True, false or uncertain? Justify your response to the following statements. Suppose that economic base of The City is experiencing a change in technology. Suppose that the dominant local industry, which produces something needed by all other local industries, used to display increasing returns to scale. The new technology reduces the average cost of production (given the current level of production) and displays constant returns to scale. a) Would this change in technology affect the equilibrium size of the city? b) Would the profit earned by local companies in other industries in equilibrium increase, decrease or stay the same because of the change in technology in the dominant industry?
The Correct Answer and Explanation is:
) True. The change in technology would affect the equilibrium size of the city.
b) The profit earned by local companies in other industries would decrease.
Explanation:
a) Effect on the equilibrium size of the city:
The equilibrium size of a city is influenced by agglomeration economies and the cost structure of its dominant industries. When the dominant industry exhibits increasing returns to scale, average costs fall as production increases, creating strong agglomeration effects. This tends to attract more firms and workers, leading to city growth.
If a new technology changes the dominant industry’s cost structure to one with constant returns to scale, the strong incentives for clustering diminish. The economic advantage of operating in a larger city becomes weaker. As a result, the agglomeration benefits that drove city expansion are reduced, and the city’s equilibrium size may shrink or at least stop growing. Thus, the statement is true — the change in technology affects the equilibrium size of the city.
b) Effect on profits of local companies in other industries:
When the dominant industry previously operated under increasing returns to scale, it likely provided cheaper and more efficient inputs to other local industries, enhancing their productivity and profitability.
However, with the shift to constant returns to scale, even though the average cost at the current level of production is lower (due to better technology), the industry no longer benefits from further reductions in cost as it grows. This limits the productivity spillovers to other local firms.
As a result, the support that other industries received from the dominant industry’s increasing efficiency weakens. Moreover, with reduced agglomeration effects, input costs or logistical advantages for local firms may decline, leading to lower profits in equilibrium. Therefore, profits in other industries are expected to decrease.
This reasoning assumes competitive markets and free entry, which would drive profits toward normal levels as cost advantages shrink.
