Basic Employment vs. Sectors with Spillovers

Standard urban economics discusses Economic Base Theory. A nice definition is via Tim Chapin:

The economic base technique is grounded in the assumption that the local economy can be divided into two very general sectors: 1) a basic (or non-local) sector or 2) a non-basic (or local) sector.

Basic Sector: This sector is made up of local businesses (firms) that are entirely dependent upon external factors. For example, Boeing builds and sells large airplanes to companies and countries located throughout the world. Their business is dependent almost entirely upon non-local firms. Boeing does not sell planes to families or households locally, so their business is very much dependent upon exporting their goods. Manufacturing and local resource-oriented firms (like logging or mining) are usually considered to be basic sector firms because their fortunes depend largely upon non-local factors, they usually export their goods.

Non-basic Sector:The non-basic sector, in contrast, is composed of those firms that depend largely upon local business conditions. For example, a local grocery store sells its goods to local households, businesses, and individuals. Its clientele is locally based and, therefore, its products are consumed locally. Almost all local services (like drycleaners, restaurants, and drug stores) are identified as non-basic because they depend almost entirely on local factors.

A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King
A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King

Economic development practice is to entice/enhance “basic” industry. The example of Boeing is especially timely, given the recent issue of Boeing potentially moving airframe production if it didn’t get labor givebacks. I don’t imagine most of the places that Boeing was considering moving to have an airframe sector, or upstream or downstream vendors or customers, or a workforce skilled in airframe manufacturing, which would generate benefits beyond “jobs, jobs, jobs”. Similarly, ED advocates often argue for new infrastructure , despite at best weak evidence that in a mature (roadrailtransit) network there will be much accessibility gain, and thus little resulting economic development.

But the key point to remember from welfare economics is that everything is non-basic at a global level, and everything is basic at the household level. While it might be locally preferred to have more basic employment (we get money in exchange for stuff), that makes no difference on the global scale. Economic development practice is parochial (which is no surprise as it is funded by place-based local and state governments).

Yet that is not to say that local development is neither good nor bad. The reason it might actually be better to have local concentrations is because of various types of economies: in particular economies of scale of various kinds (including economies of agglomeration, which in places with very large employers, may all be internalized), and network economies. These economies produce spillovers, not just for the firm, but also for upstream and downstream supplies and customers, and potentially for competitors as well. I will call these Spillover Sectors.

Economies of scale mean that the cost goes down the more that is produced, (economies of scale are within firm, economies of agglomeration are within place, but between firms), so we can lower global costs if we specialize. The core reasons for this include large fixed costs associated with plants.

Reasons for Economies of agglomeration are also plentiful (from the Transportation Economics Wikibook):

Type of scale economy Example
Internal 1. Pecuniary Being able to purchase intermediate inputs at volume discounts
Technological 2. Static technological Falling average costs because of fixed costs of operating a plant
3. Dynamic technological Learning to operate a plant more efficiently over time
External or Agglomeration Localization Static 4. Shopping Shoppers are attracted to places where there are many sellers
5. Adam Smith Specialization Outsourcing allows both the upstream input suppliers and downstream firms to profit from productivity gains because of specialization
6. Marshall labor pooling Workers with industry-specific skills are attracted to a location where there is a greater concentration.a
Dynamic 7. Marshall-Arrow-Romer Learning-by-doing Reductions in costs that arise from repeated and continuous production activity over time and which spill over between firms in the same place
Urbanization Static 8. Jane Jacobs innovation The more that different things are done locally, the more opportunity there is for observing and adapting ideas from others
9. Marshall labor pooling Workers in an industry bring innovations to firms in other industries; similar to no. 6 above, but the benefit arises from the diversity of industries in one location.
10. Adam Smith division of labor Similar to no. 5 above, the main difference being that the division of labor is made possible by the existence of many different buying industries in the same place
Dynamic 11. Romer endogenous growth. The larger the market, the higher the profit; the more attractive the location to firms, the more jobs there are; the more labor pools there, the larger the market—and so on
12. Pure agglomeration Spreading fixed costs of infrastructure over more taxpayers; diseconomies arise from congestion and pollution

Source: World development report 2009: reshaping economic geography By World Bank, Adapted from Kilkenny, Maureen (1998) “Economies of Scale” Lecture for Economics 376, Rural, Urban, and Regional Economics, Iowa State University, Ames Iowa

Economies of scale are so pervasive we don’t notice them. Every road is an instance of economies of scale, we walk/ride/drive along roads because it is faster than going across unimproved space, even though it is less direct, but we individually could not afford to build the road, so we share the fixed costs with lots of people. The cost per person for roads is lower the more persons we spread the cost over. Economies of scale may also be played out (exhausted) at the margins we observe. Just because we had economies of scale in the roads we have built to date does not mean there are still economies of scale waiting to be picked up off the street like the proverbial $10 bill.

Two economists are walking down the street when one points to the ground and says, “Look, a ten dollar bill!”

The second economist replies, “That’s crazy. If that was a ten dollar bill someone would have picked it up already.”

In fact, most of the easy things have been done. Not to be as pessimistic as Tyler Cowan, but it is true that we pick the the projects with the highest Benefit/Cost ratios (low-hanging fruit) first, and work our way down-the list (up the tree), until the cost of building the project outweighs the benefits (the cost of getting the fruit outweighs the pleasures of consuming it). Clearly new projects are often on the low B/C side of the equation.

Network economies mean that the value of something increases the more people who use it. These are also so pervasive we don’t always notice them. The more people who use MSP airport, the better the airport is for me, because it will have more flights. Roads are also examples of network economies, as the more people who use the road, the higher quality road we will build and the more accessibility (by auto) I will have. Thus we have interstate highways because we have hundreds of millions of drivers. If there were only one driver, even Bill Gates, we would not have an interstate system.

So to get back to types of employment. When doing economic development we should not be thinking about Basic vs. Non-basic. We should be thinking about employment that has benefits from concentration, either economies of scale and agglomeration, or network externalities, or both, and then working toward establishing concentrations of those sectors to maximize the benefits to society.  This usually means considering where local strengths already are, rather than starting from scratch. Complement the existing rather than dropping in an alien business.  The job multiplier from two jobs paying $75,000 may be the same, but the one in a spillover sector will lower costs for others in the sector and/or improve benefits.  It means not going after projects just because they generate jobs, but encouraging firms to relocate into specialist concentrations where there are spillover benefits from those concentrations.

In contrast, sectors which have losses with concentration (think natural monopolies, where competitors split the market so that no firm can recover fixed costs), should be encouraged to remain dispersed.

Agglomeration, Accessibility, and Productivity: Evidence for Urbanized Areas in the US (working paper)


Daniel Graham, Patricia Melo, and David Levinson (2012) Agglomeration, Accessibility, and Productivity: Evidence for Urbanized Areas in the US. (Working paper)

This paper undertakes an empirical analysis with the aim of improving the current understanding of the relationship between labor productivity and urban agglomeration economies across a sample of urbanized areas in the US. Agglomeration economies are represented with driving time measures of employment accessibility to establish a direct account for the link between transport and agglomeration economies. The paper investigates the presence of nonlinearities in the relationship between labor productivity and agglomeration economies, and examines the spatial decay pattern of the effects arising from this relationship. The findings indicate that there is considerable nonlinearity in the relation between productivity and transport induced agglomeration effects, implying that the estimation of country-level aggregate elasticities is likely to misrepresent the actual magnitude of any productivity gains from urban agglomeration. The results also suggest that the magnitude of the productivity-agglomeration effects decays very rapidly with time and is very strong within 20 minutes driving time. This suggests that knowledge spillover externalities are likely to be a very important Marshallian source of agglomeration economies.
JEL Classification: J31, R12, R40
Key words: agglomeration economies, network accessibility, labor productivity

Comments on “Why The Bay Area Should Have 11 Million Residents Today”

Tim Lee writes in Forbes: Why The Bay Area Should Have 11 Million Residents Today – Forbes:

“Today, the Bay Area has about 7 million residents. In a free housing market, the population of the San Francisco Bay Area would have been growing rapidly over the last two decades. For example, between 1900 and 1920, the growth of the auto industry helped the population of the Detroit metro area nearly triple, from 540,000 people to 1.4 million people. If the San Francisco Bay Area had grown that fast since 1990, it would have about 16 million people today.”

Having lived in the Bay Area for half a decade, I don’t doubt there are housing restrictions in some municipalities. There are many municipalities. Some would welcome development. Other just demand more side payments. Where is the boom in the East Bay? In the East Bay development is more welcome than the Valley. Where are the hordes clamoring to live in Oakland? Why have the bad neighborhoods areas not been gentrified? Why are existing zoning caps not reached (with buildings torn down and rebuilt more intensely). Because, the demand is too weak.
The so-called economies of agglomeration are just not large enough to justify side payments, or they would be made, or overcome social problems constraining gentrification.
Those 4 million come from somewhere. Maybe they come from Phoenix or Dallas or Houston or Atlanta (or of course everywhere?), but then those places have the infrastructure, land, and housing stock, where if the demand were lower would just see lower land prices, not less people (mostly).
Maybe some development would not have been built there. But that development (i.e. roll back the last 10 years of US development for 2 million housing units, reallocate that to the Bay Area, as is implied in the article) and most of that would be single family houses that would be unbuilt. Preferences for 2 million single family homes cannot physically be satisfied in the Bay Area, so residents would thus face a far worse housing situation than preferred.
We have a friend from Minneapolis we nicknamed “Pre-Millenium Man”, since in the early 2000s he wanted to live the hipster dream of San Francisco in the 1990s, and he did move to the Bay Area and works in software development. Nothing stopped him. He undoubtedly bid out someone who did not care to live there quite as much. So the people who are bid out contribute much less to the economies of agglomeration than the average person who is there (their wages reflect willingness to pay for housing, and are determine by their productivity). Adding 2 million marginals to the pool won’t increase the total productivity as much as the average person today, and will reduce average productivity. It will worsen the aggregate productivity elsewhere. There are diminishing economies of agglomeration, and increasing negative externalities with larger populations.
The entire rationale for housing regulations is to reduce negative externalities, both perceived and real. If we lived in a world where those externalities were otherwise internalized, great, communities would be much more willing to allow more development, as the negative spillovers would not exist. We do not yet live in that world.
I know the Bay Area (thinks it) is the most important place in the world, delivering us the future. I know that future would just be so much worse without famous investments like Real productivity is created there, but so is crap. A much better strategy would be to stop wasting so much effort on duplication, drivel, and so on, and incentivize those competent software developers to make things that are worthwhile. If people can no longer find good investments, or can no longer distinguish between good investments and crap, perhaps the economies of agglomeration have been exhausted.

Linklist: February 14, 2012

Yglesias: Developers Should Be Able To Bribe Homeowners [Yes and Yes]

Liz Hoffman @ Law360 (behind a firewall) Obama Budget Would Double Infrastructure Spending:

““Most of what’s being proposed are nonstarters,” said David Levinson, a transportation policy expert at the University of Minnesota. “Infrastructure is a big part of what [Obama] is trying to do on the economy, but he’s unlikely to get most of what he’s asking for.”
” [The interview was much longer, but I guess this was the money quote].

The Commanding Heights

Marin Civic Center
Marin Civic Center

Reihan Salam at NRO questions the Kotkin hypothesis, asking: “Are people choosing low-density metropolitan areas — or did rising prices in high-density metropolitan areas [like Marin County, in the Bay Area pictured -ed.] drive the population shift?”
What is cause, and what is effect, is not immediately obvious. There are trade-offs. High-density areas are naturally more expensive (due to greater demand, otherwise they would not be high-density). High-density areas are also typically formed by physical constraint, meaning less supply. They are also more regulated due to their higher density. Density naturally produces more regulation because density naturally produces more externalities [See tomorrow’s post]. Even expensive metro areas have inexpensive housing in places, it just tends to be either lower quality, or in less desirable neighborhoods.
I wrote Height limits produce a positive externality recently, to which the technology/urbanist/libertarian blogger Timothy Lee tweeted (but I took more than a month to respond to, since I don’t live on Twitter), and I replied (this is reformatted for presentation, but I think captures what was said in the right sequence)…:

You don’t think there’s a shortage of space near multi-line transit stops like Metro Center and Gallery Place/Chinatown?

The higher you build there, the shorter you build elsewhere. There is plenty of land in DC that could be denser at less than 10 stories.

why does taller buildings one place mean shorter buildings elsewhere? There is a region-wide housing shortage.

Regional demand is largely fixed. Someone who can’t get in block X will be far more likely to locate in block Y than Charlotte.

you don’t think real estate prices affect migration between metro areas?

not much. People have jobs before they migrate. Firms locate for lots of reasons, but a shortage of hsg in a small dtwn no.
there is plenty of moderately priced real estate in metro DC, SFO and elsewhere, how else could poor people live there?
Only if the savings on the labor costs outweigh the savings on economies of agglomeration. This indicates few e of a.

I recommend…

I read Avent and Glaeser, I believe they overstate e of a. The more important point is full social costs. New dev. should pay.

Firms move to save on labor costs (which are connected to housing costs) all the time.

If everyone paid full social cost, (and compensated losers) build away. In the absence of FSC pricing, we regulate.

Clearly Twitter is not a good way to have an academic discussion. Blogs are much, much better. There are several points wrapped up in this:

  • Empirical questions about Intra-urban vs. Inter-urban migration
  • The rights of the property owner vs. the rights of the community
  • Economic productivity (positive externalities?) vs. Pollution/Congestion etc. (negative externalities)
  • Empirical questions about the scarcity of land
  • Empirical questions about what constitutes good urban form
  • Empirical questions about the need to be downtown or simply in the metro area [plenty of suburbs even in DC would be happy to accommodate growth]
A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King
A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King

In short, I think height limits are not the dominant issue in any US metropolitan areas. This is not to say that regulation does not matter at all, as there are lots of regulations beyond height limits, but that its effect is limited. I discussed this previously in Zoning and Externalities.
If there is value, where are the side payments from otherwise rejected developers? My perhaps cynical view, ‘No side payments, no evidence of super-normal social profits, no evidence of huge value being lost’. While the developer may be losing potential profits, society is not, as those who are negatively affected are not being given compensation to offset the negative effects they would receive were the project to go forward. I realize there are transactions costs limiting the ease of implementing side payments, but surely some institution could arise to facilitate this.
I also wrote on the Limits to agglomeration, suggesting that agglomeration economies arguments are overstated, and in fact it is agglomeration externalities that create density, not (or not so much) vice versa.
DC and New York are both edge cases, being political and financial capitals respectively, both of which at least historically generated important economies of agglomeration.
One of the critical problems here, as with much research is the difference between marginal and average effects. E.g. Clearly transportation matters. If there were no transportation there would be no economic activity. However, that does not mean that a marginal increase in transportation supply will have a significant, or even positive, effect on economic activity, that depends on context. The network is mature, the marginal returns to new investment now are much lower than the historical average returns. Similarly, the marginal returns to density might be much smaller than average returns. Cities exist for a reason. That reason is economies of agglomeration in various forms. That said, where cities are continuing to grow, those economies must be valuable. Where suburbs are growing, the daily face-to-face inter-firm interactions emerging from the classical 19th and early 20th century transit-based downtown has declined relative to the need to be within auto-commuting distance of places that are to be dealt with on a short-term basis. When new cities grow, new patterns of economic activity are forming, and these may be more valuable than incremental changes to mature cities.
All of which is to say cities and their economies are dynamic, and the first order factor is the underlying market economics, while regulations (which are themselves the product of political market preferences) are second order effects.

Cities and Cities

Matt Yglesias has an interesting post Cities and Cities where he almost connects the dots. But its hard because his model of the city is Washington DC.

A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King
A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King

But I think that it’s important to try to be clear about what we mean by the word “city.” In an economic context, the most relevant concept is often that of a “metropolitan area”–a socially and economically integrated set of places that cross municipal boundaries. That’s different from “city,” a central municipality as opposed to a “suburb” which is a municipality that’s near a central municipality. And that’s also different from “city” in the sense of a walkable urban neighborhood as opposed to a “suburban” auto dependent neighborhood. Washington DC the metropolitan area is one of the richest in America, but Washington DC the municipality is merely above average. The Washington DC metro area also includes a large minority of transit-oriented walkable urban neighborhoods. Many of these neighborhoods are in the Washington DC municipality but some of them are in Arlington County, VA or Montgomery County, MD and some of the neighborhoods in the DC municipality are very auto-oriented and suburban and feel.
When someone talks about the economic value of cities that person (especially if he’s Ed Glaeser) could be plausibly talking about the economic value of metropolitan areas, in which case subsidization of rural and micropolitan places clearly is relevant. Alternatively, that person (especially if he’s Christopher Leinberger) could be plausibly talking about the economic value of walkable urban neighborhoods, in which case subsidization of rural and micropolitan places doesn’t seem relevant to me. Meanwhile, if I’m complaining about structural problems in city governance then I’m probably talking about municipalities, which is a whole different thing. I would put this all together by saying that metropolitan areas (mostly composed of people living in suburban neighborhoods in suburban municipalities) benefit from the existence of a strong urban core (composed of people living in walkable urbanist neighborhoods, most of them presumably in the central city municipality) which is more likely to happen if you have a functional municipal political system (in the central city municipality). That’s because if one particular suburban jurisdiction starts to be malgoverned, firms and households that want to be located in suburban neighborhoods can fairly easily relocate to a different-but-similar suburban neighborhoods in a different suburban jurisdiction. But in most cases, a firm or household that wants to be in a urban neighborhood often can’t just leave the central municipality for a different jurisdiction, it would have to go to a whole different metropolitan area.

There are two key elements that would help him connect the dots. The first is the idea that people vote with their feet (a la the Tiebout Hypothesis) which he alludes to but doesn’t name. The second is that we need competition in urban municipalities, like say, The Twin Cities, which enable people who need to be urban to live in one of two urban cores, and to choose one which has the best mix of taxes and services.
The problem is that the urban cores are monopoly governments in most metropolitan areas (and in areas that once had competition (e.g. New York) annexation combined them. The issue is the merits of competition in inducing innovation, reducing costs, increasing monitoring, benchmarking, etc. vs. the merits of economies of scale (so New York City might be more efficiently governed if Manhattan and Brooklyn are under one umbrella (or Westminster and the City of London, or Minneapolis and St. Anthony, etc.). This is an empirical question, I don’t believe there is a universal answer, it is very context-dependent (the context depending on technology, politics, etc.).

The Limits to Agglomeration (or Agglomeration and Density)

A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King
A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King

Cities are positive feedback loops in space. Cities exist only because it is more important for people and organizations to be near each other than far from each other.
There has been recent chatter (Ryan Avent again) about agglomeration making cities wealthier, and only if densities were higher would more agglomeration benefits be achieved.
Certainly evidence shows cities with greater density produce greater “wealth”. Glaeser argues it is about the speed of the spread of ideas, in addition to the classical reasons about transportation costs for people and goods. However cause and effect are not clear. I will pose a contrary hypothesis:
Cities with firms that are more agglomeration-benefitting produce higher densities; cities with firms that are less agglomeration-benefitting produce lower densities.
In other words, density is the effect of agglomeration economies, rather than the cause of agglomeration benefits.
The agglomeration-benefits of an industry change over time, and are more important when an industry is young, and in the growth phase than when it is old, mature, and locked-in.
This hypothesis imples, e.g., increasing densities in Phoenix will not suddenly make Phoenix more productive because the firms in Phoenix don’t benefit much from the additional clustering (and disbenefit from the negative externalities of density such as crowding, pollution, congestion, and the higher costs of services and land that accompany high density). A city like New York or London, in which the Finance Industry (among others) locates, or Washington in which the Government Industry locates, benefits more significantly from the daily walking distance, face-to-face interactions possible by agglomeration. However even in those capital cities there may be limits to agglomeration such that the marginal benefits of an additional person or job may not outweigh the marginal cost.
Since there can only be one national capital per nation, and perhaps one financial capital per nation, the opportunities for creating financial mega-cities of the order of New York, London, Paris, Tokyo, etc. are limited, just as there can only be one effective political capital; second order cities will not magically become first order just by increasing their density.
To take a case I am familiar with, Minneapolis, downtown has not seen much new commercial growth in over a decade, though there has been a significant (though regionally relatively small) increase in residential density. Minneapolis might be termed a provincial capital. It has a large hinterland, a Federal Reserve Bank, many regional and national bank operations (Wells Fargo, US Bank, etc.), and a large number of headquarters of large firms (regionally especially, though many are not downtown, Target, Best Buy, General Mills, 3M, Medtronic, etc.), as well as emerging clusters in a few economic sectors.
In Downtown there are plenty of vacant lots (i.e. parking lots) for development to occur, and no real constraints on new office (or residential) construction downtown. Clearly the private benefits of building downtown are not as great to the firms making location decisions as locating that new building in suburban areas. Unlike New York, the zoning downtown is not a binding constraint. In brief, the private share that firm will attain from agglomeration benefits of the CBD do not outweigh the costs, (including the opportunity cost of building in some other locale). Those suburban places too have some (weaker) agglomeration benefits, but those may be sufficient. The location within a metro-area still produces benefits (which are weaker than the CBD benefits on daily walking distance face-to-face metric, but still enable daily or weekly driving distance face-to-face), such as shared labor pools, and all that.
If there are agglomeration benefits of locating downtown, they are not sufficient that the local firms (acting through local government) bribe these non-CBD locating firms to move downtown to enable those spillovers. Only a few cases where the spillovers are believed strong result in sufficient side payments (bribes, tax increment financing, etc.) (the Minnesota Twins and the Target HQ building come to mind).
The Twin Cities has some tax-based sharing, so may differ from other regions in the local willingness to bribe, but it also suggests that if agglomeration benefits exist for the marginal new business choosing a location, they are relatively weak. The mental model of agglomeration producing huge benefits if only density limits (as in New York and Washington) were lifted may not apply in many other cities.

Architecture – Plan Calls for Rebuilding Haiti Away From Port-au-Prince

From NYT: Architecture – Plan Calls for Rebuilding Haiti Away From Port-au-Prince

“the plan is built around a bold central idea: to redistribute large parts of the population of Port-au-Prince to smaller Haitian cities, many of them at a safe distance from areas most vulnerable to natural disaster. In the process the plan would completely transform Haiti from a country dominated by a single metropolis to what the planners call a network of smaller urban “growth poles.”
“This will only work if these poles become magnets of attraction — with agriculture, tourism, industry and especially jobs,” Mr. Voltaire said. “Otherwise, these people are going to come back.””

by doing so the planners are forgoing economies of agglomeration at Port-au-Prince. What were the positive externalities that led to massive growth there rather than elsewhere. Do they no longer exist? Can they be replicated elsewhere? Will government be decentralized as well? Will businesses move?