Being cheaper may not be an advantage at all in a dynamic, knowledge based economy
It’s axiomatic in the world of local economic development that the sure-fire way to stimulate growth is to make it as cheap and easy as possible to do business in your community. Area Development, a trade journal for industrial recruiters rates states every year. They’re clear about their criteria:
What’s it take to be recognized as a top state for doing business? . . . The overall cost of doing business is, of course, a primary consideration, one that encompasses a wide range of components, from real estate costs to utility rates to labor expenses.
So it’s a seeming paradox that some of the most expensive, highly regulated places are routinely the most entrepreneurial and innovative. Cities like New York and San Francisco have some of the most expensive rents, and their workers are highly paid. And yet, year in and year out, they generate many of the most creative and successful businesses.
In part, we suspect it’s because cities function as rigorous selection environments for businesses. By selection environment, we mean that the characteristics of the city systematically favor some kinds of enterprises and disadvantage others. If you have a low margin, low growth business that’s sensitive to land costs or worker wages, you’ll likely find that its cripplingly expensive to do business in a San Francisco or New York. The only businesses that can survive in such a location are the ones that are innovating quickly enough to be able to afford to be there. You need to be highly profitable, or on a plausible track to generate profits in order to pay the bills. Businesses that can’t meet those tests don’t start there, are more likely to fail, or will move away. The result is that surviving businesses are likely strong competitors.
As Frank Sinatra told us in the the famous refrain from New York, New York:
If I can make it there, I’ll make it anywhere
The tough competition for market share, recognition, capital and talent in these cities means that, disproportionately, the strongest business concepts and capable management teams move forward. The press of competition also forces firms move quickly, lest they be left behind.
The converse is also true: low cost locations may insulate businesses from the need to innovate. If rents are cheap, taxes are low, and labor is docile and low paid, there may be little reason to undertake the risk and expensive of new equipment investment, worker training, or research and development. Economists often speak of “the resource curse“–that an abundance of some valuable natural resource, like gold or oil, skews a local economy’s activity away from innovation and entrepreneurship. In a sense, cheap housing and low business costs can be a kind of resource curse.
There’s an additional factor as well: cheap housing tends to attract and retain low skilled workers. If you live in a place with low housing costs, you may find it too expensive to move to a place like New York and San Francisco–unless you have the kind of skills that will get you a job that pays enough to afford high rents. So workers may self-select as well–and as a result, employers in low cost housing markets will have a lower skilled labor force.
Selective factor disadvantages: What doesn’t kill you, makes you stronger
Economists tend to focus on the story of comparative advantage: that economies tend to grow and flourish in those industries to which their natural and human resources are most conducive, relative to other locations. But in some cases, as business strategist Michael Porter has pointed out, comparative disadvantages can prompt innovation.
What is not so obvious, however, is that selective disadvantages in the more basic factors can prod a company to innovate and upgrade—a disadvantage in a static model of competition can become an advantage in a dynamic one. When there is an ample supply of cheap raw materials or abundant labor, companies can simply rest on these advantages and often deploy them inefficiently. But when companies face a selective disadvantage, like high land costs, labor shortages, or the lack of local raw materials, they must innovate and upgrade to compete.
With a lack of coal and high cost electricity, Italian steelmakers were an absolute competitive disadvantage to British and German steelmakers. Their disadvantages forced them to innovate, and their highly efficient electric mini-mills made them a flexible, low cost producer.
The fact that some factor disadvantages can stimulate an adaptive response with an economic upside doesn’t mean that one should treat this observation as a universal rationalization for high business costs. The key word in Porter’s formulation is “selective.” That suggests that you need to look at business costs, and the business climate, in a more comprehensive and nuanced way than is presented in the usual index rankings compiled by Area Development and its ilk.
You can build a simple, static model of economic competition in which having the low cost always wins. But in a rapidly changing knowledge economy, the ability to continuously create new ideas, new products and new businesses is the key to success and being “dynamically efficient,” as Douglas North put it. Cities are the selection environment that gives rise to new businesses, and the cheapest location is unlikely to be the one that optimally selects robust competitors.