4. Agglomeration Economies and Economic Growth
To what extent will New Zealand be able to generate sufficient domestic economies of scale in order to compensate for the reduced domestic trade protection effects associated with falling international transactions costs? In attempting to answer this question, it is first necessary to consider the underlying factors which determine the not only the generation of economies of scale, but also the uneven spatial distribution of such scale economies. Then we can apply these analytical and empirical arguments to the particular case of New Zealand.
The current thinking on these issues generally revolves around the notion of industrial clustering and the associated potential benefits of external agglomeration economies. The existence of domestic agglomeration economies within a country may allow for a more rapid economic growth on the part of the country as a whole. Here the arguments tend to focus on the role which geographical proximity can play in the fostering, facilitating and nurturing of flows of inter-firm information which then allow for the local generation of mutually beneficial information externalities. This kind of logic underlies each of Alfred Marshall’s (1920) three explanations for the existence of positive agglomeration externalities in situations of urban industrial clustering.
Marshall’s first observation concerned the existence of ‘informal’ information spillovers, where informal refers to the fact that they are non-traded information spillovers between agents, primarily of a tacit nature. Such informal and tacit information spillovers can take place between geographically proximate agents, in cases where all the agents are firms, or where some of the agents are units of labour. Marshall’s assumption is that information spillovers operate specifically at the level of the individual urban area, and it is over this spatial extent that transactions costs are assumed to become critical. In other words, from the point of view of information transactions, it is the geographical scale of the individual urban area which is critical in terms of determining economic performance. This is also the particular spatial logic which has been adopted by the ‘new economic geography’ models of Krugman (1991) and Fujita et al. (1999).
Marshall’s second explanation for local external economies arises due to the presence of non-traded specialist local input providers, who find the investment in such input provisions profitable in situation where they are servicing locations of clustered producers of a similar sector. Once again, the validity of this argument depends on the availability of local information allowing for not only the provision, but also the efficient consumption of these specialist inputs.
The third argument of Marshall in favour of the existence of local external economies is based on the fact industrial clustering permits the rise of specialist pools of skilled labour. Here, geographical proximity allows not only for a more efficient search and matching process within the labour market, but also an easier adjustment to adverse shocks within the local labour market, as long as the shocks are not correlated across sectors (Mills 1970). As such, Marshall’s observations suggest that industrial clustering better allows both firms and workers to reduce the downside risk costs associated with investment in any particular capital technology, whether physical or human. Both net returns and profit growth will be maximised because the industrial clustering itself provides a mechanism for firm-employee matching within the local labour-matching process which requires a much reduced need for third-party intermediaries to undertake search activities. This appears to be particularly so for complex inter-firm production arrangements involving many small firms.
The Marshallian arguments outlined here provide possible explanations for the scale economy and efficiency benefits of industrial clustering. In the case of New Zealand, an economy with very small urban concentrations both with respect to OECD and global standards, these arguments may be a cause for concern because they imply that New Zealand may not benefit greatly from such agglomeration externalities. However, it is still not entirely clear why New Zealand should be concerned by these arguments. Just because there has been a recent increase in the perceived importance of these agglomeration phenomena as potential determinants of economic growth does not necessarily mean that there is any substantive change to the competitive conditions faced by the New Zealand economy. As we have already seen, there have been widespread technological and institutional changes which appear to have largely reduced many aspects of spatial transactions costs, thereby potentially benefiting peripheral economies. Similarly, large cities and industrial clusters have been a longstanding feature of our economic system, so why should there be a recent focus of interest on these questions?
In response to these arguments, Glaeser (1998) argues that if we consider the changes in the transactions costs of goods-shipments alone, then the rationale for industrial clustering and the existence of modern cities disappears. On the other hand, he argues that the transportation costs involved in ensuring that people have both widespread and frequent face-to-face contact across a range of individuals in order to facilitate the transfer of tacit information, is the crucial driving force behind the generation of modern cities and industrial clusters. In other words, the overcoming of increased modern information transactions costs is the primary rationale underlying the existence of modern cities.
Yet, although in principle we can accept the various arguments suggesting that geographical proximity is highly advantageous in many cases where information is varied and complex, empirically identifying the critical spatial extent which defines whether a location is advantageous or not is very difficult (Glaeser et al. 1992; Henderson et al.1995). This problem is typical of the types of empirical problems encountered when dealing with externality issues. Indirect methods therefore have to be employed, such as observing the spatial patterns of patent citations (Jaffe et al. 1993; Acs 2002), joint-ventures (Arita and McCann 2000), joint-lobbying activities (Bennett 1998) or real-estate price movements (Gordon and McCann 2000). These empirical techniques tend to confirm the argument that many aspects of information spillovers are constrained primarily within the individual urban area, thereby implying that the urban area is often the critical geographical range of advantage for localised economies of scale.
In addition, there are two other sources of evidence which support the argument that spatial information transactions costs have increased over recent decades, thereby increasing the importance of the urban area as the potential source of economies of scale. The first source of evidence comes from observations of telephone usage patterns (Gaspar and Glaeser 1998). Using data from Japan and the US they observe the relationship between the density and frequency of telephone usage and the location of the users.
Firstly, they find that users who are geographically closer together, and for whom greater face-to-face contact is therefore easier, spend more time talking to each other on the telephone, than do users who are at greater distances from each other. Secondly, the same result also holds for urban size, in that users in larger urban areas generally talk to each other more by telephone than users in smaller urban centres. Thirdly, the frequency of airline business travel has also increased more or less in line with the growth in telecommunications usage, after controlling for the effects of cost reductions. While this indirect evidence is not conclusive the point here is that the evidence suggests that communications technology and face-to-face communication tend to be complements rather than substitutes.
The second source of evidence suggesting that the individual urban area has become progressively more important as a source of economies of scale involves an assessment of the rates of global urbanization. Over the last three decades, the proportion of people living in urban areas has increased in all parts of both the developed and developing world (United Nations 1997). While the reasons for this are complex, and particularly in relation to the out-migration of labour from rural areas in developing economies, the ubiquitous urbanization phenomenon in the developed parts of the world where information technologies are mostly applied, also suggests that the geographical proximity of firms and people within individual urban areas is becoming relatively more important over time.
The implication of these empirical observations is that the individual urban industrial area is, if anything, becoming even more important nowadays as a determinant of domestic scale economies of than it was previously. The reason for this is that while international transactions costs are generally decreasing, the (opportunity) costs of the spatial transactions contained within individual countries are actually increasing. This is because information and communications technologies and face-to-face contact, are not necessarily substitutes for each other, but are often complements for each other.
In other words, a general increased usage of information and communications technologies often leads to an increase in the quantity, variety and complexity of the information produced, which itself leads to an increase in spatial information transactions costs, and an associated increased need for spatial proximity to facilitate face-to-face contact. At the same time, an increase in the levels of spatial proximity encourages a greater usage of information and communications technologies, and the production of more varied and complex information, such that the process becomes cumulative. Glaeser’s arguments (Glaeser 1998; Gaspar and Glaeser 1998) therefore suggest that in the modern world, the Marshallian foundations of agglomeration externalities are becoming an ever-more significant determinant of domestic economies of scale.
Although in relative terms New Zealand is one of the most highly urbanised countries in the world (United Nations 1997), the low national population level means that all of the major cities of New Zealand are very small by international standards. Therefore, the Glaeser and Krugman arguments together appear to pose serious problems for the long-term growth prospects of New Zealand. The is because in a world of generally falling international transactions costs, the small urban scales of New Zealand’s major cities will not sustain localised agglomeration economies which are sufficient to compensate the national New Zealand economy for the increased exposure to international market competition. The reason for this is that the New Zealand cities are not large enough to generate the sufficiently varied and complex tacit information transactions and input linkages required in order to sustain significant localised agglomeration externalities. The local input markets, where ‘inputs’ here are assumed to include all the qualitative varieties of factor and information inputs, are too ‘thin’ to provide string micro-foundations for local economies of scale.
According to these arguments even Auckland, with a total metropolitan population of the order of one million, will still suffer from this problem of input market weakness, because the other potential urban sources of market variety within New Zealand are all too far away to provide the required quality and quantity of inputs on a sufficiently frequent basis. The implication is that New Zealand firms in all domestic locations will therefore become successively more vulnerable to the vagaries of international markets, relative to similar firms in larger, more highly-urbanised economies. In other words, an inherent geographical-structural weakness within the New Zealand economy itself will limit New Zealand’s ability as a geographically peripheral economy, to respond to the new international competitive pressures afforded by falling international transactions costs.
The agglomeration arguments of Glaeser and Krugman therefore provide grounds for serious concern on the part of New Zealand’s policy-makers, because current changes in spatial transactions costs appear to lead to a process which does not favour New Zealand’s long-term trade and growth prospects. Moreover, from this perspective the New Zealand government would appear to be very limited in its ability to influence the country’s long-term trade and growth performance via intervention. On the other hand, a simple reliance on the market mechanism alone to correct for inefficiencies in the domestic economy, as a means of bolstering trade and domestic growth, would also appear to be entirely ineffective in the face of such long-term global economic changes.
