What are the main determinants of industrial location?

T H E E U R O P E A N S P A T I A L E C O N O M Y E C 5 5 5

Introduction

The last years have seen a strong increase in the study of industrial location and economic geography. The deepening economic integration within so called tax and customs unions such as the European Union has fuelled new interest in the field of industrial location. The fact that industrial production has a tendency to agglomerate in central regions has been a major concern to policy makers not just within the EU. Recent findings by researchers such as Fujita, Krugman and Venables (1999) identifying new modelling tricks to compare industrial organizations, international trade and economic growth more accurately has led to an increasing number of studies being conducted.

The Three Main Schools of Industrial location

Developments of the theory of industrial location can be tracked down by following the evolution of the three main schools of thought as outlined below. For a tabular illustration, please refer to the Appendix.

One of the first studies of trade and location is Ricardo’s classical theory of comparative advantage (1817), which was later on linked with the Heckscher–Ohlin (H-O) model. The H-O model predicts that the patterns of trade between countries are based on the characteristics of the countries. The H-O model says that a capital-abundant country will export the capital-intensive good while the labour-abundant country will export the labour-intensive good. Those studies contributed to the establishment of the Neo-classical theory (NCT), which is characterised by perfect competition, homogeneous products and falling returns to scale. Krugman (1993) named the factors determining location “first nature”. He explains that economic activity is spread or concentrated over space according to the spread or concentration of the following features: The spatial distributions of natural endowments, technologies as well as factor endowments and factor intensities. However, he argues that the dominating location pattern is inter-industry specialisation: sectors of industry tend to settle in locations with a matching comparative advantage. Assuming zero trade costs, the spatial distribution of demand only affects the patterns of trade, but not the location of production. Assuming trade costs and evenly distributed demand over space, then the locational dispersion of activity will correlate positively with the level of trade costs. Following the geographical distribution of demand, high levels of trade costs therefore induce perfect dispersion of industries.

New trade theories (NTT) were developed to explain high levels of intra-industry trade and the large proportion of world trade that takes place between similar countries. NTT excludes the exogenous, 'first nature' elements, but places a major emphasis on market size. Theoretical modelling has shown that the interaction of scale economies and trade costs encourages the concentration of manufacturing production in countries that have good access to large markets. The presence of scale economies encourages firms to choose only one location, and the presence of trade costs encourages them to locate in the country that has the larger market for their goods. According to Krugman it is determined primarily by the size of the labour force in a particular country, while assuming that labour force is immobile across countries. These models introduce activity-specific features, which Krugman (1993) labelled “second nature”, such as imperfect competition, differentiated products and increasing returns. The typical outcome has two layers. First, there is inter-industry specialisation, with sectors clustering in locations which offer best access to product markets. Second, there is intra-industry specialisation across firms, each of which produces a unique, horizontally differentiated variety of the industry's product. Intra-industry trade will take place as long as some firms are left in the smaller market. As trade costs fall towards zero, however, all increasing-returns activity will tend to concentrate near the core market, and intra-industry trade between the core and the periphery vanishes.

In the New Economic Geography (NEG) models, location becomes entirely endogenous: 'second nature' is the main determinant of location. Because production factors are assumed mobile, even market size is explained within the model. The analytical starting point is normally a two- or three dimensional space with uniformly distributed labour and output of a single industry. This distribution tends to be unstable, due to the assumed 'second nature' characteristics of the economy, such as market-size externalities and input-output linkages. These characteristics generally produce self-reinforcing agglomeration processes. Therefore, any shocks to the initial distribution will cause the economy to reach a ...

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Illustrated below are the multiple equilibria which can arise in a so called Bifurcation model: A non-linear relationship between the share of manufacturing labour between two regions and trade cost. The starting point, which is marked by two different levels of trade cost (T) in turn determines profitability of firms. Depending on the starting point, they either predict convergence or divergence. At high values of T it is most profitable to produce in both locations, leading to divergence. At low levels of T, production will tend to locate in a single location (the core).

Bifurcation Core Periphery Model

In view of the multiple outcomes which can be accommodated in this theoretical framework, empirical evidence is limited. In these models, agglomeration mechanisms are confronted with increases in the prices of the immobile factors. The outcome may be high agglomeration levels resulting in the centre-periphery structure, which in turn lead to higher economic integration. The new economic geography literature extends this line of research by showing that international or inter-regional demand differences are themselves likely to be endogenous - either because of mobility of workers (Krugman, 1991) or because of mobility of firms which demand intermediate goods (Venables, 1996).

In industries, which are linked through an input–output structure, the downstream industry will form the market for upstream firms. The home-market effect1 then means that upstream firms are drawn to locations where there are relatively many.

In addition to this demand (or backward) linkage there may also be a cost (or forward) linkage. Having a larger number of up-stream firms in a location benefits downstream firms who obtain their intermediate goods more cheaply - by saving transport costs, and perhaps also benefiting from a larger variety of differentiated inputs or more intense competition in the upstream industry. The combination of these backward and forward linkages creates the possibility of a clustering of vertically related industries. Since these demand and cost linkages are stronger when the proportion of intermediate goods in production of final goods is higher, we should expect the level of geographical concentration to be higher in industries that are more intensive users of intermediate inputs in final production.

Why does the removal of trade barriers lead to pressures for industries to relocate?

Based on the NEG literature, there are two factors that will influence industrial location of firms across EU countries: Access to customers and access to suppliers (Fujita, Krugman and Venables, 1999). Another factor outlined includes the dispersion forces: As production concentrates, the price of immobile factors will rise relative to locations where production does not take place. Agglomeration and dispersion forces decide where firms locate (Fujita, Krugman and Venables, 1999). Trade barriers will affect both trade costs and to a degree the mobility of labour.

Free trade allows for the separation of consumption and production, and comparative advantage shows how the location of production is determined by differences in the technology or factor endowments of regions or countries. One expects that as trade barriers are reduced production will relocate solely according to comparative advantage.

The changes in demands for factors of production that follow from this will tend to equalize factor prices across countries. Differences in institutions and infrastructures should change the efficiencies of factors of production across countries, and even small remaining trade barriers or transport costs can disrupt the predicted pattern of trade.

On one hand, a reduction in trade barriers facilitates the separation of production from consumption, allowing geographical advantage to play a more important role. On the other hand however, if trade barriers and transport costs become extremely small, then differences in these costs across locations become minor. The balance between these forces usually resolves itself in an inverse U-shaped relationship, saying that geographical advantage will be greatest at some intermediate level of trade costs. Hence, in moving from very high trade barriers to ‘intermediate’ ones, the theory predicts that activity will be drawn into regions with good market access (core). However, as regions integrate more and more as can be seen in the EU, the process becomes reversed: Trade costs become relatively small so firms are less willing to pay the higher core wages, and a reverse flow of industry to peripheral regions occurs.

If one examines recent developments in the European Union single market, it is striking that the regions on the perceived periphery of the EU, such as Portugal and Ireland have been doing better in economic growth terms than regions associated with the core such as France and Germany. Especially high-tech industries in Ireland have been doing very well. This may be explained by the fact that these industries are considered somewhat “footloose”. It may partly also be explained by the EU’s regional policies, which transfers financial aid from the more prosperous member states to regions which are seen to be economically underdeveloped. However, Midelfart-Knarvik and Overman (2002) note that these countries, in particular Ireland, have been doing so well because she was able to increase specialisation. They conclude that the lack of labour mobility (relative to capital mobility) has prevented other regions within the perceived core member states from adjusting effectively in order to capitalise on comparative advantage.

Conclusion

Initially, this essay has described what determines industrial location using the three strands of location theory.

In the second part we have seen that in theory firms should only be competing on comparative advantage, once trade barriers have been removed. However, continuing integration means that at intermediate levels of transportation cost, geographical advantage becomes of strong importance leading to concentration of businesses. At high levels of transport cost, firms in custom-unions are likely to move to the periphery as the trade-off becomes more favourable.

Towards the end of the essay we have seen that a number of industries that were initially spatially dispersed have become more concentrated on the periphery of the European union, especially in high technology ‘footloose’ industries in countries like Ireland.

Appendix 1:

Overview of the developments in the Spatial Trade models

Bibliography

AJ Venables, Localization of industry and trade performance Oxford Review of Economic Policy, 12(3), 1996 pp 52-60

AJ Venables, The assessment: trade and location Oxford Review of Economic Policy, 14(2), 1998 pp. 1-6

K L M Midelfart Knarvik and H G Overmann: Delocation and European Integration, Economic Policy, 2002

M Amiti, New trade theories and industrial location in the EU: a survey of evidence Oxford Review of Economic Policy, 14(2), 1998, pp. 45-53

M Brülhart, Trading places: Industrial specialisation in the EU, Journal of Common Market Studies, 36(1998) 319-346

M Brülhart, Economic geography, industry location and trade: the evidence, The World Economy, 21(1998) 775-802

M Fujita, P Krugman, A J Venables, The Spatial Economy: Cities, Regions and International Trade (1999)

P R Krugman: Geography and trade, MIT press, Cambridge, Massachusetts (1991)

P R Krugman and A J Venables, Integration, Specialization, and the Adjustment, European Economic Review, Vol. 40, 959-967 (1993)

1 The point was made by Krugman (1980), who modelled consumers in two countries as having different tastes, and showed that trade liberalization leads each country to specialize in and export those goods towards which domestic consumers are biased. Demand differences therefore lead to amplified differences in production, creating what has become known as the ‘home market’ effect.