1. Market Forces in the Development of Cities
Chapter 2
Market Forces in the Development of Cities

2. 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!

3. 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.

4. The Legacy of 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.

5. 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
Coconuts
Fish 1
Clearly, Fred is better at making both goods

6. Fred’s maximum output in a day if he produces only
Fred’s PPC
Fred’s maximum output in a day if he produces only
Coconuts
Fish 2 6
Coconuts
If there is no trade,
assume Fred chooses
this production and
consumption.
Assume that he works 6 days a week, we can construct his PPC as follows 12 36 A 4 24
Fish
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7. Kate’s maximum output in a day if she produces only
Kate’s PPC
Kate’s maximum output in a day if she produces only
Coconuts
Fish 1
Coconuts 6
If there is no trade,
Assume Kate chooses
this production and
consumption.
Assume that she works 6 days a week, we can construct her PPC as follows B 1 5
Fish
Copyright©2003 Southwestern/Thomson Learning

8. 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? ? ? 14

9. The Opportunity Cost 2 6 1 Who has a comparative advantage in Coconut?
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
Coconuts
Fish 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

10. The Opportunity Cost 2 6 1 Who has a comparative advantage in 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
Coconuts
Fish 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

11. The Opportunity cost of
The opportunity costs
The Opportunity cost of
Coconut
Fish
Fred
3 fish
1/3 coconut
Kate
1 fish
1 coconut
Who produces coconut cheaper?
Who produces fish cheaper?
Kate has a comparative advantage in coconut
Fred has a comparative advantage in fish.

12. 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. 10

13. 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? 10

14. How Trade Expands the Set of Consumption Opportunities
Fred’s Production and consumption
Coconuts
Fred gives Kate 10 fish for 5 coconuts.
Fred’s
consumption
with trade 12 36 A* 5 26
Fred’s
production
with trade 4 24 A
Fish
Copyright©2003 Southwestern/Thomson Learning

15. How Trade Expands the Set of Consumption Opportunities
Kate’s Consumption and Production ’
Coconuts
Kate’s
production
With trade
Kate gives Fred 5 coconuts for 10 fish. 6
Consumption
and Production
without trade
Kate’s
consumption
with trade B* 10 1 5 B
Fish
Copyright©2003 Southwestern/Thomson Learning

16. Gains from Trade
Coconut
Fish
Fred 1 2
Kate 5
Total 7

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. Output/ Hour Bread Shirts North 2 6 South 1
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

24. 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.

25. Opportunity Cost Output/ Hour Bread Shirts North 2 6 South 1
South has a comparative advantage in making bread.
Output/ Hour
Bread
Shirts
North 2 6
South 1
Opportunity Cost
Bread
Shirts
North
South
3 shirts
1/3 loaf
1 shirt
1 loaf
North has a comparative advantage in making shirts.

26. 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.

27. 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.

28. Economies of Scale in Exchange
Cost of transporting one unit
The unit transportation cost for the household 10
The unit transportation cost for a trading firm that transports 20 units 3 1 20

29. 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.

30. 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.

31. 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?

32. Economies of Scale in Production
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
Output/ Hour
Bread
Shirts
Factory - 6
Household 1

33. What is the factory wage?
Output/ Hour
Bread
Shirts
Factory - 6
Household 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

34. 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

35. 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?

36. 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
Distance to the factory 8

37. 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.

38. 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.

39. 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.

40. 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.
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
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.

41. 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.

42. 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.

43. 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 40 48
Distance from a coast line

44. 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

45. 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

46. 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

47. Market Area of a Plant
Consider a plant located 40 miles away from the coast line. The transportation cost is $¼ per mile. 40
Net price per ton of beet to the farmer 30 40
200
Distance of a farmer from the coast line

48. 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.
A system of factory towns develops around the processing plants 40
Net price per ton of beet to the farmer 30 40 80
120
Distance of a farmer from the coast line