THE FIVE AXIOMS OF URBAN ECONOMICS

 THE FIVE AXIOMS OF URBAN ECONOMICS

Urban economics explores the location choices of households and firms, and so it is natural to assume that people and firms are mobile. Of course, people don’t instantly change their workplaces and residences when circumstances change; therefore, a model of perfect mobility tells us more about long-term changes than short-term ones. The average household changes its residence every seven years, meaning that about 14 percent of the population moves every year. Although most models of urban economics assume perfect mobility, there are exceptions, and we will high-light the analysis that assumes less than perfect mobility.

 In this part of the chapter, we introduce five axioms of urban economics. An axiom is a self-evident truth, something that most people readily understand and accept. For our purposes, “most people” are people who have taken at least one course in economics. The five axioms lie at the heart of urban economics and together provide a foundation for the economic models of location choices. As you go through the book, these five axioms will appear repeatedly.

1. Prices Adjust to Achieve Locational Equilibrium

A locational equilibrium occurs when no one has an incentive to move. Suppose that you and Bud are competing for two rental houses, one along a beautiful beach and one along a noisy highway. If the two houses have the same price (the same monthly rent), you would prefer the beach house, and so would Bud. Flipping a coin and giving the beach house to the winner wouldn’t generate a locational equilibrium because the unlucky person in the highway house would have an incentive to move to the more desirable house.

Locational equilibrium requires a higher price for the beach house. To eliminate the incentive to move, the price of the beach house must be high enough to fully compensate for the better environment. The question is, How much money are you willing to sacrifice to live on the beach? If your answer is $300 and Bud agrees, then the equilibrium price of the beach house will be $300 higher than the price of the highway house. In general, prices adjust to generate the same utility level in different environments, getting people to live in both desirable and undesirable locations.

 The same sort of economic forces operate in the labor market. Workers compete for jobs in desirable locations, causing lower wages in more desirable locations. Suppose you are competing with Ricki for two jobs, one in Dullsville and one in Connellsville, a city with a more stimulating social environment. If a $500 gap in the monthly wage fully compensates for the difference in the social environment, the equilibrium wage will be $500 lower in Coolsville. The two workers will be indifferent between the two cities because a move to Coolsville means a $500 wage cut. In the labor market, wages adjust to get people to work in both desirable and undesirable environments.

The price of land also adjusts to ensure locational equilibrium among firms. Office firms compete for the most accessible land in a city, and land at the center is the most accessible and thus the most expensive. In equilibrium, office firms on less accessible land far from the center pay lower prices for land, and can be just as profitable as firms on the most accessible land.

2. Self-Reinforcing Effects Generate Extreme Outcomes

A self-reinforcing effect is a change in something that leads to additional changes in the same direction. Consider a city where the sellers of new automobiles are initially spread evenly throughout the city. If one seller relocates next to another seller on Auto Road, what happens next? Auto consumers compare brands before buying, and the pair of sellers on Auto Road will facilitate comparison shopping and thus attract buyers. The increased consumer traffic on Auto Road will make it an attractive site for other auto sellers, so they will move too. The ultimate result is an “auto row,” a cluster of firms that compete against one another, yet locate nearby. 

Self-reinforcing changes also happen in the location decisions of people. Suppose artists and creative types are initially spread out evenly across a dozen cities in a region. If by chance one city experiences an influx of artists, its creative environment will improve as artists (1) are exposed to more ideas and fabrication techniques and (2) can share studios, print shops, tool suppliers, and other facilities. The cluster of artists will attract other artists from the region, causing a concentration of artistic production in one city. In recent decades, cities that have attracted artists and creative folks have experienced relatively rapid growth (Florida, 2002).

3. Externalizes Cause Inefficiency

In most transactions, the costs and benefits of the exchange are confined to the individual buyer and seller. The consumer pays a price equal to the full cost of producing the good, so no one else bears a cost from the transaction. Similarly, the consumer is the only person to benefit from the product. In contrast, an externalize occurs when some of the costs or benefits of a transaction are experienced by someone other than the buyer or seller, that is, someone external to the transaction. 

An external cost occurs when a consumer pays a price that is less than the full cost of producing a product. The price of a product always includes the costs of the labor, capital, and raw materials used to produce the product, but it usually does not include the environmental costs of producing the product. For example, if burning gasoline in automobiles generates air pollution, part of the cost of driving is borne by people who breathe dirty air. Similarly, when you enter a crowded highway, you slow down everyone else, meaning that other drivers bear a cost.

An external benefit occurs when a product purchased by one person generates a benefit for someone else. For example, painting my peeling house improves the appearance of my neighborhood, increasing the value of my neighbor’s house as well as mine. Education generates external benefits because it improves communication and thinking skills, making a person a better team worker. In other words, some of the benefits of education are experienced by a person’s fellow workers, who become more productive and thus earn higher wages.

When there are external costs or benefits, we do not expect the market equilibrium to be socially efficient. In the case of external cost, people pay less than the full social cost of an action like driving, so they drive too much. In the case of external benefit, people get less than the full social benefit from an action like education, so they stop short of the socially efficient level of education. As we’ll see later in the book, cities have all sorts of external costs and benefits. In many cases there is a simple solution: Internalize the externalize with a tax or a subsidy, and let individuals, who then bear the full social cost and benefits of their actions, decide what to do.

4. Production Is Subject to Economies of Scale

Economies of scale occur when the average cost of production decreases as output increases. For most products, if we start with a relatively small production operation and double all inputs, the average cost of production decreases. In the jargon of economics, when the long-run average cost curve is negatively sloped, we say that there are scale economies in production. Scale economies occur for two reasons:

• Indivisible inputs.

 Some capital inputs are “lumpy” and cannot be scaled down for small operations. As a result, a small operation has the same indivisible inputs as a large operation. For example, to manufacture frisbees you need a mold, whether you produce one frisbee per day or a thousand. Similarly, to produce microprocessors you need a clean room and other expensive equipment, whether you produce one processor per day or a thousand. As output increases, the average cost decreases because the cost of the indivisible input is spread over more output.

• Factor specialization.

In a small one-person production operation, a worker performs a wide variety of production tasks. In a larger operation with more workers, each worker specializes in a few tasks, leading to higher productivity because of continuity (less time is spent switching from one task to another) and proficiency (from experience and learning). The notion of factor specialization is captured in the old expression, “Ajack of all trades is master of none.” Adding to this expression, we can say that a specialized worker is a master of one task. As we’ll see later in the book, scale economies play a vital role in urban economies. In fact, as we’ll see in Chapter 2, if there are no scale economies, there will be no cities. It is costly to transport products from a production site to consumers, so centralized production in cities will be sensible only if there is some advantage that more than offsets transport costs. 

The extent of scale economies in production varies across products. Micropro- cessors are produced in $5 billion fabrication facilities with a highly specialized workforce performing hundreds of complex tasks, resulting in large scale economies in production. In contrast, pizza is produced with a $5,000 pizza oven with just a few production tasks, so scale economies are exhausted sooner. In general, the extent of scale economies is determined by the lumpiness of indivisible inputs and the opportunities for factor specialization.

5. Competition Generates Zero Economic Profit

When there are no restrictions on the entry of firms into a market, we expect firms to enter the market until economic profit is zero. Recall that economic profit equals the excess of total revenue over total economic cost, where economic cost includes the opportunity costs of all inputs. Two key components of economic costs are the opportunity cost of the entrepreneur’s time and the opportunity cost of funds invested in the firm. For example, suppose an entrepreneur could earn $60,000 in another job and invests $100,000 in the firm, taking the money out of a mutual fund that earns 8 percent. The economic cost of the firm includes $60,000 in time cost and $8,000 in investment cost. Once we account for all the opportunity costs, the fact that economic profit is zero means that a firm is making enough money to stay in business, but not enough for other firms to enter the market. Earning zero economic profit means earning “normal” accounting profit.

In urban economics, competition has a spatial dimension. Each firm enters the market at some location, and the profit of each firm is affected by the locations of other firms. Spatial competition looks a lot like monopolistic competition, a market structure in which firms sell slightly differentiated products in an environment of unrestricted entry. Although this sounds like an oxymoron such as “tight slacks” and “jumbo shrimp,” the words are revealing. Each firm has a monopoly for its differentiated product, but unrestricted entry leads to keen competition for consumers who can easily switch from one differentiated product to another. With spatial competition, each firm has a local monopoly in the area immediately surrounding its establishment, but unrestricted entry leads to keen competition. Firms will continue to enter the market until economic profit drops to zero.