Category Archives: network economics; privatization; road pricing; simulation of network evolution; transportation financing

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.

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.

The Economics of Road Network Ownership: An Agent-Based Approach – International Journal of Sustainable Transportation

Recently published:
Zhang, Lei and David Levinson (2009) The Economics of Road Network Ownership: An Agent-Based Approach. International Journal of Sustainable Transport Sept. 2009 3(5) pp. 339-359. [doi]

This paper explores the economic impact of alternative ownership structures on transportation system performance, social welfare, and regulatory needs. Road pricing, investment, and ownership decisions are jointly considered in an agent-based evolutionary model applicable to large networks. Results suggest that a centralized public regime with average-cost pricing is far from socially optimal with even moderate demand growth. When properly regulated, a completely privatized transportation network could achieve net social benefits close to the theoretical optimum and distribute a high percentage of welfare gains to travelers. But an unregulated private road economy would suffer from higher-than-optimal tolls and overinvestment.
Keywords: network economics; privatization; road pricing; simulation of network evolution; transportation financing