Chapter 2

Report
1
Chapter 2
Market Forces in the
Development of Cities
Consider your typical day:
 You wake up to an alarm clock made in Korea.
 You pour yourself orange juice made from Florida
oranges.
 You put on some clothes made of cotton grown in
Georgia.
 You watch the morning news broadcast from New
York on your TV made in Japan.
 You drive to class in a car made of parts
manufactured in a half-dozen different countries.
. . . and you haven’t been up for more than two hours yet!
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Interdependence and the Gains
from Trade

Why is interdependence the norm?
 Interdependence occurs because people are
better off when they specialize and trade with
others.

What determines the pattern of production
and trade?
 Patterns of production and trade are based upon
differences in opportunity costs.
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The Legacy of David Ricardo
 David
Ricardo
 In his 1816 book Principles of Political Economy
and Taxation, David Ricardo developed the
principle of comparative advantage as we know it
today.
 According to Ricardo specialization and trade
should be based on comparative advantage.
 Even if one person is better at making all goods,
there are still gains from trade.
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Example
Consider an
economy with two
people: Fred and
Kate.
 Two goods:
coconut and fish.

Fred’s maximum output in a day if
he produces only
Coconuts
Fish
2
6
Kate’s maximum output in a day if
she produces only
Clearly, Fred is better at
making both goods
Coconuts
Fish
1
1
5
Fred’s PPC
Fred’s maximum
output in a day if he
produces only
Coconuts
Fish
2
6
Assume that he
works 6 days a
week, we can
construct his PPC
as follows
Coconuts
If there is no trade,
assume Fred chooses
this production and
consumption.
12
A
4
0
24
36
Fish
6
Copyright©2003 Southwestern/Thomson Learning
Kate’s PPC
Kate’s maximum
output in a day if she
produces only
Coconuts
Fish
1
1
Assume that she
works 6 days a
week, we can
construct her PPC
as follows
Coconuts
6
If there is no trade,
Assume Kate choose
this production and
consumption.
B
1
0
5
6
Fish
7
Copyright©2003 Southwestern/Thomson Learning
Opportunity Cost and
Comparative Advantage
Opportunity cost is what must be given
up to obtain some item.
 The producer who has the smaller
opportunity cost of producing a good is
said to have a comparative advantage in
producing that good.

?
Who has the comparative advantage in the
production of each good?
?
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The Opportunity Cost
Fred’s maximum output in a day if
he produces only
Kate’s maximum output in a day if
she produces only
Coconuts
Fish
Coconuts
Fish
2
6
1
1
• What is the opportunity
cost of one coconut for
Fred?
• 3 Fish
• What is the opportunity
cost of one coconut for
Kate?
• 1 Fish
• Who has a comparative advantage in Coconut?
• Kate
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The Opportunity Cost
Fred’s maximum output in a day if
he produces only
Kate’s maximum output in a day if
she produces only
Coconuts
Fish
Coconuts
Fish
2
6
1
1
• What is the opportunity
cost of one fish for Fred?
• 1/3 coconut
• What is the opportunity
cost of one fish for Kate?
• 1 coconut
• Who has a comparative advantage in fish?
• Fred
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The opportunity costs
The Opportunity cost of
Who
produces
coconut
cheaper?
Kate has a
comparative
advantage
in coconut
Coconut
Fish
Fred
3 fish
Kate
1 fish
1/3
coconut
1 coconut
Who
produces
fish
cheaper?
Fred has a
comparative
advantage
in fish.
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Specialization and Trade

Suppose instead Kate and Fred decide
to specialize and trade…
 Both would be better off if they specialize in
producing the product they are more suited
to produce, and then trade with each other.
Fred produces fish.
Kate produces coconuts.
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Specialization and Trade
After specialization, they agreed to
trade.
 The terms of trade: 1 fish for ½ coconut.
 Fred gives Kate 10 fish for 5 coconuts

Who will benefit from trade?
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How Trade Expands the Set of
Consumption Opportunities
Fred’s Production and consumption
Coconuts
Fred
gives
Kate 10
fish for 5
coconuts.
12
Fred’s
consumption
with trade
A*
5
4
Fred’s
production
with trade
A
0
36
24
26
Fish
14
Copyright©2003 Southwestern/Thomson Learning
How Trade Expands the Set of
Consumption Opportunities
’
Kate’s Consumption
and Production
Coconuts
Kate
gives
Fred 5
coconuts
for 10
fish.
6
Kate’s
production
With trade
Kate’s
consumption
with trade
Consumption
and Production
without trade
B*
B
1
0
5
6
10
Fish
15
Copyright©2003 Southwestern/Thomson Learning
Gains from Trade
Coconut
Fish
Fred
1
2
Kate
0
5
Total
1
7
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Why Do Cities Exist?
The purpose of this chapter is to identify
the key factors behind the development
of cities
 Specialization and trade is the norm.
 In a market economy, individuals offer
their labor for wage income used to buy
goods and services.
 Cities exist for society to realize the
benefits of centralized production and
exchange.
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Backyard Production Model
The Backyard Production Model illustrates
conditions under which cities DO NOT
exist.
Two households: North and South
 Two goods are produced: bread and
shirts.
 Land and labor are the two inputs to
production.

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Assumptions
Equal Productivity across the two
households: output per worker and
output per land.
 Exchange is costly.
 Constant returns to scale in exchange.
 Constant returns to scale in production.

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Implications

Specialization and trade results in
 Zero benefits since households are equally
productive.
 Positive cost since transactions are costly.
 Therefore, if individuals were to specialize
and trade they would realize net losses.
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Implications

In a self sufficient economy, there are no
benefits from concentration.
 If population was concentrated in a certain
area, land price would rise
 This encourages people to move out to
surrounding areas
 In locational equilibrium people will be
evenly distributed and the price of land
would be the same.
 Cities do not develop.
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A Trading City

To understand why cities develop, we
will drop the assumptions of the
backyard production model one by one.

Assume: Individuals are not equally
productive.
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North is more productive than South in both bread and shirts
Are there gains from trade?
Output/ Hour
Bread
Shirts
North
2
6
South
1
1
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Comparative advantage
Each region should specialize in the
good for which it has a comparative
advantage.
 A region has a comparative advantage
in making a certain good if it has the
lower opportunity cost of making it.

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Opportunity Cost
Output/ Hour
Bread
North
South
2
1
South has a
comparative
advantage in
making bread.
Opportunity Cost
Shirts
6
1
North
South
Bread
Shirts
3 shirts
1 shirt
1/3 loaf
1 loaf
North has a
comparative
advantage in
making shirts.
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Exchange

Each North household will link up with a South household to
exchange shirts and bread directly without intermediaries.
North
household
South
household
Specialization and trade by itself does not necessarily give rise to cities.
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Trading Firms




Trading firms will emerge if there are
economies of scale associated with exchange.
A trading firm could use an indivisible input to
transport output from North to South.
Therefore, the cost of transporting one unit by
the trading firms decreases with the goods
transported.
Because trading firms have lower transaction
costs, households will pay them to handle
exchange.
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Economies of Scale in Exchange
Cost of
transporting
one unit
10
The unit
transportation
cost for the
household
3
1
20
The unit
transportation
cost for a
trading firm
that transports
20 units
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Exchange

A trading firm has lower transaction costs than households.
North
household
South
household
Concentration of trade workers, bids up land prices. People economize on
land giving rise to an area with high population density- a Trading City.
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Trading Cities
Trading cities develop when
comparative advantage is combined
with scale economies in transport and
exchange.
 Workers in trading cities do not produce
goods but collect and distribute goods
produced elsewhere.
 Historically, firms in the trading city
provided insurance, credit, banking and
legal services.

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Economies of Scale in Production
We will drop another assumption of the
backyard production model.
 Assume: there are economies of scale
in shirt production.
 The factory uses an indivisible input that
makes workers more productive.
 Will shirt production take place in
the backyard or in a factory?

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Economies of Scale in Production

Output/ Hour
Bread Shirts
Factory
-
6
Household
1
1
Assume that
 All values are in
terms of loaves of
bread
 Prices in the factory
town are 50% higher
 The factory uses an
indivisible input that
costs ½ loaf of bread
in an hour
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What is the factory wage?
Output/ Hour
Bread Shirts
Factory
-
6
Household
1
1

The wage should
make the worker
indifferent between
living in the rural area
and between living in
the factory town.
3/2 loaves of bread
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Cost of a Factory Shirt
Who can produce shirts cheaper?
 Cost of producing a shirt in the backyard is 1
loaf of bread.
 Given 6 shirts are produced / hr in a factory,
then
Labor Cost/ hr
1½ loaf

Cost of indivisible
input/ hr
½ loaf
Total cost /hr
2 loaf
Cost of one shirt
1/3 loaf
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Cost of a Factory Shirt
The cost of producing a shirt in the
factory is lower than that in the
backyard.
 The net price of a factory shirt to the
consumer is 1/3 loaf plus the cost of
transportation to the factory.
 Do all households buy shirts from the
factory?

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Market Area of a Shirt Factory
Assume the cost of transportation is 1/12 loaf
per round trip mile.
 Who buys from the factory?

Cost
of a
shirt
1
6/12
4/12
8
2
0
8 Distance to the factory
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The Factory Town

Households within the market area of the factory buy
shirts from the factory.
household
Concentration of factory workers, bids up land prices. People economize on
land giving rise to an area with high population density- a Factory Town.
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Industrial Revolution and the Factory
Town

The 19th century industrial revolution
resulted in innovations that shifted
production from the home and the small
shop to the factory.
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Innovations in Manufacturing

Eli Whitney’s system of interchangeable
parts.
 Large batch of each part
 Identical parts
 Unskilled workers could be quickly
trained to assemble them.
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Innovations in Manufacturing

Eli Whitney’s system of
interchangeable parts.
 Standardized production replaced
manual production by skilled artisans
 Mass production: Interchangeable
parts, specialized labor and steam
powered machines.
Model 1792 rifle manufactured at the US
Armory at Harper's Ferry. Instead of
individual hand-crafting by a
blacksmith/gunsmith, rifles were made
with machine tools and had the advantage
of interchangeable parts.
In 1793, Eli Whitney invented
the cotton gin. The cotton gin
(short for "cotton engine") was
a machine used for removing
the seeds from cotton.
Whereas before the seeds had
to be picked out by hand,
people (specifically, slaves)
were able to use this machine
to significantly increase their
productivity
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Other Innovations

Innovation in transportation:
 canals, steamship, the railroad system.

Innovations in agriculture:
 Cast iron plow, horse drawn harvesting
machines.

Energy Technology:
 Water wheels, coal steam engine, electricity.
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System of Factory Towns
Firms can enter the shirt industry by
building factories at different locations.
 As a result of free entry, firms will
continue to enter until profit is driven
down to zero.
 The result is a system of factory towns
located close to one another where each
firm has a local monopoly.

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System of Factory Towns
Each firm is a monopoly in its own region but charges a
price equal to average cost.
Complete specialization within the region:
shirts produced in factories, bread in rural area
Home
made
cost
1
factory
cost 4/12
8
16
24
32
Distance from a coast line
40
48
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System of Factory Towns

In equilibrium:
 Each firm, while it is a local monopolist,
charges a price equals to average cost and
realizes zero economic profit
 Wages adjust so that workers are indifferent
between working in the factory and working
in the rural area
 The price of land adjusts so that rural
residents are indifferent between locations
that differ in their accessibility to the factory
town
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Materials Oriented Firm
The shirt industry is an example of a
market oriented industry where the cost
of transporting output is large relative to
that of inputs.
 In a material’s oriented industry the
opposite is true.
 Example: the beet-sugar industry where
it takes 7 tons of beet to make 1 ton of
sugar

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Market Area of a Plant





Economies of scale in processing sugar
from sugar beets.
Processing firms locate their plants close to
the sugar beet farms.
Farmers sell their sugar beets to plants and
pay the transportation costs.
Farmers sell to the plant where the net
price is higher.
The market area of a plant will depend on
the net price to the farmers
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Market Area of a Plant
Net price per ton of beet to the farmer
Consider a plant located 40 miles away from the
coast line. The transportation cost is $¼ per mile.
40
30
40
Distance of a farmer from the coast line
200
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Many Plants
Consider another plant that locates 120 miles away
from the coast line. Each farmer sells to the plant
with the higher net price.
Net price per ton of beet to the farmer
A system of factory towns develops around the processing plants
40
30
40
80
Distance of a farmer from the coast line
120
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