Inthaphonh, Souphaphone (MPP,

Jung, Yunseok (MPP_ED, 2010

Kim, Sunjin (MPP, 200931102)

Urban Economics & Policy

Assignment 2 (Group Project)

1a. Provide a real‐life example (not yet discussed in class) of a cluster driven by agglomeration
economies. Specify the industry (or industries), and explain how agglomeration economies lead to
clustering.

Guadalajara is located in the western-pacific area of

Mexico with a population of about five million. Guadalajara
is called Mexican ‘Silicon Valley’ because the city's
economy is based on industry, especially information
technology with a large number of international firms
having manufacturing facilities. According to the Ministry
of Economy of Mexico, there are 700 companies with
manufacturing in Guadalajara. Guadalajara is the main
producer of software, electronic and digital components in
Mexico. Telecom and computer equipment from
Guadalajara accounts for about a quarter of Mexico's
electronics exports. Companies such as General Electric, IBM, Intel Corporation, Freescale
Semiconductor, Hitachi Ltd., Hewlett-Packard, Siemens, Flextronics, TCS and Jabil
Circuit have facilities in the city or its suburbs. GE Engines has 600 engineers working there, and
first-tier automotive supplier, Delphi, has 2,200 engineers working on projects in the area.
This industrial community is made up of three layers. The first layer is composed of OEMs such as
IBM and HP. The second layer consists of contract manufacturers (CMs) such as SCI,
Flextronics and NatSteel. Suppliers which provide parts for OEMs and CMs form the third layer.

Layers of Industry Firms

OEMs IBM, Hewlett Packard, Motorola
CMs SCI Systems, Solectron, Jabil Circuit, Flextronics, NatSteel
Suppliers CADELEC, YAMAVER

The biggest reason why Guadalajara is suited to IT cluster driven by agglomeration economies
is because of the easiness to find labor force (Labor-pool sharing & Labor matching).
Many universities are located in the area, allowing easy recruitment of high-quality engineers and
technicians. There are six universities as well as many technical and vocational schools in
and around the city of Guadalajara. These institutions make Guadalajara’s educational standard as
high as that of Mexico City and Monterrey. Guadalajara has some 5 million residents, and people in
Guadalajara are relatively young (average age: 19 years old) so factory workers are abundant.

b. Design at least one policy (public or commercial) aimed to make that cluster (in part a) work
better. Explain.

Due to the heavy reliance on foreign contract manufacturers and imported inputs, IT industry in
Guadalajara generated few backward linkages which can be an important channel for knowledge
spillovers to Mexican firms. Moreover, since most of what was produced was exported, there were few
forward linkages through diffusion to domestic markets. Also, IT firms in Guadalajara are
employing a largely temporary and semi-skilled workforce with little opportunity for technology
spillovers. Therefore, Mexican government should develop an adequate environmental regulatory
policy in order to increase efficiency in other sectors of the economy through backward and
forward linkage and to increase productivity of local firms through human capital.
2a. Which sources of agglomeration economies are driven by pecuniary externality? Explain.

Among four sources of agglomeration economies, intermediate-input sharing, labor-pool

sharing, and labor matching are driven by pecuniary externality because these three are mediated
by market, which means, there is price effect among firms or consumers because the action of on
agent has increased the price of a good to other agents.
i) Intermediate-input sharing: If a firm that increases its purchase of inputs raises the price of
those inputs and imposes a pecuniary externality on other firms.
ii) Labor-pool sharing: A cluster of firms facilitates the transfer of workers from firing firms and
hiring firms. Also, as we saw the example in the class comparing between the isolated firm and cluster,
there is an incentive for firm to cluster to share a pool of workers.
iii) Labor matching: A large city can improve the matching of workers and firms decreasing training
costs and increasing productivity. The presence of a large workforce attracts firms that compete for
workers, generating better skill matches and higher net wages for workers.

b. Which sources of agglomeration economies are driven by non‐pecuniary externality? What is the
policy implication?

Knowledge spillovers are driven by non-pecuniary externality because it is not meditated by

market. This is not observed, hence, it cannot be measured and it is not obvious what policymaker can
do. Therefore, policy makers have to focus on more pecuniary externalities in designing and
implementing policy.

3a. What is the common feature of both localization and urbanization economies?

The common feature of both localization and urbanization economies are the sources of
agglomeration economies, for example natural resource, labor marching and knowledge spillovers.

b. What is the key difference between localization and urbanization economies?

The key different between localization and urbanization as bellow:

• Localization is they many firms in one industry and those firms benefit from being together.
• Urbanization is the firms in different industries cluster. The idea is that the presence of firms
in one industry attracts firms in other industries.

c. Is it possible for an agglomeration economy to be both a localization and an urbanization economy

at the same time? Explain.

Yes, it’s possible for agglomeration economy to be both a localization and urbanization economy at the
same time. For instant, when multiple firms in the same industry (competitors) clusters, there may be
advantages because that clusters attract more suppliers and customers than any single firm could
alone. More firms in related industries cluster together; costs of production may decline significant.

4. Consider a firm that must choose between an isolated production site and a cluster. A table (next
page) shows labor productivity for different number of workers employed. Good times and bad times
are equally likely. In bad times, the price of output is $5, and in good times $10. The demand for labor
is = output price × labor productivity. In the isolated site the supply of labor is fixed at five workers.
Assume locational equilibrium for workers.

a. Which location should the firm choose, and why? Show your calculations.

The firm should choose cluster due to the higher expected profits (110.625) than the expected
profits of isolated site (93.75).
1 1
Expected Wage E(W)= ×30+ × 60=45
2 2
1 1
Expected Profits in isolated site E ( P )= ×125+ × 62.5=93.75
2 2
 1 1
×5 ×50=125 , Bad time= × 5 ×25=62.5
Good time=
2 2
1 1
Expected Profit in cluster E(P)= ×211.25 + ×10=¿110.625
2 2
1 1
Good time= ×6.5 ×65=211.25, Bad time= ×2 ×10=10
2 2

number of workers 1 2 3 4 5 6 7 8
demand for labor
100 90 80 70 60 50 40 30
(good time)
demand for labor
50 45 40 35 30 25 20 15
(bad time)

b. Which location should workers choose, and why? Show your calculations.

Workers should choose either cluster because they can be better off by receiving stable wages.

c. Defend your answer with a completely labeled graph.

d. What kind of externalities (if any) are generated in the cluster? Who generate the externalities (if
any), and who benefit from these externalities (if any)? What is the value of the externalities (if any) to
the firm?

In the cluster, pecuniary externalities including labor-pool sharing and labor matching are generated.

stable wages for workers and higher profits for firms are generated.

5. Knowledge spillovers are an instance of positive externality. What is your strategy if the goal is to
promote the city’s economic development by taking advantage of knowledge spillovers? Explain.
In what industries should the government invest in order to facilitate knowledge spillovers?

- Strategy: Higher Productivity through Co-opetition (= Cooperation + Competition)

Cooperation (Social capital)

: People have strong and sticky relationship as sharing their ideas and knowledge with the same
culture and language. Face to face contact that is superior to distance communication will be
encouraged.

Competition (Innovation)
: Innovations that are a creation about not only science and technology but also the ability to
deliver new value to customers are promptly discussed, improved, and adopted actively.

- Industries to be invested

Knowledge based Industries should be invested. IT sector would support communication

infrastructure that helps make strong social capital and is typical knowledge based industry.
Entertainment and Food industry would help people share their ideas and knowledge like coffee bean
effect. Education would be the fundamental and driving force of the innovations to create new value
through science and technology and deliver the value to customers.

6. New Economic Geography

a) Given Cobb‐Douglas preferences, U = F 1−δ * Mδ, show that δ = 0.9 implies consumers always spend
10 percent of their income (Y) on food.

Preference: U = F1−δ * Mδ - (1)

Budget constraint: Y = Pf * F + I * M - (2)
Lagrangian Γ = F1−δ * Mδ + k (Y – F – IM) (Food is numeraire, Pf = 1)

First-Order Conditions;

∂Γ −δ δ
=( 1−δ ) F M −k = 0
∂F

( 1−δ ) F−δ M δ =k - (3)

∂Γ
=δ F1−δ M δ−1−kI = 0
∂M

δ F 1−δ M δ−1=kI - (4)

Take the ratio of the FOCs:

(1−δ)
∗M
δ - (5)
=I
F
Using (2) equation, Y = F + I * M

IM = (δ / (1-δ )) *F
Y – F = (δ / (1-δ )) *F
Y = (1 / (1-δ )) *F
F = (1-δ )Y

IM = (δ / (1-δ )) *F
IM = (δ / (1-δ )) * (Y-IM)
IM = δ Y

b) Suppose that consumption of Manufacture (M) is a Dixit‐Stiglitz function of the consumption (ci) of
N different manufacture products:
M = ¿¿
Show that 0 < ρ < 1 implies consumers’ love for varieties.

Suppose all varieties are consumed in equal quantities;

C i = … = C = … CN
1
Then M = ¿ ¿ = ( N∗C ρ ) ρ
So, when 0 < ρ < 1, the more varieties (N) and the less amount (C), the more utilities are yield. It can
say that 0 < ρ < 1 implies consumers’ love for varieties.

c) Continuing part (B), show that ρ > 1 implies consumers prefer “a lot of a few varieties” to “a little bit
of many varieties.”

Suppose the same condition with the above answer;

1
M = ¿ ¿ = ( N∗C ρ) ρ
So, when ρ > 1, the less varieties (N) and the more amount (C), the more utilities are yield. It can say
that ρ > 1 implies consumers prefer a lot of a few varieties to a little bit of many varieties.

d) Continuing part (b), what is the policy implication of consumers’ love for varieties on the
economic development of cities?

To meet consumers’ love for varieties it is encouraged that slightly or totally different products will be
invented with not much amount. This will maximize the utilities and then productivity will be
maximized as well.