Basics of economic geography

Explanations of the WHERE economic activity occur, of why some places are rich, of why some places grow fast, all draw on notions of geography.

First-nature geography explains the location of economic activity in terms of natural geography: natural harbours, navigable rivers and differences in resource allocation, climate and distance. Economists also argue that so-called second-nature geography is important. With this we mean that external economies occur in specific places and they drive the local growth.

Economies of scale (also sometimes labelled as increasing returns to scale) refer to the circumstances where an increase in the level of output produced leads to a decrease in the average cost per unit of output of a firm (Brakman et al., 2001:26).  This fall in the average cost occurs because of externalities – costs or benefits that spill over beyond the private costs of, or benefits to, the individual firm.

In this it is possible to distinguish between internal and external economies of scale.  Internal economies of scale occur at firm level where increased production results in a cost advantage over smaller firms.  This implies market power and a market structure of imperfect competition.
External economies of scale occur at industry level.  In this case, an increase in the output of the industry as a whole leads to a decrease in average costs.  Such external economies of scale can be further divided into pure (or technological) external economies, and pecuniary external economies.
In the case of pure external economies, an increase in industry-wide output causes a change in the technological relationship between inputs and output for each individual firm.  There are two examples of this.  The first is that of knowledge sharing, learning and innovation: As industry output rises, the stock of knowledge rises and information spills over to firms.  This is a positive external benefit that is not paid for, reducing cost and causing an increase in the level of output at the firm level.  Glaeser, Kallal, Scheinkman and Shleifer (1992) distinguished between three types of these externalities: 
(i) Marshall-Arrow-Romer externalities that are due to knowledge sharing, learning and imitation between firms in the same industry and where local monopoly fosters these spillovers;
(ii) Porter externalities that are industry-specific knowledge spillovers, but where local competition fosters the spillovers; and 
(iii) Jacobs externalities where knowledge spillovers occur between firms of different industries and where local competition stimulates these spillovers.  The second type of spillover from non-market institutions involves public goods.

The supply of public goods and services provides benefits to members of a community – benefits that are non-rivalrous and non-excludable in consumption.  Non-rivalry in consumption means that each individual’s consumption does not detract from any other individual’s consumption of the good or service.  Non-excludability in consumption means that it is impossible to exclude anyone from consumption – even when they are not willing to pay for the benefits.  Public goods or services thus have external benefits that lower costs and enhance efficiency, giving rise to increasing returns in the aggregate.  In both these cases it is important to note the importance of proximity.  Proximity makes it possible to capture the spillovers of knowledge, or from infrastructure, which increase productivity and lower costs.

In contrast to such pure externalities that affect the production function, pecuniary externalities affect a firm’s output decisions through price effects that are transmitted via the market.  Two approaches to pecuniary externalities can be distinguished: The Chamberlainian approach to the diversity of intermediate inputs and the Smith-Marshallian approach to the matching process on the labour market.

The Chamberlainian approach rests on the idea that a large market allows for a large number of intermediate commodities and final goods.  Particularly, diversified and non-tradable inputs, such as legal and communication services, non-traded industrial inputs, maintenance and repair services and finance can enhance the productivity of the final sector (Fujita & Thisse, 2002:98).  The economy then displays increasing returns to scale at the level of the agglomeration (city level).
The Smith-Marshallian approach holds that the size and proximity of economic activity found in agglomerations ensures a thick labour market that allows for better matching between workers and jobs.  In this approach there are two models.Helsley and Strange (1990) showed that a large city allows for a better average match between heterogeneous workers and firms’ job requirements and this enhances efficiency.  On the other hand, Duranton (1998) argued that a large market allows workers to become more specialised and, therefore, to be more efficient.  Either way, the better matching gives rise to increasing returns in the aggregate.

BRAKMAN, S., GARRETSEN, H. & VAN MARREWIJK, C.  2001.  An introduction to geographical economics: Trade, location and growth.  Cambridge: Cambridge University Press.
DURANTON, G.  1998.  Labour specialisation, transport costs and city size.  Journal of regional science, 38(4): 533-573, November.
FUJITA, M. & THISSE, J-F.  2002.  Economics of agglomeration.  Cambridge: Cambridge University Press.
GLEASER, E., KALLAL, H. SCHEINKMAN, J. & SHLEIFER, A.  1992.  Growth in cities.  Journal of political economy, 100(6):1126-1152, December.
HELSLEY, R.W. & STRANGE, W.C.  1990.  Matching and agglomeration economies in a system of cities.  Regional science and urban economics, 20(2):189-212, September.

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