Agglomeration Economies, Productivity, and Quality Upgrading

Transcription

1 RIETI Dscusson Paper Seres 16-E-085 Agglomeraton Economes, Productvty, and Qualty Upgradng SAITO Hsamtsu Hokkado Unversty MATSUURA Toshyuk Keo Unversty/KU Leuven The Research Insttute of Economy, Trade and Industry

2 RIETI Dscusson Paper Seres 16-E-085 Agglomeraton Economes, Productvty, and Qualty Upgradng * August 2016 SAITO Hsamtsu Hokkado Unversty MATSUURA Toshyuk Keo Unversty and KU Leuven Abstract Emprcal studes on agglomeraton have focused on the dentfcaton of ts productvty-enhancement effects. A reducton n margnal costs due to agglomeraton economes ncreases the operatng proft of frms, whch enables them to employ more nputs to produce hgher-qualty products. Ths study examnes such effects of agglomeraton on product qualty by usng plant-product-level data for Japanese manufacturng. Emprcal fndngs confrm that product qualty ncreases wth the market sze of regons, suggestng that agglomeraton-nducng polces are effectve for ncreasng frms profts by mprovng both productvty and product qualty. Stated dfferently, our results ndcate that the benefts of agglomeraton on profts are underestmated n prevous studes by gnorng ts contrbuton to qualty upgradng. Keywords: Agglomeraton, Japanese manufacturng, Product qualty, Total factor productvty JEL classfcaton: D24, L15, R11 RIETI Dscusson Papers Seres ams at wdely dssemnatng research results n the form of professonal papers, thereby stmulatng lvely dscusson. The vews expressed n the papers are solely those of the author(s), and nether represent those of the organzaton to whch the author(s) belong(s) nor the Research Insttute of Economy, Trade and Industry. * Ths study s conducted as part of the Project Mcroeconometrc Analyss of Frm Growth, undertaken at the Research Insttute of Economy, Trade and Industry (RIETI). Ths study utlzes the mcro data of the questonnare nformaton based on the Census of Manufactures conducted by the Mnstry of Economy, Trade and Industry (METI) and the Kougyo Touke converter provded by the RIETI. We acknowledge the support from the Japan Socety for the Promoton of Scence (KAKENHI Grant Number to Sato and 16H02018 to Matsuura). The authors are grateful for the helpful comments and suggestons from Makoto Yano, Kyoj Fukao, Masayuk Morkawa, Kesuke Kondo, and other semnar partcpants at the RIETI semnar.

3 1. Introducton Agglomeraton and ts nfluences on regonal economy have been extensvely examned n urban economc lterature (Cccone and Hall 1996, Henderson 1986, Henderson 2003). For nstance, Rce et al. (2006) demonstrate that most of the urban-rural ncome gaps can be explaned by the dfference n productvty between the two regons. Emprcal studes have dentfed agglomeraton economes (an externalty arsng from spatal concentraton of economc actvtes) as a key determnant of regonal productvty gaps (e.g., Combes et al. 2012). More precsely, productvty of frms n a regon ncreases by 3 8% when the market sze s doubled (World Bank 2009). In addton to such emprcal evdence, studes on the mcro-foundatons of agglomeraton economes have been accumulated recently (Duranton and Puga 2004). Compared to consderable research attenton on market sze and the regonal economy, the lterature has not fully explored the role of the market structure n the context of agglomeraton economes. However, ths does not mply that ts role s neglgble. For example, t s well known that when frms face a downward slopng demand curve, namely, f they have some market power, ther proft maxmzng prces are nversely related to ther productvty (Foster et al. 2008). Ths mples that the agglomeraton s mpacts on frms profts wll be partally offset because prces n ctes are reduced by agglomeraton economes. 2 2 A negatve relatonshp between agglomeraton and product prces may also arse because of transport costs. As transport costs can be saved n agglomerated regons, prces of manufacturng goods tend to be low there, accordng to the New Economc Geography lterature (e.g., Krugman 1991). Emprcally, Handbury and Wensten (2015) conclude that the prce level for food products falls wth the market sze n the Unted States. 1

4 Product qualty consttutes an mportant factor of consumer demand for vertcally dfferentated products. Product qualty, defned as a demand sfter, rases consumers wllngness to pay for the goods; to upgrade qualty, frms are requred to employ more nputs n the producton process (Pcard and Okubo 2012, Shaked and Sutton 1987). Snce agglomeraton economes rase the margnal product of nputs, frms n ctes would optmally ncrease factor nputs to mprove the qualty of ther products. Indeed, several artcles have also addressed the role of the market sze n qualty upgradng. Pcard (2015) develops a theoretcal model n whch he shows that the larger a regon s, the hgher the qualty of goods produced by frms n that regon. Ths s because a larger market sze allows them to ncur hgher fxed costs necessary for qualty upgradng. Emprcal results n Hummels and Klenow (2005) ndcate that larger countres tend to export hgher-qualty goods. Berry and Waldfogel (2010) confrm that product qualty n the newspaper and restaurant ndustres s postvely related to the regonal market sze. Yet, lttle attenton has been pad to whether agglomeraton economes mprove product qualty, or how qualty upgradng alters the agglomeraton s mpacts on the frms profts. Our contrbuton s, therefore, to demonstrate theoretcally and emprcally the role of product qualty n the context of agglomeraton economes. The results of ths study are summarzed as follows: Agglomeraton economes, modeled as Hcks-neutral techncal change n the producton functon, reduce margnal costs of producton n ctes. A reducton n margnal 2

5 costs ncreases operatng profts of frms, whch allows them to employ more nputs to upgrade the qualty of ther products. Ths fndng motvates us to emprcally explore the relatonshp between the regonal market sze and qualty upgradng. In dong so, we follow Khandelwal (2010) to estmate the qualty of products for each plant by employng plant-product-level data for Japanese manufacturng. By regressng the estmated product qualty on varables that measure the regonal market sze, we fnd statstcally sgnfcant evdence that agglomeraton of economc actvtes n a regon enhances the product qualty of plants n that regon. Ths study provdes mportant mplcatons for compettveness of frms. The producton of hgh-qualty goods s often consdered as a source of compettveness of frms, and as a precondton for economc development n the globalzaton era (Amt and Khandelwal 2013). For example, for locatng n the skll-ntensve segments of an nternatonally fragmented producton process, frms n developed countres are requred to provde hgh-qualty ntermedated goods (Tmmer et al. 2014). Japanese frms are no excepton: wthn global value chans, they have steadly ncreased the share of exports of ntermedate nputs (IMF 2015). To be compettve as supplers of such goods, they are requred to keep upgradng the qualty of ther products. Our results suggest that agglomeraton-nducng polces are effectve for ths purpose: frms n urban areas allocate the benefts of agglomeraton economes between productvty enhancement and qualty upgradng. To predct the effectveness of agglomeraton-nducng polces, prevous studes have 3

6 often examned the agglomeraton s mpacts on total factor productvty (TFP). However, f qualty upgradng nvolves the ncreased use of nputs, TFP underestmates the benefts of agglomeraton economes by gnorng ther contrbuton to qualty upgradng. To put t dfferently, the use of TFP as the base for the selecton of targets for agglomeraton subsdes can bas the (local) governments decsons: ndustres that put the hghest prorty on qualty upgradng may not be able to receve subsdes because the agglomeraton s mpacts measured by TFP wll not be very hgh for them. Another contrbuton of ths study s, therefore, to hghlght the mportance of consderng the agglomeraton s mpacts on product qualty when developng agglomeraton-nducng polces. The remander of the paper s organzed as follows: Secton 2 dscusses the economc role of product qualty and the estmaton methods, Secton 3 outlnes the conceptual and emprcal framework, Secton 4 enumerates our data sources and analytc varables, Secton 5 presents emprcal results, and Secton 6 concludes wth a summary of results and polcy mplcatons. 2. Product Qualty and ts Estmaton Understandng the economc role of product qualty has attracted sgnfcant research attenton n the lterature on ndustral organzaton and nternatonal trade. For nstance, recent studes n emprcal nternatonal trade try to ncorporate product qualty usng product-level or plantproduct-level data. As dscussed n the ntroducton, product qualty s economcally defned as 4

7 a demand sfter, whch rases consumers wllngness to pay for a commodty. In other words, f one product s of hgher qualty than another, demand for the former s greater than the latter, even f the two products have the same prce. The level of product qualty s optmally chosen by frms by alterng margnal or fxed costs, or both (Shaked and Sutton 1987). Antonades (2015) dscusses that R&D nvestment (hgh fxed costs) s necessary to promote nnovaton for qualty upgradng (see also Pcard 2015). In contrast, Kugler and Verhoogen (2012) show that hgh-qualty (hgh margnal-cost) nputs are requred to produce hgh-qualty products. The assumpton on the lnk between product qualty and margnal cost can be found n other studes, such as Baldwn and Harrgan (2011), Fan et al. (2015), and Hallak and Svadasan (2013). Indeed, we can observe margnal cost-qualty trade-offs n varous stes of producton. Frst, Crozet et al. (2011) argue that the qualty of French wne depends on the qualty of the grapes, whch are the prmary ntermedate goods. Farmers producng hgh-qualty grapes avod over-croppng to mantan the flavor, and therefore grapes from such vneyards wth a hgh reputaton tend to have hgher prces. Furthermore, champagne wne needs more tme for ts lees to acqure more complexty n ts taste. Second, Lexus, the luxury car brand from Toyota, s produced n hghly sophstcated and computerzed manufacturng plants (Kageyama 2007). Because qualty requrements for the weldng process, body panel ft tolerances, and pantng are more strngent for Lexus than for other Toyota vehcles, only veteran techncal workers are 5

8 engaged n those processes. The thrd example s that of a handmade leather bag, Brkn, by Hermès, whch s known as a symbol of wealth because of ts hgh prce and the fact that t s used by celebrtes. Accordng to Calgary Herald (2010), Brkn bags use leathers from varous tanners and are hand-sewn, buffed, panted, and polshed by expert artsans. These examples clearly demonstrate that mprovng product qualty requres not only hgher fxed costs but also hgher varable costs. Because qualty upgradng accompanes addtonal varable costs, early studes such as Schott (2004) and Hallak (2006) employ unt value as a proxy for qualty. Unt value can be easly obtaned from trade data, but s not necessarly consstent wth the defnton of product qualty. For example, even f products are suppled at an dentcal prce (unt value), those wth fashonable desgn or hgh functonalty tend to have a larger market share because they are consdered to be of better qualty. Moreover, because unt value reflects the cost structure, t s possble that hgh-qualty products have lower prces than low-qualty counterparts. For example, Chnese smartphone company Xaom s current share n the smartphone market exceeds that of Apple and Samsung n Chna. Ths s not only because t offers products wth low prces, prmarly due to low wages and mass producton, but also because ts products are compettve n terms of desgn and functonalty among Chnese consumers. To sum up, ther compettveness s not accurately reflected n a unt-value-based qualty measure. An deal measure of product qualty, therefore, should overcome such shortcomngs of 6

9 unt prce. Khandelwal (2010) follows Berry (1994) to develop an alternatve approach to measure product qualty, based on the logt demand functons. Ther approach s unque as t takes nto account the dfferences n the market share between products. Among products wth dentcal prce, the hghest qualty s assgned to the one wth the hghest market share. Khandelwal (2010) apples the above method to U.S. trade data to estmate product qualty by source countres for hundreds of manufacturng products. Usng the same qualty estmates, Amt and Khandelwal (2013) examne f trade lberalzaton stmulates qualty upgradng of manufacturng products. 3 In ths study, we ncorporate agglomeraton economes nto Khandelwal s (2010) framework to see how agglomeraton of economc actvtes affects the frms choce of qualty and productvty. 3. Conceptual and Emprcal Framework 3.1. Effects of Agglomeraton on Product Qualty Consder the market wth a monopolstc competton for product group j of ndustry k, whch conssts of plants producng product, = 1,..., I j. Consumer n s utlty for product s defned as follows: V = λ αp + ε, (1) n n where λ and p denote qualty and prce of product, respectvely. α > 0 s a parameter, 3 Other examples nclude Smeets et al. (2014) and Bernn et al. (2013). Smeets et al. (2014) nvestgate the relatonshp between product qualty and foregn outsourcng n Dansh apparel ndustry. Bernn et al. (2013) explore the effects of frm-level fnancal structure on the qualty level of French exports. 7

10 measurng the utlty loss due to an ncome fall. A random varable, ε n, represents consumer n s specfc preference for product, mplyng that products are horzontally dfferentated wthn product group j (Khandelwal 2010). Suppose ε n follows a type I dstrbuton; then, the market share of product wthn product group j s gven by the followng equaton: (2) s = exp I j l= 1 ( λ αp) ( λ αp ) exp l l. Next, consder the supply sde of the market. Followng Fan et al. (2015), we assume that to engage n the producton of dfferentated goods, frms must undertake R&D nvestment, whch unquely determnes the qualty level of the product ( λ ). The amount of nvestment, or fxed cost of producton, s: (3) FC = λ γ f, where f s the amount of R&D nvestment necessary to develop a product of qualty one ( λ = 1), and a parameter γ > 0 ndcates that developng a hgher-qualty product requres a greater nvestment. For a gven λ, the producton functon s defned by the followng equaton (Fan et al. 2015): (4) y A( G ) λ β g( ) = x, r where x s a vector of conventonal nputs and g ( ) s lnearly homogeneous n x. A parameter β > 0 shows the extent (n percentage) to whch output decreases when frms mprove product qualty by one percent, whle holdng nputs constant. In other words, Equaton (4) mples that the producton of hgher-qualty products requres more nputs. 8

11 Lastly, A( ) represents agglomeraton economes n regon r, whch ncreases wth the market sze ( G r ) of that regon, namely A G r > 0 (Henderson 2003). Provded Equaton (4), the margnal costs of producton are expressed n the followng equaton: (5) MC β λ c( w ) =, A G ( ) r where w s a vector of nput prces and c( ) s unt costs to produce a product of qualty one. Gven margnal and fxed costs, each frm, facng a demand curve n Equaton (2), maxmzes ts profts wth respect to prce and qualty: (6) max ( ) Π sm p MC FC, p, λ where M denotes the total demand for the product group. Frst-order condtons for proft maxmzaton are gven as: (7) (8) 1 p MC = 0, α MC γ 1 sm p MC γλ f = 0 λ. Second-order condton s satsfed as long as the followng condton holds: (9) B A ( β )( βmc s M ) + βγ ( β + γ 2) s MFC MC ( γ λ 1)( γfc ) > +. Suffcent condton for Equaton (9) s β > 1 and γ > λ + 1, ndcatng that producton and R&D are characterzed by dmnshng returns to scale n qualty (see Equatons 3 and 4). Equaton (7) ndcates that the prce of a product s determned by the margnal costs and the utlty loss due to an ncome fall (α). Because margnal costs are a functon of product 9

12 qualty, the optmal product qualty s mplctly determned by Equatons (7) and (8). By applyng the mplct functon theorem to these equatons, the effects of agglomeraton, namely market sze, on product qualty and prce are, respectvely, derved as: (10) (11) ( ) 2 2 ln λ A MC sm β MCsM + γ β + γ FC ln A = ln G B ln G r ln p MC ln A ln λ = β. ln Gr p ln G ln Gr r, In addton, the followng equaton can be obtaned from Equatons (2), (10), and (11): (12) ln s ln G r ( β 1) MC + ( β + γ 1) 2 λa MCsM β sm γ FC ln A = B ln G r. Equaton (12) s postve as long as a suffcent condton for Equaton (9) ( β > 1 and γ > λ + 1) holds. Because A G r > 0 from the defnton of agglomeraton economes, Equaton (10) s postve, mplyng that product qualty mproves wth the sze of the market. As shown n Equaton (5), an ncrease n product qualty accompanes a rse n margnal costs, but to a lesser extent n large markets than n small ones because of agglomeraton economes. Hence, the thrd term n the parenthess of Equaton (8) declnes wth the market sze, ndcatng that frms n large regons must ncrease the qualty level of ther products so that Equaton (8) holds. Equaton (11) shows that there are two channels through whch agglomeraton economes affect the prce of the product. The frst term n parenthess ndcates that holdng product qualty constant, an mprovement n productvty n a large regon reduces margnal costs, and therefore 10

13 reduces the prces of products n that regon. The second term n parenthess shows that qualty upgradng ncreases the product prce by the same extent as t ncreases margnal costs. The net mpacts of agglomeraton economes on prce are ambguous from Equaton (11). Lastly, Equaton (12) ndcates that regardless of the agglomeraton s mpacts on prces, the market share s larger for frms n agglomerated regons than for those n less agglomerated regons. The above results can be summarzed n the followng proposton: Proposton. Suppose qualty upgradng nvolves the ncreased use of nputs. If agglomeraton economes are modeled as a Hcks-neutral techncal change n the producton functon, then the followng result holds: The larger the sze of a market, the hgher the product qualty and the larger the market shares of frms n that regon. Ths proposton wll be emprcally tested n the followng secton. However, there are, of course, other channels through whch agglomeraton mproves product qualty. For example, prces of hgh-qualty materal mght be lower n urban areas where ntermedate goods producers agglomerate (Fujta et al. 1999), whch enables urban frms to produce hgher-qualty products than rural frms. Consequently, t should be noted that wthout explctly specfyng the spllover channel, the estmaton results n the followng secton show the overall effects of agglomeraton on product qualty (Combes et al. 2008). 11

14 3.2. Effects of Agglomeraton on Profts We next consder the mpacts of agglomeraton on frms profts. By dfferentatng frms profts wth respect to market sze, we have: (13) ln Π γ ln A = ln G γ λ r + β ln Gr αmc. Equaton (13) ndcates that agglomeraton economes (A) ncrease frms profts. The product qualty augments the effects snce the denomnator declnes wth λ. Ths fndng hghlghts the effectveness of agglomeraton-nducng polces; these polces can ncrease profts drectly and ndrectly through qualty upgradng. Qualty upgradng also has mportant mplcatons for the measurement of benefts of agglomeraton economes. In general, TFP n the lterature s obtaned as the resdual between revenue deflated by the ndustry prce ndex ( P k ) and the weghted sum of nputs n the producton functon: R (14) lntfp ln ln g ( x ). P k Note that revenue s the product of output and prce of the product: (15) R py. By substtutng Equaton (15) nto (14) and by usng Equaton (4), TFP can be rewrtten as: (16) lntfp = ln A βln λ + ln p ln P. k Accordng to Equaton (16), TFP consttutes agglomeraton economes, product qualty, prce of 12

15 the product, and the ndustry prce ndex. By dfferentatng Equaton (16) wth respect to the market sze, the followng equaton can be derved: 4 (17) lntfp MC ln A ln λ = 1 β ln G p ln Gr ln G. r r The frst parenthess represents the Lerner ndex: the hgher market power a frm has, the greater wll be the mprovement n TFP due to market sze. The second parenthess s the dfference between an ncrease n agglomeraton economes and the ncreased use of nputs for qualty upgradng, both due to an ncrease n market sze. Equaton (17) explctly ndcates that frms allocate the benefts of agglomeraton economes ( ln A ln G r ) between productvty enhancement ( lntfp ln G ) and qualty upgradng ( ln λ ln G ). 5 Hence, when r regressng TFP on the market sze (G) wthout controllng the product qualty ( λ ), the parameter r estmate on market sze does not represent the mpacts of market sze on agglomeraton economes (A). Instead, t s based downward due to the ncreased use of nputs for qualty upgradng. As shown n Equaton (13), agglomeraton economes determne frms profts. Although TFP has been wdely employed n the lterature to quanttatvely evaluate the mpacts 4 The dervatve of the ndustry prce ndex wth respect to market sze s assumed to be zero. As the ndustry prce ndex s aggregated at the natonal level, t s not lkely that an nfntesmal change n market sze of a sngle regon wll sgnfcantly affect the ndustry prce ndex. 5 Strctly speakng, the effects of agglomeraton on product qualty are also reflected n TFP through a rse n prces (Equaton 11). However, the argument that TFP underestmates the benefts of agglomeraton economes s vald as long as qualty upgradng nvolves an ncrease n factor nputs. 13

16 of agglomeraton on frms proftablty, the nterpretaton should be cautous as TFP may underestmate the benefts of agglomeraton economes by gnorng qualty upgradng as long as qualty upgradng nvolves the ncreased use of nputs Estmaton of Product Qualty Followng Khandelwal (2010) and Amt and Khandelwal (2013), our emprcal framework starts from defnng consumer n s utlty as a functon of prce, product qualty, and consumer n s specfc preference for the product (Equaton 1). If we assume that each ndvdual chooses to consume one unt of product that has the hghest utlty wthn a product group, the market share of product s gven by Equaton (2). To make the model emprcally tractable, consumers are allowed not to select any product from among alternatves but purchase an outsde product; the utlty of consumng an outsde product s normalzed to zero ( λ αp = 0 ). Then, Berry (1994) shows that the log dfference between the market shares of product and that ot ot of an outsde product can be expressed as: (18) ln s ln s = λ αp, t ot t t where t denotes the year and s ot s the market share of an outsde product n year t. Detaled product characterstcs such as the sugar content of cereals and the fuel effcency of automobles can be used as proxes for product qualty (e.g., Berry et al. 1995, 6 We cannot drectly examne the mpacts of qualty upgradng on TFP as suggested n Equatons (16) and (17) because estmaton of plant-product level TFP s not possble. Our sample ncludes many mult-product plants but we do not know how much factor nputs are used for ndvdual products. 14

17 Nevo 2001). However, n our case, such product characterstcs are not avalable. Instead of usng proxes, followng Khandelwal (2010), we assume that the product qualty λ t can be expressed as the sum of three factors: year fxed effects ( δ t ), plant-product fxed effects ( δ ), and product-year fxed effects ( δ t ). 7 Year fxed effects are supposed to capture tme-specfc macro-economc shocks on product qualty. By contrast, plant-product fxed effects measure the tme-nvarant product qualty. Stated dfferently, they are supposed to reflect the plantspecfc ablty to produce hgh-qualty products. from average qualty are treated as the resdual. Lastly, product-year fxed effects devatons Then, Equaton (18) can be rewrtten as follows: (19) ln st ln sot = αpt + ϕ ln szet 1 + δt + δ + δt. Equaton (19) s ndvdually estmated for each product group but, econometrcally, there are three ssues that need to be addressed when estmatng Equaton (19). Frst, as wll be dscussed n Secton 4, our defnton of products s based on a 6-dgt level of the product classfcaton. If products were classfed at a fner level, the market share of each product would be an aggregaton of more fnely classfed hdden varetes wthn the product. 8 Stated dfferently, the more hdden varetes a frm produces wthn the same product group, the larger wll be the market share of that frm. Followng Khandelwal (2010), we control the potental number of hdden varetes by the lagged plant sze ( szet 1 ) n Equaton (19). 7 As plant s a unt of analyss n our emprcal studes, refers to plant-product and not frm-product. 8 For example, apparel producers offer a varety of products wth dfferent colors or dfferent szes for an dentcal prce wthn each product group. 15

18 Second, the amount of consumpton of the outsde product s not known n our dataset. 9 However, we can consder the market share of the outsde product as another component of year fxed effects because t takes the same value for every product wthn the same product group by defnton. Accordngly, the equaton to be estmated can be rearranged as follows: (19 ) ln s = αp + ϕ ln sze 1 + ξ + δ + δ, t t t t t where ξ ln s + δ. Lastly, as prces and market shares are smultaneously determned n the t ot t market, approprate nstruments are needed to consstently estmate the prce parameter n Equaton (19 ). Two nstruments are used n ths study: annual gas prces by prefecture and the average prce of products (excludng the prce of plant-product ) belongng to the same product group. The dentfyng assumpton s that dstrbuton costs (gas prces) and the average prce of products represent the cost structure of plant-product n year t to some extent, and therefore can explan ts prce ( p t ). However, dstrbuton costs or common shocks to prces of other products n year t have neglgble mpacts on plant s decson on the product s qualty level n the same year ( δ t ) f we control for plant-product and year fxed effects on qualty (Nevo 2001, Khandelwal 2010) Identfcaton of Agglomeraton Economes Once we obtan the parameter estmates n Equaton (19 ), the product qualty can be estmated 9 Imported products are often used as the outsde product n prevous studes. However, we cannot obtan the value of mports for each product because the concordance table between the product classfcaton n the Census of Manufactures and that n trade statstcs s not avalable. 16

19 for each plant-product and year as follows: (20) ˆ λ ˆ ˆ ln ˆ ˆ ln ˆ t = δ + δt = st + αpt ϕ szet 1 ξt. Year fxed effects ( ξ t ) are deducted n Equaton (20) because they reflect not only tme-specfc shocks on product qualty but also the market share of the outsde product. Gven the product qualty estmates, we can evaluate the mpacts of agglomeraton on product qualty from the followng equaton: (21) ˆ λt = κ0 + κ1ln Grt + θ + µ t. A statstcally sgnfcant postve sgn on market sze ( G ) ndcates that agglomeraton economes enhance product qualty. Plant-product fxed effects ( θ ) are ncluded n Equaton (21) to control for unobserved rt plant heterogenety (Henderson 2003, Martn et al. 2011). The product qualty mght be hgh n ctes not because of agglomeraton economes but due to spatal sortng of plants producng hgh-qualty products nto ctes (Pcard and Okubo 2012). In addton, the parameter on market sze can be spurous due to the smultanety bas caused by the correlaton between the market sze of a regon and unobserved economc shocks on the qualty of plant-product n the regon ( µ t ) (Combes and Gobllon 2015, Martn et al. 2011). We apply the GMM estmaton to the frst dfference of Equaton (21) to correct for the smultanety bas: (22) ˆ λt = κ 1 ln Grt + µ t. We nstrument frst-dfferenced explanatory varables n Equaton (22) by ther level at year 17

20 t 2. Suppose market sze converges over tme to a certan level. Then, the frst dfference n the log of market sze should be negatvely correlated wth the level of that varable at year t 2 ; however, the excluson restrcton remans vald as long as market sze at year t 2 does not affect the change n unobserved shocks between t 1 and t (Martn et al. 2011). 4. Data and Varables The Census of Manufactures, publshed by Japan s Mnstry of Economy, Trade and Industry (METI), s the prmary data source n ths study. Its mcrodata are avalable only for plants that have four or more employees. 10 A unque dentfcaton number s assgned for each plant and each product, whch allows the constructon of a panel of ndvdual plant-product from 1994 to The product classfcaton s frequently revsed; however, revsons wthn ths perod are relatvely mnor. Hence, products from dfferent years can be easly matched wth each other by usng the concordance table. Our key varables value of shpment and quantty are avalable at the 6-dgt level of the product classfcaton. 12 However, we exclude mscellaneous products such as mscellaneous telecommuncaton equpment from the sample because METI does not ask plants to report the quantty of those products. 13 In addton, followng Khandelwal (2010), we restrct our sample to dfferentated products classfed based 10 All establshments n the manufacturng sector are covered n a census n calendar years endng n 0, 3, 5, and 8. By contrast, only establshments wth four or more employees are covered n other years. 11 The plant dentfcaton number s revsed every fve years. Thus, we use the concordance table provded by the RIETI to construct a panel of plant-product-level data. 12 The frst four dgts of the product codes mostly correspond to the 4-dgt Internatonal Standard Industral Classfcaton. 13 For example, among 1,842 product groups, quantty shpped s reported for 765 groups n

21 on Rauch (1999) s (conservatve) product classfcaton as the varatons n product qualty are zero by defnton for homogeneous goods. After the elmnaton of product groups wth a small number of observatons, 380 product groups reman n the sample. Wth regard to regonal varables, the Census of Manufactures provdes nformaton about plant locaton at two admnstratve levels: prefecture and muncpalty. We use each of the 47 prefectures as a geographcal unt (regon) because the latter unt s too small to capture agglomeraton. Workers commute and frms transact wth supplers and customers beyond the border of muncpaltes. However, prefecture s also an admnstratve geographcal unt and does not necessarly concde wth the economc boundary of regons. An offcal geographcal unt smlar to the metropoltan statstcal area (MSA) n the Unted States s not avalable n Japan; however, Asah-Shmbun (2007), a newspaper company, defnes orgnal metropoltan areas n whch muncpaltes are grouped nto 110 metropoltan areas accordng to commutng patterns. The results obtaned from usng prefecture as a geographcal unt wll be compared wth those based on metropoltan areas to check the robustness of the results. The annual gas prces by prefecture, annual prefectural populaton, and annual muncpal populaton are, respectvely, obtaned from Retal Prce Survey, Populaton Estmates, and Basc Resdent Regstraton publshed by the Mnstry of Internal Affars and Communcatons (MIC). Varables are constructed as follows. The market share of plant-product ( s t ) s the rato of quantty of product shpped to the sum of quantty of products shpped, whch belong to 19

22 the same 6-dgt product group. The prce of the product ( p t ) s measured by dvdng the value of shpment by quantty shpped. Observatons belongng to the top and bottom 1% of the prce dstrbuton for each product group are dropped from the sample to exclude outlers. Lastly, the number of employees at year t 1 s used as a proxy for the lagged plant sze ( szet 1 ). As for agglomeraton economes, prevous studes consder two types of externaltes: localzaton and urbanzaton economes (e.g., Combes et al. 2008, Martn et al. 2011). Localzaton (urbanzaton) economes are productvty-enhancng externaltes that arse from the spatal concentraton of frms n the same (any) ndustry. Followng Martn et al. (2011), localzaton economes ( LOC ) are measured as one plus the total number of employees n other t plants n the same ndustry and regon as plant. 14 Urbanzaton economes ( MP ) are measured by regonal populaton (Henderson 1986). We construct the measure of urbanzaton rt economes by employng the dea of market potental to take nto account the dscusson that admnstratve regons do not necessarly concde wth the economc boundary of regons. Market potental s an ndcator of the proxmty to ntermedate and fnal goods markets and producers, whch s orgnally ntroduced n Harrs (1954) and extensvely dscussed n the New Economc Geography lterature (Fujta et al. 1999). In most of the emprcal studes (e.g., da Mata 2007), t s defned as the weghted sum of populaton n a regon and ts neghborng 14 The defnton of ndustry s based on the 3-dgt ndustral classfcaton. As the data on employment used for the producton of ndvdual products s not avalable for mult-product plants, plants ndustral classfcaton s determned by ther major products n the year concerned. 20

23 regons usng the nverse of transport costs as weghts: (23) MP rt ct =, c Pop τ rct where Pop ct denotes populaton n regon c n year t. τ rct represents the transport costs from regon r to c n year t and s defned as: (24) τ = pd, g crt ct cr where g p ct s gas prces n regon c n year t and d cr s the great crcle dstance between regons c and r. 15 The ntraregonal dstance s gven by 23 Arear π, where Area r denotes the area of regon r. Summary statstcs of varables are reported n Table Estmaton Results The results from estmatng Equaton (19 ) for each product group are summarzed n Table 2. Overall, our data ft well wth the postulated logt demand model. Of the 380 product groups, prce coeffcents are negatve and sgnfcant for 335 groups. From among these, the regresson model satsfes the over-dentfcaton test, and has low frst-stage F-statstc p-values for 289 groups. The thrd row shows that the average and the medan of the coeffcents of the plant sze are postve, suggestng that the market share ncreases to some extent due to hdden varetes. Lastly, the medan of own prce elastcty s , whch s very close to that of - 15 Gas prces exhbted large fluctuatons (from 87 to 146 yen per lter) durng the sample perod. If average gas mleage does not vary much across years, Equaton (24) measures the average cost of fuel consumpton to transport goods between the two regons. 21

24 0.58 n Khandelwal (2010). 16 Gven the parameter estmates n Table 2, the qualty for each plant-product s obtaned accordng to Equaton (20), and s used to estmate Equaton (22). Note that the plant-product fxed effects dsappear when takng the frst dfference n product qualty n Equaton (22) and only resduals, namely, varatons n product qualty n the short run, reman n the estmaton. Thus, the estmaton results of Equaton (22) explan the agglomeraton s mpacts on qualty upgradng n the short run. In order to observe the contrbuton of such short-run varatons to overall varatons n product qualty, we carry out a varance decomposton n Table Most of the varaton n product qualty s explaned by that n the plant-product fxed effects, but the contrbuton of resduals s not neglgble. The estmaton results of Equaton (22) are presented n Table The parameters on market potental (urbanzaton economes) are sgnfcantly postve for any specfcaton, mplyng that a proxmty to ntermedate and fnal goods markets and producers s key to mprovng product qualty. In both cases (prefectures and metropoltan areas), GMM estmates of coeffcents on market potental are greater than OLS estmates. Plants facng negatve shocks on the qualty of ther products have to employ more nputs for qualty upgradng than those facng postve shocks, and thus need to ncrease the demand for producton factors, 16 Own-prce elastcty s low because parameters are estmated usng varaton wthn plant-product over tme (Khandelwal 2010). 17 Snce the average product qualty from dfferent product groups cannot be compared drectly, the average of standard devaton obtaned for each product group s presented n the table. 18 Instruments are LOCrt, MP 2 rt 2, and populaton n regon r n year t 2. 22

25 ncludng hrng of addtonal workers. Consequently, our GMM estmates could be deemed correct for such negatve correlaton between shocks on product qualty and populaton. Before we evaluate the agglomeraton s mpacts on product qualty quanttatvely, a comment on the nterpretaton of parameter estmates s n order. Although not explctly consdered n Secton 2.1, there mght exst a case that agglomeraton economes reduce the fxed costs ( FC ) necessary for qualty upgradng (Equaton 3). For example, knowledge spllovers n ctes may mprove the performance of R&D projects. Thus, a postve relatonshp between product qualty and market sze, as observed n Table 4, mght be a result of lowered fxed costs due to agglomeraton economes. However, consderng a sgnfcant tme lag between R&D nvestment and the producton of upgraded products, t s not lkely that plants nstantaneously adjust product qualty to contemporaneous shocks on market potental by alterng ther level of R&D nvestment. Alternatvely, f fxed costs for qualty upgradng do not show sgnfcant varatons n the short run, they wll be captured by plant-product fxed effects ( θ ) n Equaton (21). As a result, a postve sgn on the market potental n Equaton (22) should ndcate that qualty upgradng s realzed through a reducton n margnal costs due to agglomeraton economes. The economc nterpretaton of parameter estmates n Table 4 s obtaned by consderng how much the product qualty mproves when the market sze s doubled, and to what extent t contrbutes to varatons n product qualty n Table 3. When the market potental 23

26 s doubled, the product qualty ncreases by 0.241, or by 0.178, dependng on the specfcaton of the geographcal unt. Hence, the agglomeraton s mpacts on qualty upgradng are consderably large; 47.7% (= / 0.505) or 35.2% (= / 0.505) of the varatons n product qualty n the short run are explaned by agglomeraton economes. Snce varatons n product qualty are mostly determned by plant-product fxed effects (Table 3), dentfyng ther local determnants s also mportant. Followng Martn et al. (2011), plant-product fxed effects are regressed on the average of ln LOC and ln MP across years, t rt for each plant-product. The estmaton results are presented n Table 5. Contrary to the shortrun s case n Table 4, localzaton economes sgnfcantly mprove product qualty n ether of the specfcatons of the geographcal unts. As dscussed above, f plant-product fxed effects reflect fxed costs for qualty upgradng, the results suggest that spatal concentraton of plants n the same ndustry mproves the effcency of R&D projects and lowers the fxed costs necessary for qualty upgradng. Alternatvely, for products manly consumed wthn a local market, the sze of the local market, namely, ln LOC and ln MP, determnes the maxmum level of fxed t costs each plant n that market can afford (Pcard 2015). Therefore, the results may ndcate rt that urban plants producng locally consumed products can afford greater fxed costs than rural plants can. At the end, because the estmaton model does not explan any causalty between plant-product fxed effects and the market sze, the results may support the sortng hypothess by Pcard and Okubo (2012) that plants producng hgh-qualty products prefer to locate n regons 24

27 wth a large market. Followng ths, Equaton (22) s estmated separately for small and large plants n Table Snce small plants are more dependent on local economc condtons than ther larger counterparts, the former are more lkely to beneft from agglomeraton economes than the latter (Acs et al. 1994, Martn et al. 2011). Ths argument should hold even f product qualty s used as the dependent varable. Indeed, coeffcents on market potental are postve and sgnfcant only f Equaton (22) s estmated for small plants n Table 6. Furthermore, the magntude of those coeffcents s nearly or more than doubled when compared wth Table 4. Coeffcents on localzaton economes ( LOC ) are unexpectedly negatve and sgnfcant n the estmaton for rt large plants, mplyng that spatal concentraton of frms n the same ndustry worsens the qualty of products of the large plants. Ths mght be due to hgh congeston costs, outweghng agglomeraton benefts for large plants n large regons. Lastly, Table 7 presents the results of estmaton usng the market share as the dependent varable. Coeffcents on market potental are postve and sgnfcant n ether specfcaton of the geographcal unt, ndcatng that the larger the market potental n a regon s, the bgger s the market share of plants n that regon. Consequently, emprcal results that both the product qualty and the market share ncrease wth market sze are supportve of the proposton n Secton A plant s consdered large f the average employment of the plant durng the estmaton perod exceeds ts medan. 25

28 6. Summary and Conclusons Agglomeraton economes are the key determnant of regonal economc performance, and therefore have attracted great attenton n academc and polcy crcles. It s generally agreed that doublng the market sze enhances the productvty of frms by 3 8%. However, the effects of agglomeraton on product qualty have not been well examned n the lterature. Snce product qualty consttutes one of the mportant factors characterzng consumer demand, dentfyng effectve polces for qualty upgradng wll help mprove frms compettveness. Ths study demonstrates theoretcally and emprcally how agglomeraton of economc actvtes affects the frms choce of product qualty. To be consstent wth the defnton of product qualty, we extend Berry (1994) and Khandelwal s (2010) logt demand framework to nclude the frms decson on product qualty. The theoretcal analyss ndcates that productvty mprovement due to agglomeraton economes allows frms to employ more nputs to enhance the qualty of ther products. The emprcal analyss confrms the qualty-enhancng effects of agglomeraton by usng plant-product-level data for Japanese manufacturng. The results of ths study demonstrate the effectveness of agglomeraton-nducng polces for qualty upgradng. To be more precse, frms allocate the benefts of agglomeraton economes between productvty enhancement and qualty upgradng. We have shown that TFP underestmates the benefts of agglomeraton economes by gnorng ther contrbuton to qualty upgradng. As a result, the local governments choce of targets for agglomeraton subsdes 26

29 may be based toward ndustres where qualty upgradng s not the man concern, as long as the decson s based on how much the TFP of the frms n the targeted ndustry mproves. The agglomeraton s mpacts on product qualty should be consdered n order to mplement deal agglomeraton-nducng polces, favorng frms that balance qualty upgradng and productvty mprovement to maxmze ther overall compettveness. 27

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35 Table 1: Summary Statstcs Varable Unt Mean Std. dev. Prce Yen , Market share Index, Plant sze Person # Employees n the same ndustry and prefecture Person 2, , Market potental (prefecture) Number 5, , # Employees n the same ndustry and metropoltan area Person 1, , Market potental (metropoltan area) Number 4, , Source: METI, Census of Manufactures, varous years MIC, Retal Prce Survey, varous years MIC, Populaton Estmates, varous years MIC, Basc Resdent Regstraton, varous years Table 2: Parameter Estmates of Demand Functons Statstc Mean Medan 10th percentle 90 percentle Prce coeffcent Prce coeffcent, p-value Coeffcent on plant sze Own prce elastcty Over-dentfcaton restrctons, p-value Frst stage F-stat, p-value Observatons per estmaton Total estmatons 380 Total observatons 712,265 Note: Equaton (19 ) s ndvdually estmated for 380 product groups. Each row of the table except for the own prce elastcty presents summary statstcs of the estmaton results for each product group. Own prce elastcty s obtaned for each observaton by multplyng prce coeffcent by the prce of plant-product. Standard errors clustered at the plant level are used to obtan p-values. Table 3: Varance Decomposton of Product Qualty Std. dev. Correlaton wth product qualty Product qualty Plant-product fxed effects Resduals Note: Table shows the average of standard devaton obtaned for each product group. 33