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What is Urban Economics
Distance between different economics activitiesimplies costs for transporting goods and movingpeople. Distance also defines communication and
social interactions among consumers andworkers.
Historically, much of urban economic analysisrelies on a particular model of urban spatial
structure, the monocentric city model pioneeredin the 1960s by William Alonso, Richard Muth,and Edwin Mills.
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Axioms of Urban Economics
The five axioms of urban economics are
essential to understanding how urban
economics works and how it is applied. An
axiom is a self-evident truth. This means thateach of these five things is something that
most people can understand and accept to be
true. These five axioms provide the basis forurban economics and the foundations for all
topics associated with urban economics
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Axiom 1: Prices Adjust to Achieve
Locational Equilibrium
If the price were the same for two houses, one thatwas in Hawaii on the beautiful beach and the otherlocated in a slum in New York City, there would be anincentive for one to move to the house in Hawaii. A
locational equilibrium occurs when there is noincentive to move. In order to achieve this, the price ofthe slum house will decrease as the price of the beachhouse in Hawaii increases. That way, a person whocould afford either house before now has either an
incentive to move to the cheaper house they can affordrather than the nice beach house which a moreaffluent person can now live in.
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Axioms of Urban Economics
Axiom 1: Prices Adjust to Achieve LocationalEquilibrium
In a locational equilibrium amenities of a
location are capitalized in the rental rate: Rent on beach house > Rent on highway house
or Land rent in center > Land rent on fringe
Amenities for a location may also becapitalized in wages:
Wage in Klang Valley > Wage in Senawang
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Axiom 2: Self-Reinforcing Effects
Generate Extreme Outcomes This axiom means that if one type of person moves into an area,
then that area will become more attractive to more of the sametypes of people. For instance, a few artists may move into a cityand because of their artistic touches to the city and local night lifemore and more artists will move in until it is a complete artistic city
that will draw even more artists to the area. Another example of aself-reinforcing effect generating extreme outcomes is if one or twocar dealerships were to locate in the same area. People would thenwant to shop for cars in this area thus making it even moredesirable for auto stores and car dealerships to locate here. Thiswould then create an extreme outcome of an auto cluster. This can
happen with almost any type of neighborhood and this is why it iscommon to see a lot of the same types of things or people groupedtogether in a city
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Axioms of Urban Economics
Axiom 2: Self-Reinforcing Effects Generate
Extreme Outcomes: Self-reinforcing effects
lead to changes in same direction. For
example, auto row attracts comparisonshoppers. A cluster of artists attracts other
artists
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Axiom 3: Externalities Cause
Inefficiency An external cost is one in which the full extent of an action is not
paid by the person performing the action. It will affect otherpeople as well. For instance, if you drive on the highway it will slowdown everyone else who is also on the highway. Also, in the case ofrubbernecking, which is slowing down to see an accident on the
side of the road, your curiosity will slow down everyone else on thehighway. An external benefit is one in which something that oneperson does creates a benefit for someone else. This is mostcommon in neighborhoods where one person may makeimprovements to their property thus helping their neighborsincrease their property value because the area will suddenly
become more desirable. When there are costs and benefits insociety the market is not socially efficient.
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Axioms of Urban Economics
Axiom 3: Externalities Cause Inefficiency : A
externality is a cost or benefit of a transaction
experienced by someone other than the buyer
or seller. Examples: External cost burninggasoline affects breathers of the air. External
benefit painting a peeling house increases
values of neighboring properties.
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Axiom 4: Production is Subject to
Economies of Scale
In order to achieve economies of scale theaverage cost of production has to decrease asoutput increases. The two things that
contribute to economies of scale areindivisible inputs and factorspecialization. These are important herebecause inputs can be spread farther as
output increases and people can work in morespecialized areas thus allowing them tobecome more efficient at what they do
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Axioms of Urban Economics
Axiom 4: Production is Subject to Economies ofScale: Economies of scale describes how averagecost decreases as the output quantity increases.
There are several explainations for thisphenomenon: Indivisible inputs: required toproduce one or a thousand units. Factorspecialization : Jack of all trades master of none.
Specialized worker is a master of one task.Repetition and learning. Extent of scaleeconomies varies across activities
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Axiom 5: Competition Generates Zero
Economic Profit
This states that firms will continue entering
the market in the same location until
economic profit becomes zero. Once this is
reached, a firm will be making enough moneyto continue their business, however there will
not be an incentive for new firms to continue
entering the market
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Axioms of Urban Economics
Axiom 5: Competition Generates Zero
Economic Profit : Entry into market continues
until economic profit is zero. Economic cost
includes all opportunity cost, includingopportunity cost of time and funds. Zero
economic profit: Firms making just enough
money to stay in business; not enough toattract more entrants
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Why Do Firms Cluster?
The standard neoclassical models in Urban
Economics, e.g.
Muth-Mills and von Thnen, assume that
there is a central business
district in which all firms locate. This is taken
as an exogenous assumption outcome.
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Why Do Firms Cluster?
Why do competing firms locate close to one
another?
Two explanations:
1 Localization economies: firms in an industry
cluster
2 Urbanization economies: firms in different
industries cluster
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Why Do Firms Cluster?
There are many significant reasons why firmswould choose to cluster together in acity. The economic forces which cause this
clustering are called agglomerationeconomies. Localization economies are whenfirms locate within one singleindustry. Urbanization economies are when
firms locate across industry boundaries. Onefirm may have an incentive to move closer toanother firm eventually creating a dense city
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Why Do Firms Cluster?
Sharing Intermediate Inputs
Firms may locate close to one another in an effort toshare intermediate inputs. This is important withindustries or firms that have similar inputs and can
benefit from being close to one another. By sharingintermediate inputs they should be able to cutproduction costs and increase specialization thusmaking production subject to economies ofscale. Many high-tech products are made up of smaller
components which make it useful for firms to locatewhere these smaller components are beingmanufactured.
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Why Do Firms Cluster?
Sharing a Labor Pool
Firms are able to share workers when locating closetogether. This helps people to find what they are goodat and for firms to hire productive people for their
particular production item while a person may bebetter suited for working with a different firm. Thisalso ties into the idea of labor matching. A firm canlose a lot of money training workers who do not havethe necessary skills for their job, but in a big city, they
have a larger area of workers to choose from and thusbetter matches between workers and employers canbe produced
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Why Do Firms Cluster?
Knowledge Spillovers
This is helpful in causing firms to cluster as they cangain from one another's knowledge and hopefullyeducated workers. From examining thesedifferent concepts, it seems that firms can benefitgreatly from locating in a cluster. They can shareinputs and a labor pool, provide better skillsmatching among workers, and generate
knowledge spillovers. All of these thingscontribute to lower production costs which inturn will increase profit for the firms
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Why Do Firms Cluster?
Joint Labor Supply
Firms have an advantage to clustering when taking intoaccount joint labor supply. This refers to married coupleswho often seek places to live based on what jobs areavailable. This means that different types of firmsclustering together will attract those couples who have toconsider each individual finding a job. Having differentfirms in one area is beneficial to both the workers and thefirm. Often, those who are married and both parties areworking tend to have a higher level of education thus
adding to the labor pool from which the firms canchoose. These firms clustering lead to the development ofa larger urban area to which couples interested in jointlabor supply will be attracted.
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Why Do Firms Cluster?
Sources of localization economies
Some alternative explainations for firm
clustering include:
I Sharing Intermediate Inputs
II Sharing a Labor Pool
III Labor Matching IV Knowledge Spillovers
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Why Do Firms Cluster?
II. Sharing Intermediate Inputs
A Intermediate inputs: one firms output provides inputs forother firms
B Historical example: dresses and buttons
a Firms producing high fashion dresses must be small
b Scale economies exist in producing buttons are largerelative to the demand associated with a single dressmaker
c Face time is requires to design and fabricate buttons tofit dresses
d Variety is required in types of buttons demanded (shape,finish, color
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Why Do Firms Cluster?
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Why Do Firms Cluster?
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Why Do Firms Cluster?
Key Points in the Economic Logic
a Higher total demand for buttons allow the buttonmaker to realize economies of scale
b Button makers can specialize in types of buttons,
reducing modification costs High-Technology Firms
1 Rapidly changing products necessitates intermediateinputs
2 Face time is required for the design and fabrication ofintermediate inputs
3 Firms share suppliers of intermediate inputs
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Why Do Firms Cluster?
Sharing Pool Labour
The Isolated Firm
1 Perfectly inelastic supply of labor to firm:only employer in town
2 Variation in demand generates variation in
wages
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Why Do Firms Cluster?
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Why Do Firms Cluster?
Equilibrium with Clustered firms
1 Perfectly elastic supply of labor to individualfirm
a Each firm is one of many b Constant total demand for labor implies
constant wage (lower risk)
2 Locational equilibrium for workers: same
expected wage in cluster and isolated site = $10 3 Variation in product and labor demand
generates variation in workers hired, not wage
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Why Do Firms Cluster?
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Why Do Firms Cluster?
Clustering Increases Expected Profit
1 Year of high demand: more profit because of lowerwage and more workers
2 Year of low demand: less profit because of higher
wage 3 Good news dominates bad news: firm responds to
changes in demand
a High demand: hire more workers to exploit relatively
low wage b Low demand: hire fewer workers to cushion blow of
high wage
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Why Do Firms Cluster?
Labor Market Matching
The logic goes as follows:
1 Jobs and workers not always perfectly
matched
2 Mismatches require training costs to
eliminate skill gap
3 Larger city provide better matches
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Why Do Firms Cluster?
Knowledge Spillovers
Basic logic:
A Firms in an industry share ideas and knowledge
1 mysteries of trade are in the air
2 innovations are promptly discussed, improved, andadopted
B Widespread empirical evidence of knowledge spillovers
1 Spillovers more important in idea industries
2 Most innovative industries are the most likely to cluster 3 Spillovers have range of a few miles
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Why Do Firms Cluster?
History in Economic Thought
When an industry has chosen a locality for itself, it is likely to staythere for long; so grate are the advantages which people followingthe same skilled trade get from near neighborhood to one another.The mysteries of the trade become no mysteries; but are as if were
in the aire, and children learn many of them unconsciously. Goodwork is appreciated; inventions and improvements in machinery, in
processes and the gneeral organization f the business have theirmerits promptly discussed; if one man starts a new idea, it is takenup by others and combined with suggestions of their own; and thusit becomes the source of new ideas.
Alfred Marshall, 1920
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Why Do Firms Cluster?
Self-Reinforcing Effects Cause Industry Clusters
1 When firms cluster, they may lose exclusive marketareas
2 Clustered firms however share a larger market area
3 Clustering may increase average transport costs
4 But, these costs increases must be balanced withlocalization economies: shared inputs, labor market
pooling and skill matches, and knowledge spillovers 5 Self-Reinforcing Effects Generates an Extreme
Outcome
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Why Do Firms Cluster?
Vertical axis measures profit
gap (firm in center vs. isolated
firm)
2 Single firm in center : profit gap is zero
3 Second firm in center cuts button costs and
increases profit per firm by $6 4 If third firm joins cluster, profit gap increases
to $13
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Why Do Firms Cluster?
Evidence of Localization Economies
1 Worker productivity is higher in clusters
2 More firm births in clusters
3 Employment growth is more rapid in clusters
Why Cities Exist and How They Have
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Why Cities Exist and How They Have
Formed
In order to understand why cities exist we
must first consider a world without cities. For
there to be a place with no cities there must
be equal productivity, constant returns toscale in production, and constant returns to
scale in exchange. Equal productivity allows
each person to be responsible for his or herself and there is no specialization in any one
area thus there is no need for a city to develop
Why Cities Exist and How They Have
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Why Cities Exist and How They Have
Formed
The next thing necessary for there to be no
cities is for there to be constant returns to
scale in production. So if production is subject
to economies of scale, then households will bemore likely to involve a trading firm when
trading their products. This is because trading
firms will have the ability to effectively tradewith lower transaction costs than if the
household were to do it themselves
Why Cities Exist and How They Have
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Why Cities Exist and How They Have
Formed
The last necessary condition for cities to not
exist is constant returns to scale in
exchange. If there are scale economies in
exchange then two households will linktogether and exchange the products in which
they have a comparative advantage.
Why Cities Exist and How They Have
http://www.econport.org/content/handbook/productionpossibilities/Comparative-Advantage.htmlhttp://www.econport.org/content/handbook/productionpossibilities/Comparative-Advantage.htmlhttp://www.econport.org/content/handbook/productionpossibilities/Comparative-Advantage.html -
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Why Cities Exist and How They Have
Formed
Once all three of these conditions are changed, atrading city will emerge. Different firms locate indifferent areas based on what type of transport coststhey have. Most firms will choose to locate in a trading
city because the benefits outweigh the costs. In atrading city a firm has access to a large customer base,good access to foreign markets, and a large laborpool. This outweighs the fact that in a city there are
higher rents and the firms must pay their workershigher wages. There are two different types oftransaction costs that affect where a firm will locate
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Some firms have inputs that are cheaper to transportin the beginning than at the end and this is calledmaterial-oriented. When they focus on outputs this iscalled market-oriented and the companies will locate
where the final product will be Lets take away equal productivity first and see where
that leaves us. If there are two regions that are notequally productive then it can be assumed that one
area may be better in producing one or more productsthan the other region. This is called comparativeadvantage
http://www.econport.org/content/handbook/productionpossibilities/Comparative-Advantage.htmlhttp://www.econport.org/content/handbook/productionpossibilities/Comparative-Advantage.htmlhttp://www.econport.org/content/handbook/productionpossibilities/Comparative-Advantage.htmlhttp://www.econport.org/content/handbook/productionpossibilities/Comparative-Advantage.html -
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If one region has a comparative advantage
then it is more beneficial to produce that item
and trade for another item that another
region may have a comparative advantage inproducing. To learn more about comparative
advantage and trade visit the production
possibilities section.
http://www.econport.org/content/handbook/productionpossibilities.htmlhttp://www.econport.org/content/handbook/productionpossibilities.htmlhttp://www.econport.org/content/handbook/productionpossibilities.htmlhttp://www.econport.org/content/handbook/productionpossibilities.html -
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Considering constant returns to scale in productiononce more we can assume that production is subject toeconomies of scale. So, if a household were tospecialize in one specific thing, then the inputs wouldbe indivisible such as machines and workers couldspecialize in certain tasks thus leading to a higherproductivity and lower costs all around.
The last condition for there to be no cities is to haveconstant returns to scale in exchange. Households can
link together and directly trade, however witheconomies of scale in exchange trading firms willemerge because they ultimately have lower transactioncosts.
Why Cities Exist and How They Have
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Why Cities Exist and How They Have
Formed
Therefore, it can be seen that cities existbecause it is beneficial to produce what youare good at and use trading firms to lower
costs and trade with other cities that mayspecialize in something else. Because of thistrading effect and the fact the firms cluster,larger cities will develop with a central
business district.http://www.econport.org/content/handbook/Urbanecon/exist.html
A i 4 P d i i S bj
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Axiom 4: Production is Subject to
Economies of Scale
Why do cities exist?
Cities are places in which population density isgreater than the other parts of the countries.
In an economic context, what are the factorsbehind the creation of the cities?
Lets build up a model
Assumptions:
1. The region produces and consumes two goods:shirts and bread.
A i 4 P d i i S bj
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Axiom 4: Production is Subject to
Economies of Scale
2. People use land to grow raw materials and
take time to transform raw materials into
shirt and bread.
3. Travel within this region is by foot. Residentswalk at a speed of8 miles per hour.
A i 4 P d i i S bj
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Axiom 4: Production is Subject to
Economies of Scale
Suppose that:
1. All residents are equally productive at producing
bread and shirts. Similarly all land is equally
productive in production of raw materials.This assumption implies that there is no room
for comparative advantage. Since all residents
are equally productive at producing bread andshirts, there is no advantage of trading.
A i 4 P d ti i S bj t t
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Axiom 4: Production is Subject to
Economies of Scale
If we relax this assumption, i.e. one part of the
region may have a comparative advantage in
shirt production and the other part may have
a comparative advantage in bread production. Lets say that the region has two parts: South
and North. The production amounts in each
region are given below:
A i 4 P d ti i S bj t t
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Axiom 4: Production is Subject to
Economies of ScaleOUTPUT PERHR
(OF A WORKER)
OPPORTUNITY
COSTS
SOUTH NORTH SOUTH NORTH
BREAD 2 2 1shirt 3shirt
SHIRTS 2 6 1bread 1/3bread
A i 4 P d ti i S bj t t
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Axiom 4: Production is Subject to
Economies of Scale South has a comparative advantage in production of
bread.
North has a comparative advantage in production ofshirts.
2. Suppose that there are no scale economies intransportation. Transport cost per unit of shipped permile is independent of the volume shipped.
But, if transport cost per mile decreases as the volumetransported increases, it would be cheaper to
transport shirts and bread in bulks. This also createsintermediaries in transportation.
What are the implications?
A i 4 P d ti i S bj t t
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Axiom 4: Production is Subject to
Economies of ScaleThe trading firms will locate at places convenient for the collection and distribution of
goods. Hence, marketplaces develop at crossroads, ports and other shipmentpoints.
The location decisions of the trading firms cause the development ofcities. Themarketplace will create employment opportunities.
The employees will live near marketplace to economize on commuting costs.
Hence, demand for land near marketplace increases: Price of land increases.
Residents will economize by occupying smaller lots.
As a result, population density around the marketplace will be higher than the restof the region.
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A i 4 P d ti i S bj t t
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Axiom 4: Production is Subject to
Economies of Scale
Suppose that production is subject to constant
returns to scale. This means, each worker can
produce either 1 shirt or 1 bread per hour
regardless of how much he/she produces: Thereare no advantages from producing at large scales.
If we relax this assumption, and impose
assumption of scale economies, then factory
production may replace home production. How?
A iom 4 Prod ction is S bject to
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Axiom 4: Production is Subject to
Economies of Scale
If there are scale economies (instead of CRTS)
in production, as volume of shirt production
increases, labor required to produce one shirt
decreases (less input per unit of output, costsdecline with output).
Axiom 4 Production is Subject to
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Axiom 4: Production is Subject to
Economies of Scale
Why does the average labor time decrease as
number of shirts produced increases?
1. Factor speacialization: Each laborer specializes
in one task and their productivity increases.2. Indivisible inputs: Some inputs are indivisible
since they have minimum efficient scale. E.g.
Machines in a factory. As output increasesfactory uses more indivisible inputs hence
productivity increases.
Axiom 4: Production is Subject to
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Axiom 4: Production is Subject to
Economies of Scale
If the shirt factory produces 400 units with 100 workers and 4shirts per worker per hour:
What should be the wage level and price of a shirt?
Wage should be at least as high as to make workersindifferent between working in the factory and working athome.
If the worker works at home: He/she produces 1 loaf ofbread/hr.
If the worker works at the factory: He/she produces 4shirts/hr.
Hence, minimum wage should be 1 loaf of bread/hr.
Axiom 4: Production is Subject to
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Axiom 4: Production is Subject to
Economies of Scale
Since each worker produces 4 shirts/hr, assumingthat there are no other costs, production cost ofone shirt is 0.25 loaf of bread.
Net price of a factory shirt:
Price paid by consumer to firm (0.25 loaf)
+
Consumers opportunity cost of the time spent traveling
to and from the factory(Loss of bread production due to traveling instead of
producing bread).
Axiom 4: Production is Subject to
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Axiom 4: Production is Subject to
Economies of Scale
A resident can produce 1 loaf per hr. It will besensible to buy a factory shirt if net price of afactory shirt is at most 1 loaf.
Since, production cost is equal to 0.25 loaf, the
consumer should consider the time that a triptakes.
0.25 + trip time= 1
Then trip time can be at most 0.75 hr.
If it is less than 0.75, the consumer will prefer afactory shirt.
Axiom 4: Production is Subject to
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Axiom 4: Production is Subject to
Economies of Scale
Suppose that walking time is 8 miles per hour.According to these criteria, the market area of the shirt
factory is determined.
It is the area for within which the factory will underprice
homemade shirts for residents.In our case, it is defined as the area within 3 miles of the
factory.
Why? (We can have at most 0.75 hrs walking time, thismeans since walking time is 8 miles/hr, we can have 6miles for two way walkingto and from the factory-.That is why we end up with a circle with a radius of 3miles)
Axiom 4: Production is Subject to
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Axiom 4: Production is Subject to
Economies of Scale Factory causes the development of a small factory city. Are there any limits to city size?
1. Freight cost: We have assumed that consumers travel between homeand factory meaning they they themselves incur freight costs. This costof transporting goods limits the ability of the factory to exploiteconomies of scale in production.
What can the factory do?We know that travel speed is 8 miles/hr. and market area is a circle with a
radius of 3 miles.
If the firm becomes responsible from freight costs and creates a methodto increase the travel speed, then it can create a greater market area.
E.g. If the firm increases the travel speed to 16 miles per hr (doubles), marketarea will be a circle with a radius of 6 miles. This will increase the outputof the factory, factorys workforce and population of the factory city.
Axiom 4: Production is Subject to
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Axiom 4: Production is Subject to
Economies of Scale
Decrease in freight cost allows factory to morefully exploit economies of scale, increasing citysize.
Transportation is a very important factor affecting
the city size2. Scale economies: As economies of scale
beacome more powerful, cost of factoryproduction decreases relative to home
production.Hence, market area of the factory increases andsize of factory cities increase.
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Commuting costs: Larger cities have largescommuting times.
In larger cities factory must pay workers to
compansate for longer commuting times. But as wages increase, cost of factory shirts
increase relative to homemade shirts.
Since market area is determined according tothe net price of the factory shirts, increase inwages is a limit to the city size
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Causes of
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Causes of
Urban Expansion
1
An increase in population will increase urban expansion.
2.
An increase in household income will increase urban expansion.
3.
An increase in transportation costs will reduce urban expansion.
4.
An increase in the opportunity cost of non-urban land will reduce urbanexpansion.
Causes of
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Causes of
Urban Expansion
5.
An increase in the marginal productivity of land in housing production will causeurban expansion.
6.
An increase in the share of land available for housing development will increaseurban extent and urban expansion.
7.
An increase in marginal productivity of land in production of the export good willincrease URBAN expansion.
8.
An increase in the world price of the export good will increase urban expansion.