Robert W. Gilmer

English

Research Papers in Economics

Houston Business
A Perspective on the Houston Economy
Across the landscape of American cities, one
economic feature stands above the rest—many
industries locate most of their activity in a few cities.
Indeed, some industries are synonymous with their
chief city: financial services in New York, autos in
Detroit, entertainment in Hollywood and oil in
Houston.
Firms in the same industry cluster together pri-
marily to achieve economies that are internal to that
industry, economies that are often independent of
the city that is their home. For example, by attracting
many firms from the same industry, the city devel-
ops a pool of specialized labor specific to the
industry’s needs. This pool benefits workers as well
as businesses, as it expands the range of local job
opportunities. A similar argument holds for inter-
mediate goods suppliers, who develop greater local
expertise and specialization, as well as enjoy higher
capacity utilization, than firms outside the pool.
Finally, proximity eases the flow of information
through the industry, making it easier for firms to
keep track of new technology and the competition.
Cities may draw a cluster of similar firms for
other reasons as well as, such as the size of a large
city’s market, extensive local infrastructure, or urban
cultural and social amenities. Studies confirm that
productivity is higher for firms inside these clusters
than outside, and that economies generated inside
the industry—labor and supplier pools and informa-
tion flows—typically outweigh any advantages of-
fered by city size or specific urban amenities.
These clusters largely explain regional industrial
specialization, how cities form and where industries
locate. Once such clusters are in place, however, the
next important question concerns the growth of the
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Industries as City Builders:
What the Economist Knows
Does industrial
specialization
promote strong
regional growth, or is
local expansion better
served by industrial
diversity? Is city
growth accelerated by
the presence of highly
competitive local
industries or of large
local firms that wield
significant market
power? This article
briefly surveys several
economic theories
advanced to explain
the dynamics of
urban industrial
growth, as well as
recent efforts to test
the validity of these
theories.city over time. Does industrial specialization
promote strong regional growth, or is local
expansion better served by industrial diversity?
Is city growth accelerated by the presence of
highly competitive local industries or of large
local firms that wield significant market power?
This article briefly surveys several economic
theories advanced to explain the dynamics of
urban industrial growth, as well as recent efforts
to test the validity of these theories.
GROWTH AND KNOWLEDGE
A 1992 article by Edward Glaeser
1 and sev-
eral coauthors identified three theories of city
growth. These theories describe a city’s develop-
ment through time; all feature industry clusters
as a central element; and each has a special focus
on the transmission and sharing of information
within these clusters. New knowledge or inno-
vation must play a special role in any modern
theory of economic growth. Economic studies
that began in the 1950s found that new machin-
ery and factories put into service could account
for only a small part of past U.S. productivity
increases, measured by the growth of output
per hour. In place of capital, technological
change was moved to the forefront as the
primary force in economic growth and develop-
ment. In recent years, the pendulum has swung
back the other way, and recent studies now find
a larger role for additions of machinery and
equipment than before. However, one-third (and
perhaps more) of productivity growth still results
from additions to our stock of knowledge—to
technical innovation and the diffusion of these
ideas through the economy. This fact suggests
another perspective on clusters of firms; perhaps
firms are attracted to the fountainhead of indus-
try growth and profit and come together to share
ideas and innovations.
One way to think about city growth is to
apply the standard economic growth model, as
developed from the initial work of Joseph
Schumpeter and refined extensively by the mod-
ern economist. The key feature of Schumpeter’s
model is that firms that successfully invent and
innovate can achieve market power and mo-
nopoly profits. Adam Smith’s atomistic and per-
fectly competitive markets may provide allocative
efficiency, but they don’t offer the incentive
needed to take risks or engage in forward-
looking activities such as research. Monopoly or
market power may result in allocative ineffi-
ciency, but either is effective in rewarding the
risk-taker and innovator with large profits. In-
deed, a patent is nothing but the formation of a
legal monopoly, created under the law, to re-
ward inventive activity.
Thus, we must recognize a trade-off between
the allocative efficiency of perfect competition
and the need for large profits as a reward for risk-
takers who generate growth through innovation.
However, the existence of  such profits becomes
a target for others, inviting further inventive
activity to undermine and share monopoly prof-
its. As competitors adopt the new technology,
improve on the latest innovation or seek a new
technological path to the same end, they attack
market power and monopoly profits through
what Schumpeter called a “perennial gale of
creative destruction.” Profits disappear from the
individual firm’s point of view but do not really
disappear at all. The diffusion of the innovation
spreads its benefit throughout the economic
system, and we all see economic welfare rise
with no additional effort within the productive
system.
GROWTH IN CITIES
How does this theory apply to cities? It
suggests that market power and limited compe-
tition might be good for growth. Perhaps cities
with a few large firms, firms better able to
internalize and protect their innovations from
competitors, should see faster growth than other
far-flung companies in the same industry. The
presence of fewer firms limits the spillover of
proprietary knowledge through gossip or em-
ployees’ moving from company to company.
Harvard business professor Michael Porter
has popularized a different view in recent years.
2
Porter’s book colorfully documents small and
highly competitive clusters of firms as a global
phenomenon. Hundreds of firms cluster to-
gether under conditions of fierce competition;
Madison Avenue and advertising, Swiss pharma-
ceuticals and German cutlery provide examples.
Porter argues the key to growth is the pressure
to innovate, as any firm that fails to respond
quickly to innovations in the market simply
won’t survive. Competitors soon follow any new
technological lead and eliminate excess profits
and market power. City growth results from
constant competition among small local firms.
An alternative source of growth in these
competitive clusters is technological change thatworks against traditional assembly line methods
of production. As production moves toward
nonstandard output, we see the development
of many small and competitive subcontractors in
a production system that becomes vertically
disintegrated.
Hollywood and the film industry provide an
example, as assembly line sound stages gave
way 50 years ago to shooting movies on location
around the world. Despite closing its soundstages,
Hollywood has remained the heart of the movie
business. The studios have kept creative and
financial control of the industry but now rely on
hundreds of highly specialized contractors to
provide the inputs needed to make each movie.
No longer the place where almost all movies
were shot, Hollywood became an assembly
point for specialists, a place for face-to-face
meetings and keeping track of an evolving
decision-making network, and where studios
hire contractors and monitor their performance.
Thus, competitive clusters may result from the
development of any nonstandard product and
the flexible specialization among contractors
that follows. Many high-tech industries, and
even Houston’s oil service industry, can be
described this way.
The theories discussed so far favor industrial
specialization by cities, but there are also advo-
cates of industrial diversity as a key to city
growth. Historian Jane Jacobs has provided
dozens of concrete examples of how innovation
in one industry jumps to another, and how
diversity helps cities grow.
3 Economist Nathan
Rosenberg has been a persistent critic of
Schumpeter’s focus on big inventions at the
expense of small innovations that move across
industry lines.
4 In a well-known study of 19th
century machine tools, Rosenberg shows how
an invention from the firearms industry was
adopted, refined and advanced by other indus-
tries—embodied in sewing machines, clocks,
instruments, hardware, bicycles, locomotives
and automobiles. There are many common pro-
cesses among industries, what Rosenberg calls a
“technological convergence,” and innovation at
these convergence points will quickly cross
industry lines. Surely two of the fastest growing
industries in the United States today are such
convergent technologies—information process-
ing and telecommunications. Perhaps diversi-
fied cities provide the best mixing bowl for
innovation and growth.
IMPLICATIONS
Glaeser specifically tests these theories by
looking at employment growth rates from 1956
to 1987 among the six largest industries in each
of 170 U.S. metropolitan areas. Controlling for
differences such as wage rates and a Sun Belt
location, he asks if we find industries that grow
faster than their national counterparts in indus-
trially diversified or nondiversified cities, or in
cities that do or do not provide a competitive
local market for their core industry. The study
measures competition within industries by aver-
age establishment size. Glaeser finds statistically
significant results that favor faster growth in
cities that are industrially diversified and offer
local competition; the quantitative effect of di-
versity was small, however, while the effect of
competition on city growth was large. His focus
on large or mature industries creates a bias
against emerging industries (and early monopoly)
as a source of growth.
In a future issue of this newsletter, we will
look at implications for Houston and, more
specifically, at the oil industry as a city builder.
However, we know Houston is not industrially
diversified. A quick comparison of Houston with
other large U.S. cities (New York, Los Angeles,
Chicago or Atlanta) and regional cities (Dallas,
New Orleans, Oklahoma City or San Antonio)
shows it to be the least diversified in this group—
indeed, to be much less diversified than these
other cities. Oil, chemicals and construction
make Houston unique among large cities. Look-
ing at internal competition, large firms dominate
our industrial clusters in oil, construction and
transportation, and these clusters are not inter-
nally competitive in the sense Glaeser defined
and measured them. Outside these clusters,
however, Houston’s average establishment size
in manufacturing, finance, services and trade is
smaller than in diversified cities such as Dallas,
Atlanta or Chicago.
1 Edward L. Glaeser, Hedi D. Kallal, Jose A. Scheinkman and
Andrei Shleifer, “Growth in Cities,” Journal of Political
Economy 100 (1992, 6): 1126–1152.
2 Michael E. Porter, The Competitive Advantage of Nations
(New York: Free Press), 1990.
3 Jane Jacobs, Cities and the Wealth of Nations (New York:
Vintage), 1969.
4 Nathan Rosenberg, Perspectives on Technology (Armonk,
N.Y.: M.E. Sharpe), 1976.T he news on the Houston economy re-
mains upbeat, with encouraging numbers for
jobs, oil profits, telephone connections, new
houses and anything else that can be counted.
Moderate but healthy economic growth contin-
ues.
RETAIL AND AUTO SALES
Both September and October brought im-
proved retail sales activity, and retailer optimism
improved accordingly. Home goods and cloth-
ing have led recent sales and kept inventories
under control. Plans for the holiday season are
conservative, often flat compared with last year.
No one wants to guess too high and lose holiday
profits to excess inventory.
Auto sales were flat in September compared
with a year earlier, and October sales were
reported as being in line with seasonal expecta-
tions. The critical summer season was a success,
and sales for the first nine months of 1995 were
3 percent ahead of last year.
CRUDE OIL AND NATURAL GAS PRICES
     Crude oil prices have remained firmly be-
tween $17 and $18 for three months, and the
market is now looking ahead to the November
meeting of OPEC. Prices continued to firm
throughout October, however, with low inven-
tories of both crude oil and heating oil and with
the early arrival of cold weather in the Midwest.
     Natural gas prices continue their seasonal
upswing. Helped by early cold weather, spot
prices along the Gulf Coast have improved from
$1.60 in mid-September to $1.85 in late October.
Even without cold weather, however, natural
gas prices are now running ahead of prices at this
time in 1994.
     The market for oil services and machinery is
slightly weaker than a year ago, with domestic
activity slow onshore and Canadian activity
down sharply. Canadian drilling remains at his-
torically high levels, but there is limited pipeline
capacity to move new supplies to U.S. markets.
International drilling and strong activity in the
Gulf of Mexico continue to carry the market.
For more information, call Bill Gilmer at (713) 652-1546.
For a copy of this publication, write to
Bill Gilmer • Houston Branch • Federal Reserve Bank of Dallas
P.O. Box 2578 • Houston, Texas 77252
The views expressed are those of the author and do not necessarily reflect the positions
of the Federal Reserve Bank of Dallas or the Federal Reserve System.
Shortages of offshore equipment are growing
around the world, and offshore rigs and drill
ships are now in strong demand.
OIL PRODUCTS AND CHEMICALS
Refiners saw their margins weaken season-
ally, as the driving season ends and the heating
season has not yet arrived. Seasonal shutdowns
for maintenance reduced demand for crude and
kept product inventories low. Prices of gasoline
and heating oil were seasonally weak, although
low inventories and early cold weather quickly
pushed up the price of heating oil in late
October.
The chemical market continues to weaken,
with prices down for many products, shipments
falling in some product lines, and inventories
now too high. A Chinese embargo on petro-
chemical imports due to a shortage of foreign
exchange has hurt the market for propylene and
related products. Weaker domestic homebuilding
and auto production have hurt the market across
the board. Profits are down from the market
peak early this year but still are higher than at this
time last year.
REAL ESTATE AND CONSTRUCTION
Both new and used home sales have re-
sponded strongly to lower mortgage rates and a
growing job market. Sales of new homes this
summer were up 20 percent from a year earlier,
and starts were up about 12 percent. Used home
sales similarly surged over the summer, and the
sales pace stayed ahead of 1994 in September.
Low inventories in both markets should encour-
age builders to increase construction in coming
months.
Apartment construction has cooled off
slightly, reducing concerns about the number of
new units under construction getting ahead of
the market. Retail construction is expected to
remain strong. Some small contractors report
their once-healthy backlogs have slipped, but a
better homebuilding market should provide more
work in weeks ahead.
 
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Industries as city builders: what the economist knows

http://www.dallasfed.org/assets/documents/research/houston/1995/hb9507.pdf

Industries as city builders: what the economist knows

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