Regional Economic Integration and Economic Locations: ANote

Bin Zhou

Department of Geography

Southern IllinoisUniversity Edwardsville

Edwardsville, IL62026

Regional economic integration in the form of a custom union and/or a monetary union has receivedincreasingattention in recent years in economic geography study. However, theoretical study regarding the impacts of regional economic integration on locations of economic activities has been scarce, though hypotheses or speculations are plentiful (Scott 1998). This note discusses how regional integration, such as the formation of a monetary union, affects changes in economic locations, using an opportunity cost location model. Such an approach helps integrate the study of location theory and trade theory, while at the same time integrates the study of the domestic economy with that of the international economy.

1. The opportunity cost location model

The comparative advantage principlestates that countries specialize in producing commodities in which they have the minimum opportunity cost. For example, according to the Heckscher-Ohlin factor endowment theory, a country with rich endowment in low cost labor has a comparative advantage in making labor intensive commodities (Krugman and Obstfeld 1997). Given this, shifting resources to capital intensive commodities implies the loss of many labor intensive goods and thus a high opportunity cost in terms of labor intensive goods. Using resources in labor intensive goods means sacrificing the production of fewer capital intensive goods, and thus the low opportunity cost measured in capital intensive goods. Therefore the country is said to have a comparative advantage in, and export, labor intensive goods. Alternatively, the country is said to have a comparative disadvantage in, and import, capital intensive goods.

The opportunity cost can be expressed through the relative price of commodities, indicating the cost of one good measured in terms of the amount of another. For example, the relative price pab=Pa/Pbexpresses that one unit of good a is worth pab units of good b. The same amount of resources areworth either one unit of good a or pabunits of good b. That is, the opportunity cost of good a is pab units of good b. Countries with the lowest pab have a comparative advantage in making good a. If the world price ratio Pab is higher than pab, trade is possible. At equilibrium, the price ratio is Peab. Trade studyfocuses on the exchange pattern of at least two commodities and thus necessitates the expression of cost using relative prices.

In location study, the focus is not exchange, but the partial analysis of the location where the monetary costs of production and shipping for a certain commodity is a minimum. In a standard industrial location setting, given the production function Q=f(m1, m2, L) where Q is the amount of output, m1 and m2 are localized inputs, and Lnon-localized input such as labor, labor is regarded as a non-localized input here since it is not the factory owner's responsibility to ship workers to the firm location. The cost function is TC=∑(miPmi+miditmi)+Qdqtq +Lw, where Pmi are the prices of input mi; tmi are the shipping rates of inputs mi; tq the shipping rate of output; di the distance from input i to the firm, dq the distance from the firm to marketaccording to a certain coordinate system, and w the wage rate. When i=2, this is a typical Weberian location triangle problem. In Weber's least cost principle, the optimal location occurs where TC is minimized. Since only distances are variable, the problem becomes

Min[∑(miPmi+miditmi)+Qdqtq+Lw].

At equilibrium, there exists

Min TC=[∑(miPmi+mideitmi)+Qdeqtq+Lw]=[ ∑+L]e[1]

[ ∑+L]e is a short-hand expression of the equilibrium minimum total cost at the equilibrium location reflected in dei and deq. The unit cost is c=[ ∑+L]e/Q.

Model [1] contains no explicit term that indicates an exchange relation with other places. Divide the unit cost by Pb and we obtain

pqb=[ ∑+L]e/QPb=c/Pb[2]

Equation [2] indicates the relative price of Q measured in the units of good b. This is also the opportunity cost of Q. That is, one unit of Q is exchangeable with pqbunits of good b. This turns a location analysis into a trade analysis. If good b is used by the town where the firm is located, the opportunity cost of making one unit of Q is pqb units of good b. As long as pqb is lower than that at the market for Q, location (dei and deq) should specialize in Q. This may not always be the case.

In [2], taking the derivative with respect to d, which is the distance from location (dei and deq)

[3]

When dpqb/dd>0, (dei and deq) still has the minimum opportunity cost. This happens when

or . That is, the geographical distribution of the opportunity cost pqbvaries depending on the distribution of both c and Pb. Location (dei and deq) would still be optimal if Pb is uniform dPb/dd =0, or increases more slowly than c does, . Here d is distance from location (dei and deq). However,if, thus dpqb/dd<0, so opportunity cost in terms of good b is lower elsewhere than at location (dei and deq). This means that although the location has a minimum cost of Q, the price of good b is at such a low level that it gives the location a comparative advantage in good b. In a multi-product economy, this may not disqualify the location fromproducing Q since other goods may be imported to the location. Nevertheless, this analysis reveals the usefulness of an opportunity cost approach toward location analysis.

In general, denote P(ma, Qa, Pa, da, ta, La, wa) as unit price for good a and P(mb, Qb, Pb, db, tb, Lb, wb) as the unit price for good b, where m, Q, P, d, t, L and we assume their previousconnotations. The price ratio is

pab= P(ma, Qa, Pa, da, ta, La, wa)/P(mb, Qb, Pb, db, tb, Lb, wb). [4]

In a multi-product economy, there are prices P(mx, Qx, Px, dx, tx, Lx, wx) where x=a, b, c, d, e, … and price ratios pcb, pdb, peb, etc. Within the von Thünen location framework, pab, pac, pad, pae.. are minimum from the market up to da. The land is devoted to crop a. From distance da to db, pba, pbc, pbd, pbe.. are minimum and thus land is used to grow crop b. Between these two crop regions, there exists trade between crops a and b. That is, comparative advantagesatdifferent distances from the market give rise to varying opportunity costs and contribute to specialization in crop growing, as in the von Thünen rings. A similar analysis can be extended to other crop specialization regions for crops c, d, e, etc.

Within central place framework, places of different sizes may possess different opportunity costs for services of different thresholds. Given their resource endowments, large places have low opportunity cost in offering high order functions while small places have high opportunity cost in high order functions. Medium sized places have low opportunity cost in mid-order functions while small places have higher opportunity cost in mid-order functions. At the same time, due to resource abundance, medium and larger places also have lower opportunity cost in low order functions. Usingthe framework of price ratio in [4], opportunity cost pLH= P(mL, QL, PL, dL, tL, LL, wL)/P(mH, QH, PH, dH, tH, LH, wH) where L and H in subscribes denote low order and high order goods respectively.

For small places, P(mH, QH, PH, dH, tH, LH, wH) is high and thus pLH is low or pHL is high, highlighting the characteristics of small places specializing in low order goods alone. For large places, P(mH, QH, PH, dH, tH, LH, wH) is low due to large size operation. Thus pHL is low indicating low opportunity cost in high order goods. For pLH= P(mL, QL, PL, dL, tL, LL, wL)/P(mH, QH, PH, dH, tH, LH, wH), two factors contribute to the low opportunity cost in large places. The first factor is the large size operation. The second factor is the transport cost. P(mL, QL, PL, dL, tL, LL, wL)/P(mH, QH, PH, dH, tH, LH, wH) may be small without incorporating transport cost. However, if low order goods are made in small places and then shipped to large places, interaction of dL and tL will eventually raise the pLH to the point that it is no longer competitive importing from small places. Therefore opportunity cost is not high for both low and high order goods, and thus both will be offered in large places. Large places can be seen as places of self-sufficiency. Similarly, medium sized places offer low and medium ordered goods, but import higher order goods.

2. Location models in international context

The last section lays out the opportunity cost location model. The purpose is to incorporate variables that are relevant in an international economic context. Our basic model is the opportunity cost expressed as the relative prices or price ratios, as seen in [4]. In an international economy context, relative price is

Pab= EbaP(ma, Qa, Pa, da, ta, La, wa)/P(mb, Qb, Pb, db, tb, Lb, wb) [5]

where Eba is the exchange rate measured as the price of country a's currency in terms of country b's currency; Pab is the exchange rate multiplied by the price ratio. That is Pab=Ebapab.

In [5], re-write all terms as relative relations between two countries and we have

Pab= Ebapab(Rm, RQ, RP, Rd, Rt, RL, Rw) [6]

where Rs are relative resource endowments (m), relative industry size (Q), relative resource prices (P), relative location advantages (d), relative shipping rates (t), relative labor force size (L), and relative wage rates (w). In [6], after taking the total differential, we have

[7]

Equation [7] shows that a change in opportunity cost is the result of combined changes in exchange rates and relative terms. Any relative advantage or improvement in location, geography, agglomeration economies, resources, and factor prices can be offset by an overvalued currency;any disadvantage in these relative terms can be sheltered by an undervalued currency.

From a geographic point of view, this model illustrates how relative locational advantage or disadvantage can be suppressed or sheltered by exchange rates. For example, even if the industry in country a is not at the optimal location compared with that in country b, such disadvantage can still be sheltered by an undervalued currency Eba, contributing to a low opportunity cost. This means that borders, represented by exchange rates and a country’s monetary policy, not only protect inferior industries, but also protect inferior locations and inferior geographical patterns of production. On the other hand, relative locational advantage as a result of optimal conditions of a country over the other may be suppressed by an overvalued currency.

The same can be said about the relative size of the two industries(or two economies) and thus the effect of agglomeration economies in two countries. An effective concentration in one country relative to the other may help reduce the production price, but such an advantage may be suppressed by an overvalued currency. A dispersed pattern in oneeconomy in relation to the othermay raise the price of production but such a disadvantage may be sheltered by an undervalued currency. Expensive transport cost as a result of relatively less developed infrastructure and/poor quality roads may not hinder the flow of goods if an undervalued currency helps bring down the cost of transportation to foreigners. For the same reason, low transport cost due to developed transportation networks may still not help overcome trade barriers as a result of an overvalued currency. Relatively well endowed resources (natural and labor resources) and low factor prices may not facilitate growth due to overvalued currency, as the “Dutch Disease”testifies.

In the context of Weber's location framework, Pqb= Ebq[ ∑+L]e/QPb=Ebqc/Pb, where Ebq is the exchange rate measured as the price of country q's currency in terms of country b's currency. Take the total differential of Pqband we have . That is, the opportunity cost at location (dei and deq) is a function of both Ebq and pqb. A location of minimum pqb may not mean that of a minimum Pqb when Ebqis too high. The opposite is true.A location of higher pqb may have a minimum Pqb if Ebqis low. In von Thünen's location framework, Pab= EbaP(ma, Qa, Pa, da, ta, La, wa)/P(mb, Qb, Pb, db, tb, Lb, wb)=Ebapab. At locations from da to db, pab, pac, pad, pae… may still be minimum due to a very low Eba. Thus the land is still used for crop a. Similarly, in central place context, if small places undervalue their currency and thus lower the prices of all goods including high order goods, they can afford to offer them.

3. Effects of economic integration and roles of regional economic policy

The optimal currency area (OCA) literature asserts various trade-offs a currency union may bring about. One trade off is the gain in microeconomic efficiency as a result of reduced transaction cost, and the loss of macroeconomic flexibility due to independent monetary policy (Krugman 1993). Negative impacts from a loss of macroeconomic flexibility can be partially remedied by labor mobility, an integrated fiscal system, and flexible price and wage processes. The openness and the degree of diversification of an economy also affect the desirability of a monetary union. The more open an economy is, the more desirable a monetary union is due to its role in maintaining monetary stability. A diverse economic structure will help the economy cope with asymmetric shocks to the system (Mundell 1961; McKinnon 1963; Kenen 1969; Pomfret 2004).

From the location models of an international context developed in the last section, it becomes clear that if a monetary union is formed with a single currency or an exchange area with hard pegged exchange rates among member countries, there is another form of trade off. This is the trade off between the loss of macroeconomic flexibility and the gain of more competitive industries, or the more efficient economic locations and geography. With a monetary union being formed, previously protected industries and sub-optimal locations will be subject to competition and the pattern of economic activities within a region will change.

In a monetary union, Equation [7] becomes

[8]

That is, a lower opportunity cost can no longer can be obtained by artificially depressing exchange rates. A country’s resource endowments (m), resource prices (P),size of industries (Q), location of businesses (d), shipping rates (t), the size of labor force (L), and wage rates (w) in relation to others all come into open. Compared with other countries, less advantageous resource endowment and more expensive extraction costs, smaller agglomeration economies, less efficient economic locations, higher transport costs, more limited labor force, and less competitive labor costs are all grounds for higher opportunity costs. High opportunity costs will weaken a country’s competitiveness and thus reduce its capacity in aggregate supply. Equation [8] means that there is no longer protection of exchange rates from national monetary authorities against member countries in the monetary union. For the entire monetary union as a whole, there is still a monetary policy which may render protection for the entire union. The mechanism of protection is similar to what was previously discussed.

Given the effects of monetary integration on the national economy and economic geography of a member nation, how would the economic geography within a monetary union change? First, industries will rise or fall according to relative resource endowments and relative resource prices, the result of which is that the countries' industrial structures become more consistent with their comparative advantages. Second, in conjunction with changing economic structures, industries will shift toward their optimal locations based on the comparative advantages at various sites. Agglomeration economies as a factor of opportunity cost will stimulate concentration of economic activities from smaller to larger centers. In addition, when everything else is the same, locations with competitive labor cost will attract economic activities. Between larger centers that enjoy agglomeration economies and centers that enjoy competitive labor cost, a certain balance will have to be achieved to equilibrate the investment returns.

What should be the best course of action for regional economic policy in the wake of monetary integration?The answer depends on the purpose of regional economic policy. If the policy is to facilitate the transition of the economy toward a more efficient system, the focus of the regional policy shouldbe to foster the mobility of factors of productionand prevent price stickiness as a result of collusion or market power. Road construction strategy becomes an option to help workers migrate to more productive areas and resources to be shipped to regions of higher returns. Labor force training, investment in R&D, and infrastructure conducive to innovative industries are all part of the effort, designed to create an environment that facilitates economic flexibility and adaptability. For policy orientation that focuses on redistribution and protection, to a certain extent the union wide regional policies act as the national monetary policy prior to monetary integration. The essence is to shield less competitive industries and/or less developed regions behind the protective policies to maintain local levels of employment. Regional policy simply replaces the monetary policy.

If the regular expression of opportunity cost as shown above is divided into two components, one being the contribution to the opportunity cost from the market force and the other being the contribution from the policy, the total differential from such an expression shows that total change in opportunity cost in an industry in a region depends on the combined impacts from the market component and policy component. For efficiency oriented policy, the combined effects should further reduce opportunity cost and thus enhance a region's comparative advantage. On the other hand, for redistribution oriented policy, the combined effect should impede the market force, slowing the industrial or regional decline. The choice of actual policy mix is largely the result of political processes.

References

Kenen, P. 1969. The Theory of Optimum Currency Areas: An eclectic view. In R. Mundell and A. Swoboda, eds. Monetary Problems of the International Economy. 41-60. Chicago: University of Chicago Press.

Krugman, P.R., and Obstfeld, M. 1997. International Economics: Theory and Policy. Reading, MA: Addison-Wesley.

Krugman, P.R. 1993. What do we need to know about the international monetary system? Essays in International Economics No. 190. International Economics Section, Princeton University, NJ. July.

McKinnon, R. 1963. Optimum Currency Areas. American Economic Review 53:717-725.

Mundell, R. 1961. Theory of Optimum Currency Areas. American Economic Review 51: 657-665.

Pomfret, R. 2004. Sequencing Trade and Monetary Integration: Issues and Applications to Asia. Working Paper 2004-14. School of Economics , the University of Adelaide, Australia.

Scott, A. 1998. Regions and the World Economy. New York: OxfordUniversity Press.