The Spatial Dimension of Economics Master in Economics Spring Semester 2009 Susana Peralta Lecture 2 Space in Economic Theory

Readings

1. *CMT 2 pages 2643

Why is space absent from economic theory

The usual paradigm of

price-taking agents

constant returns to scale production

is unable to deal with location in a satisfactory manner

If one supposes two locations and wants to have trade between the locations, i.e., choose prices such that trade occurs then the rms would rather be where they are not

Otherwise stated: there is no location equilibrium

Two examples

Suppose a world with two islands Two dierent situations

1. the location of a consumer and a rm, each in an island; the rm sells the good to the consumer who works for the rm

2. the location of a rm which serves the two islands (produces in one, serves both)

We are going to show that

1. the consumer would maximize her utility by moving to the island where the rm is located; the rm would maximize its prot by moving to the island where the consumer is located

2. the rm would maximize its prot by locating in the island where it is not

so that there is no location equilibrium the competitive paradigm cannot tell us a nice story about location! Staretts impossibility theorem (1978)

The consumer and the rm

the rm produces one unit of a given good, which it sells to the consumer

the consumer is also the worker of the rm

is the travel cost of the good and the consumer (the boat ticket)

p is the price at which the rm sells the good to the consumer

w is the wage that the rm pays to the consumer

rA is the land rent in island A

rB is the land rent in island B

both the consumer and the rm take prices as given

The consumer and the rm

we want to show that there is no location equilibrium

the way to proceed is to suppose that the consumer lives in A and the rm produces in B

and show that the consumer would rather live in B and the rm would rather live in A

The consumer

Total income living in A, given that the rm is in B

yA = w p rA = w p rA

Total income if she moves to B, given that the rm is in B

yB = w p rB = w p rB

The consumer saves the boat ticket to go to work (and pays a possibly dierent rent)

The consumer wants to stay in island A if and only if her income is greater in island A

y = yA yB = + (rB rA ) > 0

The rm

Total prot producing in B, given that the consumer is in A

B = p w rB

Total prot if it moves to A, given that the consumer is in A

A = p w rA

The rm saves the boat ticket to ship the good to where the consumer lives (and pays a possibly dierent rent)

The rm wants to stay in island B if and only if its prot is greater in B

= B A = (rB rA ) > 0

Location equilibrium?

We have a location equilibrium if both y > 0 and > 0

Now the consumer stays put if

y > 0 rB rA >

but then

= (rB rA ) < = 2 < 0

so that the rm wants to relocate

And if the rm wants to stay put, the consumer wants to relocate!

Location equilibrium?

Notice that if

prices (e.g. land rent) vary with the agents

land is not homogenous (e.g. the consumer enjoys a higher utility if she lives in one island)

then we may have an equilibrium!

Location of a rm serving two markets

the rm produces X litters of beer

the cost of producing the X liters of beer is C

there is an iceberg transportation cost

if the rm locates in A, it may sell a maximum of X in A, or a maximum of X/ , > 1 in B

the rm takes the price of beer in A (pA ) and B (pB ) as given

We are going to show that

if the rm locates in A, the prices p , p such that the rm wants to A B sell beer abroad are such that the rm prefers to relocate and move to B.

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Location of a rm serving two markets

Suppose the rm locates in A.

It decides how much beer to sell in A xA and B xB so as to maximise prot A (xA , xB ) = pA xA + pB xB C

subject to the production possibility constraint xA + xB = X

We may use this to rewrite prot as

A (xB ) = pA (X xB ) + pB xB C = pA X C + xB (pA + pB )

The rst order condition is dA (xB ) = pA + pB dxB

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Location of a rm serving two markets

One of the three following situations may arise

pA + pB < 0 the rm makes a loss by selling in B, hence x = X A and x = 0 B

pA +pB > 0 the rm makes a prot by selling in B, hence x = 0 A and x = X/ B

pA + pB = 0 the rm is indierent between selling in A or B, hence any x [0, X] and x [0, X/ ] can be the optimal choice B A of the rm.

Trade occurs only with prices respecting pA + pB 0 pA 1 pB

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Location of a rm serving two markets

In an equilibrium with trade the rm as prot of

A p A X C

What is the best the rm can do by moving to B taking prices as given?

The production frontier is x A + xB = X

and we may write its prot as

B = pA xA +pB xB C = pA xA +pB (X xA )C = pB X C +xA (pA pB )

From which

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dB pB dxA

<0

because > 1

Location of a rm serving two markets

It is optimal to set x = 0 and x = X and make a prot of A B

B = p B X C

Which is greater than the prot it makes in A

Indeed,

pB X C > pA X C

because

pA /pB =

1 <1

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Location of a rm serving two markets

Again, the rm would rather move to the other location

So that we cannot have a location equilibrium (with trade)

Again, if we allow for

price-setting

heterogenous space

then we might have an equilibrium!

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