What is Urban Economics?

There are many different ways to define a city. It can be called a collection of buildings for an economic purpose or a dense human settlement. It can also be defined as any area where the value of the land may be governed by its distance to something. This something is usually the CBD or Central Business District. This is where many of the residents within the city and suburbs will commute to work. A Metropolitan area is where there is an urbanized area of at least 50,000 people. A micropolitan area contains at least one urbanized area with between 10,000 and 50,000 people. Viewing the city through an economics lens is called the field of Urban Economics. It is becoming very popular and includes many new and interesting economic discussions

What is Urban Economics?

Urban (and regional) economics adds geographical space to the economic analysis of utility-maximizing households and profitmaximizing firms. It lies at the intersection of economics and geography. Urban 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

What is Urban Economics

Distance between different economics activities implies costs for transporting goods and moving people. Distance also defines communication and social interactions among consumers and workers. Historically, much of urban economic analysis relies on a particular model of urban spatial structure, the monocentric city model pioneered in the 1960s by William Alonso, Richard Muth, and Edwin Mills.

What is Urban Economics

Modern analysis of spatial economics often uses models based on Krugmans, Fujita and Venables in which productivity follows from economic agglomeration ( CENTRALISATION)

Axioms of Urban Economics

The five axioms of urban economics are essential to understanding how urban economics works and how it is applied. An axiom is a self-evident truth. This means that each of these five things is something that most people can understand and accept to be true. These five axioms provide the basis for urban economics and the foundations for all topics associated with urban economics

Axiom 1: Prices Adjust to Achieve Locational Equilibrium

If the price were the same for two houses, one that was in Hawaii on the beautiful beach and the other located in a slum in New York City, there would be an incentive for one to move to the house in Hawaii. A locational equilibrium occurs when there is no incentive to move. In order to achieve this, the price of the slum house will decrease as the price of the beach house in Hawaii increases. That way, a person who could afford either house before now has either an incentive to move to the cheaper house they can afford rather than the nice beach house which a more affluent person can now live in.

Axioms of Urban Economics

Axiom 1: Prices Adjust to Achieve Locational Equilibrium In a locational equilibrium amenities of a location are capitalized in the rental rate: Rent on beach house > Rent on highway house or Land rent in center > Land rent on fringe Amenities for a location may also be capitalized in wages: Wage in Klang Valley > Wage in Senawang

Axiom 2: Self-Reinforcing Effects Generate Extreme Outcomes

This axiom means that if one type of person moves into an area, then that area will become more attractive to more of the same types of people. For instance, a few artists may move into a city and because of their artistic touches to the city and local night life more and more artists will move in until it is a complete artistic city that will draw even more artists to the area. Another example of a self-reinforcing effect generating extreme outcomes is if one or two car dealerships were to locate in the same area. People would then want to shop for cars in this area thus making it even more desirable for auto stores and car dealerships to locate here. This would then create an extreme outcome of an auto cluster. This can happen with almost any type of neighborhood and this is why it is common to see a lot of the same types of things or people grouped together in a city

Axioms of Urban Economics

Axiom 2: Self-Reinforcing Effects Generate Extreme Outcomes: Self-reinforcing effects lead to changes in same direction. For example, auto row attracts comparison shoppers. A cluster of artists attracts other artists

Axiom 3: Externalities Cause Inefficiency

An external cost is one in which the full extent of an action is not paid by the person performing the action. It will affect other people as well. For instance, if you drive on the highway it will slow down everyone else who is also on the highway. Also, in the case of rubbernecking, which is slowing down to see an accident on the side of the road, your curiosity will slow down everyone else on the highway. An external benefit is one in which something that one person does creates a benefit for someone else. This is most common in neighborhoods where one person may make improvements to their property thus helping their neighbors increase their property value because the area will suddenly become more desirable. When there are costs and benefits in society the market is not socially efficient.

Axioms of Urban Economics

Axiom 3: Externalities Cause Inefficiency : A externality is a cost or benefit of a transaction experienced by someone other than the buyer or seller. Examples: External cost burning gasoline affects breathers of the air. External benefit painting a peeling house increases values of neighboring properties.

Axiom 4: Production is Subject to Economies of Scale

In order to achieve economies of scale the average cost of production has to decrease as output increases. The two things that contribute to economies of scale are indivisible inputs and factor specialization. These are important here because inputs can be spread farther as output increases and people can work in more specialized areas thus allowing them to become more efficient at what they do

Axioms of Urban Economics

Axiom 4: Production is Subject to Economies of Scale: Economies of scale describes how average cost decreases as the output quantity increases. There are several explainations for this phenomenon: Indivisible inputs: required to produce one or a thousand units. Factor specialization : Jack of all trades master of none. Specialized worker is a master of one task. Repetition and learning. Extent of scale economies varies across activities

Axiom 5: Competition Generates Zero Economic Profit

This states that firms will continue entering the market in the same location until economic profit becomes zero. Once this is reached, a firm will be making enough money to continue their business, however there will not be an incentive for new firms to continue entering the market

Axioms of Urban Economics

Axiom 5: Competition Generates Zero Economic Profit : Entry into market continues until economic profit is zero. Economic cost includes all opportunity cost, including opportunity cost of time and funds. Zero economic profit: Firms making just enough money to stay in business; not enough to attract more entrants

Why Do Firms Cluster?

The standard neoclassical models in Urban Economics, e.g. Muth-Mills and von Thnen, assume that there is a central business district in which all firms locate. This is taken as an exogenous assumption outcome.

Why Do Firms Cluster?

Why do competing firms locate close to one another? Two explanations: 1 Localization economies: firms in an industry cluster 2 Urbanization economies: firms in different industries cluster

Why Do Firms Cluster?

There are many significant reasons why firms would choose to cluster together in a city. The economic forces which cause this clustering are called agglomeration economies. Localization economies are when firms locate within one single industry. Urbanization economies are when firms locate across industry boundaries. One firm may have an incentive to move closer to another firm eventually creating a dense city

Why Do Firms Cluster?

Sharing Intermediate Inputs Firms may locate close to one another in an effort to share intermediate inputs. This is important with industries or firms that have similar inputs and can benefit from being close to one another. By sharing intermediate inputs they should be able to cut production costs and increase specialization thus making production subject to economies of scale. Many high-tech products are made up of smaller components which make it useful for firms to locate where these smaller components are being manufactured.

Why Do Firms Cluster?

Sharing a Labor Pool Firms are able to share workers when locating close together. This helps people to find what they are good at and for firms to hire productive people for their particular production item while a person may be better suited for working with a different firm. This also ties into the idea of labor matching. A firm can lose a lot of money training workers who do not have the necessary skills for their job, but in a big city, they have a larger area of workers to choose from and thus better matches between workers and employers can be produced

Why Do Firms Cluster?

Knowledge Spillovers This is helpful in causing firms to cluster as they can gain from one another's knowledge and hopefully educated workers. From examining these different concepts, it seems that firms can benefit greatly from locating in a cluster. They can share inputs and a labor pool, provide better skills matching among workers, and generate knowledge spillovers. All of these things contribute to lower production costs which in turn will increase profit for the firms

Why Do Firms Cluster?

Joint Labor Supply Firms have an advantage to clustering when taking into account joint labor supply. This refers to married couples who often seek places to live based on what jobs are available. This means that different types of firms clustering together will attract those couples who have to consider each individual finding a job. Having different firms in one area is beneficial to both the workers and the firm. Often, those who are married and both parties are working tend to have a higher level of education thus adding to the labor pool from which the firms can choose. These firms clustering lead to the development of a larger urban area to which couples interested in joint labor supply will be attracted.

Why Do Firms Cluster?

Sources of localization economies Some alternative explainations for firm clustering include: I Sharing Intermediate Inputs II Sharing a Labor Pool III Labor Matching IV Knowledge Spillovers

Why Do Firms Cluster?

II. Sharing Intermediate Inputs A Intermediate inputs: one firms output provides inputs for other firms B Historical example: dresses and buttons a Firms producing high fashion dresses must be small b Scale economies exist in producing buttons are large relative to the demand associated with a single dressmaker c Face time is requires to design and fabricate buttons to fit dresses d Variety is required in types of buttons demanded (shape, finish, color

Why Do Firms Cluster?

Why Do Firms Cluster?

Why Do Firms Cluster?

Key Points in the Economic Logic a Higher total demand for buttons allow the button maker to realize economies of scale b Button makers can specialize in types of buttons, reducing modification costs High-Technology Firms 1 Rapidly changing products necessitates intermediate inputs 2 Face time is required for the design and fabrication of intermediate inputs 3 Firms share suppliers of intermediate inputs

Why Do Firms Cluster?

Sharing Pool Labour The Isolated Firm 1 Perfectly inelastic supply of labor to firm: only employer in town 2 Variation in demand generates variation in wages

Why Do Firms Cluster?

Why Do Firms Cluster?

Equilibrium with Clustered firms 1 Perfectly elastic supply of labor to individual firm a Each firm is one of many b Constant total demand for labor implies constant wage (lower risk) 2 Locational equilibrium for workers: same expected wage in cluster and isolated site = $10 3 Variation in product and labor demand generates variation in workers hired, not wage

Why Do Firms Cluster?

Why Do Firms Cluster?

Clustering Increases Expected Profit 1 Year of high demand: more profit because of lower wage and more workers 2 Year of low demand: less profit because of higher wage 3 Good news dominates bad news: firm responds to changes in demand a High demand: hire more workers to exploit relatively low wage b Low demand: hire fewer workers to cushion blow of high wage

Why Do Firms Cluster?

Labor Market Matching The logic goes as follows: 1 Jobs and workers not always perfectly matched 2 Mismatches require training costs to eliminate skill gap 3 Larger city provide better matches

Why Do Firms Cluster?

Knowledge Spillovers Basic logic: A Firms in an industry share ideas and knowledge 1 mysteries of trade are in the air 2 innovations are promptly discussed, improved, and adopted B Widespread empirical evidence of knowledge spillovers 1 Spillovers more important in idea industries 2 Most innovative industries are the most likely to cluster 3 Spillovers have range of a few miles

Why Do Firms Cluster?

History in Economic Thought When an industry has chosen a locality for itself, it is likely to stay there for long; so grate are the advantages which people following the same skilled trade get from near neighborhood to one another. The mysteries of the trade become no mysteries; but are as if were in the aire, and children learn many of them unconsciously. Good work is appreciated; inventions and improvements in machinery, in processes and the gneeral organization f 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 new ideas. Alfred Marshall, 1920

Why Do Firms Cluster?

Self-Reinforcing Effects Cause Industry Clusters 1 When firms cluster, they may lose exclusive market areas 2 Clustered firms however share a larger market area 3 Clustering may increase average transport costs 4 But, these costs increases must be balanced with localization economies: shared inputs, labor market pooling and skill matches, and knowledge spillovers 5 Self-Reinforcing Effects Generates an Extreme Outcome

Why Do Firms Cluster?

Vertical axis measures profit gap (firm in center vs. isolated firm) 2 Single firm in center : profit gap is zero 3 Second firm in center cuts button costs and increases profit per firm by $6 4 If third firm joins cluster, profit gap increases to $13

Why Do Firms Cluster?

Why Do Firms Cluster?

Evidence of Localization Economies 1 Worker productivity is higher in clusters 2 More firm births in clusters 3 Employment growth is more rapid in clusters

Why Cities Exist and How They Have Formed

In order to understand why cities exist we must first consider a world without cities. For there to be a place with no cities there must be equal productivity, constant returns to scale in production, and constant returns to scale in exchange. Equal productivity allows each person to be responsible for his or her self and there is no specialization in any one area thus there is no need for a city to develop

Why Cities Exist and How They Have Formed

The next thing necessary for there to be no cities is for there to be constant returns to scale in production. So if production is subject to economies of scale, then households will be more likely to involve a trading firm when trading their products. This is because trading firms will have the ability to effectively trade with lower transaction costs than if the household were to do it themselves

Why Cities Exist and How They Have Formed

The last necessary condition for cities to not exist is constant returns to scale in exchange. If there are scale economies in exchange then two households will link together and exchange the products in which they have a comparative advantage.

Why Cities Exist and How They Have Formed

Once all three of these conditions are changed, a trading city will emerge. Different firms locate in different areas based on what type of transport costs they have. Most firms will choose to locate in a trading city because the benefits outweigh the costs. In a trading city a firm has access to a large customer base, good access to foreign markets, and a large labor pool. This outweighs the fact that in a city there are higher rents and the firms must pay their workers higher wages. There are two different types of transaction costs that affect where a firm will locate

 Some firms have inputs that are cheaper to transport in the beginning than at the end and this is called material-oriented. When they focus on outputs this is called market-oriented and the companies will locate where the final product will be Lets take away equal productivity first and see where that leaves us. If there are two regions that are not equally productive then it can be assumed that one area may be better in producing one or more products than the other region. This is called comparative advantage

 If one region has a comparative advantage then it is more beneficial to produce that item and trade for another item that another region may have a comparative advantage in producing. To learn more about comparative advantage and trade visit the production possibilities section.

 Considering constant returns to scale in production once more we can assume that production is subject to economies of scale. So, if a household were to specialize in one specific thing, then the inputs would be indivisible such as machines and workers could specialize in certain tasks thus leading to a higher productivity and lower costs all around. The last condition for there to be no cities is to have constant returns to scale in exchange. Households can link together and directly trade, however with economies of scale in exchange trading firms will emerge because they ultimately have lower transaction costs.

Why Cities Exist and How They Have Formed

Therefore, it can be seen that cities exist because it is beneficial to produce what you are good at and use trading firms to lower costs and trade with other cities that may specialize in something else. Because of this trading effect and the fact the firms cluster, larger cities will develop with a central business district. http://www.econport.org/content/handbook/ Urbanecon/exist.html

Axiom 4: Production is Subject to Economies of Scale

Why do cities exist? Cities are places in which population density is greater than the other parts of the countries. In an economic context, what are the factors behind the creation of the cities? Lets build up a model Assumptions: 1. The region produces and consumes two goods: shirts and bread.

Axiom 4: Production is Subject to Economies of Scale

2. People use land to grow raw materials and take time to transform raw materials into shirt and bread. 3. Travel within this region is by foot. Residents walk at a speed of 8 miles per hour.

Axiom 4: Production is Subject to Economies of Scale

Suppose that: 1. All residents are equally productive at producing bread and shirts. Similarly all land is equally productive in production of raw materials. This assumption implies that there is no room for comparative advantage. Since all residents are equally productive at producing bread and shirts, there is no advantage of trading.

Axiom 4: Production is Subject to Economies of Scale

If we relax this assumption, i.e. one part of the region may have a comparative advantage in shirt production and the other part may have a comparative advantage in bread production. Lets say that the region has two parts: South and North. The production amounts in each region are given below:

Axiom 4: Production is Subject to Economies of Scale

OUTPUT PERHR (OF A WORKER) SOUTH BREAD SHIRTS 2 2 NORTH 2 6 OPPORTUNITY COSTS SOUTH 1shirt 1bread NORTH 3shirt 1/3bread

Axiom 4: Production is Subject to Economies of Scale

South has a comparative advantage in production of bread. North has a comparative advantage in production of shirts. 2. Suppose that there are no scale economies in transportation. Transport cost per unit of shipped per mile is independent of the volume shipped. But, if transport cost per mile decreases as the volume transported increases, it would be cheaper to transport shirts and bread in bulks. This also creates intermediaries in transportation. What are the implications?

Axiom 4: Production is Subject to Economies of Scale

The trading firms will locate at places convenient for the collection and distribution of goods. Hence, marketplaces develop at crossroads, ports and other shipment points. The location decisions of the trading firms cause the development of cities. The marketplace will create employment opportunities. The employees will live near marketplace to economize on commuting costs. Hence, demand for land near marketplace increases: Price of land increases. Residents will economize by occupying smaller lots.

As a result, population density around the marketplace will be higher than the rest of the region.

Axiom 4: Production is Subject to Economies of Scale

Comparative Advantage ( trading cities) scale economies in transportation ( Firms prefer transportation in bulks, Marketplaces develop at crossroads, ports, other shipment points )

Market place will create new job opprtunities ( employee will live near market place to economize communiting costs, population density around market place will be higher than in the rest of region )

Axiom 4: Production is Subject to Economies of Scale

Suppose that production is subject to constant returns to scale. This means, each worker can produce either 1 shirt or 1 bread per hour regardless of how much he/she produces: There are no advantages from producing at large scales. If we relax this assumption, and impose assumption of scale economies, then factory production may replace home production. How?

Axiom 4: Production is Subject to Economies of Scale

If there are scale economies (instead of CRTS) in production, as volume of shirt production increases, labor required to produce one shirt decreases (less input per unit of output, costs decline with output).

Axiom 4: Production is Subject to Economies of Scale

Why does the average labor time decrease as number of shirts produced increases? 1. Factor speacialization: Each laborer specializes in one task and their productivity increases. 2. Indivisible inputs: Some inputs are indivisible since they have minimum efficient scale. E.g. Machines in a factory. As output increases factory uses more indivisible inputs hence productivity increases.

Axiom 4: Production is Subject to Economies of Scale

If the shirt factory produces 400 units with 100 workers and 4 shirts per worker per hour: What should be the wage level and price of a shirt? Wage should be at least as high as to make workers indifferent between working in the factory and working at home. If the worker works at home: He/she produces 1 loaf of bread/hr. If the worker works at the factory: He/she produces 4 shirts/hr. Hence, minimum wage should be 1 loaf of bread/hr.

Axiom 4: Production is Subject to Economies of Scale

Since each worker produces 4 shirts/hr, assuming that there are no other costs, production cost of one shirt is 0.25 loaf of bread.
Net price of a factory shirt: Price paid by consumer to firm (0.25 loaf) + Consumers opportunity cost of the time spent traveling to and from the factory (Loss of bread production due to traveling instead of producing bread).

Axiom 4: Production is Subject to Economies of Scale

A resident can produce 1 loaf per hr. It will be sensible to buy a factory shirt if net price of a factory shirt is at most 1 loaf. Since, production cost is equal to 0.25 loaf, the consumer should consider the time that a trip takes. 0.25 + trip time= 1 Then trip time can be at most 0.75 hr. If it is less than 0.75, the consumer will prefer a factory shirt.

Axiom 4: Production is Subject to Economies of Scale

Suppose that walking time is 8 miles per hour. According to these criteria, the market area of the shirt factory is determined. It is the area for within which the factory will underprice homemade shirts for residents. In our case, it is defined as the area within 3 miles of the factory. Why? (We can have at most 0.75 hrs walking time, this means since walking time is 8 miles/hr, we can have 6 miles for two way walking to and from the factory-. That is why we end up with a circle with a radius of 3 miles)

Axiom 4: Production is Subject to Economies of Scale

Factory causes the development of a small factory city. Are there any limits to city size? 1. Freight cost: We have assumed that consumers travel between home and factory meaning they they themselves incur freight costs. This cost of transporting goods limits the ability of the factory to exploit economies of scale in production. What can the factory do? We know that travel speed is 8 miles/hr. and market area is a circle with a radius of 3 miles. If the firm becomes responsible from freight costs and creates a method to increase the travel speed, then it can create a greater market area. E.g. If the firm increases the travel speed to 16 miles per hr (doubles), market area will be a circle with a radius of 6 miles. This will increase the output of the factory, factorys workforce and population of the factory city.

Axiom 4: Production is Subject to Economies of Scale

Decrease in freight cost allows factory to more fully exploit economies of scale, increasing city size. Transportation is a very important factor affecting the city size 2. Scale economies: As economies of scale beacome more powerful, cost of factory production decreases relative to home production. Hence, market area of the factory increases and size of factory cities increase.

 Commuting costs: Larger cities have larges commuting times. In larger cities factory must pay workers to compansate for longer commuting times. But as wages increase, cost of factory shirts increase relative to homemade shirts. Since market area is determined according to the net price of the factory shirts, increase in wages is a limit to the city size

Why Firms Cluster

Causes of Urban Expansion

1 An increase in population will increase urban expansion. 2.

An increase in household income will increase urban expansion. 3.

An increase in transportation costs will reduce urban expansion. 4. An increase in the opportunity cost of non-urban land will reduce urban expansion.

Causes of Urban Expansion

5. 6. 7. 8. An increase in the world price of the export good will increase urban expansion. An increase in marginal productivity of land in production of the export good will increase URBAN expansion. An increase in the share of land available for housing development will increase urban extent and urban expansion. An increase in the marginal productivity of land in housing production will cause urban expansion.