The Impact of Knowledge-Intensive Employment Centers on the Rent Structure of Rotterdam
By Lukas Braunschweig, 381788
Department of Applied Economics,
Erasmus School of Economics,
Supervisor:
Frank van Oort
June, 2016
Abstract
The proclamation of clusters is a popular way to attract investment into knowledge-intensive activities. However, little research has been undertaken on their effects on the rent structure of a given city. This thesis examines how rents behave with differing distance from knowledge-intensive employment centers in the city of Rotterdam using a linear regression model while controlling for other relevant factors. The results show that distance from clusters matters for rents albeit not always in the theorized ways probably due to upwards-sloping bid-rent gradients. While moderately knowledge-intensive clusters do exhibit negative rent gradients, very knowledge-intensive one either have insignificant or even positive distance effects.
Table of Contents
Table of Contents
I.Introduction
II.A History of Bid-Rent Theory
III.Literature Review
IV.Hypotheses
V.Methodology
VI.Data
VII.Results
VIII.Discussion
IX.References
X.Appendix
I.Introduction
Arguably the most successful and famous cluster in the world is the agglomeration of technology firms just South-East of San Francisco: Silicon Valley. Its achievements in fostering innovation have helped America to claim a leading role in the digital revolution and brought significant wealth to the region.
Hence it is not surprising that clusters play an increasingly important role in economic policies on all government-levels in the European Union, as well. The European Commission plans to foster SME’s with the help of clusters in its Europe 2020-strategy (European Comission, 2010) and has set up the European Cluster Observatory to aid bureaucrats in implementing cluster strategies. National governments in the Netherlands and Denmark also have a long history of applying clusters in their economic policies (Holtz-Eakin, 2000). And even regional and city governments have recognized the importance of agglomeration economies for economic growth and knowledge creation (see for example Free and Hanseatic City of Hamburg (2011) or Paris Region Enterprises (2016)) – an ever more important feature in today’s globalized and highly competitive knowledge economy.
Alfred Marshall (1890, 1920) described three sources of agglomeration economies that lead to increased productivity, more innovation and higher business formation rates. Knowledge spillovers, in the form of an exchange of tacit (that is incomplete) information between employees, enable people in a cluster to make better decisions and foster innovation through exchange of ideas between knowledge actors. The second advantage of clusters are non-traded local inputs. In essence, this concept means that because of the great market for inputs, supplier of inputs can specialize and deliver inputs more economically than for a smaller market. Finally, the existence of a local skilled labor pool reduces the search and training costs of specialized personnel.
Being host to a cluster consisting of a few big and many small firms from the same industry certainly spells advantages for a city’s community. Various researchers have shown that large enterprises do not only pay higher wages to their staff ( (Oi & Idson, 1999) and (Brown & Medoff, 1989)) but also attract more productive (i.e. better educated) workers (Oi & Idson, 1999) which increases the human capital stock of a region. Jobs at large firms are also safer and tend to fluctuate less with overall economic conditions (Neumark, Wall, & Zhang, 2011). Finally, as McWilliams and Siegel theorized (2001) and Udayasankar (2008) confirmed empirically, larger firms are more willing to spend on Corporate Social Responsibility, part of which usually is spent in local projects. The community therefore profits from amenities that have been financed by the local employer. An illustration of this behavior can be seen in Wolfsburg where Volkswagen finances museums, galleries and theatres among others and in Eindhoven where Philips finances the museum and sport clubs(The Economist, 2016).
The presence of one or a few dominant industries also can have a negative impact on a city. Often cities’ growth depends on a small number of industries which does not only give them an out-sized influence on municipal politics but also binds the city’s fate to the industry’s. This can be two-sided blade as the demise of Detroit or spending cuts by Wolfsburg’s mayor, following Volkswagen’s involvement in an emissions-scandal which negatively impacted share prices (The Economist, 2016), show.
But hosting a highly-productive cluster can also harm a city’s residents in other ways. The fact that clusters concentrate many jobs in a small area means that roads around it will be congested and not always are companies willing to contribute to the necessary infrastructure investments (Bowles, 2016). And finally, if one follows a bid-rent framework, big firm campuses should also drive up rents in the surrounding areas, as employees want to avoid the costs of commuting, driving up demand in a housingmarket with slowly adapting supply. Intuitively this issue of clusters seems obvious. Research has shown that rents in towns with a university campus, median rents are significantly higher than in towns without academic institutions (Ogur, 1973). In a staff paper of the South Dakota State University, Langelett and Chang even showed that the bid-rent gradient of a university campus can “overwrite” the Central Business District’s gradient and be the determining factor of rents in college towns (Langelett & Chang, 2013).
However, besides McMillen (1996) who found that Chicago’s O’Hara airport, an important employment center exhibits a bid-rent gradient, scientific literature has mainly focused on the effect of university campuses on the local housing market and their bid-rent gradients and largely ignored the bid-rent gradients of employment centers other than city centers. Therefore, this thesis aims to explore the impact of theselocalized hotspots of qualitative employmenton the local rental housing market in the municipality of Rotterdam, Netherlands.
In the subsequent section a short history of bid-rent gradient theory will be provided, which is followed by an investigation into the existing literature on bid-rent gradients. Using the insights from the history and literature review this paper’s hypotheses will be developed. Section IV and Section V will introduce the data and the methodology for the empirical part of this thesis, respectively. Then the result will be presented and discussed. The paper will conclude with a discussion of the findings and their implications for the applicability of bid-rent theory in modern cities.
II.A History of Bid-Rent Theory
The Classical Beginnings of Rent Theory
Modern economic models usually assume away distance and stipulate an economy that takes place on the famous “pinhead” (Isard, 1956). This of course, is a major oversimplification of the real world. The ignorance towards distance (bar the extreme case of international trade) has a tradition that goes back to the very roots of economic science. Although Adam Smith conceptualized rent as the difference between the price of agricultural output and its production costs and recognized that the cost of production can vary with the quality of land and therefore will influence rent, he did not consider transport costs as a factor impacting rent(Smith, 1904).
It was David Ricardo who made Rent Theory his research focus and further advanced the discipline after Smith’s death. In his magnus opus “On the Principles of Political Economy and Taxation”, Ricardo saw rent as “that portion of the produce of the earth, which is paid to the landlord for the use of the original and indestructible powers of the soil”, combined with capital and interest considerations(Ricardo, 1817). The English-Portuguese economist made two important contributions to Rent Theory. First, he posited that the most productive land is used first and less valuable areas are only cultivated later, as good land becomes scarce. Secondly, he claimed that land is used in a way that maximizes economic output. This latter argument suggests that a given plot of land will go to the highest bidder who can get most value out of the land and therefore is able to pay the highest rent. This assumption is integral to bid-rent theory. However, whileRicardo acknowledged the possible effect of certain cost or productive advantages of a plot of land on rent, such as hedges, buildings or location, over an equally fertile one, he did not explicitly include distance from a market and the associated transport costs in his considerations. Ponsard attributes the engagement of the majority of classical economists in abstract analysis to Ricardo’s reduction of differences in land to differences of fertility and his neglect of spatial considerations(Ponsard, 1983, p. 11).
Rent and the Use of Land in the Von Thünen-model
This ignorance of space in economic analysis afflicted mainly Anglo-Saxon thinkers.Meanwhile, German authors thought intensively about the spatial structure of cities and their hinterlands. It is therefore not surprising that the next advancement of the thinking about rent (which thanks to its spatial considerations is actually a new branch of Rent Theory) came from a German. In his 1826 book “The Isolated State”, Von Thünen, a rural land-owner from Mecklenburg, was the first to connect economic geography and traditional Rent Theory laying the foundation for the bid-rent model. Specifically, he developed a model in which rent paid by a leaseholder is determined by the market price for the produced crops and the costs of production(McCann, 2001)[1]. Assuming that all land is equally fertile and featureless, farmers sell the same produce and have the same production function, as well as absentee landlords and free entry into the agricultural market,production costs only differ with respect to transport costs that in turn differ linearly with distance to the central market in the nearest city. In this world, the closer a farmer is to the market, the smaller his transport cost will be and therefore his profits will be higher than for farmers further away from the town. As the other farmers observe this and entry into the agricultural market is free, the rent for these better plots will be bid up, so that all farmers will just earn enough to cover their costs and survive while the landlords extract a higher rent (as Smith predicted). Therefore, while all farmers earn the same, the rents will decrease with increasing distance from the market, forming a linearly declining land-rent gradient (see Figure 1).
To illustrate let us assume a market in which corn is sold at $100, transporting corn costs $1 per kilometer and non-land input costs are independent of location and fixed at $50. A farmer living directly adjacent to the market does not incur transport costs and therefore reaps a profit of $50, while farmers at the 20 kilometer and 50 kilometer mark, will earn profits of $30 and 0$, respectively, after paying for transport ($20 and $50). Since rent is assumed to be the residual income of land (Smith, 1904) (thanks to the competitiveness of the agricultural market and a perfectly inelastic supply of land) the landlords will skim these extra profits in the form of rent, meaning that all farmers earn the same.Increasing transportation costs will make the gradient steeper and increasing market prices will shift the gradient outwards.
Of the many assumptions the one that is most readily relaxed is the premise that all farmers grow the same crop. One can easily allow for more than one crop as long as the other assumptions still hold for all crop varieties (i.e. all variables are the same for all farmers growing the same crop while they can vary between crops). In this case competition is not only between farmers but also crops which means that the crop with the more expensive transport costs will be located closer to the town and farmers of that crop will have to pay a higher rent (see Figure 2).The effective land-rent gradient will then be the envelope of both crops’ gradients.
In an example barley sells for $100 while wheat only pays $50 per bushel. However, with transport costs of $2 it is twice as expensive to move than wheat. Both crops have fixed non-land input costs of $50. We see that barley will be planted as far as 33 kilometers from the market while wheat only is viable to grow beyond that mark. Nothing is grown further than 50 kilometers from the town. We cansee that Von Thünen took up Ricardo’s assumption that land will be allocated to the use that pays the highest rents is reflected in this model.
Despite its many assumptions that largely do not hold up in the real world and its focus on only agricultural rents, the Thünen-model is exceptional because it is the first account of an effort to explain the spatial configuration of land use of cities and their hinterland in economies dominated by agriculture. Nobel Prize-winning economist Paul Krugman notes that Thüenen’s model anticipates many concepts that should become part of mainstream economics(Krugman, 1995). These include the idea of an equilibrium (the pattern of concentric land-use rings around the town), a market value instead of an inherent value of goods and factors (land gets its value through bidders competing for it), the simultaneous pricing of goods and factor inputs (the maximum possible rent depends on the market price of agricultural output), markets that achieve efficient outcomes (the highest bidder can use the best land) and finally Von Thünen recognized the role prices play in incentivizing efficient behavior (the more efficient a bidder is in his production, the higher he can bid).
The emergence of Modern Bid-Rent Theory
Maybe this foresight of ideas that later would become the heart of mainstream economics, explains why it took almost 150 years until major contributions were made to Von Thünen’s theory. Although Alfred Marshall anticipated one important prediction of modern Rent Theory, namely that higher prices will lead to higher density (Marshall, 1890), he did not produce a spatial theory of rents. Other economists, while interested in land-use patterns, did not build on Von Thünen’s work until William Alonso’s book “Location and Land Use: Towards a General Theory of Land Rent” (Alonso, 1964). In this book Alonso largely adopts Von Thüen’s assumptions but includes a small but important difference: in Alonso’s bid-rent model the land to non-land input relationships required for production are not fixed anymore but can differ. This means that land and non-land factors can be substituted for each other.
The important implication of this new assumption is that rentis not a residualanymore, as Smith, Ricardo and Von Thünen assumed, but rather one of many factors that are included in the cost function of a firm. The cost (dis-)advantages of a production location therefore do not accrue to the landlord anymore but to the landholder. This landholder therefore has an incentive to optimize his cost function. To achieve efficiency, the marginal costs (which in a competitive economy, are equal to prices) of land and non-land factors must be equal to each other. If this is not the case, a firm will substitute the more expensive factors for more of the cheaper factors until balance is restored. For bid-rent theory this means that, assuming non-land factor prices are independent of distance from the city center and the price of land decreases with increasing distance, the costs of land fall relative to non-land costs. Therefore, a profit maximizing firm will substitute non-land factors for more land. Conversely this indicates that the closer a firm is to the city center the less land and the more non-land factors it will use in its production(McCann, 2001).It is easy to see that this is exactly what Alfred Marshall predicted. The result of this observation is a shape of the bid-rent-gradient in Alonso’s model that differs from Von Thünen’s straight line: the gradient will be curved (see Figure 3). To see why, recall that while transport costs t per kilometer are assumed to be fixed, the absolute land area used, increases with d from the city center. The t per land area unit therefore decreases, which in turn decreases the rate with rent has to fall in order to compensate for the higher t.
But what about land competition in bid-rent theory? After all it is aimed at explaining the spatial structure of cities. Most generally we can say that the highest bidder will be closest to the city center. Who that highest bidder is depends on the bidder’s production functions and the substitutability of land with non-land factors and the importance of easy market access (i.e. distance to the center) in their business models. Therefore, producers whose production is relatively land-intensive will be pushed to the city’s outskirts, as other producers can just substitute non-land factors for less land and therefore move closer to the center while this is option is not available to the land-intensive producers. This is one of the reason why logistics centers or factories are seldom located in the middle of a city and why service industries and specialized retail stores can often be found in the very center of cities. An example for how activities could be distributed in a city can be found in Figure 4. The actual rent gradient for a city is (similarly to Von Thünen’s model) not determined by any single firm’s but rather is composed of the highest bidder’s at any given point. Thus, it is the envelope of all individual gradients. Finally, we can determine the edge of the city as the point at which agricultural use is the highest bidder for land.