Location theory: New Location Theory: Random Chance and Time
Recently, researchers applying location theory to international trade and FDI have begun to incorporate important new theoretical developments such as the role of chance and dynamics. Random chance plays a critical role in determining real-world patterns of production. For example, Krugman (1991) traces the location of the carpet industry in Dalton, Georgia, to Catherine Evans, who in 1895, by chance,made a tufted bedspread as awedding gift. The bedspread was regarded as so beautiful that neighbors began demanding tufted items. Fromthat beginning, with the addition of modern technology, the carpet industry grew and became concentrated in Dalton. A general theory of location or trade could not account for the chance events that give rise to global production locations such as carpets in Dalton. Rational planning, rather than historical accident, would be more consistent with the predictions of location or trade theory. The Dalton, Georgia, carpet industry example shows how chance events combine with dynamic factors such as new or increased demand, technological and infrastructure development, and the entry of new firms to create permanent global production locations. Chance and dynamics are both present in the Dalton example because the bedspread maker could have been born anywhere.
Incontrast,agglomerationeconomies oftendonot arise by chance, but they do have a dynamic component. For example, the San Francisco Bay area location of the Silicon Valley tech cluster is much less surprising and random than the Dalton, Georgia, carpet location. The Bay area is home to several of the top research universities in the world and numerous government research laboratories. The state ofCaliforniahasa largeandthrivingdefense industry. Thus both demand and supply conditions favored the creation of the Silicon Valley technology cluster.
A final new contribution to the literature on location theory, FDI, and trade is the literature on hysteresis, or path dependence. Hysteresis occurs when temporary economic shocks such as exchange rate volatility result in permanent transformations in global patterns of production and trade. For example, many Japanese auto and auto parts manufacturers that exported cars to theUnited States endured considerable economic hardship in the 1980s when the U.S. dollar began to decline. Since there was no certainty as to when the dollar would stop falling, many firms eventually decided to relocate production from Japan to North America. Thus the global pattern of production and trade was permanently changed as a result of transitory exchange rate shocks (see Baldwin and Krugman 1989).
The idea that temporary changes in the economic environment can cause permanent changes in global production patterns potentially gives significant discretion to policymakers to use short-term policies such as subsidies and tax breaks to attract global production. However, aswe discuss below, when the use of such policies is widespread both within countries and internationally, bargaining power tends to shift from states to firms, and billions of dollars in dead-weight economic loss arise every year from competition to redistribute global production.