Chapter 2
REGIONAL MODELS OF INCOME DETERMINATION: SIMPLE ECONOMIC-BASE THEORY


2.1 Economic-base concepts

Economic-base concepts originated with the need to predict the effects of new economic activity on cities and regions. Say a new plant is located in our city. It directly employs a certain number of people. In a market economy these employees depend on others to provide food, housing, clothing, education, protection and other requirements of the good life. The question which city planners and economists need to answer, then, is "what are the indirect effects of this new activity on employment and income in the community?" With these estimates in hand, we can work toward planning the social infrastructure needed to support all of these people.

Economic-base models focus on the demand side of the economy. They ignore the supply side, or the productive nature of investment, and are thus short-run in approach. In their modern form, they are in the tradition of Keynesian macroeconomics. In an introductory economics course, we might start with a simple model of a closed economy, usually with some unemployment. In regional economics we deal with an open economy with a highly elastic supply of labor.

It is appropriate to start this chapter first with a look at the place of economic-base theory in the history of economic thought and then with a review the simple Keynesian model and the elementary economic-base models. We will then look at methods of estimating the values of multipliers.

2.1.1 Antecedents

It is common to divide economies into two parts. In action, it's us against them; in primitive life, it is hunters and gatherers; in analysis, it will be primary against secondary, productive and nonproductive, basic and nonbasic, export and support, fillers and builders, productive and sterile workers, necessary and surplus labor, etc. The following notes trace obvious antecedents.(1)

Mercantilistic thought is a prime example. During the period in which the mercantilists were dominant, normally considered to be from 1500 to 1776, the nation-states of Europe were consolidating their power and gaining strength to resist or conquer others. The writers who documented the times emphasized a philosophy not unlike that of a modern merchant or chamber of commerce.

The mercantilists stressed accumulating a supply of gold with which to pursue the nation's political and military objectives. The economic base of a nation included the sectors which created a favorable balance of trade. Goods were produced for export despite the needs of a poor population, export of unprocessed materials was prohibited, shipping in local bottoms was forced whenever possible, and colonies were exploited as a source of raw materials.

Thomas Mun, a merchant in the Italian and Near Eastern trade and a director of the East India Company, was probably the most famous of these writers. His exposition of mercantilist doctrine in England's Treasure by Foreign Trade, written in 1630, explained how "... to enrich the kingdom and to encrease our Treasure." He emphasized a surplus of exports as the key

Although a Kingdom may be enriched by gifts received, or by purchase taken from some other Nations, yet these are things uncertain and of small consideration when they happen. The ordinary means therefore to encrease our wealth and treasure is by Forraign Trade, wherein wee must ever observe this rule; to sell more to strangers yearly than wee consume of theirs in value.(from Oser 1963 p.14)

The Physiocrats, led by François Quesnay and briefly prominent in France in the second half of the 18th century prior to the French Revolution, responded to the excesses of the mercantilists with several points important to later thought. They considered society subject to the laws of nature and opposed governmental interference beyond protection of life, property, and freedom of contract. They opposed all feudal, mercantilist, and government restrictions. "Laissez faire, laissez passer," the theme phrase for the free enterprise system, is from the Physiocrats. They opposed luxury goods as interfering with the accumulation of capital.

But, for our purposes, they were precursors of economic-base thought in two ways. First, they were important in their treatment of the sources of value. To the Physiocrats, only agriculture was productive. The soil yielded all value; manufacturing, trade, and the professions were sterile, simply passing value on to consumers. This classification of productive and sterile activities is similar to the basic and service classification in economic-base discussions.

And second, the Physiocrats visualized money flowing through the economic system in much the same way as blood flows through the living body. Quesnay's tableau economique was a predecessor of the circular-flow diagrams popularized in Keynesian macroeconomics.

Adam Smith, writing in 1776, and heavily influenced by these French authors, took a less extreme but nevertheless strong position. He emphasized production of material or tangible goods and considered service and government as unproductive.

Karl Marx, in das Kapital, also divided the economy into two parts. To Marx, necessary labor was the source of wealth and was paid for with a wage barely sufficient to maintain its provider. Surplus labor was also provided by workers but its value was appropriated by the capitalists in the form of surplus value. Workers had to produce not only what they consumed but also a surplus for the capitalist. Menial servants, landlords, the Church, and commercial activities were unproductive - they added nothing to total value.

Others of the nineteenth century were more generous. Jean Baptiste Say in his Treatise on Political Economy (1803) popularized Adam Smith in France. Say's famous Law of Markets, paraphrased as "supply creates its own demand," required that all work be productive, that all compensated activity creates utility.

Nevertheless, we can see a strong line of thought dividing economic activities into two parts, and we can see economic-base concepts as fitting into a centuries-old pattern.

2.1.2 Modern origins

Modern literature on the economic base has been voluminous, but plagued occasionally by scholastic sloppiness in appropriate citations.

It seems that Werner Sombart, a German economic geographer writing in the early part of this century, should receive major credit for modern concepts.(2)

Sombart was responsible for the distinction between "town fillers" and "town builders," ("Städtegründer" and "Städtefüller") which appeared in Frederick Nussbaum's A History of the Economic Institutions of Modern Europe (with full permission). But in a series of articles in the early 1950's, Richard B. Andrews quoted extensively from Nussbaum without mentioning the fact that Nussbaum had based his book on Sombart's work. Andrew's work was widely circulated and became the standard reference.

2.2 The structure of macroeconomic models

It is convenient to begin with a review of the basic elements of model building. We can start with the simplest of all macroeconomic models, the Keynesian model of a closed economy. This model is presented algebraically in Illustration 2.1 and follows the standard format we will use in all of our models: we outline definitions, behavioral or technical assumptions, equilibrium conditions, and finally the solution. Since this is a process we will follow with each new model considered, it may be worthwhile to review the nature of these model elements.


Illustration 2.1 The simple Keynesian model

Definitions or identities:
Planned Expenditures Consumption + Investment (Planned sources of income)
(1) E C + I
Actual Income (output) Consumption + Savings (Actual disposition of income)
(2) Y C + S
Behavioral or technical assumptions:
Consumption = A linear function of income (Both planned and actual)
(3) C = a + cY (c < 1 = the marginal propensity to consume)
Investment = Planned investment (an exogenously determined value)
(4) I = I'
Equilibrium condition:
Income = Expenditures, or actual income is equal planned expenditures
(5) Y = E
or, with C + I = C + S, we can subtract C from both sides to form an equivalent equilibrium condition:
Drains = Additions
(6) I = S
Solution by substitution:

Y = C + I Substitute (1) into (5)

Y = a + cY + I' Substitute (3) and (4)

Y - cY = a + I' Gather the Y, or income, terms

(1 - c)Y = a + I' Factor out Y

Y = {1/[1 - c]}*(a + I') Isolate Y through division
The simple Keynesian investment multiplier is:

dY/dI = 1/[1 - c]


A definition is a statement of fact. By definition, it is always true. In mathematics, the proper term is identity. One of the more important identities in macroeconomics is the national income identity: realized national income (actual expenditures) is the sum of realized consumption and realized investment. In the simple national model, this has to be a true statement--it is a tautology. Actual expenditures have to equal their sum!

Another important identity in the simple model is that income (which is another term for 'output') is equal to the sum of consumption and savings. We, as recipients of incomes, either spend our incomes or we save (don't spend). This identity can also be taken as a definition of saving as the difference between income and consumption.

Behavioral assumptions are equations describing the behavior of certain groups, or actors, in the economy. In this case, the key behavioral relationship is the consumption function, which postulates consumption as dependent on, or caused by, income:

C = f(Y)

which in its linear form may be expressed as:
C = a +cY

where a represents autonomous consumption and c is the marginal propensity to consume (dC/dY). The parameters of the equation are a and c. Recall that if a>0, dC/dY<C/Y. An incidental but important result of this assumption is that saving is also a function of income:

S Y - C = -a + (1 - c)Y

The other important behavioral assumption in this simple model is that investment, I, is determined outside the system. It is planned. In terms common to model building, it is an exogenous variable in contrast to consumption, which is determined endogenously (that is, 'within the system').

(An example of a technical assumption is the production function. A production function describes the relations between inputs and outputs. A familiar example is Q=F(K,L), commonly used to describe how capital and labor are combined to produce output.)

Equilibrium is a condition in which the expectations (plans) of decision-makers (actors) in the system are met. In this simple model, the equilibrium condition is that income equals planned
expenditures, or, what is the same thing, that saving (which sets the limits on actual investment) equals planned investment.

The point is that planned investment and saving do not have to be equal (even though in the end, actual saving has to equal actual investment--this is a fundamental principle of accounting). When they are equal, then all parties are satisfied. When they are not, forces are at play which will take income to a lower or higher level, bringing saving into equality with planned investment.

Good introductions to the art of model-building can be found in several readily available books (e.g. Bowers and Baird 1971; Kogiku 1968; Neal and Shone 1976). The simple Keynesian model is outlined in almost all texts on the Principles of Economics. A good reference is (Case and Fair 1994).

2.3 The "strawman" export-base model

It is common in economics to construct a "strawman" against which to rail and argue. Nowhere is this practice more common than in the regional literature. The "export-base" model, in which the sole determinant of economic growth is exports, is often built to represent the arguments of other practitioners. However, you can seldom find an "export-base" theorist who is not also an "economic-base" theorist who admits to many other determinants of growth than exports alone.

Now let us construct this strawman and see how a pure export-base stance is untenable. We move into an open economy and make exports the sole exogenous factor. If any autonomous expenditure is included (the easiest is for consumption), then regional income can exist even when exports are zero (Ghali 1977).

The model differs only slightly from the simple Keynesian model. With Keynes, the key leakage was savings. He explained the underemployment of a depressed economy as resulting when planned investment fell below full-employment equilibrium levels due to a lack of confidence in investment markets. His endogenous variable was consumption, through which most income flows occurred--the flows became disconnected in the saving-investment path.

In the export-base model, the endogenous flow remains consumption, redefined now as "domestic expenditures." We completely ignore saving and hide investment expenditures within domestic expenditures (we are concerned not about explaining depression in the whole economy but about explaining changes in regional income). The function of saving in creating a leakage from the economy is now assumed by imports, which is defined as a function of income. The function of investment is now assumed by exports, the driver of the export-based economy.


Illustration 2.2 The pure export-base model

Definitions or identities:

Total expenditures domestic production + exports (inflows) (1) E D + X
Income Domestic expenditures +Imports
(2) Y D + M, or D Y - M
Behavioral or technical assumptions:
Imports = a linear function of income
(3) M = mY (m<1,the marginal propensity to import)
Exports = an exogenously (outside-region) determined value
(4) X = X'
Equilibrium condition:
Income = Total expenditures
(5a) Y = E
or
Drains = Additions
(5b) M = X
Solution by substitution:
Y = Y - M + X Substitute (1) and (2) into (5a)
Y = Y - mY + X' Substitute (3), and (4)
Y - Y + mY = X' Gather the Y, or income, terms
mY = X' Factor out Y
Y = (1/m)*X' Isolate Y through division

The export-base multiplier is:
dY/dX = 1/m


This model obviously stresses openness and dependence of the region on events beyond its reach.

2.4 The typical economic-base model

To make the model slightly more realistic (or, rather, less simplistic!), saving and exogenously determined investment can be added back into the system. Illustration 2.3 includes these to develop an almost typical economic-base model. Only minor interpretive comments are required.


Illustration 2.3 The pure economic-base model

Definitions or identities:
Total expenditures Domestic production + Exports + Investment
(1) E D + X + I
Income Consumption + Saving
(2) Y C + S
Consumption Domestic expenditures + Imports
(3) C D + M, or D C - M
Behavioral or technical assumptions:
Consumption = a linear function of income
(4) C = cY (c = the marginal propensity to consume)
Imports = a linear function of income
(5) M = mY (m = the marginal propensity to import)
Exports = an exogenously (outside-region) determined value
(6) X = X'
Investment = an exogenously (outside-system) determined value
(7) I = I'
Equilibrium condition:
Income = Total expenditures
(8a) Y = E
or
Drains = Additions
(8b) M + S = X + I
Solution by substitution:
Y = C - M + X + I Substitute (1) and (3) into (8a)
Y = cY - mY + X' + I' Substitute (4), (5), (6) and (7)
Y - cY + mY = X' + I' Gather the Y, or income, terms
(1 - c + m)Y = X' + I' Factor out Y
Y = {1/[1 - (c - m)]}*(X' + I') Isolate Y through division
The economic-base and investment multipliers are:
dY/dX = 1/[1 - (c - m)], and dY/dI = 1/[1 - (c - m)]


The missing element is autonomous consumption (which appeared in the simple Keynesian model). Whether or not it is included seems to me to be a matter of personal preferences. On the one hand, it might be nice to be complete and consistent with the Keynesian model. In addition, it serves to warn us that the consumption function is probably curvilinear, originating at the origin and rising at a decreasing rate with respect to income. The marginal propensity to consume at the range of incomes over which we might work is less than the average propensity to consume. A positive autonomous consumption permits us to simulate this case.

On the other hand, we already have one exogenously determined nonexport variable, investment. The investment multiplier is identical to that which would be calculated for autonomous consumption--we have the results without the bother. While this is a logic which might reduce a model to pulp if pursued too rigorously, I have left autonomous consumption out of this illustration.

2.5 Techniques for calculating multiplier values

2.5.1 Comparison of planner's relationship and the economist's model

Concentrating purely on the practical need to develop an easy way to forecast community change, early planners developed economic-base ratios (T/B for the average ratio, and T/B for the marginal ratio, where the letters represent total (T) and basic (B) income or employment) by pure observation as rules of thumb. By 1952, economists (Hildebrand and Mace 1950) had developed export-base models in the same analytic framework as the Keynesian macroeconomists, with multipliers expressed as (1/(1-PCL), where PCL represents either the average propensity to consume locally produced goods (APCL) or the marginal propensity (MPCL). Could these approaches be equivalent? Yes. Charles M. Tiebout showed us how (Tiebout 1962). Tracing the metamorphosis for average propensities,

T/B = 1/(B/T) = 1/((T-NB)/T)) = 1/(1-NB/T) = 1/(1-APCL)

Here, the ratio of nonbasic activity to total activity (NB/T) is the equivalent of the average propensity to consume locally produced goods.

So, if we can obtain values of total and basic variables over a period of years, we can estimate marginal export-base multipliers by regressing the total on the basic values. With the regression line formulated as T = a +bB, the slope b is the marginal multiplier (T/B) for the region.

2.5.2 The survey method

Of course, the most straight-forward method is simply to ask businesses in the area to specify how much of their revenues is basic and to use their responses to accurately divide local business activities into basic and service components. In practice, this is seldom done.

The neglect of the survey approach is easy to explain. It is the most expensive and time- consuming of approaches. Questionnaires on sensitive issues such as revenues, employment, and markets are seldom answered freely; to obtain even a smattering of responses the study team must resort to personal interviews. And even then, the interviewers must be skilled and persuasive.
In addition, if the area is of any size, the survey would require careful planning. A canvass would be prohibitive and the sample must be carefully stratified and selected to represent the broad spectrum of activities represented in modern communities. Such care and expense would meet the test of rationality only if data collection were in the context of a much larger study. The limit to the value of a simple export-base ratio is fairly low, in the hundreds of dollars.

A final argument against this simple approach is that the survey would probably yield data for only one year, leading to calculation of an average multiplier when a marginal multiplier is the most appropriate.

2.5.3 The ad hoc assumption approach

The easiest and least expensive of methods is simply to rely on arbitrary assignment of activities to basic or nonbasic categories. This could be done by assignment of, say, employment or payrolls for entire industries into categories, or it could be accomplished with a little more finesse by estimating proportions of employment involved in basic activities.

Needless to say, the chance of errors is large even for experienced analysts, and the multiplier will again be an average one with limited use in analyzing the effect of change.

2.5.4 Location quotients

The location quotient is probably responsible for the long-life and continuing popularity and use of economic-base multipliers. These quotients provide a compelling and attractive method for estimating export employment (or income).

A location quotient is defined as the ratio

LQi = (ei/e)/(Ei/E),

where ei is area employment in industry i, e is total employment in the area, Ei is employment in the benchmark economy in industry i, and E is total employment in the benchmark economy. Normally, the "benchmark" economy is taken to be the nation as the closest available approximation to a self-sufficient economy.

Normally, the "benchmark" economy is taken to be the nation as the closest available approximation to a self-sufficient economy.

Assuming that the benchmark economy is self-sufficient, then a location quotient greater than one means that the area economy has more than enough employment in industry i to supply the region with its product. And a quotient less than one suggests that the area is deficient in industry i and must import its product if the area is to maintain normal consumption patterns.

Surplus or export employment in industry i can be computed by the formula

EXi= (1 - 1/LQi)*ei , LQi > 1,

which is easily shown to be the difference between actual industry employment in the area and the "necessary" employment in the area.

In fact, then, excess employment can be computed without reference to location quotients through this reduction of the formula:

EXi= ei - (Ei/E)*e

It is convenient to retain the initial formula as a reminder of the logic, and to compute location quotients as reminders of the strengths of exporting industries.

Now it is easy to estimate export employment for each industry in the area and to sum these estimates to yield a value for export employment for the area in some particular year. With this number and total employment, an average multiplier for the area can be computed. With a set of these values over 10-20 years, the more acceptable marginal multiplier can be estimated by simple regression.

While it is common to use employment as the primary basis for these calculations, other measures such as wages and salaries are just as appropriate. Indeed, wage data is more accessible electronically, especially on CD-ROM. County Business Patterns, a standard source of employment and payroll data, is available for years since 1986, two years per disk. In considerable detail, this is the best data for recent years, but skill with mainframe computers, tapes, and programming is required to gain access for earlier years. The Regional Economic Information System (REIS), updated on CD-ROM annually by the U.S. Department of Commerce with a two- year lag, includes a relatively aggregated 10-category employment series for the years 1969-96 as well as a more detailed earnings series for every county in the nation. This data makes earnings- based location quotients a snap, especially if historic estimates are desired.

Location quotients have been in use by regional analysts for over 40 years now, and have been commented on at length. We should look at the assumptions involved in their use as well as the advantages and disadvantages.

The literature records at least three specific assumptions: (1) that local and benchmark consumption patterns are the same, (2) that labor productivity is a constant across regions, and (3) that all local demands are met by local production whenever possible. The first assumption is not serious: not only can we not discern differences in consumption patterns without extraordinary expense but we can suspect that differences in production patterns are more important. Purchases of intermediate goods by producers differ for regions depending on industry mix. (It turns out that we can account for industry mix with input-output models, so this difference has been accounted for by the march of time.).

The constant-labor-productivity assumption is difficulty to avoid. Its impact can be ameliorated slightly through using earnings data, which can be assumed to reflect regional productivity variation through differences in wage rates. (This assumption could in turn be attacked if wages vary more by area cost-of-living than by productivity.)

The assumption that local demands are met first by local production is the more tenuous of the three. It is obviously not true, as any visit to a grocery or clothing store will attest. But it is common, and a better alternative is hard to come by.

In addition to the disadvantages accruing from these assumptions, another major fault is that the method is dependent on the degree of aggregation of the data, making comparisons among various studies of little value. To illustrate the problem, consider the food and kindred products industry in Atlanta. The location quotient computed for this broad industry should be less than one, and if excess employment were computed based on this classification, none would be credited to the food industry. But if the classification were more detailed, the soft-drink industry would show a large number of excess employees, since the headquarters of Coca-Cola is in the city.

The overpowering advantages of using location quotients are that the method is inexpensive and the exercise of computing excess employment may give the analyst an opportunity to gain insights of interest in themselves.

2.5.5 Minimum requirements

In the 1960's, when available computing technology favored frequent use of economic-base models, one of the alternatives to the use of location quotients was the minimum-requirements approach (Ullman and Dacey 1960). This variation involved a slight revision of the location- quotient formula to

EXi= ei - (Ei/E)min *e ,

where (Ei/E)min is the minimum employment proportion for industry i in cities of size similar to the subject city. You can readily see that we have substituted a varying benchmark employment proportion for a constant one:

LQi = (ei/e)/(Ei/E)min.

While still appearing in various forms in the literature, the method suffers from two major criticisms. One is that, if enough cities are included in the selected set, all regions will be exporting and none may be importing. The other is similar in that, if we use data defined in a fine level of detail (which seems an improvement, and was one in location-quotient estimates) we may reduce local needs to near zero and make almost all production for export (Pratt 1968).

At any rate, the method is not commonly used now. The location-quotient method remains the virtually sole survivor as a simple means of identifying export industries.

2.5.6 "Differential" multipliers: a multiple regression analysis

Another approach which has been used in estimating economic-base multipliers is to fit a multiple regression equation to regional data. The first of these studies arose in a study of the impact of military bases on Portsmouth, New Hampshire in 1968 by Weiss and Gooding (Weiss and Gooding 1968).

Simple economic-base models ignore the possibility that different industries may have different impacts on their community. The regression technique eliminates this simplifying assumption. Weiss and Gooding set up an equation

S = Q + b1 X1 + b2 X2 + b3 X3,

where S represents service employment, Q is a constant, and the X terms are, in order, private export employment, civilian employment at the Portsmouth Naval Shipyard, and employment at Pease Air Force Base.
With data fitted from 1955-64, their results were

S = -12905 + .78 X1 + .55 X2 + .35 X3
  (.31) (.23) (.14)

The multipliers are 1+ bi for each sector.

Weiss and Gooding used a mixture of assumption and location quotient methods in allocating export employment and assumed that the export sectors were independent and that workers in the export sectors demanded similar services.

This variation on economic-base modeling has not fallen into widespread use for several reasons: its flexibility (in number of exogenous sectors) is limited by the number of observations available, otherwise the coefficients may not be significant; determining the export content of industry employment remains a demanding chore; and with the rise of desktop computing, input-output models are better sources of industry-specific multipliers and are similar in cost.

2.6 Critique: advantages, disadvantages, praise, criticism

Economic-base models suffer from old age: they have been built by so many analysts with varying levels of quality and they have been criticized so often that little remains except the concept.

The indictment would include the following phrases:

Although castigated for decades, the economic-base model has survived as a very succinct expression of the power of demand in regional income determination. The most current, and perhaps the clearest and most complete, statement of its status is found in a recent review by Andrew J. Krikelas (1992), available from the Federal Reserve Bank of Atlanta or in .pdf format from the School of Economics Web site at Georgia Tech (http://www.econ.gatech.edu/faculty/schaffer/.)

2.7 Study questions

  1. Outline a simple export-base model and compare it with the simple Keynesian model of national income determination.
  2. Criticize the export-base model, then note its virtues.
  3. Justify classifying the minimum-requirements method for computing export-base multipliers as a special variation of the location-quotient method.
  4. Outline the methods commonly used in estimating export-base multipliers, noting their advantages and disadvantages.
  5. The "pure economic-base model" outlined in Illustration 2.3 does not include any reference to autonomous consumption. Assume that total expenditures include autonomous consumption expenditures, that the marginal propensities remain linear, and that imports are a linear function of total expenditures. Rebuild the "pure" model as a "typical" model under these assumptions. How has the multiplier changed?
  6. Collect data from an electronic source for available years and use location quotients to estimate export employment in a county.
  7. Construct the economic model on which the equation estimated to determine "differential multipliers" is based.
  8. Rebuild the models in Illustrations 0.1-3 with the equilibrium condition stated as "Drains = Additions."
  9. Build the economic model behind the estimating equation T = a - bB.
  10. Which should be the best, an average multiplier or a marginal multiplier?
  11. In Illustration 0.3, the alternative formulation of the equilibrium condition is M+S=X+I. Lay out the full model using these variables.
  12. Complete the exercise on the following page.

2.8:EXERCISE-Export-Base Multiplier Calculations

You are the planner/economist for a simple 3-industry community and need to produce a multiplier estimate for a report due this afternoon. Answer the following questions and do the calculations. State the formulas for the location quotient and export employment for an industry:

LQi =

EXi =

Data and calculations

  Employment Empl. proportions Location Export
Industry Local National Local National quotient employment
Year 1
1 10 80 ______ ______ ______ ______
2 4 20 ______ ______ ______ ______
3 2 60 ______ ______ ______ ______
Total 16 160 1.00 1.00    
 
Year 2
1 16 100 ______ ______ ______ ______
2 6 25 ______ ______ ______ ______
3 2 75 ______ ______ ______ ______
Total 24 200 1.00 1.00    

Multipliers

Concept In words In numbers Value
Average Multiplier, year 2= _______________= __________= __________=
marginal multiplier, years 1-2= _______________= __________= __________=


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