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Location Theory

• Explains the pattern of land use.

• Is concerned with the geographic location of economic activity.

• Has become an integral part of economic geography, regional science,

and spatial economics.

• Addresses the questions of what economic activities are located where

and why.

Nearly 200 years ago, the primary concern of

early location theorists, most notably Johann-

Heinrich von Thunen (1783-1850), was the optimallocation of cities and farms, balancing both land

cost and transport costs.

Johann-Heinrich Von Thunen

Least Cost Approach

Alfred Weber (1868-1958)

formulated a theory of industrial

location in which an industry is

located where it can minimize its

costs, and therefore maximize its profits.Weber’s least cost theory accounted

for the location of a manufacturing plant

in terms of the owner’s desire to

minimize three categories of cost:

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1) Transportation: the site chosen must entail the lowest possible

cost of A) moving raw materials to the factory, and B) finished products to

the market. This, according to Weber, is the most important.

2) Labor: higher labor costs reduce profits, so a factory might do

better farther from raw materials and markets if cheap labor is available.

3) Agglomeration: when a large number of enterprises cluster

(agglomerate) in the same area (e.g. city), they can provide assistance to

each other through shared talents, services, and facilities (e.g.

manufacturing plants need office furniture).

Figures 1-3 show the weight-losing case, in which the weight of the

final product is less than the weight of the raw material going into making

the product. In Figure 1, the processing plant is located somewhere between

the source and the market. The increase in transport cost to the left of the

processing plant is the cost of transporting the raw material from its source.

The rise in the transportation cost to the right of the processing plant is the



cost of transporting the final product. Note the line on the left of the

processing plant has a steeper slope than the one on the right.

The weight gaining case is illustrated in Figures 4- 6, where the final

product is heavier than the raw materials that require transport. Usually this

is a case of some ubiquitous (available everywhere) raw material such aswater being incorporated into the product. The optimal location of the

processing plant in this case is at the market. Weber established that firms

producing goods less bulky than the raw materials used in their production

would settle near to the raw-material source. Firms producing heavier goods

would settle near their market. The firm minimizes the weight it has to

transport and, thus, its transport costs.

Market Area Analysis

A market area analysis is the surface over which a demand or supply

offered at a specific location is expressed. For a factory it includes the areas

to where its products are shipped; for a retail store it is the tributary area

from which it draws its customers.

Economic Definition of a Market Area Analysis

A market depends on the relationship between supply and demand. It

acts as a price fixing mechanism for goods and services. Demand is the

quantity of a good or service that consumers are willing to buy at a given

price. It is high if the price of a commodity is low, while in the opposite

situation - a high price - demand would be low. Outside market price,

demand can generally be influenced by the following factors:

• Market Threshold and Range

• Market Size and Threshold

• Market Profitability

• Non-Isotropic

Conditions and the

Shape of Market Areas

Market Threshold and Range



The figure at the right considers a fairly uniform distribution of customers on

an isotropic plain and a single market where goods and services may be

purchased.

Market Size and Threshold

There is a direct

relationship between market

size and threshold whichimpact the geography of

retail. To support its

activities, each urban centre

needs a threshold population

that varies according to its

size. Obviously, large cities

have an important threshold,

so there may be only of few

of them on a specific

territory while there can be a large number of small villages.

Market profitability



A market area has a range and a threshold which are determining the

profitability of the economic activity generating it. The threshold is the

minimal market area an activity must have to stay in operation. It represents

the spatial threshold of profitability where spatial attributes such as

population density and income have an important influence in its

assessment. The range is the effective market area of an activity from which

it draws its customer base. On graph A, activity p will be profitable since its

threshold is inferior to its range R(A). On graph B, activity p is not profitable

because its range is inferior to its threshold.

Non-Isotropic Conditions and the Shape of Market Areas

The left part of the figure represents the standard hexagonal shape of

a set of markets under isotropic conditions. Each market has the same

market area and is evenly spaced. This theoretical condition is obviously

rarely found in reality. The two most important non-isotropic conditions

impacting on the shape market areas are differences in density and

accessibility. The middle part represents a condition where there is a

concentric gradient of population density (from low to high) and a highwaycrossing through. Their possible outcome on the shape of the concerned

market areas is portrayed on the right part of the figure.



Profit Maximization Approach

Profit maximization approach is the process by which a firm

determines the price and output level that returns the greatest profit. There

are several approaches to this problem. The total revenue–total cost method

relies on the fact that profit equals revenue minus cost, and the marginal

revenue–marginal cost method is based on the fact that total profit in a

perfectly competitive market reaches its maximum point where marginal

revenue equals marginal cost.

Basic Definitions

Any costs incurred by a firm may be classed into two groups: fixed cost

and variable cost. Fixed costs are incurred by the business at any level of

output, including zero output. These may include equipment maintenance,

rent, wages, and general upkeep. Variable costs change with the level of

output, increasing as more products is generated. Materials consumed

during production often have the largest impact on this category. Fixed cost

and variable cost combined, equal total cost.

Total cost-total revenue method



To obtain the profit maximizing

output quantity, we start by

recognizing that profit is equal

to total revenue (TR) minustotal cost (TC). Given a table of

costs and revenues at each

quantity, we can either compute

equations or plot the data

directly on a graph. Finding the

profit-maximizing output is as

simple as finding the output at

which profit reaches its

maximum. That is represented

by output Q in the diagram.

There are two graphical ways of

determining that Q is optimal.

Firstly, we see that the profit

curve is at its maximum at this

point (A). Secondly, we see that

at the point (B) that the tangent

on the total cost curve (TC) is

parallel to the total revenue curve (TR), the surplus of revenue net of costs(B,C) is the greatest. Because total revenue minus total costs is equal to

profit, the line segment C,B is equal in length to the line segment A,Q.

Computing the price at which to sell the product requires knowledge of

the firm's demand curve. The price at which quantity demanded equals

profit-maximizing output is the optimum price to sell the product.

Marginal Cost-Marginal Revenue Method



If total revenue and total cost

figures are difficult to procure,

this method may also be used.

For each unit sold, marginal

profit equals marginal revenue

minus marginal cost. Then, if

marginal revenue is greater

than marginal cost, marginal

profit is positive, and if

marginal revenue is less than

marginal cost, marginal profit

is negative. When marginal

revenue equals marginal cost,

marginal profit is zero. Since

total profit increases whenmarginal profit is positive and

total profit decreases when

marginal profit is negative, it

must reach a maximum where

marginal profit is zero - or

where marginal cost equals

marginal revenue. This is

because the producer has collected positive profit up until the intersection of

MR and MC (where zero profit is collected and any further production will

result in negative marginal profit, because MC will be larger than MR). The

intersection of marginal revenue (MR) with marginal cost (MC) is shown in

the next diagram as point A. If the industry is competitive (as is assumed in

the diagram), the firm faces a demand curve (D) that is identical to its

Marginal revenue curve (MR), and this is a horizontal line at a price

determined by industry supply and demand. Average total cost are

represented by curve ATC. Total economic profits are represented by area

P,A,B,C. The optimum quantity (Q) is the same as the optimum quantity (Q)

in the first diagram.

Firm Theory

Theory of the Firm



Behaviour of a firm in pursuit of profit maximization, analyzed in terms

of:

(1) What are its inputs?

(2) What production techniques are employed?

(3) What is the quantity produced?

(4) What prices it charges?

The theory suggest that firms generate goods to a point where

marginal cost equals marginal revenue, and use factors of production to the

point where their marginal revenue product is equal to the costs incurred in

employing the factors.

This trained member of the Chicago

School is best known for two particular

contributions to economic theory. In

Coase's work on the nature of the firm

(1937), he argued that firms should be

conceived as entities endogenous to the

economic system and whose existence is

justified only in the presence of

transactions costs to production. Firms andother economic organizations and

institutions, in effects, exist because agents find it a useful manner of

minimizing transactions costs.

Ronald H. Coase



Transaction Cost Theory

The model shows institutions and market as a possible form of

organization to coordinate economic transactions. When the external

transaction costs are higher than the internal transaction costs, the company

will grow. If the external transaction costs are lower than the internal

transaction costs the company will be downsized by outsourcing, for

example.

Ronal Coase set out his transaction cost theory of the firm in 1937,making it one of the first (neo-classical) attempts to define the firm

theoretically in relation to the market. Coase sets out to define a firm in a

manner which is both realistic and compatible with the idea of substitution at

the margin, so instruments of conventional economic analysis apply. He

notes that a firm’s interactions with the market may not be under its control

(for instance because of sales taxes), but its internal allocation of resources

is: “Within a firm … market transactions are eliminated and in place of the

complicated market structure with exchange transactions is substituted the

entrepreneur … who directs production.” He asks why alternative methods of

production (such as the price mechanism and economic planning), could noteither achieve all production, so that either firms use internal prices for all

their production, or one big firm runs the entire economy.



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