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Urban Economics and
Real Estate
Theory and Policy
Second Edition
John F. McDonald
Roosevelt University
Daniel P. McMillen
University of Illinois at Urbana-Champaign
Daniel
For Mary, Katie, Steve, and Rob
This book was set in 10.5/12 Times Roman by Thomson Digital, and printed and bound by Hamilton Printing Company. The
cover was printed by Hamilton Printing Company.
Copyright # 2011, 2007 by John F. McDonald and Daniel P. McMillen. All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying,
recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without
either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the
Copyright Clearance Center, Inc. 222 Rosewood Drive, Danvers, MA 01923, website www.copyright.com. Requests to the
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HT321.M348 2010
330.91730 2–dc22 2009052152
Preface v
Acknowledgments vii
iii
iv I Contents
This textbook has been written primarily for under- research, but that she or he can conduct a study that
graduate and master’s degree students who wish to is informed and well organized. One implication
learn about the field in which economic analysis is of this purpose is that, although many policy issues
applied to urban areas and urban real estate. The are examined, a complete catalog of urban social
title of the book has been chosen with care. The problems is not included. In the first edition of the
emphasis is on economic theory (primarily micro- book the examples and data all pertained to urban
economic theory), empirical studies that are based areas in the U.S. In this new edition we have added
in economic theory, and the policy lessons that can throughout the book material on urban areas around
be drawn from the use of economics to understand the world, including a new Chapter 2, ‘‘World
urban areas. The book includes a group of chapters Urbanization.’’
on urban real estate. We believe that the economics The book is written presuming that the student
of real estate markets and real estate investment and has a background that, at a minimum, includes a
development are essential to a course in urban strong course in the principles of microeconomics
economics. No other urban economics text includes and the ability to handle algebra. The student needs
the extensive coverage of real estate such as that to feel comfortable with the use of basic mathemat-
included in this book. This new edition of the book ics because economic analysis cannot be done
includes coverage of urban areas around the world. without it. The book does include a few mathemati-
A course in urban economics with a strong cal derivations that are more than two or three lines
real estate component would use the chapters in in length. Students who have had a course in
the book in the order in which they are presented. intermediate microeconomic theory will find that
An alternative is to use the book for a course in most of the mathematical and economic concepts
urban real estate with strong economics and public in the book are quite familiar. The book does not
policy components. In this case the course would require that the student has studied calculus. All of
begin with Chapters 9–13, the chapters on real the mathematical concepts used are covered in the
estate and urban housing. Students would then appendix at the end of the book. However, the
read Part I (Economics and Urban Areas) and student who has had a course in basic differential
Part II (Location Patterns in Urban Areas). The calculus (e.g., math for business and economics)
remainder of the course should include Part IV will find that the math is easy.
(Government in Urban Areas) and Part VI (Urban The book can be used in (at least) two ways. It
Growth). Part V (Urban Social Problems) would can serve as a text for students who are majoring in
be optional. economics. These students wish to learn about the
Those who study this book should be able to subject matter of urban economics, but they also
conduct economic studies of an urban area. We do need to gain more practice in the use of economic
not mean that the student can do original academic theory and the underlying mathematical techniques.
v
vi I Preface to the Second Edition
Several more advanced sections and appendices Statistics) and state departments of labor or employ-
have been included for these students, and they ment security. Data on urban real estate markets can
should review the appendix to the book while be obtained from private sources which often have
they are reading the first five chapters. The book free web sites. Also, most of the county tax asses-
can also serve as a text for students in related fields, sors now provide data on real estate parcels on the
such as real estate, urban planning, and urban web. Data on urban areas around the world are
geography, who do not intend to become experts provided by the World Bank and the United
in economic analysis, but who wish to apply their Nations.
knowledge of microeconomics to the urban econ- We normally require that the student read other
omy. These students can omit some of the more books and write a book review. Recommendations
mathematical appendices to the chapters. If we were for books to use are made along the way in the text.
teaching students in this category, we would allo- Here we make a few suggestions of books that are
cate some time in each of the first few weeks of the readable and insightful. They are:
course to covering the material in the appendix to
William Cronon, Nature’s Metropolis,
the book.
The book begins with five chapters that intro- W. W. Norton, 1992
duce urban economics as a field of study and discuss Anthony Downs, Still Stuck in Traffic, The
the origins and functions of cities. The rest of the Brookings Institutions, 2004
book consists of sections organized around these Anthony Downs, Real Estate and the Fi-
topics: nancial Crisis, Urban Land Institute, 2009
Location patterns in urban areas Joel Garreau, Edge City, Doubleday, 1991
Real estate and urban housing Edgar Hoover and Raymond Vernon, Anat-
Government in urban areas omy of a Metropolis, Harvard University
Press, 1959
Urban social problems
Jane Jacobs, The Economy of Cities, Ran-
Urban growth
dom House, 1969
We have been teaching urban economics to John McDonald, Urban America: Growth,
undergraduate and graduate students for many Crisis, and Rebirth, ME Sharpe, 2008
years, and this book draws upon that experience. Saskia Sassen, Cities in a World Economy
Our experience also tells us that students need to do
(3rd edition), Pine Forge Press, 2006
more than read the textbook and attend lectures.
Thomas Stanback, The Transforming Met-
They need to learn about the main data sources in
the field, they need to write, they need to read other ropolitan Economy, Center for Urban Pol-
books, and they need to go out and observe the icy Research, Rutgers University, 2002
urban area in which they live (since most of them do William Fischel, The Homevoter Hypothe-
live in an urban area). sis, Harvard University Press, 2001
The main data sources in the field are available
on the World Wide Web, and chief among the We also heartily recommend the Blackwell
relevant web sites is that of the U.S. Bureau of book of readings edited by Richard Arnott and
the Census (census.gov). We recommend that the Daniel McMillen titled A Companion to Urban
instructor show the student how to surf census.gov. Economics. These readings make a fine comple-
Another important data source is County Business ment to our textbook treatment of the subject. The
Patterns, which provides detailed employment data only supplement to this text is a web site hosted by
by industry for all counties in the U.S. Other labor Daniel McMillen. There you will find any necessary
market data can be obtained from the web sites of errata, updates, some new examples, and directions
the U.S. Department of Labor (Bureau of Labor to useful web sites.
!
ACKNOWLEDGMENTS
We owe a debt of gratitude to seven scholars who good return on his investment. And we would be
reviewed a draft of the proposal for the revised book remiss if we failed to note that Wiley-Blackwell has
and the seven who reviewed draft chapters. They a large program in urban economics, real estate, and
made many valuable suggestions. related subjects. All students and scholars in these
We also owe much to our editor George Lobell fields are in their debt.
of Wiley-Blackwell who suggested this revised
edition—including the material on urban areas John F. McDonald, [email protected]
around the world. We hope that we will provide a Daniel P. McMillen, [email protected]
vii
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!P A R T
I
ECONOMICS AND URBAN AREAS
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!
C H A P T E R
1
I N T RO D U C T I O N TO U R BA N
ECONOMICS
I A. THE NATURE OF URBAN AREAS The field of urban economics is closely related
AND URBAN ECONOMICS to other fields such as regional economics and real
estate. Regional economics is the study of regions
Urban economics is the study of economies that are that are much larger than a single urban area but are
organized as urban areas. An urban area can be smaller than an entire nation. Regional economists
defined as a place with are interested in the economy of the Midwest, the
– a very high population density, compared to Southwest, etc. But both urban and regional econ-
the surrounding area, and omists are interested in the variety of economic
experience that can occur within a single nation.
– a total population greater than some mini- Both study economic units that are defined geo-
mum number (to distinguish urban areas graphically, as opposed to industry units, demo-
from small towns). graphic groups, occupational groups, or other
Most urban areas have an identifiable central possible disaggregations of the whole economy.
point where population density is at a peak and Indeed, because both urban economics and regional
declines with distance from that point. (A few urban economics study geographic subunits of the na-
areas, such as Minneapolis-St. Paul, have more than tional economy, both make use of some of the
one central point.) Urban economies are based on same models and methods. Urban economics is
frequent contact among people and economic ac- also closely related to real estate, the field that
tivities, and high population density facilitates that studies real estate markets, institutions, investment,
contact. You will be studying economies such as and development. An urban area consists of the
Greater London, the Tokyo/Yokohama metropolitan people who live there and the land, buildings, and
area, the New York metropolitan area, ‘‘Chicago- other facilities that people use. Many urban econ-
land,’’ and the Dallas-Fort Worth ‘‘metroplex.’’ omists concentrate on the study of housing markets
Urban economics is also the study of cities— in urban areas, for example. Other urban economists
both the positive and the negative aspects of cities. study the urban land market, and some examine the
Cities are at the heart of the modern economy and causes and consequences of real estate develop-
society. They are economic centers of trade and ments of various types. Urban economics is also
finance. They are centers of culture, innovation, related to urban planning, urban sociology, urban
and education. Cities are also the home of urban politics, and urban geography. We believe that
problems, including crime, traffic congestion, urban students in all of these fields can benefit from a
sprawl, racial segregation, and discrimination. course in urban economics that provides a solid
Cities are the endlessly fascinating places where understanding of the economics of cities and how
nearly all of us spend our lives. Our proposition in market forces shape cities.
writing this book is that your education should This book uses two different, and complemen-
include a deeper understanding of the economics tary, methods for examining the economy of an
of cities. urban area. The first method is the study of location
3
4 I Chapter 1. Introduction to Urban Economics
patterns within an urban area. The location deci- We shall see that a metropolitan area that grows
sions of households, firms, and industries within the rapidly will see very rapid suburban growth and
urban area are the chief topics. For example, the may have some growth in the central city, whereas a
study of the spatial pattern of population density in metropolitan area that grows slowly will likely
an urban area is a favorite topic in urban economics. experience decline in its central areas along with
Location decisions are influenced by many factors, substantial growth in the suburbs. This combination
including public policies regarding the provision of has motivated the concern about urban ‘‘sprawl.’’
transportation facilities and other public goods and But first we offer a brief introduction to urban
services, local taxation, and zoning and other forms economics as a field of study.
of land use control. The second method is the
examination of the urban economy in the aggregate.
Spatial patterns within the urban area are largely I B. DEVELOPMENT OF THE FIELD OF
ignored. Instead the focus is on the growth or
URBAN ECONOMICS
decline of economy of the urban area. An urban
economy is quite ‘‘open’’ in the sense that imports Urban economics as something of a separate field of
and exports are large fractions of its total economic study within economics began in the late 1930s
activity. Most urban areas specialize in the produc- when economists started using the tools of macro-
tion of a certain group of goods and services for economics to examine urban economies and their
export outside the urban area. Most urban areas thus real estate markets. Basic concepts such as gross
have identifiable economic functions within the national product, exports and imports, the multi-
larger economy. Changes in the larger economy plier, and the unemployment rate were adapted to
can have sizable impacts on an urban economy, the study of urban economies. Perhaps a date for the
and at times may require that the urban area undergo founding of the field is 1956, the year in which the
a significant change in its basic economic function. New York Metropolitan Region Study was initiated.
These two methods for looking at an urban The book that summarizes this huge study was
economy are not independent. Clearly a major written by two economists, Edgar M. Hoover and
change in the economic functions performed by Raymond Vernon, and is entitled Anatomy of a
an urban area can have implications for the location Metropolis. This book, which was published in
patterns within the urban area. Chicago is no longer 1959, carries the subtitle ‘‘The changing distribu-
the ‘‘hog butcher of the world,’’ but is in fact now tion of people and jobs within the New York
the center of its nation’s air transportation system. metropolitan region.’’ This study of New York
Location patterns within the Chicago metropolitan succeeded in gathering an enormous volume of
area have adjusted accordingly as O’Hare Airport data that were presented in a well-organized fash-
and its surrounding area became a major center of ion. The trends observable in the data were then
employment. Further, does a significant change in discussed using a variety of forces that were hy-
the rate at which an urban area grows imply a pothesized to influence the location choices of firms
change in location patterns? At the same time, it and households within a metropolitan area. Anat-
is possible that the location patterns within an urban omy of a Metropolis is a classic study, and we
area can influence its ability to grow. Is the supply of recommend that you read it.
industrial sites sufficient for further industrial Some urban economists would place the found-
growth? Do those industrial sites possess good ing of the field in 1964, the date of the publication of
access to transportation facilities, suppliers, and William Alonso’s book Location and Land Use.
needed workers? Is the urban area (especially its Alonso laid out a basic theoretical model that can be
downtown and other major employment centers), an used to study the economics of location patterns
attractive place that will draw to it workers who within urban areas that is still used today. Alonso’s
possess skills that are used in the new knowledge- method makes use of the idea that households and
based economy? In the next chapter we take a brief firms are willing to make bids for land at various
look at Tokyo, London, Paris, Toronto, Mumbai, locations. Location decisions and patterns of land
New York, Los Angeles, and Chicago to begin to use can be explained by comparing the bids made
see how urban growth and location patterns interact. by different types of households and firms. The law
Development of the Field of Urban Economics J 5
firm outbids others for downtown locations, the refines or makes use of the generally accepted
electronics plant makes the highest bid for a site model (stages 4 and 5), while other researchers
near the interstate highway, the family with children are in the process of questioning the generally
bids more than others for a lot in the suburbs, and so accepted model (stages 1, 2, and 3). Sometimes
on. These ideas will be explored in detail in this those who are questioning the generally accepted
book. Richard Muth gets credit for developing a model will demonstrate that the older model needs
similar theoretical model at the same time Alonso to be abandoned in favor of their newer, better
was working on his book in the late 1950s. See approach. In other cases the older and the newer
McDonald (2007) for a detailed discussion of their models will coexist, and the matter of which model
contributions to the founding of urban economics. is better will be unresolved.
Since the 1960s a great deal of progress has Given these five stages in the accumulation of
been made in urban economics as a field of research. positive economic knowledge, can we determine a
It is also true that urban economics is still a rela- date for the founding of the field of urban econom-
tively new field of study. But what does it mean to ics? Perhaps the field begins with the accumulation
say that progress has been made in a field of of facts—the first stage listed above. If that is the
research? Research in economics can be classified case, then no date can be given because we do not
as one of two fundamental types: normative and (and perhaps can never) know when someone who
positive. Normative economics is the exploration of resembled an economist began to collect data about
questions such as, ‘‘How should the economy be cities. On the other hand, maybe a field of study is
organized to be efficient and/or equitable?’’ Some founded when someone begins to sort through the
ethical objective is specified, and what ‘‘ought’’ to facts and to find patterns and trends that seem to call
be done is deduced—given the facts of life. This for an economic model. The New York Metropoli-
type of research usually makes use of formal eco- tan Region Study is an excellent example of this
nomic theory to derive propositions such as, ‘‘The kind of work. Indeed, maybe it is the finding of such
economy should have perfectly competitive mar- patterns and trends that initiates a field in economic
kets,’’ or ‘‘A tax should be placed on polluters.’’ The science.
task of positive economics is to determine the facts Others will claim that economic science does
of economic life. not exist until the first economic model pertaining to
The development of positive economic knowl- those patterns and trends is actually formulated.
edge in fields such as urban economics typically This is why 1964, the year of the publication of
proceeds through five stages, which can be charac- Alonso’s Location and Land Use, is often proposed
terized as follows: as the date for the founding of the field. There is no
definitive answer to this question, but a stimulating
1 Accumulation of data pertinent to the field of
class discussion might be held to sort out the issues.
study.
How would you compare urban economics to other
2 Systematic examination of these data in order to fields within economics, to other social sciences,
determine the important facts that require for- and to other fields of science?
mal ‘‘explanation’’ through the development of Urban economics provides several examples of
economic models. competing models. For example, consider the anal-
3 Formulation of economic models that are capa- ysis of urban economic growth. One model places
ble of accounting for the important facts. emphasis on the demand for the exports of the urban
4 Empirical estimation and testing of such eco- area, and uses macroeconomic methods (including
nomic models. Keynesian multipliers) to explain trends in the
urban economy. Another model puts its emphasis
5 Use of the models for forecasting, policy anal-
on the supply side. The growth of an urban economy
ysis, and normative analysis.
is seen as being determined largely by its supplies of
Although research may be underway simulta- labor, capital, and infrastructure. Modern growth
neously in all five stages, often researchers at a theory emphasizes the role of technical change. Yet
single time focus on only one or two stages. Also, another model emphasizes the life cycle patterns of
some researchers may be engaged in work that the industries that are located in the urban area. Are
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