The Motu Institute recently published new research into the urban productivity premium in New Zealand, or the degree to which firms and workers in big cities tend to produce more and earn higher wages. This is an essential issue for urban and transport policy as it gets to the heart of why we have cities. As we’ve discussed in the past, cities offer opportunities for better connections between firms, workers, and customers, leading to better economic outcomes. (Economists usually describe this as agglomeration economies.)
In the paper – with the enthralling title of “Urban productivity estimation with heterogeneous prices and labour” – researcher Dave Maré sets out to update and extend some of his previous work on the topic. His new research investigates two issues that might bias estimates of the urban productivity premium:
- Imperfect competition in small markets: Firms in large cities face more competition and hence will tend to have less market power (ie ability to jack up prices) than firms in small cities. This tends to result in low estimates of the urban productivity premium.
- “Sorting” of skilled workers into cities: People with higher skill levels – which could mean more education, more experience, or better ideas – tend to gravitate towards cities. (Similarly, cities tend to have different mixes of firms and industries.) Not controlling for this can result in a high estimate of the urban productivity premium.
Even after controlling for these factors, Maré finds evidence of a non-negligible productivity premium in Auckland. That is,
We document an urban labour productivity premium, with Auckland firms having labour productivity that is 17.9% higher than that of firms in other urban areas, and 17.0% higher than firms in rural areas. Some of this premium is due to the mix of industries in different cities. Auckland has a disproportionately high share of employment in industries that have above average labour productivity. Adjusting for this composition reveals a smaller, but still sizeable, premium of 13.5% relative to other urban areas, and 11.3% relative to firms in rural areas.
Here’s a chart showing how other parts of New Zealand compare to Auckland in terms of productivity, after controlling for industry mix, workers’ skill levels, imperfect competition, and a range of other factors like firm size. (This chart is based on the first column in Table 3 of the paper.) As you can see, firms in Auckland are more productive than firms in other parts of NZ, with Wellington (4.2% less productive) and Tauranga (9.4% less productive) being closest to Auckland.
It’s worth noting that Maré’s new estimates of Auckland’s productivity premium are considerably smaller than his previous ones. In a 2008 paper, he estimated that firms in Auckland were around 51% more productive than firms elsewhere in New Zealand. These are obviously very different numbers! But, as explained in an appendix, the majority of the differences are due to different procedures regarding data selection and processing.
Notwithstanding the exact number, Maré’s new analysis raises a few important conceptual questions about the urban productivity premium. His analysis shows that a large share of the difference in productivity between big cities, small cities, and rural areas is down to the fact that skilled workers tend to sort themselves into cities. When we control for workers’ skill levels, we tend to get lower estimates of the urban productivity premium. Or, if you prefer that in economese:
The meta-analysis by Melo et al. (2009, Table 4) reports that studies that control for labour quality generally yield agglomeration elasticities that are 5 to 6 percentage points lower than studies that do not. In the current study, labour quality adjustment lowers the estimated agglomeration elasticity by 0.057 (from 0.079 to 0.022).
However, I’m not sure it is totally appropriate to adjust for skill levels, as it’s possible that cities’ ability to attract and retain talented, innovative, and motivated people (and productive firms) is in fact a type of agglomeration economy. In other words, we might be controlling away the effect of interest!
Open migration between Australia and New Zealand means that people who can’t find an appropriate place (urban and economic) in New Zealand can easily go to Australian cities. So the alternative for skilled people who are dissuaded from living in Auckland isn’t necessarily that they’ll go and start up a business in Hamilton. Instead, they might head across the Tasman, where their skills are totally lost to New Zealand.
What does this mean for urban policy in New Zealand? I’d tentatively identify two key ideas we might want to focus on in order to allow our cities to get better at attracting and retaining productive people and firms.
First, we need to think hard about whether our policies make it attractive for mobile people to come to (or stay in) our bigger cities. This is a key consideration for, say, urban planning reform, as high housing prices driven by constraints on housing development are an important barrier to people coming or staying. Evidence from the US suggests that, if left unaddressed, high house prices can systematically dissuade people from moving to productive places where they can put their skills to best use.
Second, we also need to think about how to preserve and enhance the amenities that are on offer in New Zealand cities. Our relatively clean air, reasonably well-preserved coastal environment (clean beaches, marine reserves, etc), and accessible forests and natural parks are important attractions, but other areas are letting us down. For instance, rural and small-town water quality is rapidly declining due to expanding dairy farming.
More relevant to transport, street design in New Zealand is pretty retrograde, leading to a lack of high-quality public spaces where people actually want to be. All too often, we insist upon shoving cars down corridors, heedless of the fact that some streets have higher value as places to be. But we know we can do better: places like O’Connell St and Wynyard Quarter give many people joy on a daily basis.
What do you think about the urban productivity premium? And how can we get more of it?