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IV. Twin Market Failures?

Once established, such an assembler-supplier network should provide both cost-efficiency and near-customer-specific market niches for participating car companies, as well as a likely local economic boom. Yet the intra- and inter-regional dynamics make such a structure potentially difficult to initiate, through the skewing of both private and public incentives. The resulting twin set of market failures may thus slow the rooting and growth of the new industrial district, as well as distort the optimal pattern of private and public resource allocation. Justifications for planning intervention may thus emerge.

The potential returns to a region's economy of becoming the seedbed of both the core plant and the expanding web of supplier firms are considerable. Particularly given the high value-added character of this market segment, the inflow of export earnings and multiplied manufacturing employment could significantly influence even the most marginalized area's economic fortunes. Spillovers from such enterprises to the local (service and retail) sector are likely to be exceptionally large, given both the high-wage employment structure that develops and the reverberating needs for proximate service and retail outlets (Bartik, 1992). The spoils to the victor region would flow handsomely for several generations.

However, this benevolent cycle of core-to-supply network development requires a spark by some first-moving firm. The nature of this market segment necessitates that a minimal supplier network be established alongside the pioneer assembly plant. The first-mover thus must invest in the crucial supply cornerstones herself. Initial sunk costs are tremendous. Furthermore, such infant networks have very few of the anticipated scale and scope economies, which only develop in tandem with the overall growth of the regional assembler/supplier network. Note that if such a self-reinforcing pattern of growth indeed takes place, the eventual established web of suppliers will reduce the costs for all core followers.

This strategic interaction can be modeled in a game-theoretic framework. Pioneers must weigh the risky entry into a potentially innovative location, which will shoulder them with significant supplier network costs, which could also yield sizable profits. Yet other firms might also eventually consider probing the promise of the new district, shouldering the supplier burden while costlessly illuminating the true viability of the area for that initial entrepreneur. Each player thus needs to consider the strategic implications of their actions. The market failure develops in the divergence between private and social benefit-cost considerations.

A two-person non-cooperative game theory model can be helpful in understanding this critical first-mover decision, which is similar to the perspective used to analyze incentives in urban redevelopment (Weiler, 2000). Figure 3 summarizes an extensive form game, where each player makes a decision on whether to enter (E) the greenfield area. No entry (N) results in zero newprofits (and zero losses). If a first-mover enters and fails, losses -L will result. If a first mover enters and succeeds, the first period's (monopoly) profits will be M, based on the greenfield location's quasi-rents. Further profits will depend on further entry. If the first-mover remains alone, M will continue. Otherwise, competitive profit levels C will result for both entrants, reflecting both the advantages gained by the pioneer as well as the lower supplier investment by the follower. Note that similar profitability is a conservative assumption, given that the pioneer will still have shouldered the sunk costs of the core supplier network. This game is one of incomplete information, where a probability is assigned to the uncertainty regarding the potential for success in this district. In effect, this viability probability p makes the reality of imperfect information tractable (Harsanyi, 1968). For simplicity, risk-neutrality is assumed, which allows a comparison of expected values to determine entry. This assumption sets an optimistic benchmark for investment; any risk aversion would make entry even less likely in the face of an unknown viability.

FIGURE 3

FIGURE 3


Given the game's Subgame Perfect solution to Figure 3, the first mover will receive

[ p ( M + C ) ] + [ (1-p) (-L) ]

(1)

profits if she initially enters, derived from the monopoly then competitive profits she earns if the area is viable and the losses she incurs from non-viability. Both payoffs are weighted by the probability of viability. If she does not enter, she will receive

p C.

(2)

by virtue of her second-round entry following an alternative successful pioneer. So, the condition for entry is

[ p ( M + C ) ] + [ (1-p) (-L) ] > p C.

(3)

The solution is both simple and intuitive. A company will only establish a greenfield site if it perceives the probability of success to be

p > L / (M + L).

(4)

In other words, if L is considerably larger than the expected one-period (or short-term) monopoly profits, which seems both realistic and likely, no one will move first. Curious entrepreneurs are unwilling to shoulder the substantial pioneering risk burden, which parallels Weiler's (2000) findings in the case of inner-city redevelopment. Even if successful, they have to share many of the fruits of their experiment, including the supplier network.

However, while the crucial private spark may not exist, pioneering may still be socially desirable. Spillovers to followers due to the supplier network investment represent additional external social benefits in addition to those destined for the private investor. Using S to signify such spillovers, entry is socially desirable if

[ p ( M + S ) ] + [ (1-p) (-L) ] > 0.

(5)

Monopoly profits are social benefits, since innovative pioneering (like other new inventions) creates a market where none had existed before. However, since competitive profits are assumedly equal to the opportunity cost of capital, they are not included as a social benefit.

Social planners would therefore have a lower viability threshold,

p > L / (M+L+S),

(6)

than that of the private entrepreneur. While private investors may not be willing to risk investment unless the perceived probability of viability is relatively high, social planners would be willing to accept lower viability chances given the greater total social rewards with success. Note that introducing risk aversion would make potential pioneers even more reluctant relative to local governments, who can spread risk and downside losses.

From another perspective, if the scale of losses L occurs at a level above the acceptable private maximum but below the social planner's maximum threshold

[p/(1-p)] (M+S) > L > [p/(1-p)] M,

(7)

pioneering, while socially desirable, will not occur because of the vital entrepreneur's narrower focus on her own private risk and returns. In general, such private decisions will be more socially suboptimal with greater total spillovers (S).

While establishing whether potential social benefits outweigh total costs must be considered on a case-by-case basis, it is clear that private actors will not fully incorporate the overall social impact of their actions. Marginal private investments could nevertheless yield projects with considerable net social benefits. In sum, the private market may underprovide investment to a promising greenfield area. A potential pioneer may wait (eternally, in this game) for another private investor to test the potential district first. Property rights approaches to this problem, such as buying adjacent land in anticipation of possible future capital gains, are fraught with tremendous risk alongside an even greater initial capital outlay.

While Toyota's success indicates that greenfield sites can indeed be profitable even with the sizable peripheral supplier investment, situations that have less obvious a priori viability may be neglected. Public support may thus be justified in motivating pioneers to invest, mitigating the noted market failure and enhancing broader social welfare. However, clearing that pioneering hurdle by the justifiable support of the public sector is likely to amplify the second market failure. The spoils of winning the greenfield siting of a new auto production center, with both core manufacturers and their supplier network, could substantially bolster a regional economy's fortunes (Fujita & Hill, 1995). The regional multiplier, where a further regional boost is provided by new export dollars respent locally, is likely to be enhanced by precisely the nature of the desired intra-regional production cycle.

These rewards can be expected to spawn, and have in fact produced, effective bidding wars between previously cooperative regional neighbors, given the spoils that accrue to the victor. Interestingly, these infamous incentive packages rank low in a firm's appraisal of an area's desirability for greenfield investment (Hansen, 1993; Kieschnick, 1981). Firms know that they can, and do, generally force matching packages between competing regions (Jenn & Nourzad, 1995). In such a Bertrand-type price war, the final effect of the bidding process would logically shift all the potential economic rents to the firm, since those rents are the effective bonus that a region would inherit with a successful bid. The originally efficiency-justifiable inclusion of the public sector is likely to only worsen this situation, since public officials would include the net social spillovers to the community, and thus be willing to proffer public funds to attract the desired firm.

Forthcoming work by Ellis and Rogers (2000) shows that in a game-theoretic context such a situation turns local economic development into an inter-regional Prisoner's Dilemma. The application to the present greenfield scenario is particularly noteworthy. All regions would be better off cooperating by not entering into an inter-regional competition for the new plant and its satellites. However, since the individual region's incentive at that point is to proffer just a little extra incentive to win the contest, the cooperative solution quickly unravels into its suboptimal non-cooperative counterpart. As hypothesized above, such bidding is likely to degenerate into a Bertrand-type price war. The result of such a Bertrand game is that all of the potential regional private and public gains would be bid away, leaving the winning region bereft of its spoils even before the arrival of the prize.

In addition, global efficiency losses could result, since the bidding process might distort the location decision of the firm away from the most efficient production point. The short-run political benefits of acquiring a target industry rarely match the true longer-term stream of benefits. Political considerations are thus likely to skew proper assessment of benefits, which can themselves be difficult to determine accurately. Furthermore, officials rarely discount the inevitable additional costs of a new plant, such as congestion and infrastructural wear (Blair, 1991). Public sector efficiency itself could be lost as well, as the myopic focus on the prize industry shifts resources away from other public needs which may have greater merit based on opportunity costs.

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