Chapter 2 Market Forces in the Development of Cities 1 Consider your typical day: - PowerPoint Presentation

Chapter 2 Market Forces in the Development of Cities 1

Consider your typical day: You wake up to an alarm clock made in Korea.You pour yourself orange juice made from Florida oranges. You put on some clothes made of cotton grown in Georgia.You watch the morning news broadcast from New York on your TV made in Japan. You drive to class in a car made of parts manufactured in a half-dozen different countries. . . . and you haven’t been up for more than two hours yet! 2

Interdependence and the Gains from Trade Why is interdependence the norm?Interdependence occurs because people are better off when they specialize and trade with others. What determines the pattern of production and trade? Patterns of production and trade are based upon differences in opportunity costs. 3

The Legacy of David Ricardo David RicardoIn his 1816 book Principles of Political Economy and Taxation, David Ricardo developed the principle of comparative advantage as we know it today.According to Ricardo specialization and trade should be based on comparative advantage . Even if one person is better at making all goods, there are still gains from trade. 4

Example Consider an economy with two people: Fred and Kate. Two goods: coconut and fish. Fred’s maximum output in a day if he produces only Coconuts Fish 2 6 Kate’s maximum output in a day if she produces only Coconuts Fish 1 1 Clearly, Fred is better at making both goods 5

Fred’s PPC Fred’s maximum output in a day if he produces only Coconuts Fish 2 6 Fish 4 24 12 36 A 0 If there is no trade, assume Fred chooses this production and consumption. Copyright©2003 Southwestern/Thomson Learning Assume that he works 6 days a week, we can construct his PPC as follows Coconuts 6

Kate’s PPC Kate’s maximum output in a day if she produces only Coconuts Fish 1 1 Copyright©2003 Southwestern/Thomson Learning Assume that she works 6 days a week, we can construct her PPC as follows 1 5 B 0 Coconuts 6 6 If there is no trade, Assume Kate chooses this production and consumption. Fish 7

Opportunity Cost and Comparative Advantage Opportunity cost is what must be given up to obtain some item. The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. Who has the comparative advantage in the production of each good? ? ? 8

The Opportunity Cost Fred’s maximum output in a day if he produces only Coconuts Fish 2 6 Kate’s maximum output in a day if she produces only Coconuts Fish 1 1 What is the opportunity cost of one coconut for Fred? 3 Fish What is the opportunity cost of one coconut for Kate? 1 Fish Who has a comparative advantage in Coconut? Kate 9

The Opportunity Cost Fred’s maximum output in a day if he produces only Coconuts Fish 2 6 Kate’s maximum output in a day if she produces only Coconuts Fish 1 1 What is the opportunity cost of one fish for Fred? 1/3 coconut What is the opportunity cost of one fish for Kate? 1 coconut Who has a comparative advantage in fish? Fred 10

The opportunity costs The Opportunity cost of Coconut Fish Fred 3 fish 1/3 coconut Kate 1 fish 1 coconut Who produces coconut cheaper? Who produces fish cheaper? Kate has a comparative advantage in coconut Fred has a comparative advantage in fish. 11

Fred produces fish. Kate produces coconuts . Specialization and Trade Suppose instead Kate and Fred decide to specialize and trade… Both would be better off if they specialize in producing the product they are more suited to produce, and then trade with each other. 12

Specialization and Trade After specialization, they agreed to trade. The terms of trade: 1 fish for ½ coconut.Fred gives Kate 10 fish for 5 coconuts Who will benefit from trade? 13

How Trade Expands the Set of Consumption Opportunities Copyright©2003 Southwestern/Thomson Learning Fish 4 24 5 26 12 36 A A* 0 Coconuts Fred’s Production and consumption Fred’s consumption with trade Fred’s production with trade Fred gives Kate 10 fish for 5 coconuts. 14

How Trade Expands the Set of Consumption Opportunities Copyright©2003 Southwestern/Thomson Learning Kate gives Fred 5 coconuts for 10 fish. Fish 1 5 10 B 0 Kate’s Consumption and Production ’ 6 6 B* Kate’s consumption with trade Coconuts Kate’s production With trade Consumption and Production without trade 15

Gains from Trade Coconut Fish Fred 1 2 Kate 0 5 Total 1 7 16

Why Do Cities Exist? The purpose of this chapter is to identify the key factors behind the development of cities Specialization and trade is the norm.In a market economy, individuals offer their labor for wage income used to buy goods and services. Cities exist for society to realize the benefits of centralized production and exchange. 17

Backyard Production Model The Backyard Production Model illustrates conditions under which cities DO NOT exist. Two households: North and South Two goods are produced: bread and shirts. Land and labor are the two inputs to production. 18

Assumptions Equal Productivity across the two households: output per worker and output per land.Exchange is costly.Constant returns to scale in exchange.Constant returns to scale in production. 19

Implications Specialization and trade results inZero benefits since households are equally productive.Positive cost since transactions are costly. Therefore, if individuals were to specialize and trade they would realize net losses.20

Implications In a self sufficient economy, there are no benefits from concentration.If population was concentrated in a certain area, land price would riseThis encourages people to move out to surrounding areas In locational equilibrium people will be evenly distributed and the price of land would be the same. Cities do not develop. 21

A Trading City To understand why cities develop, we will drop the assumptions of the backyard production model one by one.Assume: Individuals are not equally productive . 22

Output/ Hour Bread Shirts North 2 6 South 1 1 North is more productive than South in both bread and shirts Are there gains from trade? 23

Comparative advantage Each region should specialize in the good for which it has a comparative advantage.A region has a comparative advantage in making a certain good if it has the lower opportunity cost of making it. 24

Opportunity Cost Output/ Hour Bread Shirts North 2 6 South 1 1 Opportunity Cost Bread Shirts North South 3 shirts 1 shirt 1/3 loaf 1 loaf 25 South has a comparative advantage in making bread. North has a comparative advantage in making shirts.

Exchange Each North household will link up with a South household to exchange shirts and bread directly without intermediaries. South household North household Specialization and trade by itself does not necessarily give rise to cities. 26

Trading Firms Trading firms will emerge if there are economies of scale associated with exchange. A trading firm could use an indivisible input to transport output from North to South. Therefore, the cost of transporting one unit by the trading firms decreases with the goods transported. Because trading firms have lower transaction costs, households will pay them to handle exchange. 27

Economies of Scale in Exchange Cost of transporting one unit 1 20 3 10 The unit transportation cost for the household The unit transportation cost for a trading firm that transports 20 units 28

Exchange A trading firm has lower transaction costs than households. South household North household Concentration of trade workers, bids up land prices. People economize on land giving rise to an area with high population density- a Trading City. 29

Trading Cities Trading cities develop when comparative advantage is combined with scale economies in transport and exchange. Workers in trading cities do not produce goods but collect and distribute goods produced elsewhere. Historically, firms in the trading city provided insurance, credit, banking and legal services. 30

Economies of Scale in Production We will drop another assumption of the backyard production model. Assume: there are economies of scale in shirt production.The factory uses an indivisible input that makes workers more productive. Will shirt production take place in the backyard or in a factory? 31

Economies of Scale in Production Output/ Hour Bread Shirts Factory - 6 Household 1 1 Assume that All values are in terms of loaves of bread Prices in the factory town are 50% higher The factory uses an indivisible input that costs ½ loaf of bread in an hour 32

What is the factory wage? Output/ Hour Bread Shirts Factory - 6 Household 1 1 The wage should make the worker indifferent between living in the rural area and between living in the factory town. 3/2 loaves of bread 33

Cost of a Factory Shirt Who can produce shirts cheaper?Cost of producing a shirt in the backyard is 1 loaf of bread.Given 6 shirts are produced / hr in a factory, then Labor Cost/ hr 1½ loaf Cost of indivisible input/ hr ½ loaf Total cost /hr 2 loaf Cost of one shirt 1/3 loaf 34

Cost of a Factory Shirt The cost of producing a shirt in the factory is lower than that in the backyard.The net price of a factory shirt to the consumer is 1/3 loaf plus the cost of transportation to the factory. Do all households buy shirts from the factory? 35

Market Area of a Shirt Factory Assume the cost of transportation is 1/12 loaf per round trip mile. Who buys from the factory? Distance to the factory Cost of a shirt 0 8 8 1 4/12 2 6/12 36

The Factory Town Households within the market area of the factory buy shirts from the factory. household Concentration of factory workers, bids up land prices. People economize on land giving rise to an area with high population density- a Factory Town. 37

Industrial Revolution and the Factory Town The 19th century industrial revolution resulted in innovations that shifted production from the home and the small shop to the factory. 38

Innovations in Manufacturing Eli Whitney’s system of interchangeable parts.Large batch of each partIdentical partsUnskilled workers could be quickly trained to assemble them. 39

Innovations in Manufacturing Eli Whitney’s system of interchangeable parts.Standardized production replaced manual production by skilled artisansMass production: Interchangeable parts, specialized labor and steam powered machines. Model 1792 rifle manufactured at the US Armory at Harper's Ferry.  Instead of individual hand-crafting by a blacksmith/gunsmith, rifles were made with machine tools and had the advantage of interchangeable parts. In 1793, Eli Whitney invented the cotton gin. The cotton gin (short for "cotton engine") was a machine used for removing the seeds from cotton. Whereas before the seeds had to be picked out by hand, people (specifically, slaves) were able to use this machine to significantly increase their productivity 40

Other Innovations Innovation in transportation: canals, steamship, the railroad system.Innovations in agriculture:Cast iron plow, horse drawn harvesting machines. Energy Technology:Water wheels, coal steam engine, electricity. 41

System of Factory Towns Firms can enter the shirt industry by building factories at different locations.As a result of free entry, firms will continue to enter until profit is driven down to zero.The result is a system of factory towns located close to one another where each firm has a local monopoly. 42

System of Factory Towns Distance from a coast line factory cost Home made cost 8 24 40 4/12 1 16 32 Each firm is a monopoly in its own region but charges a price equal to average cost. 48 Complete specialization within the region: shirts produced in factories, bread in rural area 43

System of Factory Towns In equilibrium: Each firm, while it is a local monopolist, charges a price equals to average cost and realizes zero economic profitWages adjust so that workers are indifferent between working in the factory and working in the rural area The price of land adjusts so that rural residents are indifferent between locations that differ in their accessibility to the factory town 44

Materials Oriented Firm The shirt industry is an example of a market oriented industry where the cost of transporting output is large relative to that of inputs.In a material’s oriented industry the opposite is true.Example: the beet-sugar industry where it takes 7 tons of beet to make 1 ton of sugar 45

Market Area of a Plant Economies of scale in processing sugar from sugar beets. Processing firms locate their plants close to the sugar beet farms.Farmers sell their sugar beets to plants and pay the transportation costs. Farmers sell to the plant where the net price is higher. The market area of a plant will depend on the net price to the farmers 46

Market Area of a Plant Distance of a farmer from the coast line Net price per ton of beet to the farmer 40 200 Consider a plant located 40 miles away from the coast line. The transportation cost is $¼ per mile. 30 40 47

Many Plants 40 Consider another plant that locates 120 miles away from the coast line. Each farmer sells to the plant with the higher net price. 30 40 120 80 A system of factory towns develops around the processing plants 48 Net price per ton of beet to the farmer Distance of a farmer from the coast line