Monday, July 06, 2009

Increasing returns revolution requires land markets

The June, 2009, American Economic Review includes Paul Krugman's "The Increasing Returns Revolution in Trade and Geography". He recalls the jibe that (without the explicit modeling of increasing returns) "economists believed that agglomeration takes place because of agglomeration economies."

Once increasing returns can be modeled, all pecuniary externalities can be included. But urban land markets also internalize what we used to call "technological externalities", those that ocurred without any transacting.

But these too are internalized via the land market (if there is one). There are no unrealized externalities inside a shopping mall because the owner maximizes rents by arranging (and leasing) spaces such that externalities are realized in ways that maximize total rents. Well functioning land markets can realize the same outcome.

In other words, the "new" geography only works in the presence of well functioning land markets.