Adam Smith taught the world that mercantilism impoverished 18th-century nations by erecting barriers to trade and reducing opportunities for specialization and economic growth. Regulations that restrict urban development likewise reduce opportunities for innovation and specialization by limiting cities’ population size and density. Even as improvements in communications technology and falling transportation costs reduce the burden of distance, many industries still benefit from the geographical proximity of human beings that only dense development can provide. Removing land-use regulations will allow greater gains from trade as more people are allowed to live in important economic centers like New York City and Silicon Valley.
Cities facilitate innovation by placing people with diverse backgrounds and goals in close proximity. While Israel Kirzner’s research provided a comprehensive analysis of entrepreneurs in the market process and in economic growth, economists have not given sufficient attention to the geography of entrepreneurship. The settings in which entrepreneurs work – Sandy Ikeda’s “action space” – matters, and cities provide a crucial role as the action space for much of human innovation.
Silicon Valley is an urban action space where geographical proximity has made entrepreneurs more successful than they would have been without the inspiration they provided one another. The Homebrew Computer Club, a social group founded in 1975 for computer hobbyists, played a crucial role in the development of personal computers. The programmers, engineers, and inventors who attended those early meetings would go on to revolutionize computing thanks, in large part, to the information they gathered from swapping ideas, hardware, and skills from the other group members they encountered. The club began meeting in garages, parking lots, and university auditoriums, but it was only possible because these enthusiasts all worked for semiconductor companies that brought them to the same region of California.
Empirical evidence bears out the importance of cities in facilitating the space for entrepreneurship. A research group at the Santa Fe Institute headed by Luis Bettencourt and Geoffrey West has found that city size has increasing returns to scale for wealth creation and innovation. They find that city population size corresponds to wealth creation through a power law with an exponent of 1.2. Similarly, Ed Glaeser points out that Manhattanites’ hourly wages are 170% higher than the U.S. average, demonstrating the relationship between human density and productivity.
We can observe anecdotal examples of the aggregate statistics on urban productivity. In An Economist Gets Lunch, Tyler Cowen points out that one way to find great food is to find a neighborhood where there is stiff competition for a particular type of food. For example, Indian food in the East Village or Chinese food in Flushing is likely to be good because restaurants serving sub-par food will swiftly go out of business.
As David Schleicher explained here previously:
An important advantage of urbanization is market size. You can see this in all different markets. Restaurant rows are a great example of this. When you go to one of these rows where there are a lot of restaurants and bars, you have insurance that if one place you go is bad, you know you have other options nearby.
The forces of competition that are so visible in the restaurant world are at work in all industries where geography is important, leading business owners to serve customers better in major cities than they would in less competitive environments.
Chang-Tai Hsieh and Enrico Moretti have examined how regulations that prevent workers from living in high-productivity cities reduce economic output at the national level. New York, San Francisco, and San Jose are the three American cities with the highest labor productivity. Because housing supply is relatively inelastic–due to regulation–in these cities, this high labor productivity has resulted in higher wages and higher housing costs rather than through employment growth. The authors find that lowering the level of land-use regulation in these three cities to the level of regulation in the median US city would be expected to increase GDP by 9.5 percent. In other words, if the nation’s most productive cities could expand housing to accommodate more employment growth, average American wages could rise significantly.
In spite of the enormous costs of land-use regulation for economic growth, individuals who lobby in favor of land-use regulations are often rationally propping up their own land values. What is individually rational is collectively irrational. To put in perspective the estimated 9.5% increase in GDP that could result from land-use deregulation in San Francisco, San Jose, and New York City, that would translate to an average raise of nearly $5,000 per person per year. Every year that high-productivity cities prevent building and block out new residents, global standards of living suffer enormously.
Adam Smith created an enduring model of free trade that helped facilitate radical improvements in living standards starting in the early days of the industrial revolution and continuing today. Likewise, a closer examination of the economics of cities could greatly improve living standards. The arguments against free trade–domestic firms would suffer from competition, specific individuals may be harmed when consumers are given better alternatives–are similar to the arguments against liberalizing land-use regulation. Suburban homeowners are likely to see land values plummet in a more competitive housing market, but the nation-wide decrease in income and employment growth associated with zoning are too high a cost to allow housing mercantilism to persist any further into the 21st century.