New Economic Geography Begins

Once upon a time, a famous researcher in international economics wanted to win new fans in regional and urban economics. This guy was famous for good reasons: he was one of the first to use a simple model with increasing returns, trade costs and monopolistic competition to analyse international trade and to obtain clear-cut results. The "home market effect" is one of them, in Krugman (1980) conditions under which countries export goods for which they have relatively large domestic markets are, maybe for the first time, clearly established. Obviously, Linder and many other have developed similar thesis by considering that specialization can come from the domestic demand, but the use of "small models applied to real problems, blending real-world observation and a little mathematics to cut through to the core of an issue" so typical to the MIT (see Cherrier (2014)) was new in international economics. [Edit 11/10/16: Today, P Krugman uses this Home Market Effect to explain the depreciation of the pound since the vote on Brexit]

In other simple models, Krugman (1979, 1981) explains intra-industry trade another real-world observation that cannot be explained with neo-classical models. With Helpman, they wrote in 1985 an important textbook for graduate, offering a integrated treatment of a variety of issues in international trade. The ambition was nothing less than "to make this branch part of the core of trade theory rather than merely a promising new area". This monograph has been very influential to popularize the New Trade Theory (NTT).

It was also the right moment. Indeed the conclusions of the NTT were that trade policies can be used strategically to protect some industries and in the 80s, in response to globalization and in particular competition from Japan; this kind of idea were useful for policymakers. For instance in 1983 Reagan raises tariffs to protect Harley-Davidson in an incomparable way, according to the New-York Times. 

Obviously trade theorists, Krugman included, were against these policies, considering with Krishna, Hogan and Swagel (1994) that "it remains vital not to oversell such models to policymakers".

Many elements of the New Economic Geography of Krugman (1991) was already in Krugman (1980). In its own words (quoted by Robert-Nicoud and Behrens) "Why exactly I spent a decade between showing how the interaction of transport costs and increasing returns at the level of the plant could lead to the ‘home market effect’ and realizing that the techniques developed there led naturally to simple models of regional divergence (Krugman 1980, 1991a and c) remains a mystery to me. The only good news was that nobody else picked up that 100 dollars bill lying on the sidewalk in the interim."

Indeed in the 80s the bill lying on the sidewalk has not been picked but urban and regional economics has been an active field thanks to economists working on spatial competition and due to geographers.

Urban studies 1970-1990

While the international context was beneficial to economists of the NTT in the 80s, the urban situation was totally detrimental to neo-classical economists in urban studies. In the 70s and 80s, many large cities in developed countries have known dramatic downturn. 

Industrial relocation and public deregulation have led to an important decline of many metropolis that we consider now as safe and beautiful. For instance in 1980 the number of homicides was three times higher than today in NY.

Source: O’Flaherty and Sethi (2014)

The incredible increase in cocaine, crack, heroin in the streets of these cities was also a new phenomenon (Narcos, big time).

I guess that economists and theirs models with perfect competition have found an hostile ground during that period. Beatrice Cherrier reports an interesting debate between economists, with Richardson (1973) criticizing Solow and Mirrlees for their (lack of) contributions as follows:

"The key impulse to urban economic research is … the urgent policy needs of how to handle and control metropolitan cities. A danger in papers of the kind discussed here is that they are likely to distract the attention of researchers away from the policy end of the spectrum towards the mathematical modeling end …This would be a good thing if the models developed were capable of aiding policy solutions, but my fear is that … the choice of model structures will be determined by their capacity to yield to mathematical tricks, and that this implies the most abstracts and simple cases. It would be a disaster if a policy-oriented field such as urban economics went the way of growth theory"

It becomes also clearer than never for economists that a world with constant returns and competition was a "world without cities" to quote Mills (1967, p198). In 1978, Starrett even presents an impossibility theorem of agglomeration with perfect competition (and homogeneous space)... It was time for urban economists to drop out their old models with perfect competition.

Two kinds of imperfect competition were considered as crutial to analyze the spatial economy: strategic interactions between firms that compete in price but also in term of location and increasing returns. Hotelling (1929) and its principle of minimum differenciation analyzed the first kind of imperfection (the NEG is born latter on the second one linking trade costs, increasing returns and monopolistic competition).

According to Hotelling, firms which compete to attract customers, minimize their spatial differentiation. In 1979, d'Aspremont, Gabszewicz and Thisse show that Hotelling was wrong since there is no price equilibrium in pure strategies when firms are agglomerated: price competition is a strong dispersive force, and firms that sell identical products, maximize their spatial differentiation to relax this competition.  This analysis has stimulated many contributions on spatial competition in urban economics. One can notice that Hotelling was however "almost right" when firms compete in a multi-characteristic space (Irmen and Thisse, 1998). Hard to not see the agglomeration of restaurants that supply different kind of foods under that lens.

Despite these important works on spatial competition, the lack of a general model of monopolistic competition and increasing returns was clearly a drawback for economists.

About Geographers

In contrast, geographers have many new champions. Needless to say, what follows is not exhaustive, only suggestive of the dynamism of studies in human geography.

First, geography has known its quantitative revolution during the 60s. Many geographers were able to construct econometric models and to analyze very concrete problems. Brian Berry, winner of the Vautrin Lud Prize, was for instance a precursor in the analysis of many problems that are at the heart of urban economics. See for instance its JUE paper in 1976 in which he analyzes ghetto expansion and housing prices. In that study, he considers the urban housing stock as "racial filtering", black families became owners when white households left poor center for residential suburbs (see Boustan and Margo (2013) for a brief review of the literature on that subject and new results showing that up to one half of the national increase in black homeownership between 1940-1980 can be attributed to white suburbanization).

Jane Jacobs, urbanist, has also made significant contributions in urban economics. Jacobs (1969, 1984), for instance consider that technological spillovers between industries may be more important than inside industries to explain urban growth. This is an important point going against many theories (Marshall-Arrow-Romer and Porter) implying that the variety and the diversity of industries matter more than geographical specialization to foster innovation and growth.

The 70s and 80s also gave birth to behavioural and radical geography. David Harvey is a central figure of the radical movement. He wrote in 1973 a book "Social Justice and the City" which according to Urban Studies "makes quite clear that urban geography and non-marxist urban economics can never be quite the same again". In this book, which is surprisingly readable for an economist (Harvey speaks about Alonso, Muth, Smith and many other economists in respect), he proposes a marxist approach applied to cities, considering that over-accumulation of capital at the city level inevitably leads to urban crisis. After "The Limits to Capital" in 1983, the reputation and idea of Harvey were enough popular to influence many geographers and policy makers in the UK and in the US. I am however not sure of its influence on economists.

There is also new kinds of scientists interested by cities like Jay Forrester who was a computer engineer, known for the bullwhip effect, who wrote in 1969 Urban Dynamics with the aim to understand the complex system of cities with stocks, flows and many other parameters. His work has influenced the Club of Rome (its colleague, Dennis Meadows, was the director of the study "Limits to Growth") and many urban planners.

To conclude this section, one needs to keep things in perspective. Economists have met difficult challenges in the 70s and 80s and maybe the 80s have not produced long lasting models as the 60s (Alonso, 1964), or the 70s (Henderson, 1974) but many contributions were announcing the next revolution, in particular many papers by Masahisa Fujita (I will come back on that in the next post).

Furthermore, the decline of urban economics is debatable, Jennifer Roback (1982) for instance has written an important contribution on the role of amenities on wages, rents and on the quality of life that is still a reference (among many, see this paper by Rebecca Diamond on skill sorting). Furthermore, seminal models of the 60s have been used during the following decades to analyze different public policies, e.g. in urban public finance, see authors like Anas, Arnott, Brueckner, Wildasin, Zodrow etc.

The next post (here it is) is going to be on the NEG, if you cannot wait, start to read Peter Neary about the "hype and hyperbolas" of the NEG. Here the hype:

"[Fujita, Krugman and Venables] find the predictions of one model so plausible that they call it "History of the World, Part I" (p. 253); they describe the pattern of world industrialisation implied by another as "a story of breathtaking scope" (p. 277); and on his website Krugman expresses the hope that economic geography will one day become as important a field as international trade. This sort of hype, even if tongue-in-cheek, is not to everyone’s taste [...]. What next, the unconvinced reader may be tempted to ask? the tee-shirt? the movie?"


Really, read it, because it is not every day that you can find a paper in the Journal of Economic Literature that concludes by speaking about the mini-skirts and the Beatles.

F. Candau

As a soundtrack, Max proposes Esctasy of Gold, I've found this version below interesting (Backened follows with it's optimistic view "Never a rebirth, evolution's end" that may be (or not!) a topical question concerning the NEG).

  References


Alonso, W. (1964) Location and land use. Cambridge, MA:Harvard University Press.
Boustan, L, and R A Margo, 2013. "A Silver Lining to White Flight? White Suburbanization and African-American Homeownership, 1940-1980," Journal of Urban Economics.
Neary, P. (2001) Of hype and hyperbolas : introducing the new economic geography, Journal of Economic Literature 39: 536-561.
Irmen A, J-F Thisse, 1998. Competition in Multi-characteristics Spaces: Hotelling Was Almost Right. journal of economic theory 78, 76 102
Jacobs, J. (1969) The Economy of Cities. New York: Vintage.
Jacobs, J. (1984) Cities and the Wealth of Nations: Principles of Economic Life. New York:Vintage.
Krugman, P. (1979) Increasing returns, monopolistic competition, and international trade. Journal of International Economics 9: 469-479.
Krugman, P. (1980) Scale economies, product differentiation, and the pattern of trade. The American Economic Review 70: 950-59.
Krugman, P. (1991) Increasing Returns and Economic Geography. Journal of Political Economy 99: 483-499.
d'Aspremont C., J. J. Gabszewicz, and J.-F. Thisse, On Hotelling's stability in competition, Econometrica 47 (1979), 1145 1150.
Hotelling H., Stability in competition, Economical Journal 39 (1929), 41 57.
Starrett, D (1978) Market allocations of location choice in a model with free mobility. Journal of Economic Theory 17: 21-37.
von Thünen, JH. (1826) Der Isolierte Staat in Beziehung auf Landwirtschaft und Nationalökonomie (Perthes, Hamburg) English translation The Isolated State (Pergammon Press, Oxford)