FDI impacts on industrial agglomeration: the case of Java, Indonesia.

AuthorKuncoro, Mudrajad

INTRODUCTION

During the last century, geographers, economists, urban planners, business strategists, regional scientists and other social scientists have developed explanations as to why and where economic activities locate (for example Krugman, 1991, Kuncoro, 2000, O'Sullivan, 1996, Porter, 1998). An uneven regional distribution of economic activity within a nation has been a primary concern, and hence, encouraged increasing research in this field. There are three major theories that explain why and where firms tend to concentrate geographically in a certain region: neo-classical, new economic geography and new trade theory. From a theoretical perspective, we expect that some basic agglomeration forces are at work in the region. Each theory has offered some valid hypotheses. yet there is virtually no rigorous empirical work that assesses the relative importance of these three theories.

This paper examines which theory is best at explaining the geographic concentration in Java, in particular in the period of trade liberalisation. There has never been a comprehensive study on industrial agglomeration that takes Indonesia (that is Java) as a case study and uses the recent framework of the new economic geography and the new trade theory. We focus our analysis on Java for the following reasons. First, main industrial areas in Indonesia have been located overwhelmingly in Java. Most of Indonesian modern manufacturing establishments have continued to be predominantly located on Java and to a much lesser extent, Sumatra Island during 1976-2002. Even when we classify 27 provinces of Indonesia into five main islands (that are Sumatra, Java, Kalimantan, Sulawesi, Eastern Islands), Java and Sumatra provided more than 90 per cent of Indonesia's employment over the period (Table 1, Map 1). The share of Java's employment tended to decline slightly, while Sumatra's share tended to increase substantially. Java's share declined from 89 per cent in 1976 to 81 per cent in 2001. Sumatra's share grew from 7 to 11 per cent in the same period. Other main islands in Indonesia played a minor role in the Indonesian manufacturing employment. Even when we sum up the share of Kalimantan, Sumatra and Eastern Island, their share in Indonesian employment was about 4 per cent in 1976 and 7 per cent in 2002.

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Second, Java with more than half of Indonesians inhabitants offers a huge potential market and is importance by its own rights. In terms of total population, Indonesia is the fourth biggest country in the world after China, India and USA. The number of Indonesian populations was 179.4 millions in 1990 and became 194.8 millions in 1995 (BPS, 1999: 61). yet the increasing number of inhabitants, with an annual average increase 1.7 per cent between 1990 and 1990, was not followed by an equal distribution of population geographically. In 1995, according to Central Bureau of Statistics (BPS), Java Island resided by around 59 per cent of Indonesia population (that is around 115 millions) but the size of area is only 7 per cent of total area in Indonesia.

Third, most of investments, either foreign or domestic, have been concentrating in Java. During the period 1967-1994, around 63 per cent of total approved domestic investments were located in Java; while 66 per cent of total foreign investment flowed to Java (Kuncoro, 1996). Finally, perhaps more importantly, not only most firms are privately owned, in contrast to government-owned or joint venture firms in Outer Islands, but also most firms belong to footloose and more modern industries, while most industries in Outer Islands are resource-based such as timber and petroleum (Hill, 1997, Kuncoro, 1994).

Our previous studies on Java have found that there was a stable-albeit increasing trend--and persistent geographic concentration in Java over the period 1976-1995 (Kuncoro, 2000, 1999). yet some critical and unresolved questions exist: Why geographic concentration in Java persisted during this period? To what extent relevant theories and empirical literature can be used as an explicit test of competing theories on agglomeration forces?

This paper will attempt to address these unresolved questions. At the onset, three major competing theories of geographic concentration will be reviewed critically. This review will provide a guide for developing some testable hypotheses. This study will test these hypotheses in the Java context. An econometric model will be developed and tested using pooling time-series and cross-sectional data.

THEORETICAL FRAMEWORK NEO-CLASSICAL THEORY (NCT)

One of the most important contributions of NCT is its early recognition of agglomeration advantages (Preer, 1992: 34). Arguably an agglomeration arises from the behaviour of agents to seek agglomeration economies, either localization or urbanization economies (1). Traditional location theories argue that cluster of industries arise mainly because of either transport or production costs (Isard, 1956, Weber, 1909). These theories rest on some assumptions in which the geographical basis of raw material, size of consumption location and the immobile and unlimited supply of labor are regarded as given (2).

Cities offer various advantages in terms of higher productivity and income that attract new investment, new technology and educated and skilled workers to a disproportionate degree (Kuncoro, 2000). Neoclassical urban system models the centripetal forces for agglomeration as pure external economies and the centrifugal forces as arising from the need to commute to a central business district within each city.

The literature highlights two NCT of trade namely theory of comparative advantage and the Heckscher-Ohlin (H-O) model. The former is derived from the work of Ricardo in the early part of the nineteenth century, which was reinforced by Mill's reciprocal demand analysis and extended Marshall's and Edgeworth's neo-classical graphical presentations. The theory of comparative advantage postulates that: (1) countries trade in order to take advantage of their differences in natural resources; (2) regions will specialize according to their comparative advantage.

The latter is the result of Heckscher's article Foreign Trade and the Distribution of Income (1919) and Ohlin's book International and Interregional Trade (1933). The H-O analysis establishes that "comparative advantage is determined by the absolute distribution of resources between countries and particularly by the relative factor endowment ratios between countries" (Johns, 1985: 178-81).

One of the most serious problems with NCT is its failure to capture the dynamic of geographic changes at the global level. As pointed out by Preer (1992: 46-50), the major geographic changes include: (1) The decline of the traditional manufacturing belts in Europe and North America, and the rise of new industrial regions in Sun Belts; (2) The decline of cities and the growth of suburban and rural areas; (3) The emergence of large cities as centers of corporate, producer, and personal services; (4) The rise of the technopolis--propulsive regional centers of technological innovation.

THE NEW ECONOMIC GEOGRAPHY (NEG)

The recent state of play in the empirical agenda has been stimulated by the emergence of the NEG. The basic argument of NEG is that increasing returns, economies of scale and imperfect competition are far more important than constant return to scale, perfect competition and comparative advantage in explaining trade and uneven distribution of economic activity. Indeed there are at least three reasons why economists start doing economic geography and incorporating space dimension. As Krugman points out:

First, the location of economic activity within countries is an important subject in its own right ... Second, the lines between international economics and regional economics are becoming blurred ... however, the most important reason to look again at economic geography is the intellectual and empirical laboratory it provides (Krugman, 1991:8). Central to the recent development of the NEG is Krugman's works (Krugman, 1995, 1998, 1996). As has been identified by Martin & Sunley (1996), the main Krugman contributions involve: First, his effort to link external economies and regional industrial agglomeration with trade. Krugman's geographical economics is a hybrid combination of the models of imperfect competition and scale economies used in new trade theory with location theory's emphasis on the significance of transport costs. Second, the recognition that regional economic development is a historical, path-dependent process. Third, region-specific shocks can have long-term growth consequences.

Although NEG offers interesting insights on the uneven geographic distribution of economic activities, the approach still has significant drawbacks. A recent critical survey on the new 'geographical turn' in economics concludes that NEG is neither that new nor is it geography, instead it is a reworking (or re-invention) of traditional location theory and regional science (Martin, 1999). Moreover, the direct testing of the spatial agglomeration models using NEG frameworks are still in an infant stage (Ottaviano & Puga, 1998).

NEW TRADE THEORY (NTT)

The NTT offers a different perspective with that of the new economic geography (Table 2). Its basic belief is that the nature and character of international transactions have changed so much in recent years that contemporary cross-border flows of goods, services and assets are poorly understood by the traditional trade theories. Major criticism of NTT on the "old" trade theory focuses largely on the assumption of perfect competition and constant returns, devotion of too much time on the data and theory rather than the issues that drive economics, and failure to pander to protectionist causes (Dodwell, 1994).

Proponents of the new trade theory argue that market size is determined fundamentally by the size of the...

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