding against each other in attempts to
influence firm location and expansion decisions.
While the cost effectiveness of these state-level
policies have been widely challenged larger firms
can and do exert market power in
negotiations. This situation points out the
asymmetry of information in the location decision
process. The firm knows whether or not a subsidy
is truly necessary to make the site either
profitable or the site of first choice. The
community does not know this information and
thus, there is a constant danger that it will
over subsidize the already profitable decision.
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Community Economics Growth Theory
Institutional approach to location theory

Smaller and medium size firms focus mostly on two
types of institutions local governments and real
estate markets. Local governments can have
significant impacts on the location decisions of
firms. This institution determine land use laws
such as zoning regulations, building codes and in
many cases the power to deny the necessary
permits for the firm to move forward. From a
conceptual point of view, local governments can
and do affect the structure of the isocosts
discussed in the cost minimization approach. In
the name of economic development local
governments often will try to provide flexibility
in zoning, access to public infrastructure and
fiscal incentives. Local governments can have a
significant impact on the nature of local
economic development by how they structure and
enforce these local rules.
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Community Economics Growth Theory
Institutional approach to location theory

The status of the local real estate market has a
significant impact on firm location decisions.
Smaller and medium size firms more often than not
are looking for existing facilities that they can
buy or rent on the open market. Again only the
largest firms are in a position to build at every
location. Therefore the spatial supply of the
real estate market, such as office space,
industrial sites and commercial floor space, are
of prime importance for understanding the
locational choice of smaller firms.