Handbook on Urban Economic Base Analysis
Part II
Understanding Local Economic Development
Economic Development Overview and Definition1
Economic development is but one aspect of the broader process of community development. Community development may be thought of as the advancement of political, social, economic, environmental, health, technological, cultural, and recreational aspects of life in a city. In other words, it is an effort to improve the quality of life in a given city.
Economic development is a crucial component of community development as it provides the city with the financial health to make advances in other aspects of community development.
Definition of Economic Development
There is no universally accepted definition of economic development. For the purpose of this handbook, however, the term "economic development" is used within the context of the following definition. Economic development is:
* the process of increasing the rate of wealth creation by mobilizing human, financial, organizational, physical, and natural resources to create opportunities to generate marketable goods and services; and
* the practice whereby economic developers influence the process for the benefit of the whole community.
Economic development practitioners create opportunities for increased economic activity
and facilitate the exploitation of those opportunities by business. This results in wealth creation by business, and a byproduct of wealth creation is an increase in jobs and tax generation. Note that economic development is defined as both a process and a practice. The two-part definition can sometimes lead to confusion in roles related to economic development.
The Concept of Economic Development
As noted, the purpose of economic development activity is to increase the rate of wealth generation. The wealth is created by individual businesses in the private sector. There are, however, many actions that can be taken to attempt to increase the rate of wealth generation. Resources—both human and financial—are always limited, and therefore it is necessary to determine how the greatest results can be obtained given the level of resources available to invest in the economic development effort. Some of the benefits of increasing the rate of wealth creation include greater employment, sustainable business growth, greater tax generation, and an increased standard of living.
Generally, the greatest impact on the long-term rate of wealth generation is experienced when efforts are focused upon increasing basic versus nonbasic employment, which has a greater "multiplier" effect.
* Basic employment is employment created by economic activities whose goods and services are consumed by nonresidents of the area.
* Nonbasic employment is employment created by economic activities whose goods and services are consumed by residents of the area. 1This part of the handbook is largely an excerpt (with some modifications) from the Canadian Urban Institute's Guide to Economic Development & Strategic Economic Planning, used with permission.
* The multiplier effect is the effect of creating other spin-off economic activity as a result of the original activity.
An example of the multiplier effect would be a manufacturer that purchases raw material, packaging products, and business services such as legal and accounting services from local firms. This has the effect of creating employment locally in other businesses.
While other concepts or theories of economic growth also exist, this is the core concept around which most economic development activities are organized and carried out. Part IV of this handbook explores the tools available to describe and explain a local economy using the concept of basic and nonbasic activities—or more simply, "economic base analysis."
The Five Fundamental Components of Economic Activity and How They Relate to Economic Development
In order to understand how economic development can influence the wealth-generation process, it is necessary to understand the fundamental components of economic activities. There are five essential components that form the foundation of all economic activity:
* labor force,
* technology,
* infrastructure,
* financial capital, and
* leadership.
Rapid change in the world has greatly affected these five components in recent years. In the developed world, these large and rapid economic changes have presented new challenges to the processes of wealth creation and economic development. In developing or transition countries, these changes represent an even more significant challenge, as the changes are much more fundamental when combined with a lack of experience in market-driven economic systems.
Labor Force
As the nature of economic activity changes, so too do the skill requirements of the labor force associated with those activities.
Labor has always been an important component of economic activity, and this component may become even more important in the future. Whereas in the past, much of the labor component was unskilled or low-skilled, today and in the future, employees must have a broader set of skills that are immediately deployable in the workplace.
The global economy is becoming more knowledge-based, and its workers must become "knowledge workers." While many low-skill industries have experienced labor layoffs, other types of businesses cannot find workers with the right skills set for their more mentally demanding, complex businesses.
This is happening at the same time that the labor force participation rates of women and minorities are on the rise. Unfortunately (in some, but not all, developing countries), people have frequently not had an opportunity to receive the quality and level of education that would permit them to develop the adaptability, skills, and problem-solving capabilities demanded in today's technological and knowledge-based workplace. This is particularly true for women and minorities.
From the economic development perspective, labor force issues are often the most important criterion in a business investment decision. As the economy requires a more highly educated workforce with better analytical and communication skills, the relative importance of the cost of labor as a location factor declines. Conversely, the value of literate, adaptable, trainable employees increases—and the availability of such workers will be a key economic advantage to any city possessing this attribute.
While labor force education and training are frequently not the responsibility of local governments, there are some important roles they can play, depending upon their legislative authority:
* They can help improve the labor force in two ways:
_ influence (increase) the education level of the local labor force; and
_ address the needs for specific knowledge and skills in the local economy (entrepreneurship, marketing, and other small business skills).
* They can explore the possible use of incentives to support job creation (e.g., exemption from real estate tax payment for businesses creating new jobs).
Technology
Never in history has the process of change been so rapid. Many changes in all types of economic activities have been brought about by rapid technological change, especially those related to advances in computer chip technology. Technology directly affects labor, competitiveness, and productivity of economic activities.
Improvements in productivity are often linked to technological advances. Businesses wishing to stay competitive must not only build technological advances into products, they must also adopt the use of technology in business processes and practices. The adoption of new technologies by businesses (and all forms of economic activities) has resulted in a requirement for a more highly skilled labor force—whether the people are required to operate computers in an office, computerized cash registers, or sophisticated computer-controlled manufacturing processes.
The cost of advanced technology products, such as software or computer chips, is driven more by the cost of the knowledge and research required to develop them than by the cost of production. In the knowledge-intensive new
economy, information is generally a more highly traded and valued commodity (crossing international boundaries instantly and without restriction) than manufactured goods. Research resources are the fountains of new knowledge and information.
Cities that learn to harness and utilize the intellectual resources contained within their universities, research labs, and institutes will discover a renewable source of wealth generation. Other examples of possible local government involvement include supporting the development of local high technologies and the adoption of new technological innovations by:
* promoting (encouraging) interaction between research and development facilities/personnel and the appropriate economic activities;
* influencing or encouraging the restructuring of business enterprises and research departments (e.g., research laboratories) of educational institutions to respond to current and future market needs and to promote their activity; and
* encouraging an increased use of technologies within a region or city by promoting the use of technology (imported if necessary) and by attracting/facilitating foreign direct investment.
Infrastructure
Traditionally, infrastructure was viewed as roads, highways, piped services, airports, railways, electrical power, and drainage/flood control. At one time, it was simply the availability of these services that indicated a well-endowed city.
Today, in addition to the availability of these traditional infrastructure services, the quality of the services (including dependability, timeliness, and convenience) has become a very important criterion in business investment decisionmaking. For example, many technology-dependent businesses will rate the quality of electric power (lack of power interruptions and voltage fluctuations) as one of the most important locational criteria
(since power failures cause very expensive downtime). Transportation capabilities (availability and lack of congestion or delays) by air, rail, or road are very important to those businesses dependent upon just-in-time deliveries.
Other services not previously regarded as infrastructure are now seen as important in many business investment decisions. Examples include:
* educational facilities capable of delivering the appropriate training and skills development services;
* telecommunications facilities such as cellular phone networks, high-speed data communication lines (such as ISDN, T1, T3, or greater), satellite links, and fiber optic and broadband communication networks;
* day care, health care, recreational, and cultural facilities; and
* support facilities for developing the city's knowledge base such as universities, libraries, research facilities, and technology transfer centers.
Increased public investment in infrastructure results in increased rates of return on private capital, higher productivity, and higher private investment—all of which increase the rate of wealth creation.
Some examples of local government roles (depending upon legislative authority) in the infrastructure component of economic activity would therefore include:
* Improve the functioning or capacity of infrastructure systems controlled by local government:
_ by ensuring appropriate functioning of municipal services (water, heat supply, sewage, garbage collection, as well as roads, public transportation, etc.);
_ by extending services to new areas for development; and
by improving and developing health care and education systems, and recreational and cultural facilities.
* Influence the development of infrastructure not directly controlled by the municipality but which is of great importance to the area's business environment (e.g., development of telecommunications, interurban transportation systems).
Financial Capital
Financial capital is the fuel with which all businesses get started, grow, expand, introduce and market new products, and otherwise remain responsive and competitive. At different stages of its life cycle, a business will have different financial capital requirements. There are two basic forms of capital—debt and equity.
* Debt capital involves less risk to the investor, as the funds that are "loaned" to the business are secured by some form of collateral (usually business assets or the business owner's personal assets).
* Equity capital is totally at risk, because the investor's funds are unsecured by collateral. The investor normally requires shares of ownership of the business in return for the investment and may become actively involved in overseeing the management of the business.
Both forms of capital will be required at different times for different purposes and at different stages of business development. Examples are:
* pre-start-up and/or start-up capital (usually equity capital),
* early and later stage growth (usually equity capital or a mix of equity and debt),
* new product development (debt),
* longer term debt secured with collateral,
* debt for operating capital or other purposes secured by assets such as inventories or accounts receivable,
* merger and acquisition financing (either or both types of capital), and
* mezzanine financing (equity injections before an initial public stock offering).
From an economic development viewpoint, both types of capital must be readily accessible and available at reasonable costs. If not, businesses—and therefore the local economy—will not realize their full potential.
Accessibility and availability of capital is an issue that national governments must address. National or state governments should not be directly providing financing, but rather should ensure that the appropriate legislative framework exists to enable the private sector to fulfill this role. The government also needs to ensure a stable economic environment with reasonable lending rates. Further, governments can assist in ameliorating the risk to the private sector through tax or other incentives. Essentially, government needs to be the catalyst and facilitator to ensure that the private sector can fulfill its role in business financing. In addition, government should take a leadership role in directing financing initiatives toward the areas of greatest need or strategic importance.
The role of local economic development efforts should be to ensure that the state/national government is pressured to respond to any concerns related to the above issues. Local governments must ensure a business-friendly economic environment and externally promote available investment opportunities. In addition, local economic development initiatives must be aware of, and encourage access to, local capital sources, and could proactively pursue the structuring of finance deals through a local team effort.
Leadership
Without strong business leadership, businesses would not be successful. To the extent that a city can assist and support the development of
successful business leaders through education and leadership development activities, the city will enjoy a return on that investment. This is frequently the sole focus of "small business centers" or "entrepreneurship centers."
With respect to economic development, other types of leadership are also important. Local government leadership (political and administrative) is critical to the creation of a supportive business environment and to the success of local economic development efforts. The development and support of qualified economic development professionals completes the local leadership triumvirate—of business, local government, and economic development leadership—which is fundamental to successful local economic development.
The Local Leadership Triumvirate
Four Types of Economic Development Strategies
Most economic development actions can be classified into one of four general types or categories of economic strategies, described in the table on the next page.
A more complete description of these four types of economic development strategies follows.
Business Attraction
This traditional approach involves major marketing, advertisement, trade show, and travel
activities. The essence of the approach is to attract a corporate relocation, the establishment of a branch plant facility, or other form of investment from an outsider. This approach requires a city to compete with hundreds or even thousands of other cities involved in the same activity, from the neighboring municipality to municipalities around the world. While the rewards appear great, the chances of success in attracting a relocation in Western economies has grown extremely slim over the years as businesses become more sophisticated in site selection and the competition grows more fierce.
Relocations spurred by large government subsidies are frequently made by firms that are later "footloose" when the effects of the subsidy have worn off. Furthermore, relocating corporations usually bring their management and skilled labor force with them, providing less-than-expected employment for local people, which is a disadvantage in Western economies. In transition economies, however, it offers an opportunity for local staff to learn from foreign expertise.
Four Types of Economic Development Strategies
Branch plant profits leave the city and are invested elsewhere, whereas profits from locally owned operations are frequently reinvested locally. Locally owned operations tend to seek out local suppliers, while foreign-owned operations
tend to purchase a greater quantity of supplies from outside the city.
There is a greater sense of commitment to the city by a local business, and vice versa. Foreign-owned operations, with less commitment to the city, are frequently the first to be "downsized" or closed during times of financial pressure upon the firm.
These types of strategies are most successful when they are targeted to specific markets, specific industry sectors, and specific firms to achieve clearly defined objectives or results. In this context, they are frequently carried out as part of a sectoral development strategy (described below).
There are, however, several advantages to encouraging foreign investments in the developing/transition countries of Central and Eastern Europe:
* access to capital not otherwise available;
* access to foreign technologies;
* access to foreign technical, managerial, and executive expertise which can provide an "alongside" learning opportunity;
* much greater access to export markets by virtue of the credibility and access to exist
ing distribution and sales channels provided by a foreign partner; and
* access to modern business management practices and processes.
New Business Development and Entrepreneurship Development
This approach aims to create an environment that helps people develop entrepreneurial skills, and provides the tools and encouragement necessary to assist entrepreneurs in the incubation of new businesses. Creating the environment often involves attempts to influence the five fundamental components of economic activity described earlier: labor force or human resource skills, financial capital, infrastructure, technology, and leadership. The right environment also means that processes that require business interactions with local governments (for development approvals, business registration, land acquisition, and others) are transparent, open, fair to all, and completed within a reasonable time frame.
The identification and marketing of new business opportunities is also an important component. Some new business opportunities may arise through an identification of raw materials, supplies, and services that are purchased from outside the city, but that could be provided from within the city (import replacement).
Other strategies include the use of business incubators, especially in areas with very limited suitable real estate space. Another common strategy, as an alternative to business incubators, is the establishment of an "entrepreneurship center" or "small business center." Such a center would provide business information, business counseling (or even access to business mentoring), information seminars, and other services that respond to local business leadership needs.
Business Retention and Expansion
These strategies are frequently aimed at retaining the more mature enterprises that could potentially relocate elsewhere.
The most common strategy is a program of regular business visitation to ensure that local businesses have an opportunity for their concerns to be heard and dealt with. The objective is to ensure that existing businesses are given the "royal treatment," not the bureaucratic "runaround." All local business owners are potential business ambassadors. The opinion of a local businessperson with respect to the local business environment frequently weighs heavily in the decision of an outside investor.
Other programs assist in identifying and developing ideas for business expansion or diversification. Assistance programs to access financial capital and for export development can also be provided.
Sectoral Development
Sectoral development is a carefully crafted combination of the above strategies with the objective of the development of a specific economic sector, such as telecommunications, film and television, or tourism.
Often sectoral development programs will attempt to build upon and assist the natural tendency for similar and/or related economic activities to "cluster." A popular example of clustering is Silicon Valley in California. Industry clusters stimulate economic activity due to factors such as proximity, competitiveness, symbiosis, interaction, spin-offs, idea generation, availability of specially skilled labor, etc. The clustered industry sector is sometimes referred to as an "engine of growth," a reference to the multiplier effect. Business attraction activities carried out under this approach usually have an extremely tight focus; are targeted at specific firms; and often have a specific objective, such as finding a strategic alliance for a local firm.
A Model for Economic Base Analysis
To set the context for economic base analysis, it is important to tie together the above concepts. Following is a model for understanding the relationships between:
* the five fundamental components of economic activity,
* the four types of economic strategies, and
* basic and nonbasic economic activities.
The Five Fundamental Components of Economic Activity
In the "Strengths, Weaknesses, Opportunities & Threats" (SWOT) analysis of a city, the strengths and weaknesses of the five fundamental components of economic activity should be assessed. A city's economic environment will be less than ideal, and will inhibit or restrict economic growth if there are one or more fundamental components with weaknesses. A weakness would therefore suggest an economic development activity or program to address the gap.
Serious weaknesses in one or more of these five components could indicate structural problems of the national economy, which are obviously beyond the scope of municipal control. To recognize and document these serious weaknesses, however, gives local business and political leaders an agenda to pursue with the national government.
Less serious, or more localized, weaknesses in the five components suggest an area of potential economic development activity. For example, lack of experience in business management, or lack of space for businesses to locate in, are weaknesses that local economic development efforts can address.
Strengths in a particular component would suggest that there may be specific businesses types that would find it very desirable to locate, or prosperous to grow, in that city. For example, it is common to find a limited number of cities, or more often one city, within a country that is the financial center for the nation. In that city, the financial center often acts as an "engine of
growth" around which related businesses will be attracted and/or grow. For example, providers of business services such as accounting firms, lawyers, and management consultants are most often concentrated in a country's financial center.
Even after identifying a city's strengths and weaknesses related to the five fundamental components of economic activity, this type of analysis is frequently not refined enough to allow the city to develop a specific focus for its limited economic development resources. A further delineation is therefore required.
Four Types of Economic Strategies
The four types of economic strategies cut across, and are supported by, the five fundamental components of economic activity as suggested in the following illustration. Each city will select the types of economic strategies it wishes to use; for each type of strategy to be effective, it must have a solid economic foundation consisting of the five fundamental components of economic activity.
Building the Model: The Fundamental Components of Economic
For example, if a city wishes to pursue a strategy of entrepreneurship development and new business growth, the relative strengths and weaknesses of the five fundamental components in the city—as they relate to this strategy—must be examined. Often, a focus on this strategy will result in activities such as an entrepreneurship center or small business center, the objectives of such a center are usually to improve the business leadership component of economic activity. A secondary or additional objective may be to assist business people with business plans to gain access to financial capital, or to provide some form of a financial "matchmaking" service.
A city pursuing a retention and expansion strategy may wish to build upon a particular strength in one of the five fundamental components. For example, with a concentration of technology-related manufacturing, a city could attempt to build a base of related and/or supporting businesses.
Building the Model: Adding the Four Types of Economic Develop
Basic Versus Nonbasic Economic Activity
Earlier, the difference between basic and nonbasic activities was explained, and how that difference relates to economic development. This distinction provides one last delineation of efforts in the model illustrating the relationships between the five fundamental components of economic activity, the four types of economic strategies, and basic and nonbasic economic activities.
A city will usually choose to focus its efforts mainly on creating or growing basic economic activity, thereby attempting to create an engine of growth. This does not mean that a city will ignore the development of nonbasic activity, which usually accounts for the majority of employment in a city. It simply means that it will
concentrate its efforts on the growth of basic economic activity. Often, the same economic development activities aimed at assisting growth in basic activities help nonbasic activities as well. The economic development organization must therefore be aware of the needs of both the basic and nonbasic sectors, and attempt to address both at the same time while having a specific focus on the basic sector.
In order to use and apply the model, a local city must have quite comprehensive information with which to know its strengths and make its decisions. "Part III: Economic Development Information and Publications" provides examples and "how to" instructions for collecting and analyzing this information for use by the city in its economic development program.
Completing the Model: Adding Basic Versus Nonbasic Activity