New economic geography

It is only recently that economists have been able to provide an analytical framework to explain the emergence of economic agglomeration in otherwise homogenous space. In classical economics, the principle of comparative advantage i.e. efficiencies of costs as associated with Ricardo (1817) were used to explain the existence and patterns of international trade based upon relative cost advantages between different countries.36 The principle however did not explain why or how comparative advantage exists. This was later supplemented by the work of Eli Heckscher before being expanded upon by his student Bertil Ohlin (1933) in relation to patterns of trade between countries linked to asset endowment advantage. Like any theory based on comparative advantage, the Heckscher-Ohlin model advances international differences in factor endowments, which generates differences in equilibrium, prices and hence an incentive to trade. In the 1960s and 1970s, many began to question the Heckscher-Ohlin model, as it seemed to be out of step with what was happening in the real world. Trade amongst advanced economies was increasingly intra- rather than inter-related, involving the exchange of near similar rather than diverse goods (Helpman, 1981).

The prominence of intra- related trade contributed towards emergence of ‘new’ trade theory, this sought to overcome the shortcomings of the neo-classical model by dealing with trade in a more complex and sophisticated manner by incorporating a fuller range of factors. The theory combined increasing returns to scale at firm level (internal economies of scale) and the love-of-variety effect in consumer preference, giving rise to monopolistic markets. The

introduction of increasing returns to scale by Krugman (1980) advanced the notion of market structures being underpinned by imperfect competition. The theoretical challenge was to provide a trade model that incorporated imperfect competition. In this regard Krugman built upon monopolistic competition as advanced by the work of Chamberlin (1933), and Dixit and Stiglitz (1977), the latter mathematically modelling the conceptual ideas of the former. Analytically, monopolistic trade as advanced by Chamberlin (1933) is similar in the short run to a monopoly situation; the main difference relates to price elasticity, because within monopolistic markets there are different firms with differentiated substitute products.37 If a monopolistic competitor earns economic profits in the short run, new firms can (and will) enter the marketplace, gain access to those profits, and eventually drive them down. If incumbents are able to erect artificial barriers to entry, for example by using patents, they may be able to delay the day when their economic profits are driven down to zero. Another tactic for protecting economic profits is linked to non-price-based competition, where firms attempt to attract customers through real or imagined improvements in the quality of a product or service. Since monopolistic competitors by definition produce goods and services that are somewhat different, if they can succeed in further differentiating their products from others via loyalty or technological lock-in, the potential loss of customers is likely to be less as new firms enter the market.38

Whereas the Heckscher-Ohlin model was associated with trade driven by product or resource differences between countries, Dixit and Stiglitz focused upon optimum product diversity and the trade-off between the output of goods and their variety within monopolistic markets. Above all, the model allowed consideration of the implications of increasing returns to scale and product differentiation within a general equilibrium perspective. This focus was essential for analysing trade patterns, the impact of trade policy on income distribution, and the effects of international mobility. Dixit and Stiglitz used a ‘representative’ consumer to formulate assumptions about utility function. This is aggregated and treated as a community welfare function to derive demand curves for the various differentiated products and to evaluate the welfare effects of various market changes. The utility function gave mathematical expression to Chamberlin’s famous ‘symmetry’ assumption i.e. that new generic products gain demand in

equal proportion from all existing differentiated versions. An important characteristic of this model is that a change in the welfare of the representative consumer cumulatively influences society as a whole. Whilst greater differentiation implies that variety has a greater effect on utility, major criticism surrounding the Dixit and Stiglitz model rests on the assumption that individuals are identical regardless of circumstance, giving a false sense of how markets work in reality.

Intra-industry trade and monopolistic competition formed the basis for ‘new’ trade theory; Krugman (1980) later attempted to expand and take into consideration the location of industry. As a result, he utilised Hotelling (1929) to understand spatial location in the context of monopolistic competition. Within Hotelling’s model, production and transport costs are assumed to be identical, and consumers are evenly spread, while demand is inelastic. Given that firms do not compete in terms of output price (this is fixed), each firm can adjust its location in order to acquire greater market share. Taking firms A and B as competitor case examples in Figure 3.1, A in order to extend its market share moves from its initial location P1 to P2, B subsequently responds by moving from P3 to P4, and both firms now reside in the middle. If these enterprises move beyond point X they would lose market share, the middle ground becomes the optimal location as neither firm gains any subsequent advantage.

Figure 3.1 Hotelling model.

P1 P2 X P4 P3

Firm B Firm A

The process above also creates a centre and periphery effect, where consumers at the centre benefit and those at the periphery such as P1 or P3 lose out because of the increase in distance costs.39 From a welfare point of view, consumers located close to such spatial clusters tend to experience a welfare gain relative to those sited further away. If the Hotelling model were to incorporate competition (which it does not), a process would emerge leading to a situation where there would be zero profits for both parties. In this circumstance, in order to generate localised monopoly power, as prices spiral downwards, each firm would need to move away from the other in order to maintain some level of area-related market influence and consequently gain positive profits. Yet as in the case of firm A or B, neither has an incentive to initiate this move first, for by doing so, the competitor would be able to maintain price levels at the centre and dominate a larger market area. In situations where firms produce or sell identical products and where price-based competition is difficult to engage in, firms may seek to move away from each other. For example, showrooms selling a particular type of car manufactured by the same company will tend not to cluster together spatially in order to guarantee some market monopoly influence in their immediate vicinity; the result of this process is dispersion rather than concentration. Although the Hotelling model provides a coherent explanation of firm strategy in relation to location, it does not comprehensively reflect reality, because it assumes there is perfect information flow and mobility ease. Additionally, not all firms make decisions in order to maximise profits or market share, some make decisions in order to achieve alternative goals (Webber, 1972; 1984; McCann, 1995).

With regard to the issue of core–periphery development, the literature on ‘new’ economic geography has attempted (via the Dixit and Stiglitz model) to incorporate micro changes that contribute towards spatial concentration. Focusing upon centripetal and centrifugal pressures, which respectively aid or deter concentration, Krugman (1996a) advances the concept of the ‘self-organising’ economy, this essentially relates to the fact that agglomerations tend to be self-reinforcing.40 In terms of trade, economies of scale are also presumed to provide savings that underpin international specialisation (see Graham, 1923).41 In their model of monopolistic competition, Krugman and Venables (1995) assume that each product variety is produced in just one place; the origin for this is left unexplained and assigned to history. Firms and

workers engaged in specific industries are also assumed to locate within regions and nations where local demand is relatively high for their services or products; this process subsequently reinforces increasing returns and encourages in-migration. As Krugman (1980) implies:

Countries will tend to export those kinds of products for which they have relatively large domestic demand. Notice that this argument is wholly dependent on increasing returns; in a world of diminishing returns, strong domestic demand for a goodwill tend to make it an import rather than an export. This phenomenon is known as the home- market effect.

(Ibid., p. 955)

The above can be formalised within a cumulative causation model reminiscent of the Keynesian multiplier, to explain how regions that are similar or even identical in underlying structure can endogenously differentiate into core and peripheral regions. In fact, ‘new’ economic geography goes back to the approach established by ‘regional science’ based upon the logic of measuring utility in a quantifiable manner.42 As a result the theory does not really attempt to understand what makes various places unique; it therefore reverts to a homogenised perspective of territory or space. Nonetheless in criticising such an approach it is important to remember, as stated by Martin and Sunley (1998), that there exists a tradition of such research based upon mathematical models as a way of defining abstract economic theory.