Previously under the communist regime, the allocation of production was state-planned. From the 1950s until the early 1970s, the Chinese government followed a policy of industrialisation of the hinterland. Some production, such as car manufacturing and iron and steel companies, was relocated to the inland regions (Fan and Scott, 2003, p.301-2). However, since the reforms of 1978, China has been transforming into a market economy. Regional comparative advantages and economies of scale have a greater role to play in the allocation of production across the country. The coastal regions are economically more successful, because they are better endowed to attract production for domestic sales as well as the ex-port market. They also benefit from a highly developed transex-portation network.25
25The Chinese government contributed to these developments by establishing economic zones on the coast, thereby granting the coastal provinces special trading privileges.
4.7. AGGLOMERATION IN CHINESE PRODUCTION 125
Foreign investors also affect agglomeration patterns. If they only want to invest in areas experiencing economies of scale, already highly agglomerated coastal areas will be their first choice. They are also likely to cause further agglomeration. In a study on the location decisions of foreign investors He (2003) finds that although all foreign producers are attracted to the coastal regions, there is a country of origin effect. The choice of location often depends on the nationality of the investor. Those from Hongkong and Taiwan, for example, focus on Guangdong and Fujian, while Japanese and American investors prefer the large cities, such as Beijing, Shanghai, and Tianjin.26
The developments stated above are supported by the strong evidence found for the existence of economies of scale in urban production in China (Pan and Zhang, 2002). However, economies of scale differ between industries. Fan and Scott (2003) divide the Chinese economy into two sectors according to their level of agglomeration. On the one hand there are the small labour-intensive industries, such as electronics, furniture and garments, that are highly agglomerated.27 On the other hand there are large capital-intensive, often resource oriented industries, such as production of ferrous metals, nonmetallic minerals and beverages. These are often state owned and of a less agglomerated nature. Food processing is also a highly dispersed industry, because the goods are perishable in nature and require being closer to the end consumer (Fan and Scott, 2003, p.305).
There are benefits to production under economies of scale. One advantage lies in localisation economies, where one firm can benefit from producing in the vicinity of other comparable companies. Secondly, Chen (1996) finds that agglomeration has contributed to increases in productivity in the machinery and the food industry across China. Fan and Scott (2003, p.315) confirm that agglomeration and productivity are positively correlated in the Chinese electronics business.
However, these productivity increases cannot go on forever. Once agglomeration and the combined output of all firms in the industry in one region have reached a certain level, firms that produce with lower efficiency cannot compete in the market any more and exit the industry. If many producers leave the market, the benefits of economies of scale will also be reduced for all other producers.28 Pan and Zhang (2002) also calculated increases in productivity with agglomeration. They analyse the production data of 119,790 firms across
26For an in-depth survey for the investment decisions by managers according to their nation-ality, the interested reader may refer to the original article by He (2003).
27The electronics industry in particular is experiencing strong economies of scale. Production is concentrated in the Pearl River Delta, in the Guangdong and Fujian provinces on China’s East coast, in Shanghai, Zhejiang in the North, Beijing and Tianjin and their surrounding areas (Fan and Scott, 2003, p.310-3).
28Note that the exact position of these cut-off points differs greatly for the two industries. In manufacturing there are many more firms and the positive spillover effects due to agglomeration are much greater. Thus, the cut-off point is high. The food industry, on the other hand, cannot benefit as much from technology spillovers and the negative impact of increased competition in the vicinity is greater. Thus, it faces a much lower cut-off point (Chen, 1996, p.429).
28 industries and the population data of 224 cities as recorded in the Third National Industrial Survey of 1995. The authors find that doubling the size of a city results in a productivity gain of 36 per cent (Pan and Zhang, 2002, p.1176).
Although the authors suggest that many of the benefits of agglomeration have already been saturated in a large number of Chinese cities, Pan and Zhang (2002, p.2276) expect the economies of scale effect to be large for some time in many Chinese cities, that have not reached the limit of agglomeration yet.
There are some losers in the movement of production to the coastal areas. The developments have had a detrimental effect on the hinterland of the Chinese economy. With the loss of production sights, the inland provinces face high unemployment rates. Under economies of scale, the hinterland is further disadvantaged, if transport costs are high, because producers are even less likely to invest in the area. Therefore, one would assume that the inland provinces in China would attract more production, if transport costs were lower, for example due to higher investments in infrastructure. However, with lower transport costs, food prices as well as the costs for all other inputs, such as labour, will be equalised across the inland and coastal areas in the long run. Therefore, the inland provinces lose their comparative advantage in the provision of cheap labour. This again poses in a disincentive to investors to relocate production.
The disadvantages connected with lower transport costs are one reason, why local protectionism is so popular within China (Hu, 2002, p.327). However, Wen (2004, p.346) finds that lowering trade barriers between provinces could have a beneficial effect. The trade implications will be discussed in greater detail in a later section on China’s role in the world economy.
This ties in with the considerations on migration restrictions in China. If there is no interregional labour mobility, rural-to-urban migration is particulary important for the economic development of the inland provinces. Initially, the coastal regions will maintain their comparative advantage with the continuous inflow of rural migrants. However, wages will rise eventually. Thus, relocating production to the inland regions with their large rural labour surpluses and lower wage rates would become a more favourable proposition. The inland provinces would then be able to experience the benefits of economic development. However, as long as rural-to-urban migration is restricted, the advantages cannot be fully exploited (Hu, 2002, p.329). Fujita and Hu (2001, p.5) also find that restrictions on labour mobility contribute to income differentials, especially when there are economies of scale in production.
Thus, living standards in one region of China are raised at the expense of others. Gustaffson and Shi (2002, p.197) find that in the mid-1990s most of regional inequalities were spatial. Foreign investors also contribute to rising income differentials between regions. As states above, they are interested in good infrastructure and services, local entrepreneurial efforts and inter- and