Supply-Based Regional Growth Analysis

Chapter 8

Solow (1956) Swan (1956)

• Y = f(K, L, ) • Y, K, and L are the levels of output, capital, and

labor • K and L are equally productive everywhere• Constant returns to scale• Level of technical progress, , is available

everywhere• Rate of return to capital=interest rate

• MPL = wage in the perfectly competitive market

Solow (1956) Swan (1956)

• Growth occurs – When amount of resources increase – Technology shifts the production function upward– Spatial misallocation of resources is corrected (spatial

mismatch)

• “Technology” is measured as the residual after explaining growth due to other production factors. (between 1929 and 1982: > 33%)

Production function

Neoclassical wage equilibration via capital migration

Neoclassical wage equilibration via labor migration

Catch-up

• Low-wage regions would see a faster increase in growth rates and wage rates than higher-wage areas.

• Free trade and migration should induce low-income regions to catch up and converge with high-income areas.

• Restricted trade and migration should result in diverging economies.

Convergence: a reality?

• Few empirical studies have established a convergence process.

• Santa Clara County, California, average annual wage per job was $69,288 (2004)

• Garfield Co., (eastern Montana) lower land prices and an average wage $17,012 (2004)

Convergence: a reality?

• In neoclassical growth theory, differences in per capita income and growth rates across regions cannot persist without market interference

• If it works for countries: what about states? Counties? Cities? Census tracts? Households?

Solow Residual

• Amount of growth that is not explained by the quantity of inputs (the residual of the regression equation) is a measure of technological innovation.

• Knowledge and ideas are never generated. They show up instantly everywhere like manna from heaven.

Solow Residual

• No learning curve needed, but …

• Workers can neither modify nor recreate the existing technology

• Agglomeration economies, technological spillovers, or entrepreneurial ability have no role in growth.

Role of Government

• Neoclassical theory often masks a moral requirement that low-income areas should grow faster.

• Taxes should be levied on the developed regions and used to assist growth in low-income areas.

• But, taxes reduce employment in developed regions.

• Spending crowds out private sector.

Endogenous Growth theory

• Romer’s (1986): Output = f(Capital, Labor, and Knowledge).

• Modifies Solow/Swan growth model.• Diminishing marginal productivities for

capital and labor; but the marginal product of knowledge is increasing.– Once we have a certain stock of knowledge,

doubling inputs devoted to research does not double the amount of new knowledge.

Endogenous Growth theory

• But: – There is no automatic equilibrating mechanism that

requires low-income areas to grow faster than developed areas.

– Convergence is not necessary. – Growth in some regions can be slower than in others

or even stagnant.– Growth is a function of: externalities, increasing (or

constant) returns to scale, decreasing returns to producing new knowledge.

Endogenous Growth theory

• Input and output markets are not necessarily perfectly competitive.

• Most endogenous growth models assume some form of production based on:– Technology and innovation,– Unskilled and skilled labor,– Physical capital– Infrastructure and public services.

Technology and innovation

• Labor can flow from unskilled to skilled markets, with a time lag.

• Investments in human capital mean constant learning.

• Physical capital incorporates the latest technology.

Infrastructure

• Physical infrastructure – Provision and maintenance of utilities, roads,

highways, bridges, mail, telecommunications.

• Social infrastructure – Existence and respect for property rights as

well as nonobstructive bureaucracies.

Government

• Provide and maintain infrastructure

• Enforce property rights.

Technology

• The saving force. How?– Deskilling of jobs (process innovations )– Requires higher skills (product innovations )– Employment could (simultaneously) increase,

decrease, or remain stable if firms adapt newest technology

Innovation

• Using knowledge to invent and introduce a new product, process, or service into the marketplace.

• Classification: – the ratio of its spending on research and development

to its total sales, or – the industry’s ratio of research and development

employment to total employment. • Firms that innovate grow faster

– innovations cause more rapid growth or – the faster-growing firms have a greater ability to

innovate

Knowledge, Innovation, and Technological Progress

• The more that is known, the easier it is to invent and discover even more. – engineering and chemistry

• Highly innovative regions increase the technological gap.

• Imitation and diffusion reduce technology gaps

Public goods

• Nonrivalry: several people can use the same good simultaneously. Nonexcludability: it is difficult to prohibit people from using the good.

• Romer (1996): Technology is a set of ideas combined with “physical things” and used in production.

• An idea (knowledge) is a nonrival good, but the physical things are rival goods.

Dual continuum showing Pure Private and Pure public goods

A Firm’s Investment in Private R&D

• Expected rate of return on research and development

• Has to be at least equal to the expected rate of return of another project

costs D&R of luepresent va the

profits operatingnet of stream theof valuediscountedpresent the

How Does Knowledge Spill Over

• Knowledge is exchanged among people in the same industry (localization economies), or

• Among industries in geographic proximity (urbanization economies).

• By sharing inputs, backward linkages facilitate innovation in decreasing the cost of using new ideas.

Geographic concentration?

• Perroux (1950) no. Input suppliers need not even be on the same continent to be influential: hard to create policy

• Boudeville (1966) spatial proximity and agglomeration economies are fundamental for innovation.

• But innovators, research institutions, and a highly trained workforce must all interact to maintain a viable, dependable network.

Collaboration

• Innovative milieu, industrial district, technopole, science park

• Goal: Recreate Silicon Valley.• Milieu: industrial culture that promotes

collective learning • Knowledge must be acquired, maintained,

and reproduced. • “Creative forgetting” allows technical

change to progress.

Human Capital and Technical Change

• Improvements in productivity come from – Advances in physical technology integrated in

newer capital, – Increases in the stock of knowledge bridge

building, and – Incorporation of human capital in individual

workers.• Brooklyn Bridge took 14 years (1869-1883) • Verrazano-Narrows Bridge: 5 years (1959-1964)

Brooklyn Bridge

Verrazano–Narrows Bridge

Human Capital

• Theodore Schultz (1963)

• Health care, *education, job search time, job search costs (newspapers, agencies, moving), on–the–job training (learning -by-doing), job tenure.

Measures of Formal Education

• Enrollment rates proportion of school age children enrolled in school at the beginning of the academic year. – Should predict the future stock of human

capital. – Does not account for students who leave or

choose not to work after graduation.

Measures of Formal Education

• Literacy rate represents a basic level of human capital acquired by individuals at a point in time.

• How to effectively test? – For the US, in 18% of the households English

is not the primary language – Proficiency in the primary language of a

region increases productivity and potential earnings (statistically significant).

Measures of Formal Education

• Average educational attainment – Assumes workers with the same level of

education possess the same skills. (All Master’s degrees create the same skills.)

– Murphy, Shleifer, and Vishny (1991): A 10% increase in the average educational attainment leads to an average 8% increase in a state’s aggregate output.

Rates of Return to an Investment in Education

• 80% for elementary school in low-income countries to - 3% for some grad degrees

• Quality preschool: 7% and 16%.

• Bachelor’s degree at 8%

• Graduate degree 7% to 12% (average)

• Society’s RoR: individuals do not consider the positive externalities they underinvest

Education

• Learn cognitive skills.

• Self-reliance and dynamism

• More patient toward bureaucracies

• Comply more with organizational rules, Easier to train.

• Employers use to screen workers. Signals ability, achievement, motivation, and ethnic/social origin.

Social capital

• Network of informal social relations, family and community connections, common values, and respect for norms

• Encourages information spillovers

• Becomes an informal safety net

Social capital

• Includes all elements necessary to determine how the community shapes its own destiny – How to adapt to a climate and a community,– The workings of local networks– The identification of the true decision maker

• Social capital produces positive and negative effects on a community. – Reciprocity is expected. The more “social debts” a

person holds, the more social capital is available. (influence)

– “Old-boy networks,” intolerance against “outsiders” limit knowledge dissemination.

Social Mindset and Growth

• Easterlin (1981) (Economic historian)– Colonialism, absolute monarchy, the Roman

Catholic Church, and Islamic fundamentalism deter mass schooling and the free circulation of ideas.

– Protestantism and Humanism scientific progress, pure reason, and the conviction that humanity is master of its own destiny positively influence economic growth.

Social mindset

• Incomes in poorer regions cannot converge if they lack human capital, and if they are resigned that this is their fate.

• More productive individuals need to work with other high-skilled workers.

• An insufficient market for skilled labor creates a brain drain.

Role of Capital

• Tangible, physical capital

• Increasing “plant” means expanding existing firms or attracting new ones.

• Attracting new firms implies technological investment—

• New capital embodies new technology (Arrow’s (1962) vintage model of capital)

Types of depreciation

• Physical depreciation, (wear and tear).

• Obsolescence.

• Reduced demand for outmoded product.

Theory of creative destruction

• Schumpeter’s (1962)

• Innovating entrepreneurs lead the most important firms.

• Competitive, dynamic environment, relentless innovation, they continuously create disequilibrium.

Theory of creative destruction

• New technologies are superimposed on the top of past technology, and combined with the most avant-garde technologies.

• Future technologies threaten economic profits (rents) created by current research.

Theory of creative destruction

• The temptation to curtail future research to protect a process of production creates a no-growth trap. – No research, no innovations. – Economy stagnates.

• Entrepreneurs decide what innovations to adapt

Firm Births

• Urbanization and localization economies

• Presence of small, specialized firms

• Persistently high unemployment rates (unemployment desperation.) (high probability these won’t survive)

Innovation and firm size

• Old mass-production “Fordist” firms (rust belt) less likely to innovate– Internal labor markets—few new ideas– Innovating employees leave or succumb to

corporate mindset– Out-dated plant and equipment– Original location may no longer be cost

minimizing– Unions set a regional minimum wage so that

start-ups cannot successfully bid for workers.

Innovation and firm size

• The existence of many small manufacturing firms means the social structure fosters an entrepreneurial spirit and facilitates start-ups

• Small businesses outperform large ones in industries dominated by technical change

Foreign Direct Investment

• “Foreign” means ownership by investors based outside the country or anyone from outside a locality owning local capital

• Two ways it takes place:– Parent firm builds an entirely new branch in

the area (Greenfield investment), or – Parent firm acquires existing facilities.

Foreign Direct Investment

• Two theories– Internalization theory, a parent firm invests

in foreign assets instead of assets in its own region when the host region offers an advantage not available in the home region. (Greenfield investments)

– Network theory, a parent firm tries to acquire complementary assets by expanding their networks. (Purchase existing plant)

Virtuous or vicious cycles

• Virtuous cycle parent firm develops technological capability of host regions– Develops or maintains solid local networks

and encourages agglomeration economies. (network theory).

Virtuous or vicious cycles

• Vicious cycle is linked to the decline of technological capability – Assembly plant imports the majority of its

components, abandoning the existing supply networks.

– Never creates sustainable regional development

– Can delay the region’s growth potential by aggravating labor shortages or high rates of employee turnover for local firms