Localization and urbanization approaches to fostering urban economic development

Urban Economics

It would be hard to find a government official who did not stress the importance of economic development -- voters like to hear about economic growth because they like jobs and security -- but there is no magic button to push to develop an economy. Fostering economic development goes much further than simple Econ 101 answers like "lower taxes." Even where such simplistic strategies are helpful, they need to be guided by a coherent vision of economic development that is rooted in sound theory. Such an approach allows for consistent long-term policy that facilitates long-run economic development, rather than ad hoc policymaking that only seems to serve short-term interests. Many studies of late have focused on clustering as a means of building strong industries, but for government an approach like clustering has to be evaluated based more on what it does for the community and the city.

The two main approaches to urban economic development are the localization economy, which implies a relative monopoly on local development for a single industry. Specialization is the key means by which the industry develops, and in turn by which the local urban economy develops. The other approach is urbanization, which emphasizes the benefits of agglomeration, particularly with respect to knowledge transfer. When planning urban economic development, a city must consider the advantages and disadvantages of each of these approaches when setting out its vision for economic development. This paper will analyze both monopoly and diversity in the context of optimal urban economic development, incorporating theory and research into the discussion.

Background

In order to answer the question how governments should foster urban economic growth, the core concepts need to be understood. It is accepted that knowledge spillover is one of the key drivers of growth in urban economies (Glaeser, Kallal, Scheinkman & Shleifer, 1991). Cities therefore are an important way of organizing an economy, compared with rural communities where there is less room for diversity. However, the importance of diversity in fostering economies is the subject of considerable debate. Smaller centers can act as clusters for a single industry, allowing for knowledge spillover between firms in the industry. Such monopolies concentrate knowledge in a small area, and this can foster a high level of innovation.

Henderson, Kuncoro and Turner (1995) note that monopolies tend to form in smaller centers when an industry becomes mature. They note that there are externalities such as knowledge sharing that occur even in mature industries, but those industries rely less on new ideas because they tend towards a slower pace of innovation. Younger industries, conversely, thrive in diverse environments, perhaps because such industries gain more from the influence of outside ideas on their innovation processes. Thus, knowledge spillover is more important in younger industries than in well-established ones.

Regardless of the form of the urban economic development, the benefits of it rely on positive externalities (Saxenian, 1996). There are three different theories as to how different externalities emerge. The Marshall-Arrow-Romer (MAR) view holds that local monopoly is superior to local competition, because the flow of ideas to others is restricted. Thus, with specialization, an urban area can foster a high level of development in one industry, because the benefits of the externalities like knowledge spillover are kept in-house. Henderson, Kuncoro and Turner (1995) noted that these types of externalities often exist when mature firms have come to dominate the urban economy of a region. Combes (2000) saw mixed results with respect to economic development with specialization in manufacturing and services. Countering this, Henderson (1997) found strong MAR externalities for manufacturers, but that those tend to be short-lived, maybe a half dozen years or so. This might explain why Combes' long-term study showed little support for MAR externalities in his manufacturing businesses.

Porter argues that the positive effects of specialization tend only to appear where there is competition. His point is that MAR externalities are only weak until there is competition, as the competition provides incentives for knowledge transfer and to emphasize innovation. Local competition, he argues, increases the pace of innovation. An oft-cited example of this is the Silicon Valley cluster, where many firms are competitors, while others are collaborators, but most firms in the area are specialized (Saxenian, 1996). One of the underlying logics is that while the degree of technical knowledge demands that an industry be concentrated in order to experience the benefits of knowledge spillover, competition forces the companies to use their knowledge and skills more frequently. By removing the complacency that can come from monopoly, not only are the positive effects of specialization apparent but they are amplified by the need to compete.

Jacobs argues that externalities are most powerful when the economy is diverse. Ideas flow between industries in such situations, and that allows for innovations to be bolder and further from the established norm. Where competition and diversity of ideas collide, the most dynamic economies will emerge. Innovation is critical to the development of a dynamic economy in the long run, and since both diversity and competition foster innovation, these are the most effective pathways. While Henderson et al. (1995) did not find support for Jacobs externalities, other studies have supported the idea. Wagner (2000) points out that diversity needs a specific definition, something that sometimes is lacking in studies with respect to the subject of Jacobs externalities. He proposes that diversity encompasses the size of the company within the economy, a range of specializations, and linkages between the economies. Where these are present, the hypothesis goes, knowledge spillover is going to be higher than in the other urban economy structures, and this will spark greater growth.

Comparisons

To compare between these different forms of urban economy, the common threads need first to be analyzed. The common thread is knowledge spillover. This is an externality that occurs when knowledge leaves an organization and then it adopted by another organization. Where such spillover occurs, firms can adapt one set of ideas into another, deriving better solutions than if the firs operated independent of one another. All three theories acknowledge that knowledge spillover a key antecedent to strong economic growth.. Where the theories differ is in how spillover is fostered.

MAR argues that specialization is the most important form of spillover. Ideas spillover between similar companies, such that the ideas that spill over are ones that can be readily used by the knowledge recipient. As a consequence, the spillover is highly effective, being a good fit with the recipient. The MAR logic essentially downplays the value of knowledge spillover between industries, and argues that the more knowledge is compartmentalized the more likely that area is to sustain growth in the long run. An example of this might be the aircraft industry in Seattle, where the firms are either Boeing or Boeing suppliers. These firms have a homogenous industry cluster, where people can take advantage of knowledge transfer, but that transfer mostly only affects Boeing and its partners. There is no real influence of competition in this knowledge spillover, but having the industries clustered in monopoly allows for spillover to make them more effective than if the different companies were in different geographies.

The Porter logic is that competition enhances knowledge spillover and specialization. The positive effects of specialization are noted, but Porter believes that competition makes for faster innovation. First, competitive companies move more quickly to implement innovations, especially when they know that their competitors nearby are likely to have acquired the same information at the same time.. In addition to a quicker pace of innovation, there is more incentive to leapfrog the competition, so the scale of the innovation is likely going to be greater as well.

The Jacobs logic is that diversity is better than specialization. Where specialization encourages small scale leaps, there is enough knowledge within a given company that the incremental value of knowledge spillover from either partner or competing firms is minimal. Knowledge spillover that leads to high levels of innovation comes primarily from outside of an industry. Thus, economies perform better where there is diversity. Competition only serves to enhance this level of innovation. Firms will compete with each other for ideas, something that actively encourages knowledge spillover, especially in situations where there is the risk that a competitor will acquire game-changing knowledge -- firms know that they need to seek this as well. From an intellectual perspective, Jacobs externalities present the most compelling theory.

Urbanization vs. Localization

Where localization is supported by MAR and Porter, urbanization is supported by the Jacobs theory of externalities. If governments want to develop cities, they need to take into consideration which of these approaches is going to meet their goals (Monseny, Lopez & Marsal, 2012). The first thing that needs to be understood is that the goal in developing a city is that it must succeed with a long-term time horizon. Cities built around single industries in the localization model were common in the early 20th century, and further into the century in places with high levels of central planning like the Soviet Union and China. The localization approach does not account for shifts in industry conditions than can weaken even a very strong cluster. Where there is an emphasis on fostering MAR externalities, localization economies can work in the short run, but few seem sustainable. If we compare Detroit to Seattle, the reason that Seattle has emerged as a successful economy today is that it has diversified its economy. Detroit remained reliant on the automobile industry and has gone into a long-run decline.

Monseny, Lopez and Marsal (2012) note that for localization economies, it is the labor market that is critical to success. With a stronger labor market, these economies can be successful, and there is less room for knowledge spillover. They observed that knowledge spillover and other related externalities were higher in urbanization economies. The implications of this for urban development would seem to emphasis the value of Jacobs externalities. Where the government is seeking to foster localization economies, it needs to ensure that there is sufficient labor mobility. Labor mobility is generally good in the United States, but localization economies are less likely to work effectively where there are more barriers to labor mobility such as small country size, depressed real estate markets or other factors that might impede labor mobility. History shows that many successes of the past with the localization strategy have been under conditions of labor mobility. The U.S.S.R. forced labor mobility, rural poverty in China encourages it, and similar poverty conditions and massive immigration helped America's industrial cities grow with a localization model. As people become less likely to move, labor mobility is reduced, making it more difficult to successfully grow a localized model. There are exceptions that can be found, but as a rule the precursors to success appear to be more prevalent in urbanization economies, especially given how changes in communication have increased knowledge spillover in modern cities.

Building Urban Economies

Urbanization economies, instead of relying on the benefits of a set of infrastructure elements for a select few in an industry, rely on building infrastructure common use, accessible for the benefit of many (Rodrigue, 2013). Ge, Yao & Pu (2005) found that urbanization economies rely on economies of scale in part for their success. This makes sense. If diversity is a key element to knowledge spillover, then larger city sizes foster greater diversity. A bigger city will inherently have more firms, of different sizes, and they will be from a larger number of industries than would be found in a smaller city. This means that there is a greater amount of total ideas, and it would be expected that there would be a correlation between the total number of ideas and Jacobs externalities.

It is worth keeping in mind, however, that size is not the only critical factor in the development of Jacobs externalities. Links between the different industries are important as well. The strength of these links and the congruence level of the different industries will enhance the likelihood that where knowledge spillover occurs, it will be useful knowledge that can be applied across industries. This is the type of knowledge spillover that leads to the type of "quantum leap" innovations that can not only give a company or region a sustainable competitive advantage but can rearrange an industry structure. Thus, the more likelihood that an industry has of experiencing these types of industries, the better its economic development will be. Over time, the effect of having a higher level of knowledge spillover is going to be that a city grows to have multiple industries, each one strong and diverse. A city like New York has a strong banking economy, but it is also a hub for media, fashion, the arts, music and cuisine. These are all complementary businesses that can draw on each other for ideas, and as such the economy grows to have strength in multiple areas to the benefit of all industries within that economy.

To foster such development is a challenge. Fostering a localization economy is relatively easy, because it requires creating a common set of infrastructure that can be used by a single industry. This has been attempted from scratch in a few locations. Bahrain liberalized its banking regulations in order to foster growth of a strong banking economy and seek leadership of Islamic banking. In Kuala Lumpur, a high-tech cluster was developed in an area called Cyberjaya, which featured technology infrastructure superior to that found in most of the rest of the city. Singapore fostered a strong shipping industry with extensive infrastructure investments along its shores.

To foster an urbanization economy requires an entirely different approach, focusing on the development of the precursors of diverse development. At the policy level, open immigration and freedom of labor movement is important to encourage people to come to the city to start business. Housing and transportation infrastructure, along with public services must be at a very high level in order to encourage leaders to set up in a given geography.

If the government is seeking to attract businesses, it must seek out multiple businesses, rather than focusing its efforts on a single industry. For example, where many jurisdictions offer credits to film production companies to lure productions to their area, only a few like Vancouver and Toronto have built that into a broader program of economic development that encourages several different industries simultaneously. With Vancouver, film ties into other creative industries (food and fashion in particular) and the tourism and convention business that it works hard to foster. Toronto sees film as a complement to its media business. Diversification policies work best when multiple industries are targeted simultaneously and these industries have a high level on congruence.

Recommendation

Islamic banking was mentioned earlier, and that industry is good example of the best approach to fostering cities. Bahrain and Kuala Lumpur have both sought to stake a claim as the leading center of this nascent industry. As the industry grew, Dubai emerged as a power to threaten both of those other cities. Dubai, with its stronger government, superior infrastructure and strong transportation and trade links throughout the world has a much more diverse economy and this led to it becoming a major threat to take over that industry. Bahrain was seeking a localization economy built around that one industry, but firms saw the benefits of a larger location. Kuala Lumpur has more than one major industry, but struggled to win this business because its infrastructure in substantially inferior to that of Dubai. Dubai made the most compelling case as far as diversity goes. There were simply more opportunities for knowledge transfer there.