A Critical Analysis Of Firm Location Economics Essay

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For the purpose of this paper the factors contributing to the attraction and location of firms in urban areas, such as the Vaal-Triangle, will be analysed. "The ability of that region to grow could be linked to the creation of an environment conducive to the location of firms" (University of Pretoria, 2009:97). It is therefore necessary to determine the factors involved in the decision-making process that will encourage firms to choose a specific area.

It will also be assumed that firms have a profit-maximising motive. A fundamental principle of location theory is that in order for any factor to influence location decisions, it must vary across locations (University of Pretoria, 2009:97). The most important factors that a firm will evaluate in determining location will now be analysed.

Background and Regional Economics:

South Africa is quickly developing its very own unique identity. Luus et al (2005:1) indicates that South Africa's cities are undersized, dispersed, and over-concentrated. "In South Africa, households in the country's urban areas have average incomes almost thrice as high as the households in rural areas." Luus et al (2005:1) also states that more than 70% of South Africa's GDP is produced in only 19 urban regions of which the Vaal -Triangle is included. In past studies that have been carried out they have found that South Africa's urban agglomerations are too small and the cities mainly offer urbanisation economies rather than localisation economies.

A particular distinguishing factor of economic activity across South Africa is its spatial unevenness. Six cities, namely, Johannesburg, the East Rand, Durban, Cape Town, Pretoria and Port Elizabeth dominate the economic landscape. As different fields of study accelerate in their research of these cities and their surrounding urban areas, especially geographical economics and the availability of economic data, economists are able to focus on cities as drivers of economic growth and development more so than in earlier studies. (Luus et al, 2005:2)

The benefits towards firms of being located in a city are due to localisation and urbanisation economies. Localisation economies refer to the benefits a firm receives from operating amongst other firms in the same industries. Urbanisation economies refer to the advantages of the overall scale and diversity that originates in cities due to the localisation economies. (Luus et al, 2005:2)

It goes without saying that South Africa needs much higher economic growth rates to meet the needs of the more than 30% of the population that is unemployed and has to be more widely spread, beyond the six major cities. (Luus et al, 2005:3) also argues that the localities that do grow do so because of natural resources, technology, lifestyles that attract entrepreneurs, and effective local governance.

The localisation and urbanisation economies (mentioned above) tie in with the term spatial complementarities, therefore "the significance of geography is not one of determinism" (Luus et al, 2005:3). Nearby and intense economic interactions reap benefits for growth and opportunities which in turn establishes new centres of activity.

When referring to cities as drivers of growth and development it builds on the notion of spatial complementarities and external economies. External economies of scale occur at industry level. In this case, an increase in the output of the industry as a whole leads to a decrease in average costs. On the other hand internal economies of scale occur at firm level where increased production results in a cost advantage over smaller firms. (Luus et al, 2005:13)

When external economies apply, an increase in industry-wide output causes a change in the relationship between inputs and output for each individual firm. According to (Luus et al, 2005:13) there are two examples of this:

Knowledge Sharing, Learning and Innovation:

As industry output rises, the stock of knowledge rises and information spills over to firms. This is a positive external benefit that is not paid for, reducing cost and causing an increase in the level of output at the firm level. (Luus et al, 2005:14) it is also motivated that these benefits accrue due to knowledge sharing, learning and imitation in a particular area. Therefore, cities play a very important role in economic growth as they provide the versatile information that spills over and that also contributes to innovation. "The lumpiness of economic activity in South Africa may be good for economic development!"

Public goods:

The supply of public goods and services provides benefits to consumers. These benefits are non-rivalrous and non-excludable in consumption. Public goods or services thus have external benefits that lower costs and enhance efficiency, giving rise to increasing returns in the aggregate. (Luus et al, 2005:14) also notes that economic externalities not only affect the production function, but also a firm's output decisions through price effects that are conveyed via the market.

In both these cases it is important to note the importance of proximity. The concentration of consumers and producers at a specific location makes it possible to capture the spillovers of knowledge and indirectly so also create infrastructure, which increase productivity and lower costs. These are the spatial complementarities which cities and regions offer, and which may drive growth and development. (Luus et al, 2005:14)

Finally, in the case of external economies, a further distinction is possible between localisation economies and urbanisation economies. Localisation economies are industry-specific external economies. Urbanisation economies are external economies that apply to firms across industries and capture the concept of positive spillovers for a firm as a result of total economic activity at a location. (Luus et al, 2005:15)

It is these localisation and urbanisation economies that have been the focus of empirical work that seek to quantify the importance of spatial complementarities for growth and development. Typically, concentration ratios are used to measure the extent of agglomeration and the existence of localisation or urbanisation economies. The conclusions drawn from the empirical studies are concerned with whether certain regions should specialise in a certain industry or whether it should diversify more to promote growth and development. (Luus et al, 2005:15)

Theoretical models of agglomeration investigate the responsibilities of congestion, static factors and market size in spatial growth and development. Empirical approaches use absorption indices to quantify the extent of agglomeration. For the purpose of this paper a theoretical approach will be followed to determine, firstly, what the drivers and attributes for location decisions are to, secondly, establish whether policies assist and contribute to regional location. Thirdly, an example will be given to motivate that there are more measures available to enhance such methods of growth and development. In the last section the research in this paper will be reflected upon the situation in the Vaal-Triangle as the research has been carefully reviewed from the view point that it is all relevant to the current climate that is ongoing in the Vaal-Triangle.

Instruments Affecting Location Decisions:

It is clear that there are many various factors that contribute to the decision-making regarding location. These factors also mainly reflect upon competitive advantage because without it location will not be motivated amongst firms. Below is a figure that concludes the various elements that contribute to the location of firms:

Firm Location 1.bmp

Figure 1: Contributing Elements to Location Decisions Source: Cullinan, (2007:14)

Adding to the above Visser et al (2004:18) also states that firm decisions are influenced by basic conditions such as trade, labour and industrial policies. On the other hand, once the restrictions wherein firms have to operate have been defined, changing market processes and the behaviour of firms (based on the level of competition and demand-side requirements) also start to shape the existing market structure.

Urban Econ (2008:9) used the Porter Diamond approach to explain competitive advantage: the competitive advantage of a locality is founded on 4 pillars, as indicated below. Competitive advantage is at the root of business retention, expansion and attraction. When an area possesses such an advantage, it becomes highly attractive as an industrial location.

Firm Location 3.bmp

Figure 1: Porter Diamond's Competitive Advantage Source: Urban Econ, (2008:10)

For the remainder of this section more attributes will be discussed that firms take into consideration when making decisions about the location of their business:

Cost Variables:

Cost variables are those that directly affect firm cost. Given the same amenities/facilities/services, a firm will choose a location which provides a lower wage rate. However, a higher wage may be accepted if the firm chooses to have an enhanced quality of labour skill, infrastructure service and access to markets. (Kuncoro, 2000:4)

Kuncoro (2000:4) also states that small and medium scale firms that are labour-intensive struggle more when higher wage rates apply. Thus, the degree of substitutability between capital and labor may be of low significance as the lower wage incentive already suggests that they could not afford the cost of capital investment. All these statements follow the assumption that any individual firm, when choosing location, tries to maximize nominal profit.

Glen (2008:40) also mentions that the key cost factors to be considered include the cost of labour, the cost of the facility, depreciation charges of property, plant and equipment, financing costs (including interest), transportation costs, utility costs and taxes (direct and indirect taxes). The cost of industrial land and construction will be more of a factor for a firm wishing to relocate. The cost of leasing office space will also impact on the overall investment decision. Therefore, ensuring that industrial land is available for development would certainly be an advantage in business location decisions.


The distance to other business facilities is yet another essential consideration to reduce operating cost. Complementary business services are most likely to be better developed in the already existing industrial centres. Thus, the distance to the nearest business centre will also affect the location decision. According to Kuncoro (2000:5) "the distance variable also captures the need to cut transportation costs, particularly if most customers are in urban areas." The same consideration applies if a reliable supply of direct inputs can only be acquired at the closely situated business centre in question.

Infrastructure, Energy, and Communication:

The lack of infrastructure services may be a large determinant when making location decisions. Recently South Africa has had many discrepancies regarding electricity supply and the reliability thereof, and the lack of electricity provision may force firms to generate electricity by itself, which would be an additional cost (Kuncoro, 2000:5). Glen (2008:40) also comply with this issue and states that the factor remains that South Africa's cost of electricity is still competitive even after recent increases by municipalities and Eskom. It has to be noted that municipalities have an important role to play in providing an environment that is friendly to business. The rising demand for energy coupled with the steep rise in the cost of energy will add greater importance to energy availability and stability in selecting a location for investment.

Glen (2008:40) adds that the need for fast, reliable, cost-effective telecommunication is another key factor driving decisions about where to invest and do business. The growing importance of broadband and the relatively high cost thereof is an area that could be used for competitive advantage. Thus, the cost of electricity and telecommunication are imperative factors in determining business location decisions.

Traditional infrastructure (especially highways) remains the most important factor when location is at stake. Glen (2008:40) researched that industries involved in extractive productions (such as mining and oil) support this view as they receive 'subsidised aid' to improve their transport infrastructure. This is also why spending on the many upgrading infrastructure projects ahead of the 2010 FIFA World Cup bodes well to contribute to the overall competitiveness of the South African climate in general.


Local population could also be regarded as one measure of the size of the local market. Kuncoro, (2000:5) argues that a bigger population size is always coupled with urban areas. New firms are likely to locate in urban areas because local demand is high. Thus, some of the firm's products could be sold in the local market without incurring transport cost.

Tax Considerations:

Municipal rates and taxes will be key business location decision factors. However, the synchronisation of international taxes has ensured that tax is largely a neutral factor in location decision-making. (Glen, 2008:40)

Industrial Environment:

For innovative firms facing a market uncertainty, it is beneficial to choose location around other firms, predominantly because of the benefits of information spillovers. Over time the interaction among many firms in a particular location will lead to the development of specific knowledge which will be unique to that location. Another contributing factor of the existence of such a system will enable firms to avoid the high cost of creating it. (Kuncoro, 2000:6)

A Skilled and Flexible Labour Force:

From a competitive point of view any emerging economy requires a workforce that is infinitely more skilled than that required a few decades ago. Hence, the completion of secondary education has become the norm to enable a workforce to work with advanced technologies and continually improve key processes. "The modern economy also requires flexibility in the workforce to ensure sustainability in a highly competitive environment (Glen, 2008:40)."

The Department of Education (2003:5) found that "values and morality give meaning to our individual and social relationships. They are the common currencies that help make life more meaningful than might otherwise have been. An education system does not exist to simply serve a market, important as that may be for economic growth and material prosperity. Its primary purpose must be to enrich the individual and, by extension, the broader society".

The Regulatory Environment:

In determining the competitiveness of a business location, another important factor is how transparent business rules in that region are and whether they are enforced in a reasonable manner. However, government at all levels has to be aware that undue levels of red tape inhibit the competitiveness of firms. The increasing importance of environmental regulation is also impacting on the amount of compliance that firms have to achieve and adds to the overall cost of doing business. (Glen, 2008:40)

Measuring Quality of Life

According to Glen (2008:40) the key international determinants of the quality of life are "crime rates, the quality of public schools, the availability and cost of housing and healthcare". Similarly, these same determinants are also applicable to the decision-making process that firms have to make regarding location. These determinants are contributing factors to firms and their competitiveness but also a means to improve the quality of life for a population as a whole.

Research and innovation:

Constant innovation is also required to keep markets and regions in a competitive light. This could be measured by the number of science and technology graduates, as well as the monetary value spent on research and development. Research and development are generally situated close to large universities and in technology clusters operated by businesses. Glen (2008:40) states that in many such regions the cluster these kinds of activities have proven successful. Visser et al (2004:18) also comply with this topic and add that lower informational costs, greater levels of innovation, knowledge transfer, and expansion of productive capacity is possible through inter-firm sharing.

Economic Policies Contributing to Regional Location:

One of the key principles that regional governments have to embrace is that industrialization and urbanisation does not rely on market forces alone. On the contrary, it materialises from a visible set of well coordinated policies that aim to stimulate and support learning and innovation within the firm and the economy. Visser et al (2004:21) also notes that if institutional structures and policies at an industrial level do not complement the needs of firms at the micro level it is pointless to hope that they may favourably influence firm-level behaviour at a market level.

"In terms of basic conditions affecting market structure, the single greatest obstacle to intra-regional trade is transaction costs faced by individual firms" (Visser et al, 2004:10). Market access is largely hindered as a result of excessive transaction costs. There are still many features that may constitute barriers to intra-regional trade. Of these the lists of sensitive products are probably the most obvious, but the uncertainty associated with the range of invisible non-tariff barriers is likely to be the most noteworthy obstacle to integration.

The five most important non-tarrif barriers according to Visser et al (2004:10), that impede trade in the region, are communication problems; customs procedures and charges; transport problems; lack of market information; other border procedures; services (financial, electricity, technical support); and standards and technical restrictions.

Inter-firm organisational restructuring may assist with some of these prevailing issues and it involves the transfer and assimilation of knowledge and technology all along the supply chain. Information prevalent at the micro level tends to accumulate at industry level. However, this requires dynamic interaction at all levels, from conception through to production and the market. Thus, the role of networking and partnering relationships is instrumental in promoting knowledge diffusion and innovation. (Visser et al, 2004:21)

The nature of the underlying market structure in which industries operate has significant implications for firm-level conduct and performance. Invisible trade barriers significantly increase the cost and risk of doing business, thereby affecting the competitiveness of firms and, above all, prohibiting access of smaller firms to regional markets (Visser et al, 2004:10). Again, the lack of access to information about trading partners, investment opportunities and incentives all contribute to hesitance on the part of firms to extend their undertakings within the region.

"Development and competitive pricing is severely constrained by such information inefficiencies; thereby further reducing market opportunities" (Visser et al, 2004:12). In South Africa, the ability of firms to build efficient supply networks is largely obstructed by poor communication systems cased by limited infrastructure, high cost, inefficiency and unreliability due to regulated service provision. The implication is that potential social capital development among entrepreneurs and managers are severely undersized and underdeveloped.

The mixed messages from contradictory policies (within and between countries in the region) are a further major restriction to cross-border investment. Thus, it is clear that the turning point for high transaction costs to contribute to integration will only occur if a radical reduction in costs occurs. Barriers to entry, whether visible or invisible, automatically increase the risk profile of doing business within regions and therefore directly affect the behaviour of firms. (Visser et al, 2004:12)

Therefore it is safe to say that counter attacking policies need to be brought to the table. It is also essential that the role of these instruments as explanatory variables for low intra-regional trade should be considered in the formulation of industry support policies aimed at providing incentives for productivity enhancement, industrial development, investment and trade expansion. (Visser et al, 2004:11)

The real message for policy makers is that invisible controls and barriers to trade are increasingly what prohibit industrialisation and general growth in regions. Eliminating direct costs of doing business and reducing the confusing signals given to firms will hold enormous benefits for all regions in question. Such adjustments could increase trade and investment and should thus restructure economic activity towards greater competitiveness. (Visser et al, 2004:12)

Visser et al, (2004:18) states that labour policy, for example, not only impacts on micro firm behaviour and local markets, but also sets the market structure at a regional level. "Investment and location decisions will often hinge on differences between labour market flexibility, returns on capital, and the predictability of the macroeconomic conditions." In this regard labour policy can play an important role in the economic geographic pattern of industrialisation.

According to Cullinan (2007:1), "if the pre-conditions exist, good location can be created by reinforcing the elements such as better linkages, better circulation of income, income mix, greater thresholds and improved catchments through agglomeration of activity and points of accessibility." Physical attributes (both man-made and natural) also create locations.

Cullinan's (2007:23, 24) research provides a point of departure for public spending:

Economic Growth is a prerequisite for the achievement of other policy objectives.

Government spending on fixed investment should be focused on regions with high economic growth potential.

The focus should be on the population, and not on past and current inequalities. Thus, places with high levels of poverty and development potential should also receive fixed capital investment.

Social capital should be focused on areas with low levels of development potential and high levels of poverty. The focus should be on providing social transfers, human resource development and labour market intelligence in order to assist people to access economic opportunities.

Future economic development opportunities should be channelled into activity accessed or linked to main growth centres. This will also in turn play a role in overcoming spatial distortions of apartheid.

Kuncoro (2000:11) argues that the decision of government to perhaps give provincial and regional municipalities more power in several aspects of the administrative licensing system such as the choice of environmental feasibility and property tax could also contribute to development and competitive markets. That is however dependant on whether government abuse their power. If this could be the case then the immediate impact of license decentralisation on manufacturing firms will indicate more effective location preference within regions and bribes will also lower.

This section effectively described how policies could assist to attract more business to a certain region such as the Vaal-Triangle. The following section will be a contributing factor as to how to attract more business to a region. The chosen topic involves and offers a much larger scale of diversity that could be approached to assist localisation and urbanisation economies.

How to Attract More Business to a Region:

"The subject tourism involves the study of why people travel and how to meet their needs and expectations. It focuses on the tourism industry as an interrelated, broad and dynamic economic sector (Department of Education 2003:9)." The subject deal with geography, creates an awareness of the role played by South Africa in the international tourism industry, and investigates and evaluates the value of tourism. The subject also emphasises the responsibility to contribute towards sustainable tourism practices and socioeconomic growth. Therefore, the value and importance of appropriate and clear communication, a respect for diversity, and the provision of quality service are emphasised.

Tourism will in actual fact empower people to develop an understanding of the related services in the tourism industry, the interdependence of sectors and sub-sectors, and the benefit tourism brings to an economy. The Department of Education (2003:9) also mentions that the study of tourism aims to redress historical imbalances, as the majority of the population was previously excluded from tourism. This developing sector will enable people to (Department of Education 2003:9):

Acquire the skills, knowledge, values and attitudes necessary to communicate effectively with customers, identify needs and provide the required service to ensure customer satisfaction

Gain access to further learning in the chosen sector by accessing information on career opportunities in the tourism field.

Use science and technology effectively when communicating and accessing information.

Work effectively with others through the communication and interpersonal skills applied in customer care and service delivery.

Organise and manage themselves and their activities responsibly and effectively by identifying gaps in tourism development and making recommendations for improvement and growth.

Collect, analyse, organise and critically evaluate tourism information.

However, the South African tourism industry is exposed to increasing competition. It is also a complex service sector, requiring high levels of skills and resources. As a result, extending the growth of the sector and its rewards to emerging markets presents major developmental challenges. (TEP, 2008:1)

TEP (2008:2) conducted a study on the current effectiveness of this market and identified more than 5 000 enterprises and the statistical analysis were divided into:

Operational: Viable enterprises ready to provide goods and services for 2010 and beyond.

Potential: Viable enterprises which are not ready to provide products for 2010, but, given appropriate assistance, have the potential to do so.

Marginal: Enterprises on the margins of viability with no prospect of becoming meaningful service providers for 2010.

Potential enterprises significantly outnumbered enterprises in both other categories, thereby presenting development agencies with a substantive development challenge. The conclusion of the study was as follows (TEP, 2008:2):

Townships were also emphasised in the selection process. However, it still shows that most emerging tourism markets operate in urban centres and recognised tourism areas. "Although townships attract niche tourists, enterprises operating in them are out of the mainstream, which constrains their development (TEP, 2008:4)." This just indicates once again that the effects of location are difficult to overcome, but some townships and regions are starting to show significant tourism potential. Another contributing factor would be the lack of emergent travel or tourism agencies, as they could do a great deal to generate more business and improve market access for the emerging sector as a whole.

Case Study on the Vaal-Triangle:

As mentioned before, all the information gathered for the purpose of this paper has been selected from a general view point on the Vaal-Triangle. In this section some of the topics will just be lightly touched again as to substantiate the research even more.

Concerning the section on the instruments affecting location decisions it becomes clear that the Vaal-Triangle show many shortcomings. Transport is expensive and generally unreliable, and insufficient competition is perhaps the most significant obstruction to lower transport costs in the region.

Another factor that has not been mentioned is 'time'. Urban development processes take time and are generally based on long term goals and short term interventions. However, it is within human nature to abuse the benefits of 'time' as long term goals are more than often expected to happen within the short term and therefore de-motivation will be the norm to follow.

This prevailing problem could be assisted with efficient planning, well stipulated and defined goals, and patience. At the 'macro scale' planning can assist in providing a framework for thinking about public investment in space that is not purely reactive, but seeks to proactively influence development outcomes. 'Macro scale' planning is a much looser concept referring to a broad spatial scale and regional systems.

Research and innovation could also assist this problem area as well as with all the previously related issues (mentioned before). The Vaal-Triangle also shows a major advantage in this respect as there are various such facilities in the proximity. Therefore, information is easily accessible and the opportunity of generating entrepreneurs has an increasing figure attached to it. The disadvantage that remains however is the high costs involved in these sectors.

Energy on the other hand is another remaining disadvantage for this region. The increasing costs are affecting a much broader spectrum than just firms and have an extreme negative impact for sustainable economic growth and development. If these industries in question could enter a more competitive market and allow the monopoly to fall away, then maybe an increase in production and other prevailing factors could occur to benefit the large unemployment sector that remains an unanswered question.

Regarding regional policies and how they could assist economic activity it is argued that rather than creating additional policies, Southern African countries should focus on improving their investment climate from an operational perspective. To do so the economic foundations and fiscal management should be strengthened, infrastructure should be improved, and once again, power and water supply also needs to be upgraded. This, for example, will be a far greater incentive for foreign investors than foreign investment schemes that provide tax cuts and the like. Also, promoting a system of investment routes can assist in closing down space, improving access to services and opportunities.

Routes with high levels of access and continuity should become a focus for activity and economic development. Due to continuity and high levels of access along these routes, activities respond to varying levels of access by choosing points which suit their requirements. Public transport rhythms combines with the rhythms of accessibility are key elements.

In conclusion, the Vaal-Triangle should both specialize more in the manufacturing sector and diversify its markets to allow other sectors to compliment growth and development on an economic level. Is not a reactive concept but involves creating new patterns of access and opportunity.