Chapter 5 – Demand

NOT in the exam: 5.2, 5.3.3, 5.3.4, 5.6 and 5.7.

All these sections will not be included in the exam.

Problem: What are the mechanisms through which demand can act as a driver of regional growth?

Starting from now on we will not discuss any more location theories but regional growth theories.
Theories try to explain how regions present a growth in economic activity.

How? By understanding the export-based model as well as its advantages and limitations.

Another problem is how to determine the economic base of each region. This is linked to
identifying the base sector of each region, and finally the location quotient.

We will try to predict an increase in demand in some sectors. What happens if demand grows in
one specific sector and if we put it on an input and output analysis?

Refresh of basic principles

1. Production side
a. GDP  Value of final goods and services produced in the economy in each period.
b. GDP  Sum of value added in the economy in each period. We remove the
intermediate goods, and we consider only the value added.
2. Income side
a. GDP  Sum of incomes in the whole economy in each time.
3. Components of production
a. C  Consumption of goods and services bought by consumers
b. I  Investment (productive/ Real estate)
c. G  Public expenditure in goods and services bought by the state (no transfers/
no interest in debt)
d. Q  Imports of goods and services from abroad.
e. X  Export (X-Q = net export or trade balance)
4. Z = Total demand for goods
a. National expenditure  Z=C+I+G
b. Total expenditure  Z=C+I+C-Q+X
c. Total expenditure  National expenditure if X-Q=0 (closed economy)

2 assumptions:

1. There is only one market and one good being sold.

2. Firms are infinitely elastic to increases in demand.
 5. Consumption:
a. Disposable income Yd=Y-T (T= taxes net of transfers)
b. C0  Survival rate: when the income is 0, the consumer will still consume that good to
survive.
c. C1  Marginal propensity to consume (effect of 1 additional Euro of available income
on consumption)
6. Equilibrium equation
a. D = S (Where D = Z and S = Y)
Y = Z = C0 + C1(Y-T) +I+G
Y (production) is equal to Z (demand). Demand depends on income which is equal
to production (Y).

 Solve the model!

Y=1/(1-C1) (C0-C1T+I+G)

1/(1-C1) = Multiplier (always >1)

(C0-C1T+I+G) = Autonomous expenditure (AE)

The relationship between income and production in a graph is a straight line with a slope of 1
(45°). All the points in income and production are the same.

Then, we draw the demand (Z) as a function of income on the same graph. The vertical intercept is
the AE. It is a straight line with a slope of C1 (which is lower than 1, so the slope is less steep than
the other one).

The equilibrium point A is where the demand is equal to the production for a given income level.
If we suppose a 1 billion increase of C0, the demand shifts up because of the effect of the
multiplier. The increase in income is greater than the initial increase of C0 because of the
multiplier. When C0 increases the demand increases by 1 billion. Therefore, there is a
corresponding increase in production of 1 billion. This generates a second increase in demand
equal to 1 billion multiplied by C1 (the marginal propensity to consume). This corresponds to an
equal increase in production (DE). The third increase in production generates a third increase in
income equals to C1 billion of euro*C1  C1*C1 billion of euro…

Following this logic (see the slides)

Production depends on demand, which depends on income which is equal to production.

Increase in demand  Increase in production and income.

Increase in income  Increase in demand  Increase in production  …

In the end, the result is an increase in production higher than the initial increase in demand by a
factor equal to the multiplier.

The magnitude of the multiplier is linked to the value of the propensity to consume. The higher
the propensity to consume the higher the multiplier.

Synthetic indicator: GROWTH of a region´s output.

Theories of regional growth

The most important element of this theory is that growth is driven by demand. Increased demand
for locally produced goods generates an increase in employment and income in the entire area
(interdependencies).

Uniform-abstract space.

- Supply conditions (factor endowment, social and productive structure)

- Demand conditions (consumer tastes and preferences)

Are identical everywhere.

Short-term period. There is nothing in the medium or long-term periods.

∆ GDP  Gross domestic product

How much an area can increase its production/ How much an area can grow.

ΔGDP  ΔE

If you want to produce more, you need more jobs.

Reasons behind ΔGDP?

 - Increased DEMAND (MIX effect)
- Δ Demand  ΔGDP  The advantages go to the specialized regions

Increased demand (mix effect)

Consumers are located worldwide, not only in local demand.

According to their factor endowment, different regions might specialize in certain economic
activities. (goods or services)

Regions or cities rarely produce everything they need.

1. Not all the necessary goods are produced locally.

2. Locally produced goods exceed the local demand for those goods.

 Specialization is the key to trade.

 LOCATION QUOTIENT

If I don´t have the capital to produce more, resources available, the price of the goods increases
but the supply remains fixed. This is NOT true in the model that we are about to see because we
assume that production factors are always available.

Basic principle

Not all the economic activities within a region are produced for local consumption. Part of the
production goes to exports. The volume of production is more than what is needed by the local
population. We can divide the activities into city funding activities and city filling activities (services
that serve the funding activities of the region or for the population).

From this perspective, the model tries to forecast the future trajectory of regional and urban
development. These models present a clear macroeconomic origin because the region is seen as a
productive machine, as a macroeconomic system that differs from large countries simply by its
degree of openness.
The funding activities (base/specialization) become the engine of the regional dynamics. The two
models that we will see:

1. Hoyt´s model
2. Export-led model.

Hoyt´s model

He developed a model that tries to forecast the urban housing needs in the USA.

His logic started from the division of the total employment into employment in the base sector
and employment in all the other sectors.

Et=Eb+Es

- Et = Total employment
- Eb = Base sector employment (exogenous to this model = given)
- Es = Employment in the other sectors
Es = aEt 0 <a< 1 (a share of the total employment)

If the employment in the base sector increases, the total employment increases more than
proportionally because of the effect of the multiplier (see step-by-step on the slides).

P=bEt b>1

P=population

When a person moves to an area to work, he/she takes the family with them. If we substitute Et
with the past formula from the slides:

P=b/(1-a) *Eb

ΔP= b/(1-a) *ΔEb

We know how many new houses we need.

Logic of the model:

External demand increases employment in the base sector, which leads to an increase in the total
employment income, which increases the population, which increases the employment in services
(consumption) which finally increases the total employment income.
Export-led model.

Transferred the past model into macroeconomic variables.

Developed by 2 American economists in 1955. The most famous economist was Norths (also called
Norths Moder). It tries to explain what happens after an increase in demand.

We start from the identity that:

Aggregate demand = Aggregate production

- Yr= Cr + Ir + Gr + Xr – Mr

The r is because we calculate this for a specific region.

If we mode imports to the left side, we have:

- Yr + Mr = Cr + Ir + Gr + Xr

This time we are dealing with an open economy. We consider that both import and export exist.
Regional exports are exogenous (given). No variation of X is explained by this model.

Xr = Given

Private consumption is endogenous:

Cr = cYr  Function of income. As income increases, private consumption increases. (if we have
more money, we buy more goods and services).

0<c<1

c: propensity to consume.

We do not consider I and G because we try to simplify it.

M is also endogenous:

Mr=mYr  Imports are a function of income. As income increases, imports increase as well.

0<m<1

m<c

Yr=1/(1-c+m) *Xr

- 1/(1-c+m) = Consumption multiplier

- If we increase exports, production, and income increase more than proportionally.
- There is an increase in demand, which generates an increase in exports, which increases
the income to a higher level than the initial increase in demand.
The region grows if it can export its goods because the income and production increase more than
the original increase in exports.

Specialization is important BUT DANGEROUS

Limits:

- A-spatial nature adapted from macro-economic to local contexts.

- No treatment of the supply structure/ no obstacles to a supply expansion (MAIN LIMIT OF
THIS THEORY)
- The theory is not concerned with processes of convergence or divergence among regions,
and therefore with relative growth.
- No explanation on how to increase the exports.
- Unable to define the determinants of growth. Exports growth is NOT a result of the model.
- No distinction among different productive activities or different industrial specializations.
- Multipliers are considered stable over  It is impossible to use the model for long-run
analyses, no structural changes are possible.
- Ignores the roles of services sectors in an area´s growth. The level and quality of local
financial, managerial, marketing, and technological services largely determine the long-
term competitiveness of base sectors.

Input-output analysis.

Based on Leontief, 1953. Define the interdependencies within sectors. If the demand increases in a
specific sector, the whole economy will be influenced, not only by the growth of that specific
sector.

Sum by row (revenues obtained by each sector)

Sum by column (Costs of production)

SEE THE SLIDES

How many euros of product from sector “i” are needed to produce one euro from sector “j”?

 We can calculate the value of the production of each sector I activated directly
and indirectly by one euro of final demand addressed to each sector j.

Ri=∑ bij Di
j

Multiplier matrix: allows you to calculate the value of production of each sector I activated directly
and indirectly by one euro of final demand addressed to each sector j.

The multiplier seen in North's model can be disaggregated into a set nxn of multipliers, relating to
each producing sector and each good demanded.

Example

Torino – Automotive Sector

Advantages and disadvantages of being specialized in one sector.

Useful for the report as an example of what could be used to begin if my area is very specialized in
one sector. Review the history of specialization of my region.

Torino specializes in the automotive sector because Fiat is located there, and it employs many
people in the area.

Employment in the sector:

- 1971  60 000 employees

- 1988  36 000 employees
- 2001  25 000 employees
- 2014  19 000 employees
- 2022  11 835 employees

Production:

- 60s/70s  1 million cars per year

- 2006  216 000
- 2019  22 000
- 2023  80 000

Fewer and fewer cars are produced, and firms supplying the Mirafiori plant are suffering from the
crisis (bankruptcies/unemployment benefits/poor prospects for workers). This harmed not only
the employees in that specific plant but also all the spinoffs that the company was generating. The
supplying firms suffer from bankruptcy and there are very poor prospects for the workers. The
companies that depended on the plant in Turin were open where the fiat needed products. Now
that the company produces fewer cars, these supplying companies are no longer needed.
Mirafiori's three thousand employees will be on layoffs until May, and already months ago
Stellantis had reduced or eliminated orders from companies supplying seats, roofs, air filters, oil
filters, and hundreds of other components. This is what in the industry is called spin-offs.

Spin-offs = For one sector we have many spin-off activities that gravitate around the base sector.
When something happens to the base one, something happens to the spin-off activities.

… Read the slides …

Possible solutions:

- Encourage the arrival of a new producer in Italy

- New industrial policy, support for related companies able to innovate (not just incentives
for the purchase of cars: unable to contribute to reviving the system without a precise
vision)
- Creation of new centers of excellence (electric vehicles)
- Assignment of new car models to Mirafiori
- Hiring of young workers Integration of components for electric and hydrogen cars
- Strengthening of research and development

"The relaunch of Turin starts from Mirafiori"

Specialization was dangerous because after a process of outsourcing and strategic decisions
that led to some problems for Turin, that specific specialization was so important that the
workforce in that sector was very difficult to relocate to another sector.

This represents the limits that we showed today:

- They neglect supply elements such as:

o Quality of production factors
o Intersectoral synergies and agglomeration economies
o Technical progress and innovative capabilities

 true elements on which competitiveness is based, and therefore ultimately

the long-term development capacity of an area.

In the long term, the ability to replace new productions with those that may be declining is
important, as well as the ability to continuously innovate the product and relaunch the
international competitiveness of the region. RESEARCH AND DEVELOPMENT IN THE AREA ARE
MANDATORY TO HAVE THIS CAPACITY TO RELAUNCH THE SECTOR IN THE REGION.