A LEONTIEF MODEL OF INTERREGIONAL ECONOMIC GROWTH

Michael Carlberg*

Abstract

Savings are invested in the region offering the best return,

thus increasing its stock of capital. Simultaneously labour grows,
moving to the region which pays the highest wages. On which path
does this system of regions develop? Theoretical analysis shows
that the time path depends on Leontief technology, propensity to
save and on the growth of labour. In the case of isolated regions a
dynamic equilibrium only exists by chance; in the case of
integrated regions, however, a stable equilibrium is likely to
exist. There is no need for regional policy in this setting, since the
market allocates efficiently and distributes equitably.

I. Introduction

Interregional economic growth is based on free trade, capital movements

and labour migration. Products are shipped to the region paying the best price.
Savings come to be invested in the region yielding the greatest return, thus
increasing its stock of capital. At the same time labour grows, moving to the
region which offers the highest wages. This continuous process raises a number
of questions: How are capital and labour allocated to regions? Is there a trade-
off between interregional equity and aggregate efficiency? At what speeds do
the regions develop, and what are the underlying factors? Does a dynamic
equilibrium exist, and if so, will stability prevail?
A good deal of analysis has been performed on regional planning models
(Rahman (5), Mera (2), Sakashita (7)), on market models treating the region as an
annex of the nation (Botts and Stein (1)), and on foreign trade models without
capital movements and labour migration (Oniki and Uzawa (4)). Of course, real
economic growth is subject to market forces, and the nation is nothing but a
system of regions closely linked by product and factor mobility. Hence the
purpose of this paper is to discuss a market model of interregional economic
growth, focusing on free trade, capital movements and labour migration. Under
neoclassical technology, however, there would be the risk of seeing all activities
move to the most productive region. A simple solution to this problem is given
by introducing Leontief technology. This assumption can be made without much
loss, since the problem at hand is interregional and not intersectoral substitution.

*Sozialoekonomisches Seminar der Universitaet Hamburg, Federal Re-

public of Germany.

30
II. Static Analysis of Allocation

For the sake of convenience consider two regions (i = 1,2) producing a

homogeneous output (Yi) by means of two inputs (capital Ki, labour Li). Though
spatial diffusion may spread technical knowledge, we assume a distinct Leontief
technology in each region; in doing so, we take into account that regions differ
with respect to natural resources (including land, environment and climate). So
output depends on inputs and on fixed technology coefficients (capital-output
ratio vi, labour-output ratio ui):
Ki Li
Yi= rain ( vi , ui ) 9

Let the nation's endowment with capital K and labour L be given. How does the
market allocate capital and labour to regions? The answer is given by the
Edgeworth box in figure 1. Region 1 operates on ray i, region 2 on ray 2; their
intersection yields the equilibrium (A). This allocation is feasible, and there will
be full employment of capital and labour. From figure 1 follows the condition
for production to take place in both regions (interior solution):
ui L uj
vi K vj (1)

02
L

vI
01 K

Figure ]: Allocation of Capital and Labour

If capital and labour endowment is inappropriate, however, then

production is restricted to a single region (corner solution); this case is trivial
and uninteresting as far as interregional economic growth is concerned. Now
will this static equilibrium be reached by the market? Turning back to figure 1
suppose the initial state is B, where capital is abundant. If the addition to
income in region 1 exceeds the reduction in region 2, then firms in region 1 can
offer higher input prices and thereby bid away resources. Since capital is
31
abundant, the change of income is governed by migration ALl:
ALl AL 1
AYI= Ul ' AY2=- u2

If u L < u2, then the increase in region 1 is greater than the decline in
region 2. Provided however capital is scarce and labour is abundant, then the
condition for stability is v2 <. vI. Generallyspeaking, market allocation leads to
stable production in both reglons as long as holds:

ul < u 2 , vl > v 2 or u 1> u2 , v 1< v2 (2)

But if both capital and labour are more productive in region i than in region j,
then, of course, all activities will tend to region i. In static equilibrium, regional
output is determined by national factor endowment and by tlechnology. When
national input grows, there may be a change in regional shares:~
uj K-vjL Yi ujK-v.Lj

Yi uJvi-uivj , ai: = -Y
- = (uj-ui)K-(vj-vi)L

Here the question arises, whether market allocation is efficient or not. This
problem can be stated as a linear program with the objective function
maximising national output under the input constraint:

Y : Y I +Y2-* max
YI' Y2

VlYl + v 2 Y 2<_ K

UlY1 + u2Y2 <_ L

Y.> 0 ,
1

The optimum problem is illustrated in figure 2. K denotes the capital

constraint, L the labour constraint. The feasible set is represented by the shaded
area and the goal function is described by the dashed line (at an angle of 45o).
Maximum national output is reached in A, hence production takes place in both
regions. Yet it may be that production is confined to a single region; figure 3
gives a case in point (C). In A all resources are utilised, while in C capital is
abundant. In figure 3 full employment can be attained (B), but this allocation is
inefficient. Figure 2 yields the condition for production to take place in both
regions:

1See appendix 1.
32
 Y2
K
v 2

\ K
L
~2

>

K L Y1
v 1 uI
Figure 2: Production i n Both Regions
Y2

\
>

Figure 3: Production in a S i n g l e Region YI

U. U.
i L ]
v--? < t ~ < ~ and

u I<" u2 , v l > v 2 or u I > u2 , v 1 < v2

Now this again is condition (i), (2), thus the m a r k e t m a x i m i s e s national

output.

III. Interregional Economic Growth

Regional investment is not limited by regional savings, since savings flow

to the region yielding the highest return on investment. In equilibrium, national
investment is determined by national savings. National savings S, in turn, depend
on regional income and on the regional propensity to save si, which is assumed to
be constant. Nationa~investment I is allocated to reglons according to the
capital-output ratios vi :

S= s I Y I + s2 Y2' I = v I D Y1 +v2 D Y2 9 (3)

d
2D = ~ - denotes the time derivative.
33
Hence the capital constraint shifts parallel to the right, as can be seen from
figure 4; so the optimum moves from A to B. Output in region 1 grows, while
output in region 2 declines with the relocation of capital and labour to region 1.
At the same time labour grows, moving to the region which offers the highest
wages. Let the natural rate of labour growth in region i be invariant; weighting
these regional rates of labour growth ni by the spatial distribution of labour then
provides the national rate of labour growth n. Labour is allocated to regions
according to the labour-output ratios ui:
a l u I nI + a 2 u 2 n2
n= a l u I + a 2u 2 ' Lo e n t = u l Y 1 + u2 Y2 " (4)

Y2
~ nstable

~ ~ J / equilibrium

>
Y1
Figure 4: GrowthPath of the Economy
Due to migration the labour constraint shifts parallel to the right as well,
thus the optimum is situated in D. As a consequence, output and income expand,
part of which is saved; and the savings again come to be invested in the region
yielding the highest return. Simultaneouslylabour continues to grow, moving to
the region which offers the highest wages. This continuous process raises the
question, whether a dynamic equilibrium does exist, and if so, whether stability
will prevail. Turningback to figure 4, is there a time path with both regions
expanding at the same speed? And supposingthe economy is off this time path:
Will there be a tendency back to equilibrium? If, for example, labour grows too
fast, then region 1 runs out of capital and labour, production being ultimately
restricted to region 2. These questions will now be looked into more closely.
Steady-state growth is defined by capital and output expanding at a
uniform and invariant rate. On the other hand, labour grows at the natural
rate. Under Leontief technology, full employment will only prevail if th~
expansion of capital and output is concordant with the natural growth of labour:

3:~ stands for the growth rate of X.

34
 This time path is exponential, since labour grows at a constant rate. The
natural rate is already known, but what about the expansion of capital and
output? The accumulation is determined by the propensity to save, the capital-
output ratio, and by the regions' share in national output:

I S SlY1 + s2Y2 a l Sl + a2 s2
K - K - K -VlYlTV2Y2 - alvl+a2v 2

From this follows the economy's equilibrium rate of growth:

a l u l n I + a2u2n2 a l s I + a2s 2
(5)
alu I + a2u2 alv I + a 2v 2

So the equilibrium rate of growth is influenced by the spatial distribution of

labour which, in turn, is explained within the model. On account of Leontief
technology the economy expands uniformly with both regions growing at the
same speed, though the regions differ in technology, propensity to save and
natural growth of labour. Equation (5) at the same time gives the condition for
the existence of a dynamic equilibrium. For an isolated region (i.e., without
spatial mobility) we get the well-known condition ni = si/v;, whereas for
integrated regions the parameters ni, si and vi must be weighte(~ by a i. In the
case of isolated regions, this condition is fulfilled only by chance. In the case of
integrated regions, however, fraction a: can adjust so as to arrive at the steady
9 . I ~ . .

state. Solving the quadratlc equation (5) for a i immediately gives the
equilibrium rate of growth. But a two region equilibrium will not always exist,
since fraction a i is subject to the inequality:
O <-ai < 1.
Complexity is reduced if the natural rates coincide in both regions, implying such
a pattern of location:
sj - n vj
a.
1
(sj - n vj) + (n v i - s i )

a i is feasible, provided the natural r a t e of growth is s i t u a t e d b e t w e e n the

w a r r a n t e d r a t e s t h a t would prevail in the ease of isolated regions:
__<n<
vi vj
The following c a p i t a l and labour e n d o w m e n t results in the s t e a d y - s t a t e :

_K = al v I + a 2 v2
L a I u I + a 2 u2 '

Thus, the analysis reveals that the existence of a dynamic equilibrium becomes
much more likely by taking account of interregional process substitution.
Now what happens if this dynamic equilibrium is disturbed? Isolated
regions show knife-edge instability, but what about integrated regions? Willall

35
activities tend to the most productive region, or will the economy return to
equilibrium? The answer is given by the time path of the model, which is
characterized by the differential equation (3),(4):
nt
s l Y1 + s2 Y2 = Vl D Y1 + v2 D Y2' Loe = UlY1 + u2 Y2 "
Starting from an arbitrary initial state, the stock of c~pital expands at the
natural rate in the long run, provided the inequality is met:

uI s2 - u2 s1
u I v2 - u 2 v I

Under this condition the market finds the dynamic equilibriumon its own, so the
concept of equilibrium gains in importance. If, however, propensities to save
differ too much as compared with capital-output ratios, then all activities will
tend to the most productive region. How does this error adjustment mechanism
work? Suppose the growth of labour accelerates, then capital becomes scarce.
Consequently capital relocates to the more efficient region, until the additional
labour is fully employed. Hencethe overall capital-output ratio declines so as to
restore equilibrium. Yet in case the shift of activities has gone to the high-
consuming region, the overall propensity to save declines as well. Provided this
decline exceeds the fall in the capital-output ratio, then the threat of Myrdal
instability becomes reality.
On this foundation some conclusions can be drawn concerning trade,
capital movements and migration. Savings Si, consumption Ci and investment Ii
obviously follow from the relationships:

aiv i
Si=siYi, Ci=(1-si) Yi, I i - alvl+a2 v2 I.

Provided the demand for consumer and investment goods exceeds output, then
there will be an import (Y~;)
j~ of goods. And if savings fall short of investment,
then there will be a capital import (Sji):

Y j i = Ci + I i - Yi ' S j i = [ i - Si / Y j i = Sji "

The analysis reveals, that in equilibrium commodity imports are financed

by capital imports. If, however, a zero balance of trade (capital balance) should
be required, then allocative efficiency would suffer a cut-back. In dynamic
equilibrium, the rate of commodity import (capital import) will be invariant:

u _ Sii
Yi - Si = n v i - s i = const.

4See appendix 2.

36
 Interregional migration adjusts discrepancies between the supply of and
the demand for labour. The addition to labour supply D L..s results from the
natural growth_ of labour ni L:,.and from immigration Lji; the'addition to labour
demand D L i conforms to natlonal growth:

s d
D Li = n i L i + Lji , D Li = n L i
If in region i the natural growth of labour falls short of the expansion of
output, then there will be an influx of labour. In dynamic equilibrium, the rate
of immigration is invariant, too:

L..
j1 = n - n. = eonst.
Li i
Alternatively the parameters n and ni can be viewed as the (Harrod-
neutral) rate of technical progress, thus relaxing the assumption of Leontief
technology.

IV. Interregional Distribution of Income

Within this set-up, income distribution is based on interest rates ri, wage
rates wi, and output prices pi o Let firms set prices in such a way that revenue
covers cost:

YiPi = Ki ri + Li wi ~ (6)

Products are shipped to the region paying the best price, consequently output
prices coincide (excluding transportation costs):

pl=P2 = 1 .
Output prices are set to unity in order to simplify notation. In addition,
savings come to be invested in the region yielding the greatest return, thereby
equalising interest rates. Wage rates converge too, as labour moves to the region
offering the highest wages. In this sense, market mobility provides for
interregional equity:

rl=r2 =r , Wl=W2=W 9

With t h i s , e q u a t i o n (6) c a n be r e s t a t e d in t e r m s o f L e o n t i e f t e c h n o l o g y :

vi r + ui w = 1.

This y i e l d s t h e r a t e o f i n t e r e s t a n d t h e r a t e of wages, which obviously are

independent of capital and labour endowment:

u2 - uI Vl - v 2
1"- ~ W =

u2 v 1 - u 1 v2 u2 v 1 - u 1 v2

It is i n t e r e s t i n g t h a t i n t e r r e g i o n a l i n c o m e d i s t r i b u t i o n is d u a l t o t h e l i n e a r
p r o g r a m in s e c t i o n 2. T h e i n t e r e s t r a t e a n d t h e w a g e r a t e a r e d e t e r m i n e d so a s
to m i n i m i s e c o s t , b u t f a c t o r i n c o m e m u s t n o t f a l l b e l o w o u t p u t v a l u e :

37
 Z=Kr+ L w-. rain
r,w

vir +uiw> 1

r> 0

w> 0 o

Figure 5 plots the dual: The goal function (dashed line, at an angle of
-K/L) should reach a minimum under the constraint, the feasible set is shaded,
hence the solution is A. Factor prices do not vanish (interior solution) as longas:

ui u.
< L <_jJ and
vi K vj

u l<u 2 , v I> v2 or u I > u2 , v l<v 2

Once more this is the condition for production to take place in both
regions, cf. (I) and (2). In this case the interest rate and the wage rate do not
depend on capital and labour endowment, but on Leontief technology.

W
\
/
I W

I
u2

>

1 1 r
v1 v2

Figure 5: Rate of I n t e r e s t and Wage Rate ( S h a d o w Prices)

V. C o n c l u s i o n

Interregional economic growth depends on free trade, capital movements

and labour migration. The goods are shipped to the regionpaying the best price,
savings come to be invested in the region yielding the greatest return, and labour
moves to the region which offers the highest wages. Thisbehaviour is good both
for the individuals and for the economy as a whole, since it implies equal wage
rates (and interest rates) in all regions, simultaneously maximising national
output.

38
 In the case of isolated regions a dynamic equilibrium only exists by
chance, and if so, there will be the threat of knife-edge instability. In the case
of integrated regions, however, a steady-state is likely to exist; and if a
disturbance occurs, there will be a tendency back to equilibrium. Output and
income grow at the same rate in all the regions, although the regions differ in
Leontief technology, propensity to save and natural growth of labour; these
factors also determine the speed of expansion. Yet if the natural growth of
labour is too fast or too slow, then all activities tend to the most productive
region. In this case of Myrdal instability, there will be a need for regional
policy. To facilitate exposition, the analysis has been confined to two regions,
but the findings apply in the case of many regions and many inputs, too.

APPENDIX I

The amount of capital and labour required to produce Yi depends on

technology:

K =v I Y1 +v2Y2 ' L = u I Y I +u2 Y2

Conversely, how much can be produced, given the nation's endowment with
capital and labour? Solve the above equation for Yi!

APPENDIXII

Substitution gives:
d Y2
ent
(UlV2-U2Vl) d t (Ul s 2 - u2 Sl)Y2= ( s l - n v l ) L ~

Integration by varying the constant yields:

cI Lo eC2t
Y2 = n - c2 ent + c 3 with constants

sI - n vI u I s2 - u2 s1
cI - , c2 = .
UlV2-U2V1 u I v2 - u2 v I

REFERENCES

1. Botts, G. H., J. L. Stein. EconomicGrowth in a Free Market. New

York: Columbia, 1964.
2. Mera, K. A Multiregion Multisector Model of Equilibrium Growth, in
Papers of the Regional Science Association, Vol. 21, 1967, p. 53.
3. Mera, K. Income Distribution and Regional Development. Tokyo:
University, 1975.
4. Oniki, H., and H. Uzawa. Patterns of Trade and Investment in a Dynamic
Model of International Trade, in Review of Economic Studies 32, 1965, p.
15.

39
5o Rahman, M.A. Regional Allocation of Investment, in Quarterly Journal
of Economics~ Vol. 77, 1963, p. 26.
6. Richardson, H. W. Regional Growth Theory. London: MacMillan 1973.
7. Sakashita, N. Regional Allocation of Public Investment, in PaPers and
Proceedings~ Regional Science Association, Vol. 19, 1967, p. 161.

4O