Mar 10th 2011, 20:14 by R.A. | WASHINGTON
IN COMMENTS, Stephen Morris asks:
What is the evidence that cities are more efficient ways of organising economic activity? Specifically, how do we know that - in this day-and-age of telecommunications - the existence of cities arises from superior efficiency in organising economic activity, and not merely from superior efficiency in organising rent-seeking?
It's a good question. How do we know cities are productive and not just centres for rent-seeking? The answer is simple: because they export.
It's not hard to understand what Mr Morris might have in mind. Consider the San Francisco Bay area. It is, by most accounts, a very nice place to live. It's not too hot and not too cold. The city is full of rich entertainment and dining options. There are excellent universities. The scenery around the Bay is unparalleled. Wine country and top-notch snow skiing are within easy reach. The available amenities are impressive. So perhaps what we have here is a situation in which landowners collude, via zoning regulations, to restrict housing supply, thereby allowing themselves to charge and receive exorbitant sums in exchange for the right to live near these amenities. Meanwhile, the people living in the area will need to purchase goods and services. Because new construction is limited, existing businesses face little competition and can charge high rates. There's not enough cheap real estate to support free entry of, say, hairdressers, so the hairdressers that are already in business enjoy market power.
The result is high wages and an apparently high level of output, all built around the simple fact of restricted access to desirable amenities.
But there's a problem with this line of argument. Lots and lots of Bay area firms produce goods and services for sale in other markets. In the city, there are financial and business service firms that cater to clients in other cities and countries. Down the peninsula, there are industrial concerns. In Silicon Valley there are companies producing software, hardware designs, search algorithms, and so on. These firms are interested in their bottom lines, and they're all too conscious of the cost of their location in California. Expensive land means expensive office space. Perhaps more important, expensive land means that firms must compensate employees for the price of housing. Otherwise, real wages for these workers would be ridiculously low, and they'd opt to work elsewhere.
Why would a bottom-line oriented firm pay so much for land and labour? The only reasonable explanation is that they're getting something in return. There must be location-specific advantages that deliver productivity savings which compensate for higher costs. Otherwise, firms would move to cheaper locations, produce for less money, and undercut the Bay-area businesses. And what the research indicates is that skilled-worker productivity is often much higher in dense agglomerations. That's the benefit firms get. That's why the firms can afford to pay high wages.
This doesn't imply that all workers in productive areas are more productive than their peers elsewhere. When pay in one sector rises due to productivity increases, firms in other industries have to increase pay to retain workers, whether or not their workers have gotten more productive. This is Baumol's cost disease. And it is potentially a drag on local and national economies. As rising prices in unproductive sectors increase the cost of living, workers in the productive sector may demand higher wages. Such increases are only possible, of course, so long as their productivity keeps rising.
Incidentally, we have a pretty good idea what happens when location-specific advantages disappear, as they sometimes do. When transportation costs were higher, there were huge advantages to industrial agglomeration. But as transportation costs fell, those advantages weakened. As a result, producers began doing just what we'd expect them to do: moving their operations to lower cost areas and undercutting the high-cost urban firms. This destroyed the high-cost industrial firms and the high-cost economy that had grown up around them, producing hollowed out cities across the American midwest and northern Britain and Europe. Only in those cases where another industry with different location-specific advantages arose did cities recover. These new "knowledge" industries may themselves prove vulnerable at some point in the future. For the moment, however, the exporting capacity of metropolitan firms suggests that economies are deriving huge benefits from their cities.
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It may be a matter of network effects and opportunity cost.
Let's say I'm going to start a company to design integrated circuits - computer chips. I need, say, twenty electrical engineers, and at least five of them need to be first-rate talent. I might be able to start that business in, say, Salt Lake City, if I'm willing to move people. There aren't twenty people like that looking for work in Salt Lake. There probably aren't twenty people like that in Salt Lake who could be persuaded to leave their jobs.
I could do it in Salt Lake if I'm willing to do a nationwide search and move people - but that takes time. Chip design is very often a winner-take-all business, where first-to-market wins, and first-to-market is measured in weeks. The opportunity cost of having to run that nationwide search is enormous.
If I start that business in Silicon Valley, I can find those twenty people in a hurry.
So that's why the chip companies are in Silicon Valley. But why are the engineers there? Same reason. If they get sick of their current job, or want opportunity to knock on their door regularly, Silicon Valley is where they want to be.
O Ryan, patiently fighting the good fight! Spot on as usual.
Don't forget image. We once had a technical client come on because he could contact potential customers using our address, that had the same Zip Code as MIT.
If you want to start the kind of business that is in Silicon Valley, your cred will be much augmented by starting it there, without regard for any other benefits that might offset the higher cost.
I thank R.A. for his answer to my question, and I hate to take on the combined weight of experts in this field, but I do not believe it to be a complete answer.
What R.A. has done is to show that some cities in some circumstances might have agglomeration advantages in some industries, and then to apply that special case to all cities.
Correct me if I'm wrong, but R.A's analysis seems to rests on an assumption that markets operate perfectly. If markets operated perfectly there would be no rents, and cities "“ if they existed "“ would exist because of their efficiency in organising production.
But markets are not perfect. Where barriers to entry and other impediments exist, rents will exist and cities may exist "“ or exist at the size they do "“ not because of their productive efficiency but because of their ability to capture those rents.
As I will show, such cities would export even if they are less efficient at production than other centres.
Let me begin by putting some counter-examples, and then offer a different "“ a "rent-seeking" - theory of city growth. I'll begin with more obvious examples of rent-seeking and then proceed to progressively less obvious examples.
The first examples are the state and territory capitals of Australia.
Australia is a country which enjoys a comparative advantage in agriculture, mining, energy, and in some areas international tourism. These are primarily the products of rural and regional Australia. And yet the population is squeezed into the eight state and territory capital cities, cities which are increasingly congested, costly and dysfunctional.
Why?
Because the economic rents which flow from the competitive industries are captured by the state and territory governments and disbursed to those who are close to the politicians empowered to disburse them. (This behaviour has already been acknowledged by R.A. in Government of the rich, by the rich, for the rich.)
The Australian state examples are illuminating because the process of rent-capture is so transparent: the state and territory governments collect cash rents in the form of mineral royalties. They also have access to other "“ less obvious "“ rents in the form of their discretionary power to award exploration and mining leases, and to award contracts for infrastructure.
As a result, there is "money to be made" in the capital cities, and people who want a share of the spoils must move to those cities "“ within "lunching distance" of the Cabinet.
The primary rent-seekers are those with closest access to the decision-makers disbursing the rents. Around them is a halo of secondary rent-seekers providing services to the primary rent-seekers. To apply the "Time Square Abblebee's" example, the high income earned by the mining magnate makes it uneconomical for him to prepare a cut lunch each morning, so that function is contracted out to Abblebee's [or the Brisbane or Perth equivalent] which sets a price that the primary rent-seeker will bear. It thereby extract some of the rents.
And around the halo of secondary rent-seekers is a larger halo of tertiary rent-seekers, and so on.
These cities still export.
Brisbane and Perth, for example, export engineering and other services to mines which are located hundreds of kilometres away. Geology needs to be analysed. Mines need to be designed. Access roads and railways need be designed and built. Engineers and technicians waste thousands of hours a year flying to and from construction sites.
To take some personal examples, a friend and many of his colleagues spend hundreds of hours each year flying the thousands of kilometres to-and-from central and far north Queensland to supervise the building of wharfs and bridges. A geologist friend in Perth does the same, flying out to the field and back.
Why?
Why are Mackay or Port Hedland "“ much closer centres - not major cities supplying these services more efficiently?
Because the primary rents are bubbling out from the capital cities, and no-one with any ambition will live any distance from them. The bridge and wharf contracts are awarded in the state capital. A firm based anywhere else would have a hard job winning them.
Moreover, the best schools, hospitals and other services (all heavily funded by the government from its rent-stream) are located in the capital cities. Who wants to sacrifice their children to second-rate education by living outside the capital? Who wants to be at the mercy of second-rate health care when they grow old?
The Australian state and territory capitals exist not because they are efficient at production but because they are efficient at capturing rents.
I shall return presently for the next instalment on less obvious methods of extracting rents.
Let us now move on to examples of less obvious rent extraction. We will expand the horizon from state and territory governments to the Australian federal government. Then in the following section I will consider rents more generally as they arise in the US.
We have seen why cities like Brisbane and Perth might exist and continue to grow even though they are inefficient. But why does almost a fifth of Australia's population live in Sydney, and almost as many in Melbourne?
Originally these centres developed as state capitals living off their hinterlands, and by the time of federation were the two largest centres in Australia.
As the power of the federal government has grown, it has come to take over the rent-extraction function from the states, and distribute the proceeds to powerful voter blocs in the largest cities. As more people are drawn in to share in those rents, their power as a voter bloc increases.
Lets look at some of the less transparent ways of extracting rents:
- industry protection:
- "competition" policy and other business regulation; and
- taxes.
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