Is New Economic Geography (or Krugman) right….

 

Jessie H. Handbury and David E. Weinstein of Columbia University have this superb paper.

Crux of New Economic Geography (or NEG) developed by Krugman is:

Economies of scale may lead to rapid urbanization. Since 2007, for the first time in history, more than half of the world’s population live in cities. Paul Krugman has shown how economies of scale along with falling transportation costs can trigger a self-reinforcing process whereby a growing urban population gives rise to more large-scale production, higher real wages and a more diversified supply of goods. This, in turn, stimulates further migration to cities. The end result may well be that regions become divided into an urbanized core and a less developed “periphery”.

This paper looks at this issue of whether larger cities lead to higher varieties and lower costs:

In awarding Paul Krugman the Nobel Prize in economics for his work for international trade and economic geography, the committee characterized his contribution to economic geography as follows: “The new economic geography initiated by Krugman broke with … tradition by assuming internal economies of scale and imperfect competition. Agglomeration is then driven by pecuniary externalities mediated through market prices as a large market allows greater product variety and lower costs [emphasis in original].”

It is interesting to note, however, that, despite this award, there have been no tests of whether larger markets actually do have greater product variety and whether differences in the number of available varieties are sufficient to lower costs. This paper is the first to fill this gap by testing empirically whether large markets are actually characterized by lower prices of traded goods, and more importantly, whether this, in conjunction with greater product variety lowers costs for consumers. In other words, is the fundamental mechanism underlying new economic geography models correct?

The paper says yes both NEG and Krugman are right. Larger cities lead to lower costs and more varieties. The prices of houses go up as more people come in but prices of goods comes down once we look at the increase in varieties:

Consistent with earlier analyses, we show that the price index for identical goods rises with city size. However, we also demonstrate that if one controls for the household making the purchase and the amenities of the store in which the purchase is made this result is not robust. In fact, we find that prices for the same good purchased are actually lower in larger cities once we control for these forces. This is the first empirical confirmation of Krugman’s conjecture about how the prices of traded goods vary with city size. Moreover, if we control for the fact that prices in larger cities embody land prices, we find that prices net of land costs are even more negatively correlated with city size as Helpman (1998) hypothesized.

Second, our study is the first to document that the variety of traded goods available for consumption is substantially higher in larger cities. The elasticity of the number of products with respect to city size is a whopping 0.2-0.3 (depending on the specification) which means that there is enormous variation in the number of available varieties across cities. For example, residents of New York (population 9.3 million) can choose between 97,000 different types of groceries, whereas residents of Des Moines (population 456,000) only have access to 32,000 varieties. This greater availability of varieties in larger cities means that variety-adjusted costs are likely to be substantially lower in large cities, as NEG models predict, setting the stage for our econometric exercise seeking to quantify the importance of the availability of varieties for welfare.

Our results show that, while the prices of identical goods are higher in larger cities, the variety effect more than offsets this price effect resulting in similar variety-adjusted costs across cities. Since the prices of identical goods are lower in larger cities when we control for purchaser characteristics, the variety-adjusted costs are substantially lower for a consumer in a large city than for a consumer sharing the same characteristics in a small city. For example, a household that moved from Des Moines to New York and purchased goods from the same type of stores in the same types of neighborhoods in the two cities would realize a 9 percent drop in the overall cost of its grocery purchases. This suggests that the price effects hypothesized by Krugman are indeed important.  

Hmmm… This never really struck me… The paper also points to earlier research on NEG as well.

One often cribs how costly India’s metros are compared to other towns. The above paper turns the whole thing upside down. Surely one gets more varieties in metros compared to smaller cities. Would adjusting for this high variety lead to lower grocery inflation in India’s metros as well?

Here one would have to see whether Indian people opt for varieties as well like seen in US.

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