Location Theory

• Explains the pattern of land use.

• Is concerned with the geographic location of economic activity.

• Has become an integral part of economic geography, regional science,

and spatial economics.

• Addresses the questions of what economic activities are located where

and why.

Nearly 200 years ago, the primary concern of

early location theorists, most notably Johann-
Heinrich von Thunen (1783-1850), was the optimal
location of cities and farms, balancing both land
cost and transport costs.

Johann-Heinrich Von Thunen

Least Cost Approach

Alfred Weber (1868-1958)

formulated a theory of industrial
location in which an industry is
located where it can minimize its
costs, and therefore maximize its profits.
Weber’s least cost theory accounted
for the location of a manufacturing plant
in terms of the owner’s desire to
minimize three categories of cost:
 1) Transportation: the site chosen must entail the lowest possible
cost of A) moving raw materials to the factory, and B) finished products to
the market. This, according to Weber, is the most important.

2) Labor: higher labor costs reduce profits, so a factory might do

better farther from raw materials and markets if cheap labor is available.

3) Agglomeration: when a large number of enterprises cluster

(agglomerate) in the same area (e.g. city), they can provide assistance to
each other through shared talents, services, and facilities (e.g.
manufacturing plants need office furniture).

Figures 1-3 show the weight-losing case, in which the weight of the
final product is less than the weight of the raw material going into making
the product. In Figure 1, the processing plant is located somewhere between
the source and the market. The increase in transport cost to the left of the
processing plant is the cost of transporting the raw material from its source.
The rise in the transportation cost to the right of the processing plant is the
cost of transporting the final product. Note the line on the left of the
processing plant has a steeper slope than the one on the right.

The weight gaining case is illustrated in Figures 4- 6, where the final

product is heavier than the raw materials that require transport. Usually this
is a case of some ubiquitous (available everywhere) raw material such as
water being incorporated into the product. The optimal location of the
processing plant in this case is at the market. Weber established that firms
producing goods less bulky than the raw materials used in their production
would settle near to the raw-material source. Firms producing heavier goods
would settle near their market. The firm minimizes the weight it has to
transport and, thus, its transport costs.

Market Area Analysis

A market area analysis is the surface over which a demand or supply
offered at a specific location is expressed. For a factory it includes the areas
to where its products are shipped; for a retail store it is the tributary area
from which it draws its customers.

Economic Definition of a Market Area Analysis

A market depends on the relationship between supply and demand. It

acts as a price fixing mechanism for goods and services. Demand is the
quantity of a good or service that consumers are willing to buy at a given
price. It is high if the price of a commodity is low, while in the opposite
situation - a high price - demand would be low. Outside market price,
demand can generally be influenced by the following factors:

• Market Threshold and Range

• Market Size and Threshold

• Market Profitability

• Non-Isotropic
Conditions and the
Shape of Market Areas

Market Threshold and Range

The figure at the right considers a fairly uniform distribution of customers on
an isotropic plain and a single market where goods and services may be
purchased.

Market Size and Threshold

There is a direct
relationship between market
size and threshold which
impact the geography of
retail. To support its
activities, each urban centre
needs a threshold population
that varies according to its
size. Obviously, large cities
have an important threshold,
so there may be only of few
of them on a specific
territory while there can be a large number of small villages.

Market profitability
 A market area has a range and a threshold which are determining the
profitability of the economic activity generating it. The threshold is the
minimal market area an activity must have to stay in operation. It represents
the spatial threshold of profitability where spatial attributes such as
population density and income have an important influence in its
assessment. The range is the effective market area of an activity from which
it draws its customer base. On graph A, activity p will be profitable since its
threshold is inferior to its range R(A). On graph B, activity p is not profitable
because its range is inferior to its threshold.

Non-Isotropic Conditions and the Shape of Market Areas

The left part of the figure represents the standard hexagonal shape of
a set of markets under isotropic conditions. Each market has the same
market area and is evenly spaced. This theoretical condition is obviously
rarely found in reality. The two most important non-isotropic conditions
impacting on the shape market areas are differences in density and
accessibility. The middle part represents a condition where there is a
concentric gradient of population density (from low to high) and a highway
crossing through. Their possible outcome on the shape of the concerned
market areas is portrayed on the right part of the figure.
Profit Maximization Approach

Profit maximization approach is the process by which a firm

determines the price and output level that returns the greatest profit. There
are several approaches to this problem. The total revenue–total cost method
relies on the fact that profit equals revenue minus cost, and the marginal
revenue–marginal cost method is based on the fact that total profit in a
perfectly competitive market reaches its maximum point where marginal
revenue equals marginal cost.

Basic Definitions

Any costs incurred by a firm may be classed into two groups: fixed cost
and variable cost. Fixed costs are incurred by the business at any level of
output, including zero output. These may include equipment maintenance,
rent, wages, and general upkeep. Variable costs change with the level of
output, increasing as more products is generated. Materials consumed
during production often have the largest impact on this category. Fixed cost
and variable cost combined, equal total cost.

Total cost-total revenue method

 To obtain the profit maximizing
output quantity, we start by
recognizing that profit is equal
to total revenue (TR) minus
total cost (TC). Given a table of
costs and revenues at each
quantity, we can either compute
equations or plot the data
directly on a graph. Finding the
profit-maximizing output is as
simple as finding the output at
which profit reaches its
maximum. That is represented
by output Q in the diagram.

There are two graphical ways of

determining that Q is optimal.
Firstly, we see that the profit
curve is at its maximum at this
point (A). Secondly, we see that
at the point (B) that the tangent
on the total cost curve (TC) is
parallel to the total revenue curve (TR), the surplus of revenue net of costs
(B,C) is the greatest. Because total revenue minus total costs is equal to
profit, the line segment C,B is equal in length to the line segment A,Q.

Computing the price at which to sell the product requires knowledge of

the firm's demand curve. The price at which quantity demanded equals
profit-maximizing output is the optimum price to sell the product.

Marginal Cost-Marginal Revenue Method

 If total revenue and total cost
figures are difficult to procure,
this method may also be used.
For each unit sold, marginal
profit equals marginal revenue
minus marginal cost. Then, if
marginal revenue is greater
than marginal cost, marginal
profit is positive, and if
marginal revenue is less than
marginal cost, marginal profit
is negative. When marginal
revenue equals marginal cost,
marginal profit is zero. Since
total profit increases when
marginal profit is positive and
total profit decreases when
marginal profit is negative, it
must reach a maximum where
marginal profit is zero - or
where marginal cost equals
marginal revenue. This is
because the producer has collected positive profit up until the intersection of
MR and MC (where zero profit is collected and any further production will
result in negative marginal profit, because MC will be larger than MR). The
intersection of marginal revenue (MR) with marginal cost (MC) is shown in
the next diagram as point A. If the industry is competitive (as is assumed in
the diagram), the firm faces a demand curve (D) that is identical to its
Marginal revenue curve (MR), and this is a horizontal line at a price
determined by industry supply and demand. Average total cost are
represented by curve ATC. Total economic profits are represented by area
P,A,B,C. The optimum quantity (Q) is the same as the optimum quantity (Q)
in the first diagram.

Firm Theory
Theory of the Firm
 Behaviour of a firm in pursuit of profit maximization, analyzed in terms
of:

(1) What are its inputs?

(2) What production techniques are employed?

(3) What is the quantity produced?

(4) What prices it charges?

The theory suggest that firms generate goods to a point where

marginal cost equals marginal revenue, and use factors of production to the
point where their marginal revenue product is equal to the costs incurred in
employing the factors.

This trained member of the Chicago

School is best known for two particular
contributions to economic theory. In
Coase's work on the nature of the firm
(1937), he argued that firms should be
conceived as entities endogenous to the
economic system and whose existence is
justified only in the presence of
transactions costs to production. Firms and
other economic organizations and
institutions, in effects, exist because agents find it a useful manner of
minimizing transactions costs.

Ronald H. Coase
Transaction Cost Theory

The model shows institutions and market as a possible form of

organization to coordinate economic transactions. When the external
transaction costs are higher than the internal transaction costs, the company
will grow. If the external transaction costs are lower than the internal
transaction costs the company will be downsized by outsourcing, for
example.

Ronal Coase set out his transaction cost theory of the firm in 1937,
making it one of the first (neo-classical) attempts to define the firm
theoretically in relation to the market. Coase sets out to define a firm in a
manner which is both realistic and compatible with the idea of substitution at
the margin, so instruments of conventional economic analysis apply. He
notes that a firm’s interactions with the market may not be under its control
(for instance because of sales taxes), but its internal allocation of resources
is: “Within a firm … market transactions are eliminated and in place of the
complicated market structure with exchange transactions is substituted the
entrepreneur … who directs production.” He asks why alternative methods of
production (such as the price mechanism and economic planning), could not
either achieve all production, so that either firms use internal prices for all
their production, or one big firm runs the entire economy.