Winners and Losers in the Urban System*

Transcription

1 6/March/18: Wnners and Losers n the Urban System* Anthony J. Venables, Unversty of Oxford, CEPR and Internatonal Growth Centre. Abstract he urban system dvdes nto ctes that are nternatonally compettve n goods or servce producton and those that produce just for the domestc economy. Agglomeraton economes make t dffcult to start new tradable actvtes, wth the consequence that negatve trade shocks and also many postve ones have the effect of ncreasng the number of a country s ctes that produce just non-tradables. hs paper sets out a smple model of ths process and shows how such shocks wden the gap between cty types, causng ctes specalsng n non-tradables to lose populaton and ncome (especally land rent). Responses to ths growng urban dchotomy are dscussed. Keywords: Globalsaton, urban, de-ndustralsaton, polarsaton. JEL classfcaton: F12, F60, R11, R12. * Paper wrtten for Urban Empres, eds. E. Glaeser, K. Kourtt and P. jkamp Author s address: A. J. Venables, Department of Economcs, Manor Road, Oxford OX1 3UQ, UK tony.venables@economcs.ox.ac.uk 0

2 1. Introducton he success of many ctes s rghtly celebrated by authors wrtng n ths and other volumes. 1 rumphant ctes are centres of nnovaton, drvng up ncomes for ther nhabtants and delverng the fruts of techncal progress to the wder world. her success s based on cumulatve processes of learnng and productvty growth that go under the collectve ttle of agglomeraton economes. Such spatally concentrated economes of scale are partcularly mportant n sectors where hgh frequency exchange of nformaton s mportant, such as hgh-technology nnovaton, creatve actvtes, meda, and n the fnancal sector. Whle trumphant ctes are part of the new urban world, study and analyss of ths world s ncomplete wthout ncorporatng three further facts. he frst s that most economc actvty does not nvolve hgh frequency exchange of nformaton or any of the other drvers of agglomeraton. Most of a modern economy s engaged n relatvely low-skll servce actvty n sectors such as retal, personal servces, lesure, government, logstcs, property mantenance, constructon and so on. hese are sectors that show lttle propensty to agglomerate spatally or that would create much by way of ncreasng returns to scale f they dd. A further 10% or so of the labour force s engaged n tradtonal manufacturng sectors. here are reasons for manufacturng sub-sectors to cluster together (e.g. auto-ndustry clusters formng to concentrate components and assembly) but these are no longer sectors that are drvng dynamc ctes. Furthermore, many manufacturng supply chans are global, rather than urban. he rest of the labor force s employed n the prmary sectors of agrculture, resource extracton, and the processng of these products. he locaton of these sectors s drven largely by avalablty of land and resources, and these sectors are not prncpal drvers of urban growth. Followng from ths, most ctes do not have much or any employment n the sectors that exhbt strong agglomeraton economes. 2 hese sectors are nherently concentrated n relatvely few places. here are smply not enough such sectors (defned for these purposes as dstnct sectors not closely lnked through agglomeraton forces) for t to be possble for them to play a major role n more than a small subset of the ctes of the developed and emergng world and even less so n ctes of the less developed world. he thrd fact s that s the dvergence of cty performance. Whle some ctes have become global superstars and others at least natonal or regonal champons, many more have performed relatvely poorly. here s polarsaton of the urban system, wth boomng ctes mrrored by a larger number of stagnant areas of relatve, f not absolute, declne. Florda et 1 otably Glaeser (2012), Morett (2013). 2 Glaeser and Gottleb (2009) demonstrate that n the US agglomeraton appears strong only n relatvely sklled labour abundant ctes. 1

3 al. (2017) report how 49 alpha ctes have a domnant share n output, venture captal, and wealth. Focusng on house prces, Gyourko et al. (2013) pont to the wdenng gap between prces the most expensve and the average US ctes. he laggng performance of many towns and ctes shows up not only n economcs, but also n socal, health, and poltcal outcomes. 3 hese facts rase a number of questons. What drves ths pattern of urban dvergence? Why does t appear to be persstent? When shocks occur, are economc adjustment mechansms a force for convergence or do they amplfy the shock, ncreasng dvergence? Countres, regons and ctes are ht by shocks from many sources, above all from nternatonal trade and from technology. A large lterature studes the mpact of these shocks on employment and wages, n some cases tryng to quantfy ther relatve mportance. 4 he cty level adjustment mechansms have receved less attenton. Standard economc reasonng mght suggest that adjustment wll be a force for convergence, as there are complementartes between economc actvty n dfferent places. hus, a postve shock to one place would typcally be expected to beneft others, as rsng ncome n one cty ncreases demand for goods suppled from other ctes and creates upwards pressure on wages throughout the economy. Smlarly, the mpact of a negatve shock wll be spread around the system. he core argument of ths paper s that whle these complementartes are present they are domnated by an algnment of technologcal factors that create partcularly powerful ncreasng returns n some sectors and ctes, but not n others. Agglomeraton s the product of two forces. One s a range of technologcal factors and market mperfectons that create ncreasng returns to scale. he other s dmnshng returns mposed by the sze of the market; an expandng sector may face a declnng prce as ts supply ncreases. hus, the net strength of agglomeraton forces depends on both the strength of ncreasng returns to scale and on whether a cty s output s nternatonally tradable, supplyng a global market, or s non-tradable, supplyng just a local or natonal market. One can magne two worlds. One has trade largely n prmary products (not subject to ncreasng returns) whle sectors that exhbt ncreasng returns (n ths world manufactures and some servces) are largely traded wthn rather than between countres. In ths world natonal centers of automoble producton of fnancal servces may form, but they are not of global scale. Sectors wth the most agglomeraton potental are constraned by a relatvely low degree of tradablty. 3 See for example Rodrguez-Pose (2017) 4 For a revew of ths lterature see Autor et al. (2016). 2

4 In the other world, some sectors that are technologcally prone to ncreasng returns fnancal servces, creatve and nnovatve sectors and manufactures are also nternatonally tradable. At the same tme sectors that are nether globally tradable nor subject to ncreasng returns personal servces, customer servces, government become an ncreasngly large share of the economy. In ths world the forces of ncreasng returns and tradablty have become algned, wth two consequences. One s that centres of ncreasng returns actvtes may become much larger, wth all the mplcatons that follow n terms of cty sze and land prces. he other s that trade shocks now operate on these ncreasng returns sectors and ctes, rather than on sectors that are more orented to prmary producton. As we wll argue n ths paper, economc adjustment mechansms can then amplfy rather than dampen the mpact of trade shocks. hs paper s not an emprcal or hstorcal study of these two possble worlds. Instead, t takes the second world n whch ncreasng returns and tradablty are algned and thnks through the mplcatons of ths for the way n whch the economy responds to shocks and the possblty of persstent urban dvergence. It does so by developng a smple economc model. hs s reduced to bare essentals, focussng attenton on the dstncton between two types of ctes. hose that are compettve n ncreasng returns and nternatonally tradable sectors, and those where employment s concentrated n non-tradables, producng only for the domestc market. hs dchotomy emerges even though the model abstracts from many mportant features of the dfferences between ctes, assumng for example that there s a sngle type of labor, undfferentated by skll level. he model allows for central arguments to be made n a compact way, and s the subject of secton 2 of the paper. Sectons 3 and 4 look at shocks, and at the short- and long-run response of the urban system to these shocks. We argue that the man effect of mport competton (secton 3) s to cause ctes to swtch type, and ths ncreases polarzaton of the urban system. Boomng export sectors (secton 4) can have exactly the same effect, beneftng some ctes but damagng others. Secton 5 of the paper turns to possble polcy responses. 2. Cty systems and the urban dchotomy: Ctes are expensve, yet productve, centers of economc actvty. her sze and economc performance s the outcome of the balance between urban costs the addtonal costs of lvng that are ncurred n an urban envronment and urban productvty, the productvty premum assocated wth ntense economc nteracton and agglomeraton economes. Urban costs are manfest smply n the fact that larger ctes are more expensve than small ones. he hgher costs are partly real costs, such as commutng, congeston, and provson of 3

5 nfrastructure needed to mtgate these costs. And they are partly land rent, not a real resource cost but a transfer payment,.e. a cost to the renter and a beneft to the landowner. For the purposes of the analytcal arguments and thought experments of ths paper we suppose that urban costs ncrease wth cty sze, and the rate at whch they do so s the same for all ctes; n other words, ctes are dentcal n ther fundamentals although not necessarly n the economc outcomes that emerge. urnng to urban productvty, the productvty advantages of the economc scale and densty that ctes can delver are well known. he agglomeraton forces that support ncreasng returns come from well-documented sources: scale and specalsaton, matchng and knowledge spllovers. Each of these s facltated by close and ntense economc nteracton often nvolvng face-to-face contact. hus, thck labour markets enable better matchng of workers to frms skll requrements. Better communcaton between frms and ther customers and supplers enables knowledge spllovers, better product desgn and tmely producton. A larger local market enables development of a larger network or more specalsed supplers. A good example s gven by specalst workers or supplers. he larger the market the more lkely t s to be worthwhle for an ndvdual to specalse and hone sklls n producng a partcular good or servce. he specalst wll be pad for the product or servce suppled but, dependng on market condtons, s unlkely to capture the full beneft created. Snce the beneft s splt between the suppler and her customers there s a postve (pecunary) externalty. hs creates a postve feedback more frms wll be attracted to the place to receve the beneft, growng the market, further ncreasng the returns to specalsaton, and so on. hs s the classc process of cluster formaton, and occurs even though these nteractons mght apply to only a small part of the fnal product for example R&D but not assembly. he strength of these mechansms vares across sectors, and there s some consensus that the effects are strongest n hgh-skll actvtes and/ or creatve actvtes, such as R&D ntensve sectors, meda, busness servces and fnance. As noted n the ntroducton, these productvty effects can be offset by prce effects, so the tradablty of the sector s output matters. radable goods have prce set on the world market, essentally ndependent of the output of any one producer or cty. on-tradables have sales lmted by the sze of the local market, so ncreasng supply reduces the prce. For the purposes of ths paper we smply assume that ncreasng returns and tradablty are perfectly algned at the sector level, so there are two-types of productve sectors. Sectors wth sgnfcant agglomeraton economes are also readly tradable and we refer to sectors of ths type as -sectors, standng for tradable, or perhaps technology. Other sectors we refer to as -sectors, standng for non-tradables. hese nclude servces that have to be consumed at the place of producton (harcuts and restaurant meals), and those that are traded natonally but not nternatonally the mantenance, logstcs, customer servce centers, etc, that form 4

6 much of urban actvty. hese sectors may be produced under dmnshng, constant, or weakly ncreasng returns to scale. However, the fact that they are traded on a natonal market, rather than on the much larger global market, means that an ncrease n supply of these products decreases ther prces by a relatvely large amount. hus, -sectors exhbt overall dmnshng returns to scale. A consequence of these assumptons s that ctes specalse. Some ctes specalse n sector- actvtes, and we refer to these as type- ctes. 5 he remander go to the default opton, specalsng n sector- goods, and are referred to as type- ctes. hs specalsaton follows from the presence of agglomeraton economes operatng at the cty level and wthn a partcular productve sector (localsaton economes). hs s the fundamental dchotomy n cty types that, as we shall see, can lead to dvergence of economc performance. What about the economc adjustment mechansms that equlbrate the cty system n response to shocks? In the nternatonal context we expect shocks to be largely absorbed n wages, and t s ths that enables adjustment. hus, f a country s export sector has a negatve shock the adjustment mechansm s a real deprecaton,.e. a reducton n ts wage and unt costs relatve to ts tradng partners, and ths reducton contnues untl other sectors become compettve. However, wthn a country the performance of a cty depends largely on ts absolute advantage, not ts comparatve advantage. hus, f a cty wthn a country suffers a negatve shock there may be lttle flexblty of relatve wages between regons because factor moblty means that labour markets are tghtly ntegrated. Of course, there are some mmoble factors, such as land and houses. her prces wll fall n the adversely affected regon but snce these factors only represent a small fracton of costs they have lttle leverage n brngng other sectors to the pont of compettveness. here are two dstnct reasons for the lmted flexblty of spatal wage dfferentals. One s that there may be wage rgdtes and labour market mperfectons, arsng perhaps from natonal wage agreements or conventons that gnore local labour market condtons. Such rgdtes can create cty specfc unemployment, and underpns much of the emprcal work of labour economsts. 6 he other mechansm s smply that there s n the long-run at least hgh ntra-country moblty of workers n response to real wage dfferentals, and ths places bounds the extent to whch nomnal wages vary wthn a country. In ths paper we take the 5 For smplcty, we assume that all sector- goods are tradable natonally (.e. we gnored harcuts and restaurant meals), so that specalsaton s complete. Relaxng ths assumpton complcates analyss but does not qualtatvely change t. 6 otably the work of Autor, Dorn and Hanson (revewed n Autor et al. 2016) who look at the mpact of trade on regonal and urban performance, and n partcular the mpact of Chnese competton on the US labour market. 5

7 latter route, so markets do adjust to economc shocks. However, as we shall see, the adjustment mechansm can lead to unsatsfactory outcomes. Adjustment s also shaped by the fact that t s hard to start a type- actvty n place. Agglomeraton economes mean that the returns to nvestng n a place depend on who else s (or s expected to be) there. hs n turn creates a frst-mover problem: no one wants to move to a new place whle uncertan about ts future development. Coordnated acton by frms or a large developer can solve the problem, but wthout ths no frm wants to be the frst n the sector to establsh n a new locaton, uncertan as to whether t wll be followed by other frms, cluster creaton, and the consequent hgh level of productvty. It follows from ths that the dvson of ctes between the two types s not unquely determned. he proporton of ctes of each type les n a range, not at a sngle pont. hs matters greatly for the adjustment of the system to shocks as dscussed n followng sectons. But frst, to understand why ths range exsts, t s useful to thnk about Fgure 1, based on the full descrpton of the model as set out n the appendx. he horzontal axs of Fgure 1 has the dvson of ctes between types. he number of ctes n the country s set at 100, and the number of type- ctes s measured from left to rght, the number of type- from rght to left. hus, at pont AA there are 40 type- ctes and 60 type-. he vertcal axs has nomnal wages pad, wth W beng those pad by -sector frms n type- ctes, and W those pad by type- frms (whch, n equlbrum, are all n type- ctes). At pont AA these nomnal wages are hgher n type- ctes than type-, but ths s a long-run equlbrum where no worker wants to mgrate. he reason s that type- ctes are larger, so workers face hgher urban costs of commutng and rent and hence requre hgher nomnal wages to equalse real wages. otal rents earned n a cty of each type are gven n the lower of the fgure. At pont AA these are hgher n type- ctes, reflectng both larger populaton and land area n these ctes, and hgher rents per unt land. he crtcal pont about ths framework s that the equlbrum dvson of ctes between types s not unquely determned. Any dvson between {mn, max} s an equlbrum. Explanng ths requres gong behnd the curves on the fgure. he curve W gves the wage that s pad n type- ctes f all the sector- producers n these ctes are breakng even, makng zero abnormal profts. It slopes upwards because, movng to the rght, there are fewer type- ctes, and hence less supply of type- goods that therefore fetch a hgher prce. Frms enter and jobs are created, ths ncreasng nomnal wages. he curve W s the correspondng curve for type- ctes. he prce of type- goods s fxed on world markets (removng a potental source of dmnshng returns). But movng to the rght there are more type- ctes, each of whch s therefore smaller. Because each cty s smaller t has lower agglomeraton economes and lower productvty, ths draggng down wages. 6

8 he straght lne at the bottom of the fgure, W, gves the wage that a sector- frm could pay f t were to set up n a type- cty; dong so, t receves no agglomeraton benefts from other frms n the same sector, so has low productvty. he gap W mnus W s the productvty dsadvantage that would be suffered were a sector- frm to leave a type- cty and produce wthout the benefts from beng n ts sector- cluster. Why s any dvson of ctes between {mn, max} an equlbrum? he reasonng s best seen by lookng at dvsons that are not equlbra. o the rght of max (more type- ctes) t would be proftable for a frm producng sector- goods to set up n a type- cty; t would earn W per worker, but the gong wage rate n a type- cty s less than ths, W. Essentally, to the rght of max there are so few type- ctes that the prce of -goods s hgh enough for t to be proftable to set up such a frm even n a type- cty. o the left of mn t would be proftable to produce sector- goods n a type- cty. Productvty n -producton s lower as agglomeraton economes are foregone. However, there are so many type- ctes that W s very low. Even wthout the beneft of agglomeraton the per worker earnngs of a -sector frm n a type -cty, W, are greater than the gong wage n a type- cty, W. Stuatons wth fewer than mn tradable ctes are therefore not equlbra some frms wll want to change locaton. In the nterval {mn max} nether of these arguments apply, so there s no ncentve for any frm to relocate. he fundamental reason s the coordnaton falure no frm wants to be the frst to establsh -sector producton n a place wth no exstng producton n the sector. 7 hs framework and example shows how ctes of dfferent types coexst even over a range of dvsons. Wth ths set up, how does ths system react to shocks? As these occur, who gans and who loses? 7 In the absence of coordnaton falure (e.g. f a large developer can create the coordnated establshment of a larger number of frms) the equlbrum set would shrnk to pont S on Fgure 1. At ths pont ctes of each type are the same sze. 7

9 Fgure 1a: Wages, productvty and equlbra W type- frms n a type- cty A S W type- frms mn A W type- frms n a type- cty max o. of type- ctes Fgure 1b: Real rents earned n each cty otal rent n each type- cty otal rent n each type- cty A mn A max o. of type- ctes 8

10 3. Import competton In recent years the compettve advantage of hgh-ncome countres n many sectors has been removed by global competton. Some of these sectors were concentrated n type- ctes, specalsng n sectors such as textles and steel. How does the economy adjust to such shocks? he short-run mpact s mmedate and drect; the affected cty smply loses employment n the sector. In the medum to long-run ths elcts two responses; outmgraton from the cty and a fallng nomnal wage. When does ths process stop? he answer comes from Fg. 1. akng AA as the ntal poston the affected cty moves down along dashed lne AA. Startng at the ntersecton of AA wth the W schedule the nomnal wage falls to level W, at whch pont non-tradable sector frms fnd t proftable to set up n the cty. he key pont s that n the nteror of the range {mn, max} W s greater than W, the wage at whch t would become proftable to establsh a new sector- actvty from scratch. he cty therefore swtches from beng type- to type-. he economy s flexble enough for new jobs to be created, but the frst-mover problem means that these are not n -sectors. 8 Instead, the jobs are created n sectors we have classfed as type-,.e. customer servces, warehousng, logstcs and perhaps the (lower value) backroom jobs of the fnancal and nsurance sectors. hs has further mplcatons throughout the economy. As affected ctes swtch from type- to type- so the equlbrum moves to the left on Fg.1 (as llustrated by the arrows). here s now ncreased supply of sector- goods, so ther prce falls and nomnal wages, W, fall n all competng type- ctes. hs leads to out-mgraton from all type- ctes, partally, but not completely offsettng the ncrease n supply of sector- goods. he fnal restng place s as follows: - Affected ctes swtch from type- to type-. - All type- ctes are smaller and have lower nomnal wage than before. - he share of the populaton n type- ctes has ncreased. - Remanng type- ctes have hgher nomnal wages and are larger than before. otce that n ths process real wages are equalsed across cty types (followng drectly from the assumpton of perfect labor moblty) although nomnal wages dverge. he prncpal losers are people who own land n type- ctes all type- ctes, not just those that suffer the drect shock, as the effect s shared va a fall n the relatve prce of sector- goods. he ganers are, of course, landowners n the type- ctes. hese ctes boom as there s an nflux 8 It would take a large wage reducton to nduce a new -sector to move n. But the space would have already been taken by -sector producton that does not face the frst-mover dsadvantage. 9

11 of labor, possbly enhancng agglomeraton economes and rasng productvty. Rents are bd up, the amount dependng on the supply of land and housng n the cty. Startng from a poston n whch type- ctes are larger than type- (.e. anywhere to the left of pont S on Fg. 1, the shock causes further dvergence of cty. Snce rents are convex n cty sze, the share of rents n the economy as a whole rses. 9 he message s that there s an adjustment mechansm, so affected ctes converge to a new equlbrum. However, the dchotomy between cty types ncreases, wth type- gettng larger and type- gettng smaller. he number of people lvng n type- ctes ncreases, the share of rents n the economy ncreases, wth land-owners n remanng type- ctes the benefcares. 4. Export booms Some tradable sectors receve postve shocks growng world demand for ther output or techncal change that rases the productvty of the sector n whch they are specalsed. he effect of a postve shock of ths type depends on whether or not t affects all tradable sectors. In the unlkely event that all -sectors are affected, t splls over postvely throughout the cty system. he drect effect s to rase wages n tradable sectors and ctes (ths shftng the W curve on Fg. 1 upwards). hs sets n tran two other forces. One s that ths addtonal ncome generates addtonal spendng on sector- goods so ther prce, and hence the wage n type- ctes, W, ncreases. he ncrease n W s typcally less than the ncrease n W, so there s mgraton from type- ctes to type- untl real wages have once agan been equalsed. Overall, ths s a story of complementarty; boomng tradable goods sectors also beneft the rest of the economy. radable goods sectors are, n realty, heterogeneous. Most obvously, there are new sectors n technology, creatve sectors, and fnance, and old ones, such as many manufacturng sectors. What f the postve shock s restrcted to the new sectors? hese sectors wll expand, rasng both the nomnal wage and employment n affected ctes. hs wage ncrease s however a negatve shock for old-sector tradable ctes. hey are competng for labor and the wage has gone up, undermnng ther competveness. If the survval of some of these sectors s margnal then the wage ncrease puts them out of busness, and further effects are as descrbed n secton 3. Old-sector type- ctes swtch to type- producton, the supply of -goods ncreases, reducng ther prce, reducng W, and leadng to contracton of all type- ctes. he net effect s that, whle tradable ctes that receve the 9 he convexty of rent n cty sze follows from the fact that larger ctes have more land and hgher rent per unt land. 10

12 postve shock boom, other tradable ctes and all non-tradable ctes are negatvely affected. And as before, much of the effect ends up n changes n rents, wth these boomng n the growng ctes and fallng everywhere else. In short, a postve shock to some tradable sectors has a negatve mpact elsewhere, tendng to polarse the urban system. he ntuton behnd ths result s best understood n terms of the Dutch dsease. hs s a term from resource economcs and refers to the fact that countres wth large exports of natural resources (the phrase was coned n the context of natural gas exports from Holland n the 1970s) wll tend to have apprecated exchange rates, a consequence of ther large foregn exchange earnngs. he apprecated exchange rate damages the country s non-resource tradable goods sectors and was argued to lead to de-ndustralsaton. he argument extends beyond the context of natural resources to other boomng tradables sectors. hus, t s suggested that the strength of London s fnancal servces sector s damagng to the rest of the economy, va ths mechansm of rasng the exchange rate and makng other tradable sectors and ctes uncompettve. Whle ths s the ntutve reasonng, the full formal analyss s gven n Venables (2018). Constructng a model wth two types of tradable sectors, as well as non-tradables, the paper makes the pont that t s just the relatve prce of the outputs of the two types of tradable sectors that matters. hus, an ncrease n the world prce of one set of tradable sectors s techncally dentcal to reducton n the prce of the other set. A postve trade shock to new tradable sectors has the same mpact on urban structure as does a negatve trade shock to old tradable sectors. In each case ext of the relatvely badly affected type- ctes occurs, ncreasng the number of type- ctes wth adverse effects on all of them. 5. Responses We have argued four man ponts. he frst s that trade and technology shocks can knockout some tradable goods sectors and hence some ctes dependent on these sectors. hs most obvously arses through negatve shocks such as drect mport competton but can also arse as a consequence of postve shocks. Postve shocks to some cty-sectors wll make others less compettve through general equlbrum effects n labor markets and real exchange rate apprecaton. Second, f sectors of actvty face localsaton economes, then t s hard to start up new actvtes n new places. he spatal economy s replete wth market falures that make adjustment to change dffcult whle, n contrast, much nternatonal economcs has put nave fath n adjustment occurrng because everywhere has a comparatve advantage. he latter statement s true, but rrelevant n an ntegrated economy. It becomes postvely msleadng f 11

13 there are barrers to startng actvtes n new places, such as those created by localsaton economes and coordnaton falure. hrd, the adjustment mechansm n response to shocks takes the form of ctes that loose tradable actvty swtchng to non-tradables, sectors that do not have large localsaton economes and coordnaton falure. he dentfcaton of sectors wth localsaton economes wth tradable goods, and vce versa, s of course not exact; there are surely some tradable goods that do not cluster, and some non-tradables that do. But makng ths assumpton smplfes our thought framework. Fourth, f the adjustment mechansm s such that a wde range of shocks leave the economy wth more non-tradable ctes, then there wll be ncreasng polarsaton of the urban system. he relatve prce of non-tradables falls, and wth t the wages of people n towns and ctes producng such goods. Moble factors wll move n response to ths loss, so the negatve mpact s transferred to mmoble factors. hese means land, and also ndvduals who are unable or unwllng to move. he socal and economc consequences of ths are apparent. he core of the economc problem s that the market mechansm does not create suffcent ncentves to start new tradable actvtes (or more generally, new actvtes that can acheve hgh value productvty through agglomeraton economes and ncreasng returns to scale) n places that have lost hstorc specalsms. What can start such actvtes? One possblty s based on nnovaton. If the economy s creatng new actvtes, not lnked to exstng agglomeratons, then t s possble that they start up n relatvely low cost type- places. hs possblty s emphassed n Morett (2013), and exemplfed by Seattle. In the 1970s Seattle was a cty wth a declnng port and manufacturng sector, unemployment twce the US natonal average, losng populaton and famous for the 1971 bllboard sayng wll the last person leavng Seattle turn out the lghts. Mcrosoft arrved, losng lttle f any productvty n movng from ts orgnal base of Albuquerque. he cluster of software actvty then grew up around Mcrosoft. Of course, the move of Mcrosoft from Albuquerque was due to the fortutous crcumstance that both Bll Gates and Paul Allen had grown up n Seattle. hus, whle the nnovaton route has been successful n transformng some ctes, t seems unlkely that there are enough dstnct new nnovatve clusters for ths to be a soluton for more than a few fortunate ctes. A second route s to try to address the coordnaton falure by polcy that targets partcular places for economc development, possbly n specfc sectors. Economc reasonng suggests suggests that large developers may be able to nternalse the externaltes created by agglomeraton, overcomng coordnaton falure by launchng development at scale. Publc polcy to support ths may take the form of cty plans and the locaton of nfrastructure (e.g. 12

14 placement of transport hubs). Specal economc zones offer regulatory, fscal, and nfrastructure benefts, concentrated n one place wth the hope of creatng cluster benefts. Developng countres offer some successful example, such as Shenzhen, Dhaka, and Penang. However, there are many more falures. 10 Developed countres have used fscal ncentves n the form of regonal nvestment or employment subsdes and subsdes to nfluence plant locaton decsons. Revews of such polces suggest that, even f polces have had some mpact, they have generally faled to jump-start new economc actvtes and trgger the development of self-sustanng prvate sector clusters (see e.g. eumark and Smpson 2015, Morett 2013). Perhaps one reason for ths s that such polces succeed n attractng nontradable actvtes, movng publc sector jobs or securng nvestments n warehousng or customer servce centres; polces may even be targeted at these sectors. hey fal to attract nternatonally compettve tradable sectors, so ther effect s smply to accelerate the adjustment process descrbed n ths paper, draggng down ncomes n all other non-tradable ctes. A thrd possblty s that parts of -sector actvtes are able to splt off from ther core cty and relocate to a lower wage type- cty. hs brngs the dual beneft of job creaton n type- ctes and creatng space for core actvtes to expand n type- ctes. he extent to whch ths s possble depends on the scope functonal and spatal of agglomeraton economes. he growth of offshorng ndcates that t s possble to geographcally separate back-offce actvtes from parts of the busness that beneft from presence n a cluster (e.g. n some fnance and nsurance sectors). However, two caveats are n order. Frst, the nternatonal context s one of much larger nomnal wage dfferences than those that arse between ctes wthn a country. And second, the move to reshorng s llustratve of the fact that many frms found the costs of geographcal fragmentaton of actvtes to be greater than antcpated. he fnal opton s to accept ncreasng polarzaton of the urban structure and the attendant declne of many towns and ctes. In a smple framework such as that presented n ths paper ths could be welfare mprovng, partcularly f boomng ctes are enabled to expand by constructng nfrastructure and housng to mtgate effects on commutng costs, land prces and rents. However, the further costs are evdent. Many people are unable or unwllng to move, wth economc, socal and health costs that are apparent. Mtgatng these costs s mportant, and we note that there s a sgnfcant resource that could be used to fnance ths. As we saw above, the benefcares of urban polarsaton are those fortunate to receve wndfall gans from ownng land n the boomng ctes, gans whch are admnstratvely, economcally, and ethcally f not poltcally rpe for taxaton. 10 See Duranton and Venables (2017) for analyss of place-based polces developng economes. 13

15 References: Autor, D.H., D. Dorn and G. H. Hanson (2016) he Chna Shock: Learnng from Labor- Market Adjustment to Large Changes n rade, Annual Revew of Economcs, 8: Duranton, G Urban Evolutons: he Fast, the Slow, and the Stll Amercan Economc Revew, 97(1): Duranton, G. and D. Puga, (2004). Mcro-foundatons of urban agglomeraton economes, n: J. V. Henderson & J. F. hsse (eds.), Handbook of Regonal and Urban Economcs, volume 4, chapter 48, pages , Elsever. Duranton, G. and D. Puga, (2015). Urban Land Use, n: G. Duranton, J. V. Henderson and W. Strange (eds.), Handbook of Regonal and Urban Economcs, volume 5, chapter 8, pages , Elsever. Duranton, G. and A.J. Venables (2017). Place-based polces for development, World Bank, Washngton DC. Florda, R., C. Mellander and K.M. Kng (2017) Wnner-ake-All-Ctes, Martn Prosperty Insttute, dp 2017-MPIWP-002. Glaeser, Edward L, & Gottleb, Joshua D. (2009) he wealth of ctes: Agglomeraton economes and spatal equlbrum n the Unted States. Journal of Economc Lterature, 47. Glaeser E.L. (2012) he rumph of the Cty, Macmllan, London Gyourko, J., Mayer, C., Sna,. (2013) "Superstar Ctes," Amercan Economc Journal: Economc Polcy, 5(4), Henderson, J. V. (1974). he Szes and ypes of Ctes. Amercan Economc Revew 64(4), Henderson,J.V. and A.J. Venables (2009), he dynamcs of cty formaton, Revew of Economc Dynamcs, 12, Morett, E. (2013) he ew Geography of Jobs, Marner Books, ew York. eumark, D. and H. Smpson. (2015). Place-based polces In: G. Duranton, J. V. Henderson, and W. C. Strange, Handbook of Regonal and Urban Economcs, volume 5B. Amsterdam: Elsever, Rodrguez-Pose, A. (2017) he revenge of the places that don t matter (and what to do about t), CEPR dp no Venables, A. J. (2018) Globalsaton and Urban Polarsaton, Oxford. 14

16 Appendx A small open economy s endowed wth a sngle factor of producton, labour n quantty L, whch s moble between ctes. he number of ctes s fxed at M, each has a geographcal structure of the usual Alonso-Mlls-Muth form, n whch jobs are located n the central busness dstrct (CBD), workers occupy resdental land, commutng s costly, and land rent adjusts to make workers ndfferent between resdental locatons. here are two types of producton sector, tradables and non-tradables. on-tradables are produced under constant returns to scale and are freely traded wthn the country but not nternatonally; ther prce s set on the natonal market. radable sectors produce goods or servces that are freely tradable at fxed world prces and are subject to cty specfc agglomeraton economes (localsaton economes). Each cty specalses, beng ether type- (specalsng n a sngle tradable sector), or type- (producng only non-tradables). he number of type- ctes s endogenous and denoted M, and the remander are type-, producng non-tradables (M = M M). he prce of tradables s p, exogenously fxed at the world level, and the number of workers employed n each type- cty s denoted L. Productvty, q, n each type- cty s ncreasng n the level of employment n the cty, q '( ) 0. Labour s the only nput to producton, so L w p q L ). (1) ( on-tradables have prce non tradable output so hence wage p and offer wage w. One unt of labour produces one unt of p w. Employment n each type- cty s L. he prce (and w ) of non-tradables s determned by market clearng condton ( M M ) L w M w L ( M M ) w L. (2) he left hand sde s the value of supply of non-tradables, and the rght hand sde s the value of demand, where the term n square brackets s total ncome and θ s the share of ncome spent on non-tradables. All ncome n each cty s spent on a composte good whch s a Cobb-Douglas aggregate of tradables and non-tradables wth prce ndex 15 P 1. p w akng tradable goods as the numerare, p 1 and the prce ndex of the composte good s P w. (3) u w bpl / P w / P bl. he term n Workers per capta utlty n a cty of type- s brackets s the wage net of urban costs, these consstng of commutng and rent payments. Urban costs ncrease wth cty populaton L at rate b and are ncurred n unts of the composte good wth prce ndex P. Expendture net of urban costs goes on the composte good, so utlty s spendng net of urban costs deflated by the prce ndex. Labour moblty equalses utlty across all ctes so

17 w / P bl w / P bl. (4) Fnally, natonal labour market clearng s L M L ( M M ) L. (5) Equlbrum condtonal on the number of type- ctes, M, s the soluton of the fve equatons above for endogenous varables w, w, L, L P., he urban costs borne by each worker are dvded between commutng costs and land rent accordng to resdental locaton. 11 For a worker at the cty edge they are entrely commutng costs whle adjacent to the CBD they are entrely rent. If the cty s lnear and commutng costs are lnear n dstance then, snce the commutng cost pad by the margnal worker (lvng at the cty edge) s 2 bpl, ( =, ), the total of commutng costs and rent cty wde s 2 2 bpl. otal commutng costs are half ths, bpl / 2, the remander beng rent, bpl / 2. 2 Rents are spent on the composte good so real rents (deflated by P) are R / 2. otce bl that total real rents are ncreasng and convex n cty sze. he quadratc form comes from our assumptons of a lnear cty wth lnear commutng costs, but convexty s a much more general property as large ctes have both more land and hgher average rent. he total utlty generated by a cty of type s the real ncome of workers plus land rents, u L R. Fg. 1a traces out values of varables solvng eqns. (1) (5) as a functon of M, wth the horzontal axs gvng the proporton of ctes that are type- and the vertcal gvng wages. Fg. 1b gves the correspondng total real rents n a sngle cty of each type. he fgure s constructed wth L = 100, M = 100, θ = 1/2, b = 0.3, q( L ) L. 11 For detaled exposton of the Alonso-Muth-Mlls model of urban land-use see Duranton and Puga (2015). 16