Download Regional economic integration and economic locations: a note

Regional Economic Integration and Economic Locations: A Note
Bin Zhou
Department of Geography
Southern Illinois University Edwardsville
Edwardsville, IL 62026
Regional economic integration in the form of a custom union and/or a monetary union has
received increasing attention in recent years in economic geography study. However, theoretical
study regarding the impacts of regional economic integration on locations of economic activities
has been scarce, though hypotheses or speculations are plentiful (Scott 1998). This note
discusses how regional integration, such as the formation of a monetary union, affects changes in
economic locations, using an opportunity cost location model. Such an approach helps integrate
the study of location theory and trade theory, while at the same time integrates the study of the
domestic economy with that of the international economy.
1. The opportunity cost location model
The comparative advantage principle states that countries specialize in producing commodities in
which they have the minimum opportunity cost. For example, according to the Heckscher-Ohlin
factor endowment theory, a country with rich endowment in low cost labor has a comparative
advantage in making labor intensive commodities (Krugman and Obstfeld 1997). Given this,
shifting resources to capital intensive commodities implies the loss of many labor intensive
goods and thus a high opportunity cost in terms of labor intensive goods. Using resources in
labor intensive goods means sacrificing the production of fewer capital intensive goods, and thus
the low opportunity cost measured in capital intensive goods. Therefore the country is said to
have a comparative advantage in, and export, labor intensive goods. Alternatively, the country is
said to have a comparative disadvantage in, and import, capital intensive goods.
The opportunity cost can be expressed through the relative price of commodities, indicating the
cost of one good measured in terms of the amount of another. For example, the relative price
pab=Pa/Pb expresses that one unit of good a is worth pab units of good b. The same amount of
resources are worth either one unit of good a or pab units of good b. That is, the opportunity cost
of good a is pab units of good b. Countries with the lowest pab have a comparative advantage in
making good a. If the world price ratio Pab is higher than pab, trade is possible. At equilibrium,
the price ratio is Peab. Trade study focuses on the exchange pattern of at least two commodities
and thus necessitates the expression of cost using relative prices.
In location study, the focus is not exchange, but the partial analysis of the location where the
monetary costs of production and shipping for a certain commodity is a minimum. In a standard
industrial location setting, given the production function Q=f(m1, m2, L) where Q is the amount
of output, m1 and m2 are localized inputs, and L non-localized input such as labor, labor is
regarded as a non-localized input here since it is not the factory owner's responsibility to ship
workers to the firm location. The cost function is TC=∑(miPmi+miditmi)+Qdqtq +Lw, where Pmi
are the prices of input mi; tmi are the shipping rates of inputs mi; tq the shipping rate of output; di
the distance from input i to the firm, dq the distance from the firm to market according to a
certain coordinate system, and w the wage rate. When i=2, this is a typical Weberian location
triangle problem. In Weber's least cost principle, the optimal location occurs where TC is
minimized. Since only distances are variable, the problem becomes
Min[∑(miPmi+miditmi)+Qdqtq+Lw].
At equilibrium, there exists
Min TC= [∑(miPmi+mideitmi)+Qdeqtq+Lw]=[ ∑+L]e
[1]
[ ∑+L]e is a short-hand expression of the equilibrium minimum total cost at the equilibrium
location reflected in dei and deq. The unit cost is c=[ ∑+L]e/Q.
Model [1] contains no explicit term that indicates an exchange relation with other places. Divide
the unit cost by Pb and we obtain
pqb=[ ∑+L]e/QPb=c/Pb
[2]
Equation [2] indicates the relative price of Q measured in the units of good b. This is also the
opportunity cost of Q. That is, one unit of Q is exchangeable with pqb units of good b. This turns
a location analysis into a trade analysis. If good b is used by the town where the firm is located,
the opportunity cost of making one unit of Q is pqb units of good b. As long as pqb is lower than
that at the market for Q, location (dei and deq) should specialize in Q. This may not always be the
case.
In [2], taking the derivative with respect to d, which is the distance from location (dei and deq)
dpqb
dd

dP
dc
c b
Pb dd
dd
[3]
When dpqb/dd>0, (dei and deq) still has the minimum opportunity cost. This happens when
dpqb
dP
dP
dc
dc

 c b  0 or
 c b . That is, the geographical distribution of the
dd
Pb dd
dd
Pb dd
dd
opportunity cost pqb varies depending on the distribution of both c and Pb. Location (dei and deq)
would still be optimal if Pb is uniform dPb/dd =0, or increases more slowly than c does,
dP
dP
dc
dc
. Here d is distance from location (dei and deq). However, if
c b 
 c b , thus
Pb dd
dd
dd Pb dd
dpqb/dd<0, so opportunity cost in terms of good b is lower elsewhere than at location (dei and deq).
This means that although the location has a minimum cost of Q, the price of good b is at such a
low level that it gives the location a comparative advantage in good b. In a multi-product
economy, this may not disqualify the location from producing Q since other goods may be
imported to the location. Nevertheless, this analysis reveals the usefulness of an opportunity cost
approach toward location analysis.
In general, denote P(ma, Qa, Pa, da, ta, La, wa) as unit price for good a and P(mb, Qb, Pb, db, tb, Lb,
wb) as the unit price for good b, where m, Q, P, d, t, L and we assume their previous connotations.
The price ratio is
pab= P(ma, Qa, Pa, da, ta, La, wa)/P(mb, Qb, Pb, db, tb, Lb, wb).
[4]
In a multi-product economy, there are prices P(mx, Qx, Px, dx, tx, Lx, wx) where x=a, b, c, d, e, …
and price ratios pcb, pdb, peb, etc. Within the von Thünen location framework, pab, pac, pad, pae.. are
minimum from the market up to da. The land is devoted to crop a. From distance da to db, pba, pbc,
pbd, pbe.. are minimum and thus land is used to grow crop b. Between these two crop regions,
there exists trade between crops a and b. That is, comparative advantages at different distances
from the market give rise to varying opportunity costs and contribute to specialization in crop
growing, as in the von Thünen rings. A similar analysis can be extended to other crop
specialization regions for crops c, d, e, etc.
Within central place framework, places of different sizes may possess different opportunity costs
for services of different thresholds. Given their resource endowments, large places have low
opportunity cost in offering high order functions while small places have high opportunity cost in
high order functions. Medium sized places have low opportunity cost in mid-order functions
while small places have higher opportunity cost in mid-order functions. At the same time, due to
resource abundance, medium and larger places also have lower opportunity cost in low order
functions. Using the framework of price ratio in [4], opportunity cost pLH= P(mL, QL, PL, dL, tL,
LL, wL)/P(mH, QH, PH, dH, tH, LH, wH) where L and H in subscribes denote low order and high
order goods respectively.
For small places, P(mH, QH, PH, dH, tH, LH, wH) is high and thus pLH is low or pHL is high,
highlighting the characteristics of small places specializing in low order goods alone. For large
places, P(mH, QH, PH, dH, tH, LH, wH) is low due to large size operation. Thus pHL is low
indicating low opportunity cost in high order goods. For pLH= P(mL, QL, PL, dL, tL, LL, wL)/P(mH,
QH, PH, dH, tH, LH, wH), two factors contribute to the low opportunity cost in large places. The
first factor is the large size operation. The second factor is the transport cost. P(mL, QL, PL, dL, tL,
LL, wL)/P(mH, QH, PH, dH, tH, LH, wH) may be small without incorporating transport cost.
However, if low order goods are made in small places and then shipped to large places,
interaction of dL and tL will eventually raise the pLH to the point that it is no longer competitive
importing from small places. Therefore opportunity cost is not high for both low and high order
goods, and thus both will be offered in large places. Large places can be seen as places of selfsufficiency. Similarly, medium sized places offer low and medium ordered goods, but import
higher order goods.
2. Location models in international context
The last section lays out the opportunity cost location model. The purpose is to incorporate
variables that are relevant in an international economic context. Our basic model is the
opportunity cost expressed as the relative prices or price ratios, as seen in [4]. In an international
economy context, relative price is
Pab= EbaP(ma, Qa, Pa, da, ta, La, wa)/P(mb, Qb, Pb, db, tb, Lb, wb)
[5]
where Eba is the exchange rate measured as the price of country a's currency in terms of country
b's currency; Pab is the exchange rate multiplied by the price ratio. That is Pab=Ebapab.
In [5], re-write all terms as relative relations between two countries and we have
Pab= Ebapab(Rm, RQ, RP, Rd, Rt, RL, Rw)
[6]
where Rs are relative resource endowments (m), relative industry size (Q), relative resource
prices (P), relative location advantages (d), relative shipping rates (t), relative labor force size (L),
and relative wage rates (w). In [6], after taking the total differential, we have
dPab  p ab ( Rm , RQ , R P , Rd , Rt , R L , Rw )
Eba (

Pab
dEba 
Eba
Pab p ab
P p
P p
dRm  ab ab dRQ  ab ab dRP
p ab Rm
p ab RQ
p ab R P
Pab p ab
P p
P p
P p
dRd  ab ab dRt  ab ab dR L  ab ab dRw )
p ab Rd
p ab Rt
p ab R L
p ab Rw
[7]
Equation [7] shows that a change in opportunity cost is the result of combined changes in
exchange rates and relative terms. Any relative advantage or improvement in location, geography,
agglomeration economies, resources, and factor prices can be offset by an overvalued currency;
any disadvantage in these relative terms can be sheltered by an undervalued currency.
From a geographic point of view, this model illustrates how relative locational advantage or
disadvantage can be suppressed or sheltered by exchange rates. For example, even if the industry
in country a is not at the optimal location compared with that in country b, such disadvantage can
still be sheltered by an undervalued currency Eba, contributing to a low opportunity cost. This
means that borders, represented by exchange rates and a country’s monetary policy, not only
protect inferior industries, but also protect inferior locations and inferior geographical patterns of
production. On the other hand, relative locational advantage as a result of optimal conditions of a
country over the other may be suppressed by an overvalued currency.
The same can be said about the relative size of the two industries (or two economies) and thus
the effect of agglomeration economies in two countries. An effective concentration in one
country relative to the other may help reduce the production price, but such an advantage may be
suppressed by an overvalued currency. A dispersed pattern in one economy in relation to the
other may raise the price of production but such a disadvantage may be sheltered by an
undervalued currency. Expensive transport cost as a result of relatively less developed
infrastructure and/poor quality roads may not hinder the flow of goods if an undervalued
currency helps bring down the cost of transportation to foreigners. For the same reason, low
transport cost due to developed transportation networks may still not help overcome trade
barriers as a result of an overvalued currency. Relatively well endowed resources (natural and
labor resources) and low factor prices may not facilitate growth due to overvalued currency, as
the “Dutch Disease” testifies.
In the context of Weber's location framework, Pqb= Ebq[ ∑+L]e/QPb=Ebqc/Pb, where Ebq is the
exchange rate measured as the price of country q's currency in terms of country b's currency.
Pqb
Pqb
Pqb
dEbq  Ebq (
dc  c
dPb ) .
Take the total differential of Pqb and we have dPqb  p qb
Ebq
Pb c
Pb
That is, the opportunity cost at location (dei and deq) is a function of both Ebq and pqb. A location
of minimum pqb may not mean that of a minimum Pqb when Ebq is too high. The opposite is true.
A location of higher pqb may have a minimum Pqb if Ebq is low. In von Thünen's location
framework, Pab= EbaP(ma, Qa, Pa, da, ta, La, wa)/P(mb, Qb, Pb, db, tb, Lb, wb)= Ebapab. At locations
from da to db, pab, pac, pad, pae… may still be minimum due to a very low Eba. Thus the land is still
used for crop a. Similarly, in central place context, if small places undervalue their currency and
thus lower the prices of all goods including high order goods, they can afford to offer them.
3. Effects of economic integration and roles of regional economic policy
The optimal currency area (OCA) literature asserts various trade-offs a currency union may bring
about. One trade off is the gain in microeconomic efficiency as a result of reduced transaction
cost, and the loss of macroeconomic flexibility due to independent monetary policy (Krugman
1993). Negative impacts from a loss of macroeconomic flexibility can be partially remedied by
labor mobility, an integrated fiscal system, and flexible price and wage processes. The openness
and the degree of diversification of an economy also affect the desirability of a monetary union.
The more open an economy is, the more desirable a monetary union is due to its role in
maintaining monetary stability. A diverse economic structure will help the economy cope with
asymmetric shocks to the system (Mundell 1961; McKinnon 1963; Kenen 1969; Pomfret 2004).
From the location models of an international context developed in the last section, it becomes
clear that if a monetary union is formed with a single currency or an exchange area with hard
pegged exchange rates among member countries, there is another form of trade off. This is the
trade off between the loss of macroeconomic flexibility and the gain of more competitive
industries, or the more efficient economic locations and geography. With a monetary union being
formed, previously protected industries and sub-optimal locations will be subject to competition
and the pattern of economic activities within a region will change.
In a monetary union, Equation [7] becomes
dPab 

Pab p ab
P p
P p
P p
dRm  ab ab dRQ  ab ab dRP  ab ab dRd
p ab Rm
p ab RQ
p ab RP
p ab Rd
Pab p ab
P p
P p
dRt  ab ab dRL  ab ab dRw
p ab Rt
p ab RL
p ab Rw
[8]
That is, a lower opportunity cost can no longer can be obtained by artificially depressing
exchange rates. A country’s resource endowments (m), resource prices (P), size of industries (Q),
location of businesses (d), shipping rates (t), the size of labor force (L), and wage rates (w) in
relation to others all come into open. Compared with other countries, less advantageous resource
endowment and more expensive extraction costs, smaller agglomeration economies, less efficient
economic locations, higher transport costs, more limited labor force, and less competitive labor
costs are all grounds for higher opportunity costs. High opportunity costs will weaken a
country’s competitiveness and thus reduce its capacity in aggregate supply. Equation [8] means
that there is no longer protection of exchange rates from national monetary authorities against
member countries in the monetary union. For the entire monetary union as a whole, there is still
a monetary policy which may render protection for the entire union. The mechanism of
protection is similar to what was previously discussed.
Given the effects of monetary integration on the national economy and economic geography of a
member nation, how would the economic geography within a monetary union change? First,
industries will rise or fall according to relative resource endowments and relative resource prices,
the result of which is that the countries' industrial structures become more consistent with their
comparative advantages. Second, in conjunction with changing economic structures, industries
will shift toward their optimal locations based on the comparative advantages at various sites.
Agglomeration economies as a factor of opportunity cost will stimulate concentration of
economic activities from smaller to larger centers. In addition, when everything else is the same,
locations with competitive labor cost will attract economic activities. Between larger centers that
enjoy agglomeration economies and centers that enjoy competitive labor cost, a certain balance
will have to be achieved to equilibrate the investment returns.
What should be the best course of action for regional economic policy in the wake of monetary
integration? The answer depends on the purpose of regional economic policy. If the policy is to
facilitate the transition of the economy toward a more efficient system, the focus of the regional
policy should be to foster the mobility of factors of production and prevent price stickiness as a
result of collusion or market power. Road construction strategy becomes an option to help
workers migrate to more productive areas and resources to be shipped to regions of higher
returns. Labor force training, investment in R&D, and infrastructure conducive to innovative
industries are all part of the effort, designed to create an environment that facilitates economic
flexibility and adaptability. For policy orientation that focuses on redistribution and protection, to
a certain extent the union wide regional policies act as the national monetary policy prior to
monetary integration. The essence is to shield less competitive industries and/or less developed
regions behind the protective policies to maintain local levels of employment. Regional policy
simply replaces the monetary policy.
If the regular expression of opportunity cost as shown above is divided into two components, one
being the contribution to the opportunity cost from the market force and the other being the
contribution from the policy, the total differential from such an expression shows that total
change in opportunity cost in an industry in a region depends on the combined impacts from the
market component and policy component. For efficiency oriented policy, the combined effects
should further reduce opportunity cost and thus enhance a region's comparative advantage. On
the other hand, for redistribution oriented policy, the combined effect should impede the market
force, slowing the industrial or regional decline. The choice of actual policy mix is largely the
result of political processes.
References
Kenen, P. 1969. The Theory of Optimum Currency Areas: An eclectic view. In R. Mundell and
A. Swoboda, eds. Monetary Problems of the International Economy. 41-60. Chicago: University
of Chicago Press.
Krugman, P.R., and Obstfeld, M. 1997. International Economics: Theory and Policy. Reading,
MA: Addison-Wesley.
Krugman, P.R. 1993. What do we need to know about the international monetary system? Essays
in International Economics No. 190. International Economics Section, Princeton University, NJ.
July.
McKinnon, R. 1963. Optimum Currency Areas. American Economic Review 53:717-725.
Mundell, R. 1961. Theory of Optimum Currency Areas. American Economic Review 51: 657665.
Pomfret, R. 2004. Sequencing Trade and Monetary Integration: Issues and Applications to Asia.
Working Paper 2004-14. School of Economics , the University of Adelaide, Australia.
Scott, A. 1998. Regions and the World Economy. New York: Oxford University Press.