2.  Background and motivation

2.1  Background

2.1.1 New Zealand’s economic performance

New Zealand’s overall economic performance picked up in the early 1990s compared with previous decades. From 1994 to 2004 GDP grew at an annual average rate of 3.4 per cent. GDP per capita over a recent 6-year period (1997-2003) grew at an annual average rate of 2.56 per cent compared with an OECD average of 2.10 per cent (MED and Treasury, 2005). Nevertheless the level of New Zealand’s GDP per capita remains low in the OECD rankings in twentieth place. Moreover, the relatively high GDP per capita growth has been driven more by fast growth in labour utilisation than by good labour productivity growth. New Zealand’s level of labour productivity is low by OECD standards and its growth rate is also below average (MED and Treasury, 2005).

The scope for further per capita growth through achieving a higher fraction of the population in paid work is limited – New Zealand has the second highest level of labour utilisation in the OECD. This has been achieved through one of the lowest unemployment rates in the OECD and above average levels of labour force participation. Therefore the main challenge for New Zealand in order to maintain and enhance its per capita growth rate and achieve higher relative levels of GDP per capita must lie largely in achieving higher labour productivity growth (MED and Treasury, 2005).

It is difficult to find clear answers to explain New Zealand’s relatively slow labour productivity growth. On most policy settings and in its institutional architecture, New Zealand measures up well compared to other OECD economies. It may be that slow labour productivity growth is a by-product of fast employment growth – both because most growth in employment has been at the lower end of the skill distribution and because firms have expanded output more through hiring labour than by investing in plant and equipment and the modern technology embodied in it (McLellan, 2004; Hyslop and Yahanpath, 2005).

Another hypothesis is that New Zealand struggles to achieve higher productivity because of the small size of its domestic market and its distance from markets in other countries. These factors limit competition, create higher transport costs and other barriers for exporters, and slow down technology adoption. The economic geography literature that highlights size and distance as influencing factors in economic performance focuses mainly on so-called agglomeration economies[2]. These arise either from clusters of firms within an industry (the Silicon Valley syndrome) or the dense co-location of a variety of industries and skilled people in cities.

Some commentators point to cities that stand out as centres of creative innovation and high value-added industries, places such as Boston, San Francisco, London, Helsinki, Dublin, Amsterdam, Singapore, Sydney and Melbourne. In terms of size, Auckland is on the cusp of having the population that is typical of some of these successful smart cities. A question for policy analysts interested in New Zealand’s economic performance is whether Auckland is playing the energising role of one of these dynamic cities within the national economy? The key motivation for the research reported in this paper is to throw a little more light on this question by examining how well Auckland has performed relative to other regions in New Zealand.

2.1.2 Agglomeration economies and cities

This section describes some of the reasons that at least some cities achieve the status of drivers of innovation and productivity growth within national economies. It also refers briefly to evidence on these factors. Conceptually cities are simply dense agglomerations of people and firms. Through history cities have been a feature of the economic landscape, but the reason for their economic importance has changed over time (Glaeser, 1998). In Glaeser’s framework “all of the benefits of cities come ultimately from reduced transport costs for goods, people and ideas”.

Transport and manufacturing are both sectors in which high fixed set-up costs and other forms of increasing returns have meant high returns from large-scale production and from locating production close to consumers. In the past, location in cities provided both these advantages. But reductions in transport costs of goods and in the importance of manufacturing in developed economies over the last 50 years have greatly diminished the role of cities in providing these advantages.[3] On the other hand, the ability of cities to lower the transport costs of people and ideas appears to be increasingly important.

The ability of dense cities to transport people at low cost (principally because it eliminates distance between them) benefits firms and residents of the city for several reasons. First it enables the occupational specialisations required to support a fine division of labour. In accordance with one of the enduring insights of Adam Smith such division leads to higher productivity. In a small town, an actor or lawyer has to be a generalist. In New York or London, these professions are highly specialised and this provides benefits to the firms and individuals who consume their services.

A second benefit of cities is their ability to provide thick labour markets for workers and firms. As Alfred Marshall pointed out (Marshall, 1920), the thickness of these markets provides an effective insurance for workers against firm- or industry- specific shocks. It also gives workers more bargaining power because they have many prospective employers, and this security encourages workers to invest more in their human capital (Rotemberg and Saloner, 1991). Firms also benefit because the thick market raises their chances of finding in a short time good matches to meet their skill needs.

Thirdly urban agglomerations can play a key role in economic growth by lowering the cost of transporting ideas. There are two aspects – one is the much noted tendency of knowledge and information to spill over between firms and people. The other is the role of cities as centres of learning and skill acquisition. As Marshall (1920) wrote on the first of these, in dense areas “the mysteries of trade become no mystery but are, as it were, in the air ….”. Other writers who focus on the role of cities in the production and diffusion of ideas which lie behind economic growth include Jacobs (1969) and Lucas (1988). The agglomerations can be either industrial clusters such as Silicon Valley, or diversified cities. The question of whether it is concentration or diversity that is more powerful as a catalyst for new ideas remains unsettled. Both appear to work.

Cities host a key process that consists of young workers learning and acquiring skills that raise their productivity. These skills and knowledge then spread when the young workers move to new jobs or start up their own firms. The density of the city speeds up the rate at which people interact and these interactions lead to faster human capital accumulation. In addition, “cities are even more effective in training workers when they are particularly full of knowledgeable or successful people and if cities offer a particularly wide range of ‘educational’ experiences” (Glaeser, 1998). There is a plausible story of young workers coming to cities where they learn faster, experience higher wage growth as a result, and take their knowledge, higher productivity and higher wages with them when they leave (Glaeser and Mare, 2001).

There is clear evidence that higher productivity comes about when people cluster densely in cities but much less on the relative importance and precise nature of the different possible mechanisms.[4] Three papers illustrate the former proposition. First, there is direct evidence that the fineness of the division of labour increases with the level of urbanisation (Ades and Glaeser, 1995). Secondly, for workers with the same qualifications, wages are higher in cities, reflecting higher productivity (Rauch, 1993). Thirdly, based on evidence from U.S. counties, Ciccone and Hall (1996) find that doubling employment density in a location results in a 6 per cent increase in average labour productivity.[5] While real wages are not connected with city size (the higher wages in cities being completely offset from the workers point of view by the higher cost of living in cities), from a firm’s viewpoint, it is prepared to pay higher wages to get the higher productivity of workers in cities. In some cities at least, there have been periods in which prices have risen faster than wages suggesting that the cities were providing increasing and substantial non-pecuniary (amenity) benefits to their residents[6].

Dumais, Ellison and Glaeser (2002) find evidence for the thick-labour-market benefits of cities – over a recent 20-year period they found that sharing a common labour market pool was the most important determinant of which industries located together. There is less available evidence for the benefits of cities in facilitating informational spillovers. Much of it tends to be more based on case studies and anecdotes (Saxenian, 1996; Scott, 1988) rather than rigorous statistical analysis. An exception is Audretsch and Feldman (forthcoming).

For the US, Berry and Glaeser (2005) highlight that cities with high levels of college graduates in 1990, became increasingly skilled over the 1990s (at a faster rate than cities with lower qualification levels in 1990). This tendency of initially skilled places to become more skilled over time suggests a form of increasing returns at work. One possibility is that the higher productivity of the initially skilled stimulates employment growth of other skilled and high-productivity workers. An alternative explanation is that the presence of existing skilled workers raises the amenity value of the location (e.g. through better restaurants and recreational facilities) that in turn attracts the more skilled. A study by Shapiro (2005) estimates 60% of the skilled growth coming from the productivity effect with the rest caused by growing quality of life.

Overall, there is now a strong body of ideas and supporting evidence that cities play an important role in economic growth. Many of the mechanisms appear to depend on forms of increasing returns and spillovers and therefore their strength may be subject to initial conditions and cumulative causation. In New Zealand, there is a natural focus on Auckland as the largest city and the question of the extent to which it is following the paradigm of an innovative, high-skill, high-productivity-growth large urban centre.