The New Economic geography


Alfred Marshall, the most influential British economist in the era of the second industrial revolution from the 1880s to the 1930s, advanced the Ricardian analysis in his book Principles of Economics. Marshall analyzed externalities of specialized industrial locations. His prototypical industrial district was Manchester. In the Marshallian industrial district the concentration of firms enjoys the same economies of scale that giant firms normally get. In that sense, a Marshallian industrial district is an alternative to a giant firm that nowadays is a multinational. Marshall highlighted the presence of the so-called industrial atmosphere, although he did not elaborate its social foundations. Marshall was aware of the fact that there is the overlapping between the social and the productive systems.

In Marshall’s conceptualization of industrial district, the possibility to benefit from external economies, due to spatial contiguity[1], is the main reason that induces firms to locate near each others. The concept of externalities refers to the benefits that a firm takes from being located in an industrial district. In Marshall’s analysis, industrial districts can contribute to the external economies of the regionally concentrated firms. In the theory, geographical agglomerations and regional imbalances result as an equilibrium solution of a tension between centripetal[2] and centrifugal[3] forces. Marshall described the three most important centripetal forces, called Marshallian triad, that are at the base of the existence of agglomeration:

1. Effects resulting from specialization due to the division of labour with an industrial district

2. Effects resulting from creation of infrastructure, information, communication and R&D that a single firm can take advantage of

3. Effects resulting from the availability of high specialized labour force

Gunnar Myrdal[4], the famous socio-economist after the Word War II, has developed the core-periphery model that is a simple yet useful conceptualization to be used at different geographical scales (global, national, regional, etc). Myrdal proposed that the key concept of spatial development is cumulative causation that can be explained by spread and backwash effects. In relationships between core and periphery countries, there are spread and backwash effects. Spread effects are the positive benefits in terms of technology transfer from core countries to periphery countries. The brain drain, which refers to the tendency of highly educated citizens in periphery countries to migrate to core countries, can be considered as an example of the negative backwash effects[5].

Many industries (including service industries such as banking) are geographically concentrated, and such clusters are clearly an important source of international specialization and trade. Regional clusters in general seem to perform better that the national average in the US[6]. A comparative survey of 34 regional clusters (of which approximately half are traditional and half science-based) in 17 European countries reveals that that young and science-based clusters dominate the European landscape[7]. They are relatively small in size compared with the US’ clusters.

Paul Krugman is one of the leading economists that has competed the Marshallian triad. Krugman has made following summary of the centripetal agglomeration economies that are relevant in the global economy[8]:

1. Market-size effect (demand and cost linkages, also called backward and forward linkages).

A large local market creates a large local market(s) that in turn creates both demand linkages (sites close to large markets are preferred location for the production of goods) and cost linkages (the local production of intermediate goods lowers the production costs of other producers and provides savings on transportation costs). An example is the financial services industry, clients and ancillary services concentrated in New York.

2. Thick labour markets

A local concentration supports the creation of a thick labour market, especially for specialized skills (where employees and employers are readily matched) and spatial externalities (the extensive division of labor of industry-specific co-dependent innovations), so that employees find it easier to find employers and vice versa.

3. Pure external economies

A local concentration of economic activity may create more or less pure external economies through information spillovers.

But Krugman (1995) identifies also centrifugal forces that affect geographical concentration:


1. Immobile factors

Certainly land and natural resources are always immobile, and in an international context, people. Therefore, some production must go to where the workers are and from the demand side dispersed factors create a dispersed market, and some production will have an incentive to locate close to the consumers.

2. Land rents

Concentrations of economic activity generate increased demand for local land, driving up land rents and thereby providing a disincentive for further concentration. For instance in Los Angeles land rents are a centrifugal force.

3. Pure external diseconomies

Concentrations of activity can generate more or less pure external diseconomies such as congestion. Congestion is a state of excessive accumulation or overfilling, like the traffic congestion.

Krugman uses the name New Economic Geography that has been driven by considerations of modeling strategy to concentrate on the role of market-size effects in generating linkages that foster geographical concentration, on one hand, and the opposing force of immobile factors working against such concentration, on the other.

In the beginning of the 21st century, core countries are rich and developed. The average citizen achieves a high standard of living. The USA, EU, Japan, Canada and Australia are recognized as core countries. The periphery countries are less developed having low economic growth and poorly educated, housed and fed population. Many countries in Africa, Asia and Latin America are recognized as periphery countries. The semi-periphery countries seem to improve their position in the global economy whereas many periphery countries are stagnating. Newly industrializing countries (NICs) such as the ‘Four Dragons’ (South Korea, Taiwan, Hong Kong and Singapore) and the ‘Little Dragons’ (Malaysia, Thailand, Indonesia and the Philippines), owing to impressive economic growth rates in recent years, can be classified as semi-periphery.

In the EU, the economic integration has created new economic regions that are rich and developed in the global perspective. The new regional division of labour has many new forms. In the European context, in the deepening and enlargement process of the European Union the economic integration includes institutional development, which requires that participating countries have fairly high and similar levels of development[9]. Economic integration is divided into stages depending on how far the member states have advanced in cutting down barriers impeding economic activity among each other and how far the implementation of common policies has advanced[10].

The economic integration and globalization are the two trends of the current development of the world economy, and the role of states has been declining. Economic decision making has been devolving downwards to sub national units. At the same time some part of this power has also moved upwards to multiregional organizations (like the EU) due to formal integration[11].

According to customs union theory, the creation of customs union will lead to trade creation and trade diversion. Trade creation occurs when domestic production is replaced by importing from a cheaper member country. This means specialization according to comparative advantage. Trade diversion means that original imports from world markets are replaced by imports from a more expensive member country. This phenomenon leads to a move from efficient producers, to less efficient producers, causing welfare losses. For similar reasons it is not invariably in the interests of a particular multinational or country to promote regional integration if that would mean subjecting an established market to increased competition from new entrants.

Due to liberalization of trade, Krugman’s agglomeration economies are all relevant. Market-size effect in the core areas of the EU markets is remarkable. Demand linkages mean that the area from Milan in Italy to London in England is a preferred location for the production of high value-added service industries like financing. Some growth areas have a historical ground and have existed for a long time in certain growth poles like the ‘Third Italy’, Baden-Württemberg, and London-City. Regionally contemporary emerging economies of scale might be found in the new transition economies of Central and Eastern Europe. The development of these countries will depend on both internal as well as on external factors. There are new local, regional and supra-national location alternatives for firms to build up their competitive position and develop networks of relationships in the value chain. This can be done in order to reduce production costs, create distribution and logistics channels, outsourcing of non-core production and so forth.

The core-periphery model by Myrdal is dynamic. Paul Krugman (1995) has proposed increasing returns to scale (through backwash) and expansion to other nearby areas (through spread). Referring to Albert Hirschman[12], it is possible to claim that core cities grow through increasing returns (to knowledge), with the satellites of leading technology innovators’ spread by knowledge exploitation nearby. Urban ghettos are parts of the famous Silicon Valley production system as are the engineering laboratories at Stanford, or the military R&D facilities.[13] In the US, the main reason for the clustering around universities has been the availability of government-funded technology has been a catalyst of agglomeration economies in modern science-based industries. Today, universities and their related research laboratories spread throughout most regions in the US. Geographical proximity can be expected to serve the incubation of new technologies. As firms expand their competitive edges, their activities may move out of the region generating ‘spread’ of technological innovations globally.

According to Krugman[14], differences in economic development are the very least associated with location. Those countries that are located close to the equator tend to be poorer than those in colder temperate zones. Krugman has also found that per capita income within Europe seems to follow a downward gradient from the northwest corner of the continent. The Nordic countries are success stories of the EU and the global economy. How much this fact is dependent on geography is the key issue in application of cluster models. It is apparent that there are both large regional inequalities in development within countries and, often, a powerful tendency for populations to concentrate in a few densely populated regions. The problem of countries that are located close to the equator is not the tropical climates. It is more or less political history. These countries were colonies during the time from the 1880s to the 2000’s when the technological and commercial dominance of Northern Hemisphere regions, especially the US, the EU and Japan, was created.

The economic destinies of locations are not determined by location. Like Krugman points out small historical accidents can cause one country to become part of the industrial core or periphery with the site of a 10-million-person metropolitan nightmare. What is the pattern of evolution of countries and continents in the global economy is an interesting research question to tackle. Michael Porter presents a model to describe the different stages of competitive development that a nation’s industries move through. Porter (1990, 545-565) suggests four distinct stages of national competitive development:

1. Factor-driven

Practically, any of the internationalized or globalized industries have drawn their competitiveness from the basic factor conditions, such as low-cost labor and access to national resources. Firms typically produce commodities more than specialities. The rate of technology and R&D investments is low. The local economies are highly sensitive to fluctuations in commodity prices and exchange rates. There are only a few truly international firms. Domestic demand for exported goods is modest. The role of foreign firms is considerable, as they act as a channel for foreign markets and they bring foreign technology, knowledge and management with them to the host country. Technology is assimilated through imports, imitation, or foreign direct investment.

2. Investment-driven

In the investment-driven stage, countries develop their competitive advantages by improving their efficiency in producing standard products and services, which become increasingly sophisticated. While the advanced technology still comes mainly from abroad, with licensing and joint ventures, local firms’ invest in process technology and modernization of production facilities etc. Firms often produce under contract to foreign manufacturers that control marketing channels. Home demand is still rather undeveloped, and related and supporting industries are not functioning optimally. It is typical to this stage that wages and input prices are higher than before and employment is increasing. Public policy concentrates on long-term matters. One of the major areas are infrastructure projects. Harmonization of customs, taxation, and corporate law may allow the economy to integrate more fully with global markets.

3. Innovation-driven

In the innovation-driven stage, the number of industries operating successfully at international level increases and broadens. Firms create new technologies and methods and compete with low costs due to high productivity rather than low production factor costs. Home demand increases and becomes more sophisticated. Clusters are well developed, fostering innovation and technological change. A country's competitive advantage lies in its ability to produce innovative products and services at the global technology frontier using the most advanced methods. Institutions and incentives supporting innovation are crucial for further development. The economy becomes stronger against outer shocks, like cost shocks, because of its ability to compete with technology and product differentiation. Improvements related to externalities, market imperfections and incentives are important to develop the well-functioning factors, product and financial markets.

4. Wealth-driven

Unlike other stages the wealth-driven phase is driven by past accumulation of wealth and becomes unable to generate new wealth. Firms become more vulnerable to uncompetitiveness. They innovate less and the investment rate decreases. Employees begin to lose motivation and so on. The result is that firms lose competitive advantage compared with foreign firms and may even start to move their headquarters from their original home country to other countries. The standard of living and welfare is still rather high. The policy attempts in this stage try to increase the dynamism of the economy, innovations and profitability.

The first three stages involve successive upgrading of a nation’s competitive advantages and will be associated with progressively rising economic prosperity[15]. The wealth-driven stage leads to the decline of competitive advantages of a nation, because the driving force in the economy is the wealth already been achieved. An economy driven by past wealth cannot maintain its dynamism since the motivation of investors, managers, and individuals undermine sustained investment and innovation. The transition through the four stages is not automatic since countries may get stuck in a stage. In Africa investment-intensive economies such as South African republic are finding that their relatively high-cost labor make them vulnerable to competition from really lower-wage countries, especially China.

Porter believes that we can identify the predominant pattern of the competitive advantage model that a country, through its firms, poses at a particular time[16]. For instance, in the factor-driven stage, the competitive advantage in the production of either primary goods or labour-intensive goods is different from the investment-driven stage or from the innovation-driven stage. Thus, the transition from the factor-driven to the investment-driven stage generates outward investments towards lower-wage countries in labour-intensive manufacturing, particularly if the critical competitive edge happens to be organization of mass production. Similarly, the transition from the investment-driven to the innovation-driven stage brings about simultaneously inward investments in technology-intensive industries and outward investments in intermediate goods industries.

In the global economy, any country, if it is serious about raising its standard of living, must open its economy so as to avail itself of opportunities of trade, interact with and learn from the already advanced. Japan's rapid post-war structural transformation clearly demonstrates rapid evolution through different stages of Porter’s model[17]. From US viewpoint, Rugman[18] thanks Porter for the brilliant concept of the diamond, the identification of clusters and the four stages of economic development that are justified. What is the validity of Porter’s model of economic development is the major concern. The global economy is not only economic in its nature. These phases cannot be separated too accurately. However, they describe the main components to which a country's economic and industrial competitive development at certain stages is based on. These phases also reflect the sources of advantage of a nation's enterprises in international competition and the nature and extent of internationally successful industries. The growth firm in the EU is a major challenge to be tackled. In the global markets, the mix of relevant mobility barriers is, perhaps, different from that of the GATT period from the World War II to the year 1995.

In the new paradigm based on the emergence of knowledge economy the importance of access to and the use of knowledge increases. Globalization, on the other hand, means increasing competition and also emphasizes the importance of specialization and the use of local comparative advantages. The global economy has its dark side. Substituting labor with capital and technology, along with shifting production to lower-cost locations has resulted in waves of corporate downsizing throughout Europe and North America[19].



[1]The Law of Contiguity refers to the fact that things that occur in proximity to each other in time or space are readily associated.
[2] Centripetal forces tend to promote geographical concentration.
[3] Centrifugal forces tend to prevent geographical concentration.
[4] Myrdal, Gunnar (1957) Economic Theory & Underdeveloped Regions, London: Duckworth.
[5]Braudel, Fernand (1981) The Perspective of the World, NewYork, Harper & Row.
[6]The importance of geographic proximity is clearly shaped by the role played by the scientists who will live in the regions occupied by multinationals that are best buyers of the new, scientific knowledge. The triad of New York, London and Tokyo that dominate global financial services is an example of permanent clusters (Sassen, Saskia (1991) Global Cities: New York, London, Tokyo. Princeton: Princeton University Press).
[7] Regional clusters in Europe, Observatory of European SMEs 2002/ No. 3, European Commission.
[8]Krugman Paul (1998), What’s New About the New Economy Geography, Oxford Review of Economic Policy, Vol 14, No 2, pp. 7-17.
[9] Robson, Peter (1993) The New Regionalism and Developing Countries, Journal of Common Market Studies, Vol 31, No. 3.
[10] Balassa also makes a difference between certain types of integration, namely: 1. Trade integration, which means removing barriers, 2. Factor integration, which refers to liberalization of factor movements, 3. Policy integration consisting of harmonization of economic policies, and Total integration, i.e. complete unification of the policies of participating countries. (Balassa, Bela (1976) Types of Economic Integration, in Economic Integration: Worldwide, Regional, Sectoral (ed. Machlup, Fritz) The Macmillan Press Ltd. London.
[11]Strange, Susan (1996) The Withdrawal of State, Cambridge University Press. Cambridge.
[12] Hirschman, Albert (1958) The Strategy of Economic Development, New Haven, Yale University Press.
[13]Saxenian, Annalee (1994) Regional Advantage: Culture and Competition in Silicon Valley and Route 128, Cambridge: Harvard University Press.
[14] Krugman, Paul (1999) The Role of Geography in Development International, Regional Science Review, Vol. 22, No. 2, pp.142-161.
[15] This is exactly what happened in Finland since the 1880s until the 1990s.
[16]As mentioned earlier, the four distinct stages are: 1. factor-driven, 2. investment-driven, 3. innovation-driven, and 4. wealth-driven.
[17]Ozawa, Terutomo (1991) Japan in a new phase of multinationalism and industrial upgrading: functional integration of trade, growth and FDI, Journal of World Trade, 25 (February), pp. 43-60.
[18] Rugman, Alan (1991) Diamond in the Rough, Business Quarterly, Vol. 55, 1991, pp.61-64.
[19] Baily, Martin, Bartelsman, Eric, and Haltiwanger, John (1996) Downsizing and Productivity Growth: Myth or Reality? Small Business Economics, 8(4), pp. 259-278.