Are Cities Really Efficient?

Are cities – especially Australian cities – actually “efficient” as is so commonly claimed?

Why is it that rural and regional Australia is home to those industries which enjoy a
comparative advantage on world markets, whilst the metropolises for the most part are
engaged in activities which do not?

This puzzle calls into question the whole doctrine of supposed "metropolitan efficiency" or
"agglomeration efficiency" which has gained favour amongst metropolitan elites worldwide
in recent years.  This simple economic model observes the higher incomes of metropolitan
centres and concludes that they must therefore be more productive.  In some cases it even
suggests that metropolises be subsidised (or further subsidised) to promote greater efficiency.
It insists that population densities be increased – to propitiate the God of Growth – even
though psychological evidence suggests that the higher the population density of the
immediate environment the less happy people report being1.

Like so much simplistic economics, the agglomeration theory assumes that income is to equal
the value of output. In other words, it ignores the possibility of economic rent and
externalities.  Net incremental output is actually income LESS the economic rent component
LESS the deadweight losses incurred in extracting that rent LESS external costs of generating
it PLUS external benefits.

The agglomeration school recognises only external benefits.

Conventional economists (especially metropolitan economists) have a blind spot when it

comes to considering rent. They readily accept the existence of rent-seeking by individuals.
They readily accept the existence of rent-seeking by firms. They even accept rent-seeking by
groups of firms – such as a cartel – working for their common benefit.

But when it comes to rent-seeking by a group of players in the form of a metropolis, rent-
seeking is somehow out of the question. The economists assume that if metropolitan incomes
(i.e. labour costs to the firm) were too high, firms would move elsewhere. The mere
existence of metropolises is taken as “proof” of their efficiency.

That line of argument ignores the possibility that the metropolis itself might be a rent-seeking
organisation which offer firms – and their employees – rent-seeking opportunities not
available elsewhere. And it is the refusal to acknowledge that fact which leads economists to
vastly underestimate the incidence of rent in the economy.

There are some cases where income is entirely offset by rent and deadweight losses. To take
one example, the “private infrastructure” industry (in which I worked and which I know
every well) employs tens of thousands of skilled professionals doing at vast expense
something which governments used to do quite simply and cheaply by issuing government
bonds. The salaries of all those professionals is going into GDP. The cost is ultimately met
by consumers paying – directly or indirectly – more for their infrastructure. But the
contribution to welfare is zero2.
Indeed, the net contribution is less than zero because the misallocation of highly trained
professionals to a pointless activity means they are not available to do something really useful
. . . say, weeding public gardens or organising children’s parties.

How can such a destructive industry continue to exist? We’ll return to that question later.

Conventional economists also have a weakness when it comes to seeing external costs. In
some cases income is completely offset by externalities. Consider, for example, a marginal
increase in advertising in an environment saturated with advertising. Human cognition and
memory is limited, and the imprinting of one brand or message in the mind comes at the cost
of driving out recollection of other brands and messages. At saturation, advertising becomes
a positional good. Each successfully implanted message comes at the external cost of
displacing another message. This is an arms race which no-one can “win”. The resources
thrown at ever greater arsenals of flashing neon lights contribute nothing to welfare.

And yet – just as defence spending contributes to GDP – so advertising expenditure is taken
to have a “value” equal to the cost of resources used in it . . . even at the point of saturation
where it is producing nothing. At least defence spending is separately identified and
recognised for what it is.

And again, we might ask: “How does such misallocation occur? How is it allowed to
continue?”

To be sure, some cities do seem to demonstrate agglomeration efficiencies. The paragon of

this type of city is Silicon Valley where the planet’s highest concentration of intelligent
individuals – sharing ideas – are literally re-designing the world we live in. And making
fortune.

Even here, however, the effect may be overstated. Even the vast wealth of Silicon Valley
relies on:

a) the system of intellectual property rights which concentrates enormous rents in the hands
of a few dominant firms, rents far in excess of the returns required to attract investment in
such fields; and

b) a refusal by governments to uniformly tax economic rents, either directly through rent
taxes3or indirectly through an annual tax on the capitalised value of future rents (i.e. a wealth
tax).

Moreover, the really great innovations of Silicon Valley occurred long before it grew in size.
So are the high incomes of Silicon Valley due to its size? Or did it grow in size – and does it
continue to grow in size – because people move there to grab a share of the windfall rents
generated by new technology which just happened to be located there?

In the same way, people kept moving to Detroit long after the Golden Age of innovation in
vehicle design. New technologies generate a momentum which may continue long after
innovation ceases. It is a case of “path-dependence”.
But if there is some error in applying the agglomeration efficiency model to Silicon Valley,
there is vast error in applying it elsewhere. That is the fallacy of generalising from the
particular. 

To understand why, we must go beyond the dollars and cents of simplistic economic theory
and look to both the psychology and the constitutional political economy of how rent in
distributed.

The constitutional political economy takes into account the response of governments to
collective action. Well organised rentier groups are more effective in setting and maintaining
government policy than the dispersed and disorganised citizens who must foot the bill.

The psychology includes "proximity bias"4. That is the tendency of human beings to trust,
favour and reward those who are physically proximate.  In the purely commercial arena it
underpins the creation of the professional and commercial networks, oligopolies and cartels
which allow their members to extract rents from the rest of the community. Agglomeration
efficiency includes agglomeration efficiency in rent-seeking, but this is something
metropolitan apologists choose to ignore.

But the role of proximity bias in the commercial arena is nothing compared with its role in
government.  And this is especially true of Australia’s Westminster system.

Under the Westminster system – with its generally supine Legislature – the Cabinet has vast
discretion to disburse economic rents to the Ministers’ favourites. This creates a powerful
centripetal force drawing people in towards the Cabinet.  The Cabinet is the “Fountainhead of
Rent”. 

This phenomenon has been known to historians (but apparently not economists) for centuries.
It is the reason that Courtiers had to remain at Court. Absence from Court was a death
sentence.

With the evolution of Absolute Monarchy into the elective dictatorship of the modern
Westminster system, this effect has not gone away. Court was replaced by Cabinet, and
Ministers reward those modern-day courtiers – the primary rent-seekers – who are physically
proximate. Primary rent-seekers must live within “lunching distance” of the Cabinet.

The elevated incomes of the primary rent-seekers draws in a second circle of secondary rent-
seekers, who in turn draw in further circles, the ripple of rents radiating outwards from the
Fountainhead.

The net result is a vicious cycle of inefficiency.  As ever more people squeeze in closer to the
Fountainhead, their concentrated voting power gives them ever more influence over
government policy.  Policy becomes ever more favourable to metropolitan rent-seeking even
though the metropolis  may enjoy no comparative advantage.

This explains why Australians do not live in any old cities.  They live in the State and
Territory political capitals.  It also explains why an increasing proportion of Australia's
population lives in those political capitals even as the total population grows.  This is contrary
to the agglomeration efficiency theory by which we would expect to see an increasing total
population cause more towns to reach "critical mass" and develop into metropolises.  Why,
for example, have towns like Newcastle, Mackay, Townsville or Albany - pleasant places on
the coast with good ports and prosperous hinterlands -  not grown into huge metropolises? 
Why does the population drift to Sydney, Brisbane or Perth? 

Intuitively one might expect that where the Executive branch of government has wide
discretion (as in the Westminster system) power and wealth would concentrate around that
Executive, whereas in those countries with a more powerful Legislature (for example the
United States) agglomeration efficiencies would prevail. And this does indeed appear to be
the case.

We can see the effect in the UK where far-and-away the largest per capita recipient of
identifiable public spending (excluding social welfare and agriculture) is not Scotland or
Northern Ireland as one might imagine, but London!5

Of course, metropolitan apologists argue that Londoners deserve more being spent on them
because (as everybody knows; just ask a Londoner) they are the clever, virtuous, hard-
working people who “create all the wealth”. Just look at their high incomes.

But that's clearly a chicken-and-egg argument. Do Londoners deserve lavish spending

because they generate wealth?  Or are they wealthy because the government lavishes
spending on them?

To give an example, as a child I lived about a mile from Lord’s Bridge Railway Station, the
first stop outside Cambridge on the Cambridge-Oxford railway (the so-called “Varsity Line”
or “Brain Line Railway”). The Varsity Line was spared the Beeching Axe in 1963 but you
won’t find Lord’s Bridge Station on modern maps. That’s because in 1967 the government
decreed that money should be dedicated instead to improving the speed of services into and
out of the political capital. To go cross country from Oxford (or further south and west) to
Cambridge (or further north or east) one would travel to Paddington, cross London by Tube
to Liverpool Street, then resume the train journey.

On 31st December 1967 the Varsity Line was closed, the infrastructure dismantled, and the
track bed meticulously ploughed back into the farmland.

Varsity Line demolition near Bourn, December 1968

Fifty years later the policy of concentrating traffic through London has necessitated 18 billion
pounds of public money being spent on the Crossrail Project to ease the congestion. 

But hey! That 18 billion pounds increases the incomes of Londoners, thereby “proving” how
productive they are.  Isn’t economics wonderful?

There is talk of re-building the Varsity Line to connect the innovation centres of Oxford  and
Silicon Fen, but the Government insists that it somehow be funded privately. Public money
is being dedicated to the HS2 project (west coast main line) designed to concentrate even
more activity in the capital city.

Meanwhile back in Australia, we have metropolitan rent-seeking at every level:

a) at the State level, mineral royalties prop up Brisbane and Perth;

b) top class health and education facilities are concentrated in the capitals;

c) arts and sports funding is concentrated in the capitals;

d) lucrative public works contracts are handed out to Mates in the capitals;

e) at the federal level, company tax on commodity exporters is disbursed – largely per capita
– to the capital cities;

f) special imposts such as fuel excise act as a “tax on distance”, sucking money out of the
regions (and even from the poorer outer suburbs which rely more on car transport) to be
disbursed to the capitals;

g) specific industry protections inflate metropolitan incomes. The policy of mandatory

superannuation (for example) is now diverting over $30 billion a year into the hands of
Sydney and Melbourne funds managers and their support industries. But – just like the
private financing industry – having thousands of people are running around in circles
complying with the red tape of a needlessly inefficient pensions system does not mean that
they’re producing anything of value. It is properly accounted for as part of the deadweight
loss of rent-seeking: a pointless misallocation of resources that exists only so that politically
powerful rent-seekers can divert income into their pockets; and

h) the acceptance of oligopolies in major (metropolitan) industries further increases

metropolitan incomes.

And because of all those people crammed into the metropolis, trying to be within lunching
distance of the Cabinet, we see projects like the $17 billion WestConnex tunnel in Sydney
which cost more to build that a new green-fields city somewhere else.

But hey! That $17 billion increases the incomes of Sydneysiders, thereby “proving” how
productive they are.  Once again, isn’t economics wonderful?

Human beings are belief-driven creatures, and an economic theology that tells powerful
metropolitan people that their wealth and power is well-deserved (and perhaps even that they
should be further subsidised to promote their supposed "efficiency") will be readily accepted
by the beneficiaries . . . even if the theory is fatally flawed.

Unfortunately, for Australia as a whole the net result is allocative inefficiency - the
misallocation of resources to inferior uses - on a continental scale.

And it gets worse every year.

1
https://www.theage.com.au/world/why-smart-people-are-better-off-with-fewer-friends-20160319-
gnma12.html
2
See https://www.scribd.com/document/388209151/QTPWC-Toll-Road-Inquiry-Submission-165
3
http://taxreview.treasury.gov.au/content/ConsultationPaper.aspx?
doc=html/publications/Papers/Consultation_Paper/appendix_e.htm
4
See, for example, “Out of sight, out of mind. People who work from home are less likely to be promoted”, The
Economist, 13th October 2012. http://www.economist.com/node/21564581
5
https://fullfact.org/news/are-english-paying-lavish-scottish-spending-promises/