“Ioannides has accomplished a remarkable survey and synthesis of the scattered literature on urbanization as a response to nonmarket factors. He starts with an overview of the theory and econometrics of social interactions. Then, the book surveys the large and diverse studies on the economic and social interactions within and among cities. The studies are given unity by reference to the basic theory of social interactions, always including the market implications. This is an important synthesis of material to which the author has been a major contributor.”–Kenneth J. Arrow, Stanford University, Nobel Laureate in Economic Sciences

“From Neighborhoods to Nations studies how interactions between individuals are formed, sustained, enhanced, or hindered by their context. Importantly, it analyzes how these interactions aggregate up from families, to social groups, neighborhoods, cities, nations, and, ultimately, the global economy. Organized by a clear and useful overarching view, this book ambitiously brings together a wealth of theoretical and empirical knowledge from the last two decades in a unified and consistent way.”–Esteban Rossi-Hansberg, Princeton University

“A comprehensive and rigorous overview of the growing literature on social interactions, this impressive book blends formal theory with empirical work. Ioannides considers what exactly is a social interaction, how we measure it, and the causes and consequences of such interactions among households and firms. Rare is the economist who can approach such a broad topic from microeconomic and macroeconomic perspectives.”–Matthew E. Kahn, University of California, Los Angeles

“From Neighborhoods to Nations brings urban economics and social interactions into a unified framework, and derives theoretical and empirical conclusions about cities and regions. Presenting a consistent and systematic approach to urban social economics, this book has no equivalent.”–Yves Zenou, Stockholm University

Yannis M. Ioannides is the Max and Herta Neubauer Professor of Economics at Tufts University.

From Neighborhoods to Nations

The Economics of Social InteractionsBy Yannis M. Ioannides

PRINCETON UNIVERSITY PRESS

Copyright © 2013 Princeton University Press
All right reserved.
ISBN: 978-0-691-12685-2

Contents

Preface………………………………………………………………………xiChapter 1 Introduction…………………………………………………………1Chapter 2 Social Interactions: Theory and Empirics………………………………..11Chapter 3 Location Decisions of Individuals and Social Interactions…………………79Chapter 4 Location Decisions of Firms and Social Interactions………………………148Chapter 5 Social Interactions and Urban Spatial Equilibrium………………………..200Chapter 6 Social Interactions and Human Capital Spillovers…………………………248Chapter 7 Specialization, Intercity Trade, and Urban Structure……………………..292Chapter 8 Empirics of the Urban Structure and Its Evolution………………………..349Chapter 9 Intercity Trade and Long-Run Urban Growth……………………………….398Chapter 10 Urban Magic: Concluding Remarks……………………………………….451Notes………………………………………………………………………..457Bibliography………………………………………………………………….483Index………………………………………………………………………..517

Chapter One

Introduction

PHILOSOPHY MASTER: [E]verything that is not prose is verse, and everything that is not verse is prose.

MONSIEUR JOURDAIN: And when one speaks, what is that then?

PM: Prose.

MJ: What! When I say, “Nicole, bring me my slippers, and give me my nightcap,” that’s prose?

PM: Yes, Sir.

MJ: By my faith! For more than forty years I have been speaking prose without knowing anything about it, and I am much obliged to you for having taught me that.

—Moliére, Le Bourgeois Gentilhomme, 1670, act two, scene 4

We engage in social interactions “without knowing anything about it” throughout our lives; these interactions teach us new skills and influence our choices. Examples are easy to find: recycling and composting practices; sending a child to a charter school; ideas for software innovations that come from a chance encounter in a Silicon Valley, California, or Austin, Texas, bar; learning from classmates—about school work or about getting pregnant or how to avoid it; gaining weight; attending a church, synagogue, or mosque; joining a gym or a country club; supporting a sports team; getting involved in a civic association or spending time working for a nonprofit; keeping up with college friends in person or on Facebook; enforcing, or failing to enforce, building code and zoning regulations; dying one’s hair to hide the gray. These are just a few examples.

Economic models of cities increasingly focus on the microfoundations of the multitude of interactions underlying innovation and creativity as well as on the pollution and congestion associated with cities as places where social interactions are most dense. Empirical work using data made more accessible by modern technologies of interpersonal communication has followed suit and is expanding the set of metaphors we can use to understand cities and urbanization. While social interactions are most dense in cities, this is not the only place where they are found.

Scholars in recent years have begun to explore the ways these social interactions influence our behavior and their broader implications for policy, asking questions like: How does access to mobile telephones in Africa influence farmers’ productivity and the farming techniques they use; does that in turn influence the size and growth of settlements? What is the reach and influence of places where urban buzz occurs? Is obesity—or depression or acne—contagious? How do racial and ethnic prejudices start and evolve, and can we deter them? Can interactions between neighbors help revitalize a decaying urban neighborhood, and why do they cause urban decline in one neighborhood and not in another? Did Edinburgh’s streets and urban form contribute to the interactions that led to the Scottish Enlightenment in the eighteenth century?

Some of our actions change prices. When families move to a community with good schools, property values rise, and that in turn is relevant for people who do not have school-age children. In other words, prices record the value of social interactions and can signal their quality. Economists’ questions about interactions started from but have moved well beyond direct influences on prices and markets.

In all the examples above social interactions are present, making individuals’ actions interdependent and in turn affecting their lives. Sometimes spatial proximity implies interaction, as in keeping up with the Joneses. Other times the links are professional, social, or familial, and agents interact at long distances from each other. Widespread adoption of information and communication technologies means that personal and social interaction tempt some to claim “the death of distance.” Travel (still costly albeit cheaper than in the past) is also growing, allowing the physical proximity we sometimes need to clinch deals or collect ideas, to share unique events, or just to spend time together. International migrants now use email and the Web, and make telephone calls using Skype—but that communication is a complement and not a substitute for visits home and from family members. Academics work on joint papers on the Web, but conferences become even more important as an opportunity for face-to-face contact that consolidates the trust needed for long-distance collaboration.

The United Nations has already defined more than half the world’s population as being urban, with rapid further growth forecast in urban populations. Face-to-face interpersonal interactions remain indispensable, and research on social interactions has strengthened the argument that the close proximity of economic, social, and cultural forces (and the density of social interactions) in cities is one, perhaps the most, important reason for cities’ continued growth and economic relevance.

1.1 FROM URBAN EXTERNALITIES TO URBAN INTERACTIONS

Economists typically emphasize the role of markets. Thus, urban economists focus on housing and labor markets and on the economic activities of households, firms, and public institutions that define modern economies. A common concern of economists is what to do if markets are not “functioning well.” A common cause of dysfunctionality in urban markets is widespread externalities—direct agent-to-agent interactions that are not mediated through the markets. Externalities are pervasive and naturally generated in urban settings with their high density of population and economic activity. Market outcomes in such cases are typically socially inefficient. It is possible to rearrange things and make some individuals better off without hurting others. An earlier urban economics and policy literature used the pervasiveness of allegedly negative externalities to justify the massive interventions in cities in the 1960s and 1970s that came to be known as urban renewal in the Western world and slum clearance in developing countries.

Some of these projects rejuvenated urban downtown areas; many others were disastrous. The character of the urban neighborhoods and urban life and lives destroyed has since been mourned as a lost positive force in those cities’ economic and social spheres. Economists and other social scientists now see many kinds of urban externalities instead as instances of social interactions. This broader term refers to preferences or tastes that individuals have for the types of other individuals near whom they live and for those individuals’ actions. Interactions may be undesirable, but they cannot be ignored. Urban amenities are not only attractive scenery, parks, and natural settings but also the characteristics, habits, and activities of individuals’ neighbors. The examples at the beginning of the chapter all involve such direct agent-to-agent interactions. Urban places acquire a “life” of their own as magnets for formal and informal activities. Some of these activities are so persistent that they confer some specialization on their particular locales, contributing to the vibrancy and variety of life in large cities. Some come to be seen by outsiders as characterizing the larger city. Such places attract professionals, tourists, and locals in varying proportions. Well-known locales in this sense include Soho and the City in London; the Left Bank and the Marais in Paris; Wall Street, Greenwich Village, the Garment District, and Brooklyn Heights in New York; Harvard Square in Cambridge, Massachusetts; Hollywood in Los Angeles; Ginza in Tokyo; the Grand Bazaar and Istiklal Caddesi in Istanbul; and Darb Al-Ahmar (the historic city) and Tahrir Square in Cairo.

Why do some urban activities produce great things? Peter Dougherty (2002, 19) urges economists to talk about cities not in the same way that psychologists talk about sex, that is, without taking “the fun out of it.” How can the tools of economics help explain the role of cities in bringing “the vast variety of human creative resources together in an ongoing spontaneous and combustible mix”? (Dougherty 2002, 18). Can rigorous theory support Florida’s (2002) claim that imaginatively selected measurable variables (such as the percentage of gays or of people with bohemian lifestyles) can explain a big part of a city’s attractiveness. Can economists marry “thought to feeling” so as to help in “reaffirming the exciting connections that unite the historic wisdom of Adam Smith with city life”? (Dougherty 2002, 19).

An answer needs to combine economic variables, such as prices, with noneconomic ones. Education and health are critical in individuals’ social personas and yet are components of human capital, an economic concept par excellence. The distinction between economic and noneconomic variables has become increasingly blurred, but in the analysis explored here the strength of economics is the rigor and discipline afforded by its theoretical and empirical tools.

The contemporary theory of social interactions is an important example of how these tools provide a powerful framework. Becker (1974) was one of the earliest economists to talk explicitly of social interactions; subsequently they were used extensively in empirical work. Loury (1982) pioneered using variables to measure the impact of community and family background on educational achievement. Yet, it was the Manski (1993, 2000) model that provided the canon for empirical modeling of social interactions. Manski’s approach provides a typology of social influences within individuals’ social milieus and raises key identification issues.

The Manski model distinguishes influences that emanate from: one, the decisions of members of one’s reference group (endogenous social effects), such as keeping up with the Joneses; two, the effects on an individual of characteristics of members of one’s reference group(s) (exogenous or contextual effects), as when individuals value living close to others with similar ethnic backgrounds, or with other characteristics they view as conducive to practices they themselves value; and three, individuals acting similarly because they have similar observable or unobservable characteristics, or face similar institutional environments (correlated effects). This book adds the role that prices play in conveying “social” effects to the categories proposed in Manski’s paper. It is precisely because individuals take the price of a good as given and beyond their control, making their decisions accordingly, that equilibrium prices ultimately reflect the characteristics of all market participants.

The fact that the actions of individuals in social contact with one another are interdependent is an important notion, and the concept of social interactions can be a powerful tool, as the following examples demonstrate. In seeking to explain one individual’s actions, we can no longer use just the actions (or choices) of neighbors as explanatory variables in a regression. Such magnitudes are not independent of the error. Instead, more elaborate econometric approaches are called for. Nonetheless, even when individuals choose their neighbors and thus their neighborhood effects, results by Brock and Durlauf (2001b) establish that it is possible to actually identify different social effects separately. To do that we need to correct appropriately for the selection bias associated with individuals’ having chosen their neighbors. Sometimes interactions are group-based, in which case individuals value aggregates describing entire communities and aggregates of the actions of the members of those communities. At other times, interactions are one-to-one. In the second case social network models can provide a critical focus on the microstructure of interactions. Heterogeneity in interactions across individual pairs is an important focus of the econometric analysis.

1.1.1 Location Decisions of Individuals

In deciding whether or not to locate in a particular city or neighborhood, each individual weighs numerous factors from their own perspective. These factors can be classified neatly as market variables, endogenous social effects, and contextual variables. When individuals decide where to locate, pursuing equilibrium strategies, their own individual characteristics contribute to defining the equilibrium values of prices and the distribution of characteristics by location. In the process individuals sort themselves into neighborhoods. Some of the sorting is sorting on observables. As Rosen (2002) underscores, it is important to assess such sorting in order to, inter alia, understand the social valuation of neighborhood amenities when individuals are heterogeneous. For example, if some people value neighborhood safety more than others, then those who value it less will sort to less safe neighborhoods. Estimates of the average value to society of neighborhood safety based on those who sort to more safe neighborhoods will be biased upward, while estimates based on those who locate in less safe neighborhoods will be biased downward. Most realistic settings with social interactions involve sorting on unobservables as well as observables. Social interactions models help us understand individuals’ location decisions, as well as membership decisions more generally.

The inherent difficulty in determining what drives the growth of cities is an example of the problem of correcting for sorting on unobservables. We want to know whether the factors that drive location decisions are due to the direct attraction of being near many others (agglomerative forces) or to underlying (unobserved) factors that those who make the location decision have in common. Economic geography provides examples where we can distinguish between the attraction of natural features of the landscape, first nature, and spatial features of the economic system, which include but are not limited to the effects of the landscape, second nature. I discuss the relative importance of first nature versus second nature and how it motivates empirical research at length in several chapters.

1.1.2 Location Decisions of Firms

Decisions made by firms, like those made by individuals, are influenced by factors resembling social interactions; this book exploits this similarity methodologically and links decisions of firms, in particular, with the theoretical underpinnings of new economic geography (NEG) (Fujita, Krugman, and Venables 1999). The case of firms introduces a new angle—spatially dispersed social interactions. The idea that firms interact in the context of the urban economy is an old concept, but to fully understand the benefits firms derive from being near other firms we need to articulate the origin of those benefits. In particular, economists since Marshall (1920) have asked whether proximity to other firms in the same industry generates an effect that is different from proximity to firms in other industries or from other factors such as proximity to a larger city or to a particularly suitable labor force. Moreover, numerous firms may be attracted by the same advantageous local factor, such as attributes of the local labor force. Similarly, workers may be attracted to a location by a factor in common with firms such as good weather and/or other physical amenities in addition to the job opportunities at that location. In such cases it may appear that a single common factor operates as a force of attraction for both individuals and firms.

Yet to understand what is really happening we must distinguish among the multiple types of attractions that are in fact involved. Distinguishing the attraction of other firms, for example, from the attraction of labor force characteristics or of first nature attributes of a place, such as the weather, can be critical for public policy choices that set out to encourage local economic development. If firms are attracted by the presence of a skilled labor force and those workers in turn are attracted to Silicon Valley by the weather, then investments that attempt to reproduce other aspects of that region in a midwestern city are likely to fail.

1.2 ECONOMIES OF CITIES AND NEW ECONOMIC GEOGRAPHY

Since individuals and firms benefit by locating in close spatial proximity to one another, it is fruitful to apply the analysis of social interactions in examining the economies of cities. The social interactions approach to the study of that allow us to understand and predict how individual economic agents benefit from the size of the city where they live and work. Urban concentrations generate costs as well as benefits. The most obvious costs are those due to pollution and congestion. Two natural questions follow: How large should cities be? Will cities in free market economies attain their optimum sizes? The system-of-cities literature has dealt elegantly with these questions (Henderson 1974, 1977a, 1988a).

(Continues…)

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