May 13, 2012

Economic Geography Scale Models

Exiting column by The Economist on transport costs and the returns to scale

I think Matt Yglesias' intuition in this post—that Asia's relative economic importance is sure to grow, other things equal, given its huge share of global population—is on the mark. In the details, though, he gets a bit wobbly:

Obviously in the world-as-it-exists the low wages in China are an important issue. But if you imagine a long-term trajectory that's bending toward similar wages around the world with similar prevailing technology, then the key thing for Americans to consider is that Asia is the dominant choice for production even under a level playing field. That's because Asia is where the bulk of the people are.

Ask yourself within the western world why the United States ahas an aviation industry and New Zealand doesn't. It's not because we're undercutting their wages. It's because the total market for airplanes in New Zealand is small so it doesn't make sense to locate a factory there. Instead, they trade sheep for airplanes. And by all accounts they have a high standard of living doing so. But they're not exactly winning the future.

Yet it's difficult to see what a remote nation with relatively few citizens could possibly do to become a world leader in heavy industry or cutting edge technology.

Transport Costs
We need to introduce two very important concepts here: transport costs and the returns to scale. If transport costs were infinitely high, then the global distribution of population wouldn't much matter. Production would be widely distributed because it would be too expensive to ship goods from market to market.

From Scranton to Shanghai
New Zealand would have a manufacturing sector, as would every other country (and indeed, every village). On the other hand, if transport costs were effectively zero, then the distribution of population also wouldn't matter. A business could serve the Chinese market as easily from Scranton as from Shanghai. Because transport costs are somewhere in the middle, location does matter, but how much it matters has varied considerably over the course of the past two centuries.

Global Supply Chain
The migration of manufacturing that serves American markets from expensive American places to cheap American places and then to cheap foreign places was made possible by steady declines in transport and communication costs. It's interesting, then, to read that the Asian wealth this shift has created should attract still more manufacturing to Asia. It's not crazy; obviously, proximity still matters across much of the global supply chain. I wouldn't read the economic history of the past century as indicating strongly that all activity will end up in Asia, though.

Return to Scale
The other concept worth mentioning is the return to scale. Most economists will tell you that New Zealand doesn't lack an aircraft industry because it's small or remote. It lacks an aircraft industry because it lacks an aircraft industry. That is, the incredible capital-intensity and economic barriers to entry of the aircraft industry mean that there are increasing returns to scale. It takes a lot of work and investment to get that first jumbo jet off the assembly line. Once the line is up and running, however, margins improve with each new order.

An existing manufacturer will therefore enjoy new-plane costs that no would-be competitor can match. It took heavy European subsidies to get Airbus off the ground—a cost Europe considered worth bearing in order to wrest away manufacturing dominance from Boeing. Europe has more people than America, but it took subsidies to get European aircraft manufacture off the ground because scale was the issue.

Why we have cities
Few industries face scale issues that significant, but increasing returns to scale are a fairly common occurence in the modern economy. They are the reason we have cities, for instance; workers become more productive when they crowd together. Where there are increasing returns to scale, we can expect to observe agglomeration—essentially bunching together. Given the greater population and population density of Asia relative to, say, North America, we might expect relatively more specialisation and innovation, giving rise to the development of more clustering industries, leading to the location of a disproportionate share of economic activity in Asia.

Silicon Valley
This is by no means a given, however. By many standards, Silicon Valley is a relatively underpopulated and remote place. It has nonetheless managed to reign as the world's leading centre for technological innovation for half a century.

Source: R.A. , The Economist, Washington

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