Localization economies, product differentiation and sustainable regional economic development

Daisuke Nakamura
ICSEAD, The International Centre for the Study of East Asian Development, Kitakyushu

Abstract

The Japanese economy has been involved in a severe international cost competition,and the enhancement of regional economic activity may have significant roles. This paper will
reveal the impact of changes in product-differentiation strategies by regional economic activity
on the long-run sustainability of the domestic industries. The first part of the paper examines
recent changes of market conditions with the international cost competition. An alternativemodel is then introduced to established industrial location theory with the notion of spatiallyconstrained internal and external economies as well as the network of interregional transportationand communication. The final part explores the methodological connectivity of the alternativemodel framework with hypothetical scenarios.

The outcome is expected to show that thespatially-constrained internal economies of complexity or vertical integration may include
important elements for enhancing revenue increases and cost savings through the opportunity oflearning for the demand condition of the market by the upstream stages of production. Moreover,roles played by horizontal and lateral integrations in addition to external economies are alsoinvestigated.

JEL Classification: D83, L14, L23, O18, R58
Keywords: agglomeration economies, externality, product differentiation, sustainable economic
development

EXECUTIVE SUMMARY

The main part of the paper is summarized as follows.
Industries in developed nations are now involved in a severe international competition
with developing countries where significant cost-saving opportunities are available. Due tolower-price preferences of consumers, suppliers of these countries tend to replace their contracts
to foreign firms from the domestic producers. One of the biggest problems can be the hollowingout in particular industries. Parr et al., (2002) provided details of recent structural changes offirm and establishment.
In such circumstances, local areas may have more important role to enhance economic
force by value-added productions than the core area, since the core area already has excess
economies of agglomeration these are called urbanization diseconomies.

The value-added

productions are directly relevant to product differentiation of goods and services which can be analternative method to sustain from cost-saving market system of products. The theoreticalexpansions of the product differentiation are made with entry deterrence, which should refer toSchmalensee (1978), Gabszewicz and Thisse (1979) and Kawashima (1983).
The main concern of this paper is to examine roles played by vertical integration ininternal term as well as localization economies at local areas together with the network ofinterregional transportation and communication in external term.

Regarding agglomeration

economies, these can be divided into three parts; namely, the economies of scale, scope andcomplexity according to the categorization by Parr (2002). There, vertical integration may berelevant to spatially-constrained internal economies of complexity and localization economies areto spatially-constrained external economies of scale.
In this paper, the analysis initially investigates a processing stage model with respect torevenue maximization and cost minimization for producers under the condition whereinformation of the market is available or unavailable. The theory of information between amanager and a worker or a retail firm and a customer is examined as the principal-agent problem
in Varian (1992: 440-472) and Hart (1995). These are left as further extension of the analysis,
since the objective of this paper is to reveal the importance of market information for upstream
stages of processes which can be enhanced by vertical integration and localization economies.

The following conditions are assumed in the model framework. The producer selects thecombination of each input and output level. There is no fixed cost. The producer has thefollowing two choices. One is cost minimization processes P  1 and another is processesmaximizing market information that may not minimize cost P  0 . The processing cost can be
expressed as:Cx  P  c1x1  c2 x2 1     1  P  c1x1  c2 x2 1   (1)where P = a parameter ( P  0 or 1), ci = the unit input cost i  1,2 , xi = the amount of inputand  ,  = parameters ( 0      1 ). Since the cost minimization processes are assumed only
if P  1 ,c1x1  c2 x2 1     c1x1  c2 x2 1    .

(2)

If the producer has no information of the final market and solely knows prevailed goods which
are sold by a number of other producers, then P  1 and the cost minimized processing may be
selected. Here, the isoquant is defined as:q  q* x , x1 (3)This particular combination of inputs x1 and x2 satisfies the cost minimization of processing theproduct where the isoquant is tangent to the iso-cost line in Fig.1 .

If the producer has

information of the final market and knows that existing goods are under severe price competition,then P  0 and potential revenue maximized processing can be chosen.

Fig. 1 The isoquant and the iso-cost line

In the long run, the cost increase by P  0 can be set-off by innovation through changing
the shape of production function. In order to estimate an optimal production function, theproducer has to obtain more complete information of the market with forecasting expectedconsumer preferences for the relevant product.

Once the producer specifies the demandcondition, the production function can be controlled by technological externality with innovation
enhancing agglomeration economies in terms of scale and complexity. These economies enable
the producer to negotiate detailed examinations for further improvement of machinery to otherspecialized firms within the industry maximizing their spatial proximity. Also, agglomeration
economies allow firms to share specific knowledge and information of the relevant market. Suchefficient and cost-saving opportunities may reflect either to the form of production function or
factor cost curve. According to Meade (1952) and Scitovsky (1954), the former type relates tothe technological term of externality, while the latter is relevant to the pecuniary term ofexternality. For reasons of simplicity, the technological term of externality can be assumed toadd B in equation (3), referring to Nakamura (2007):q  qx , x1 , B (4)where B = an additional variable as spatially-constrained external economies. This variableenables the producer to process more quantity of output under the same condition of the iso-costline.
qx , x1 , B   qx , x1 (5)For the pecuniary term of externality, the direct impact can be observed by implicit
declines of input costs c1 and c2 within the set of 1  P  in equation (1).

If this type of

externality sufficiently works, the following condition may be achieved.

c1x1  c2 x2 1     c1x1  c2 x2 1   
where 0      1 .

(6)

Hence, fully utilization of market information with agglomeration

economies changes the condition (2) by shifting the isoquant from solid to dashed curve in Fig. 1.
This shift may have various patterns with respect to changes in the amount of two types of input

x1 and x2 .References in full paper
Gabszewicz, J. J. and Thisse, J. J. (1979) “Price competition, quality and income disparities,
Journal of Economic Theory, 20: 340-359
Hart, O. (1995) Firms, Contracts, and Financial Structure, Oxford University Press, Oxford
Kawashima, Y. (1983) “Product differentiation, prices, and market structure”, European
Economic Review, 22: 75-96
Meade, J. E. (1952) “External economies and diseconomies in a competitive situation”,
Economic Journal, 62/245: 54-67
Nakamura, D. (2007) “An integrated framework of market areas and supply areas: combining
market-area systems with supply-area systems” in REAL Discussion Paper, REAL 07-T-3:
Regional Economics Applications Laboratory, University of Illinois
Parr, J. B. (2002) “Missing elements in the analysis of agglomeration economies”, International
Regional Science Review, 25/2: 151-168
Parr, J. B., Hewings, G. J. D., Sohn, J. and Nazara, S. (2002) “Agglomeration and trade: someadditional perspectives”, Regional Studies, 36/6: 675-684
Schmalensee, R. (1978) “Entry deterrence in the ready-to-eat breakfast cereal industry”, Bell
Journal Economics, 9/2: 305-327
Scitovsky, T. (1954) “Two concepts of external economies”, Journal of Political Economy, 62/2:
143-151
Smith, A. (1776) The Wealth of Nations, Reprinted by Prometheus Books, New York, in 1991
Varian, H. R. (1992) Microeconomic Analysis, Third Edition, W. W. Norton & Company, Inc.,New York