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MAY/JUNE 1992 ECONOMIC PERSPECTIVES A review from the Federal Reserve Bank of Chicago The 199 0 C lean A ir A ct: a tougher regulatory challenge facin g M idw est industry Producer services: trends and prosp ects for the Seventh D istrict 3 FEDERAL RESERVE BANK OF CHICAGO Contents The 199 0 C le a n A ir A c t: a tougher regulatory challeng e facin g M idw est in d u stry................................................................................................ 2 Donald A . Hanson A market incentive system for reducing sulfur dioxide emissions is one of the highlights of the 1990 Clean Air Act Amendments. The author discusses this and other issues in an overview of the 1990 CAA Amendments and illustrates the economic impact of environmental regulations using a simple economic model. Producer service s: trends and p rosp ects for the Seventh D is t r ic t ............................................................19 W illiam A . Testa Does the economic future of the Midwest depend on selling advertising and management consulting rather than wheat and widgets? The author discusses the evidence for and against the idea that growth in producer services can independently spur regional economic growth. ECONOMIC PERSPECTIVES M ay/Ju ne, 1992 Volum e XVI, Issue 3 Karl A. Scheld, Senior Vice President and Director of Research ECONOMIC PERSPECTIVES is published by the Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and do not necessarily reflect the views o f the management of the Federal Reserve Bank. Single-copy subscriptions are available free of charge. Please send requests for single- and multiple-copy subscriptions, back issues, and address changes to Public Information Center, Federal Reserve Bank o f Chicago, P.O. Box 834, Chicago, Illinois 60690-0834, or telephone (312) 322-5111. Articles may be reprinted provided source is credited and The Public Information Center is provided with a copy o f the published material. Editorial direction Carolyn McMullen, editor, David R. Allardice, regional studies, Herbert Baer, financial structure and regulation, Steven Strongin, monetary policy, Anne Weaver, administration Production Nancy Ahlstrom, typesetting coordinator, Rita Molloy, Yvonne Peeples, typesetters, Kathleen Solotroff, graphics coordinator Roger Thryselius, Thomas O’Connell, Lynn Busby-Ward, John Dixon, graphics Kathryn Moran, assistant editor ISSN 0164-0682 The 19 9 0 Clean A ir A ct: a tougher regulatory challenge facing M idw est industry Donald A . Hanson Protecting the environment and human health is very important. Toward these goals, several new programs have been initiated under the 1990 Amendments to the Clean Air Act (CAA). This article provides an overview of these pro grams and their potentially extensive impacts and discusses the attendant challenges facing management and workers in U.S. industry. According to preliminary U.S. Environ mental Protection Agency (EPA) estimates, the annual cost of these regulatory programs will be around $20 billion [U.S. EPA (1990a)], but other estimates are considerably higher [Fumento (1992)]. The potential for a greater burden is due to a number of considerations which are difficult to quantify: 1) a greater need for compliance planning, including con tingency planning; 2) administrative costs, potential delays, and a loss of operating flexi bility for industrial facilities because of a com plex, new permitting program; 3) direct compli ance costs from more stringent regulations requiring higher pollutant removal rates and the potential for even tighter regulations in the future, as provided in the 1990 Amendments; 4) increased monitoring and reporting require ments; 5) new, stringent civil and criminal enforcement penalties; and 6) various rigidities which may aggravate economy-wide effects. The term “rigidities” refers to elements in labor markets or in markets for goods and services which may lead to deviations from full employ ment and efficient growth. Increased protection of the environment and health will require significant changes in 2 management, worker, and consumer attitudes and behavior. In attempting to lessen the costs of more stringent regulations, consumers and producers will act more judiciously in choosing among products purchased and the processes and materials used to manufacture them. But even with these adjustments, national and re gional incomes as traditionally measured, which exclude many of the benefits of environ mental improvements, may still be lowered by environmental regulations. Because of its manufacturing orientation, the Midwest economy faces a greater challenge in striving for improvements in products and manufacturing to reduce environmental residu als. If the region can master these challenges, it may be possible not only to mitigate much of the potential cost of environmental legislation, but even to transform a regulatory burden into enhanced growth and welfare. By developing expertise in the design and manufacture of clean processes and environmental controls, some businesses could potentially cultivate a new source of income. The challenge will not be easily mastered, however, because many of the requirements (or alternative options) for CAA compliance are ambiguous or have yet to be determined. Businesses will have to work with multiple federal, state, and local govemDonald A. Hanson is a visiting scholar at the Feder al Reserve Bank of Chicago, manager of the energy policy section at Argonne National Laboratory, and adjunct professor of economics at the University of Illinois at Chicago and DePaul University. The author w ould like to thank W illiam A. Testa fo r his extensive and insightful com m ents on several versions of this article. ECONOMIC PERSPECTIVES ment agencies in a heretofore untested partner ship. Further, scientists do not fully understand the physical mechanisms leading to environ mental effects. These uncertainties will require flexible business decision making and contin gency planning. In addition to providing an overview of the CAA, a second objective of this article is to present a simple economic model which illus trates more rigorously the nature of the costs associated with environmental regulations. In the model, environmental expenditures are placed in the context of the larger economy in order to investigate the macroeconomic, indus trial, consumer, and regional impacts. The model identifies one of the potential reasons for macroeconomic cost impacts: workers may not be willing to accept the lower wages (reflecting clean air costs) which would be necessary to maintain full employment. Such so-called “sticky wages” can magnify the economic costs of the CAA program substantially; a numerical example shows costs under such a scenario to be higher by a factor of two compared with direct abatement expenditures. Addressing labor compensation issues in the face of in creased real abatement costs and, in many cases, strong international competition, is a great challenge for industry and labor alike. From fairness and political points of view, it is probably undesirable for environmental regula tory costs to fall h eavily on labor incom e; how ever, if the costs are borne by capital income, there may be less incentive for investment and future economic growth. This model addresses the cost side of environmental regulation but does not attempt to estimate the future benefits from a cleaner, more healthful, and productive environment. The second section of this article provides an overview of the 1990 Amendments. The third section describes the acid rain regulations and highlights compliance within the Midwest region. The fourth section reviews the other major CAA areas: ambient air quality stan dards and nonattainment, prevention of signifi cant deterioration, visibility and other air quali ty values, industrial air toxics, and stratospheric ozone depletion. Some of the burdens and challenges to the economy under the CAA programs are illustrated using a simple model presented in the fifth section. Conclusions are presented in the final section. FEDERAL RESERVE BANK OF CHICAGO O rigins and o v e rv ie w o f th e 1 9 9 0 C A A A m e n d m e n ts Following a rising tide of environmental awareness in the United States during the 1980s and a decade of research and congressional de bate on acid deposition controls, the Bush Ad ministration took a lead in the reauthorization of the Clean Air Act. Compromise legislation was finally crafted among the Administration’s pro posed bill, a House version, and a Senate ver sion, which resulted in the 1990 CAA Amend ments, signed by President Bush in November of 1990. A system of tradable sulfur dioxide (SO,) allowances was adopted as the central approach to reducing acid deposition. This approach was recommended in a December 1988 study spon sored by Senator Wirth, Colorado, and Senator Heinz, Pennsylvania, entitled Project 88, Har nessing Market Forces to Protect Our Environ ment: Initiatives for the New President. The study participants included not only academic economists but also business leaders and repre sentatives of environmental groups, such as the Environmental Defense Fund. The adoption of this market based approach helped achieve the passage of the CAA legislation in Congress and hopefully may foreshadow considerably more reliance on market incentive approaches to other environmental regulations in the future. Recent ly, round two of Project 88 has been published, further assessing the applicability of market incentives for environmental improvements. Overview of the main titles Three new innovative titles have been add ed: Title IV on acid rain control, Title V on com prehensive source permitting, and Title VI on stratospheric ozone protection. Many modifica tions and additions to existing titles were also made. For example, the hazardous air pollutant section of the 1970 CAA, Section 112, which had been an unworkable framework for control ling toxic air emissions, has been totally replaced with a new program; and the difficult urban ozone nonattainment problems have been tackled with new stringent requirements under Title I (see Box l).1 A cleaner environment is no free lunch Acid rain control was a contentious issue during the 1980s because of the sharp divergence of regional interests and the perceived high con trol costs, estimated to be about $4 billion per 3 year [NAPAP (1991)]. The 1990 CAA Amend ments authorize two significantly larger pro grams than acid rain control—urban ozone regulation and industrial air toxic pollution control—which are each likely to be two or three times as expensive to the nation and the Midwest economy as acid rain controls [see Portney (1990) and U.S. EPA (1990a)]. Other provisions of the CAA may also impose significant regulatory and compliance BOX 1 ] The major titles under the new Clean Air Act and the relationship to the titles in the 1990 Amendments Structure of new Clean Air Act Comments and relation to 1990 Amendments Title I Central title o f the CAA Air pollution standards and controls Part A Sec. 109 Provides for setting National Ambient Air Quality Standards (NAAQS) for common pollutants. SIPs and NSPS continue to be required after the 1990 Amendments 110 Requires states to develop State Implementation Plans (SIPs) to attain NAAQS in nonattainment areas and to maintain air quality in attainment areas. SIPs require federal approval. 111 New Source Performance Standards (NSPS) must be met as a minimum level o f control for new sources or existing sources undergoing a major retrofit. 112 Control of hazardous air pollutants Sec. 112 of the 1970 CAA was replaced with a new program, Title III of the Amendments. 113 Federal enforcement This section o f the 1970 CAA was replaced with a much stronger provision in the Amendments Title VII. PartC Prevention o f Significant Deterioration applies to maintaining air quality in areas already in attainment with NAAQS. Part B o f 1970 CAA was replaced with a more stringent ozone control program under Part D. Part D Nonattainment areas Additional provisions were added for ozone nonattainment controls, carbon monoxide, particulate matter, sulfur dioxides, nitrogen oxides, and lead. Title II Mobile Source Emissions Title III General Administrative/Misc. Title IV Acid Deposition Control New title Title V Permits New complex permitting program Title VI Stratospheric Ozone Protection New title Additional Titles VIII - XI under the Amendments call for more research, a visibility impairment assessment, and other matters. 4 ECONOMIC PERSPECTIVES costs. The new Title V comprehensive permit ting program could be a sleeping giant. If each significant piece of industrial equipment emit ting at least one regulated pollutant, such as an industrial furnace, is defined by the EPA as requiring a permit, the paperwork and attendant delays could be overwhelming. Operating flexibility of industrial facilities will be reduced and continuous monitoring, record keeping, and periodic reporting will increase. Even though the 1990 CAA Amendments require that each state have its own permit program (with the federal government running the permit pro gram, if a state refuses), each source permit may be reviewed by the EPA and the designat ed Federal Land Manager, such as the National Park Service. Further, after the federal review there still can be intervention by affected par ties in the state or adjacent states. For example, sulfates affect the atmospheric process of light scattering and can cause visibility impairment. Because of the long range transport of sulfates, it is possible that sulfur dioxide (SO,) reduc tions needed to obtain a permit will be much more stringent than would be necessary under the acid rain control program, Title IV of the 1990 CAA Amendments. Restrictive permits may also interfere with the effectiveness of the tradable SO, allowance program, which is de scribed later in this article. Advantages of market approaches to emission reduction The CAA pioneers the heretofore under used market based approach to reducing emis sions. The market based approach grants firms pollutant emissions allowances while ensuring that total pollution does not exceed national or regional limits. The overall limit ensures that society’s goals for clean air are met. The mar ket based approach allows firms to trade their emissions allowances so that pollution reduc tions are made by those firms that can make them most cheaply. Market approaches, such as tradable emis sion allowances, can lower society’s costs of pollution reduction by providing a level playing field for emission reductions among potential sources while, over time, stimulating the devel opment of new abatement methods and technol ogy. These characteristics of market approach es differ markedly from technology or regulato ry standards. For example, if the law requires industry to install the “best available control FEDERAL RESERVE BANK OF CHICAGO technology,” then there may be little or no incen tive to innovate in ways that reduce pollution because the government would only proceed to make emission standards more stringent. Also, more stringent standards on new sources than on existing sources encourage the continued use of existing equipment beyond the point at which it would otherwise have been economical to mod ernize and replace the equipment. Hence, some critics argue that new source performance stan dards lower investment and reduce economic growth. In contrast, the level playing field under a market approach encourages new investments, reducing emissions and the need to purchase emission permits. In addition to the national market for SO, allowances, a tradable permit program is being proposed to address the region al smog in the southern California air basin around Los Angeles. Interaction among the requirements Urban ozone is one of the pollutants for which National Ambient Air Quality Standards (NAAQS) have been set to protect human health and other environmental values under Title I of the CAA. Those airsheds in which the pollutant concentration exceeds the NAAQS are classified by the EPA as nonattainment areas for that pol lutant. The six common pollutants which are associated with NAAQS are shown in Box 2, along with a summary of the reductions in these pollutants since the mid-1970s achieved so far under the CAA. The interaction and overlap between air programs can lead to uncertainty about compli ance strategies. A single source may be regulat ed under more than one program. Many volatile organic compound (VOC) sources will be regu lated under both urban ozone nonattainment and industrial air toxic provisions. Nitrogen oxides (NOx) will be regulated under Title I in nonat tainment areas and under Title IV on acid rain control. Sulfur dioxide is regulated under Title I, Title IV, and may be further controlled in the future to improve regional visibility. Any new source not only must go through New Source Review and meet New Source Performance Standards (NSPS), but also must meet possibly more stringent regulations due to being in nonat tainment areas or being subject to prevention of significant deterioration applicable to cleaner air areas. Sources of hazardous air pollutants re ferred to as air toxics must also meet Maximum Achievable Control Technology (MACT). 5 BOX 2 Trends since the mid-1970s following the original CAA Regulations implementing the original CAA, such as State Implementation Plans (SIPs), have taken effect over various lengths o f time. Mean while, the composition o f economic activity has been shifting away from material intensive process ing, a trend working in the direction of lowering the amount o f pollution per dollar o f GNP. For exam 1975 to 1990 % change Pollutants affecting am bient air quality standards Sulfur dioxide (S 0 2) Oxides of nitrogen (NOx) Volatile organic com pounds (VOC) -19 -5 -26 Carbon m onoxide (CO) -28 Lead -95 Particulate matter -32 Energy use Electricity 46 Coal 59 Oil Gas 4 -4 Economic activity ple, the share o f manufacturing in GNP has de creased from 24 percent to 19 percent from 1977 to 1989. In spite o f these complexities, it is interesting to compare the changes which have taken place over Existing sources are also subject to the New Source Review if operating changes increase emissions or if a major capital outlay is re quired to refurbish a unit. While the new state permit program is designed to consolidate over lapping requirements on a source, obtaining permits may involve lengthy delays and the permit might require even stronger controls to protect what the CAA refers to as “air quality related values.” With the attention focused on urban ozone nonattainment, any changes in operation of a facility will be scrutinized carefully, and per mits for sources of VOCs or NOx will be grant ed only with stringent controls. The cleanup of existing sources will need to be extended to the multitude of small sources and small busi nesses such as dry cleaners and auto repair 6 Real GNP 58 Em ployment 40 the 16 year period from 1975 to 1990. The time trends for the three precursors o f acid deposition are shown in Figure 1. Hence, emissions of major pollutants regulated under the CAA have decreased significantly while measures of economic value o f output and employ ment have risen dramatically. Electricity and coal use have grown at about the same rate as GNP, whereas oil and gas use are nearly unchanged. garages using surface coatings, solvents, and cleaning fluids. Emission sources in the U.S. and Midwest The sources of three of the major pollut ants regulated under Title I on nonattainment areas, Title IV on acid deposition control, and under other regulations are shown in Figure 1a for the U.S. and compared with the Midwest in Figure 1b. For the purpose of this Figure, the Midwest is defined as the East North Central Census Division which includes Illinois, Wis consin, Indiana, Michigan, and Ohio, plus the states of Iowa, Minnesota, and Missouri. Figure 1 shows that the major sources are different for each pollutant. Most of the S 02, less than half of the NOx, and essentially none of the VOCs are emitted by electric utilities. ECONOMIC PERSPECTIVES Highway transportation emits NOx TABLE 1 and reactive hydrocarbons (VOCs) Share of emissions and economic activity but not SO,, although in the past, in the Midwest in 1985 diesel ships on the Great Lakes Pollutant or Share in M id w e s t by sector (%) have often used high sulfur oil. A economic Industrial significant amount of VOC emis activity All Transportation and other U tility sions comes from wood burning, which is included in Figure 1 in the so2 16.4 37.3 42.9 25.1 industrial and other category. 24.2 NOx 30.9 22.6 17.6 Table 1 presents the shares of VOC 21.6 22.2 21.6 21.6 these pollutants in the Midwest and Gross state compares these shares with the product (GSP) 21.5 share of economic activity in the Midwest, that is, the 21.5 percent of gross state product that was gener utilities. This is due to the Midwest’s heavy ated in the Midwest in 1985. For example, 42.9 reliance on locally mined, high sulfur coal for percent of SO, emissions from electric utilities are emitted in the Midwest. The share of emis electricity generation. sions in the Midwest approximately mirrors its A cid rain c o n tro l o f c o a l-fire d e le c tric share of economic activities except for the u tilitie s higher amount of SO, emitted from electric The acid deposition title, Title IV, of the 1990 Clean Air Act Amendments is innovative in its approach to environmental protection policy; it creates a market incentive system based on SO, “emission allowances.” An al lowance must be obtained for each ton of SO, emitted, as described below. Once allocated by the EPA, allowances can be traded among companies or be reserved for future use or to hedge against higher emission allowance pric es. Allowances are tradable between years, a concept called “emission banking.” A two phase approach in Title IV is also innovative, as are the use of incentives to encourage flue gas desulfurization (FGD), also known as scrub bing, and the adoption of clean coal technology (CCT). The acid rain title is scheduled to cut sulfur dioxide (SO,) emissions from electric utility power plants from 16 million tons in 1985 (see Figure 1) to about 9 million tons in the year 2000. The ambient air quality standards for SO, had already reduced SO, emissions from their peak national level of 29 million tons for all sectors in 1977 to about 23 million tons in 1990 (see Figure 1 in Box 2).2 However, the previous standards did not achieve the level of reduction that was sought for acid deposition control. If the high emitting power plants, many of which bum high sulfur midwestem coal, were to retire at age 30, then SO, emis sions would rapidly decline in the 1990s and perhaps no Title IV would have been necessary, FEDERAL RESERVE BANK OF CHICAGO 7 because the New Source Performance Stan dards (NSPS) regulations would have assured very low emission rates for replacement units. However, the general trend in the electric utili ty industry has been to refurbish, life extend, or even repower existing power plants with new clean coal technology (CCT) combustors [see U.S. Department of Energy (1989)]. The choice to maintain the existing higher emitting plants rather than retire and replace them was the result of a desire to avoid more stringent regulation of new sources as well as the diffi culties which have beset the utility industry, such as lower than expected load growth, ex cess capacity, prudence reviews by state public utility commissions, the high cost of capital, rising construction costs, and high debt for those utilities that embarked on large nuclear energy programs. W ith no end in sight for the cleanup of the existing high S 02 emitting plants, many of which are in the Midwest, those concerned with the acid rain issue wanted a newly focused approach to S 02 controls. Marketable emissions allowances Emissions trading and banking provide cost savings over mandatory technologies in achieving long run environmental goals. These gains are achieved because, rather than manda tory control technology, firms gain the flexibili ty to reduce pollution by choosing among the cheapest technologies, alternative fuels, or alternative schedules in lowering emissions. Factors which will affect the least cost choice are: plant design suitability for retrofit, land availability, economies of scale in abatement technology, access to alternative fuels including differences in competition in transportation to power plants at different locations, and alterna tive local air quality requirements. Gains from trade can be illustrated with a simple example. Suppose 100 tons of emission reduction are needed to meet the environmental objective. Suppose plant A has a marginal abatement cost (MAC) of $300 per ton and plant B has a MAC of $500 per ton. Under a uniform rollback policy each plant would re duce emissions 50 tons at a total cost of $40,000. However, suppose each plant is is sued 50 tons of tradable emission allowances. Then plant A, which has a lower MAC, can sell its allowances to plant B for, say, $400 per ton. Plant A then reduces emissions 100 tons for $30,000, and gains $20,000 in revenue from the 8 sale of allowances. Thus, the net cost to A of the reduction in emission is $10,000. Plant B’s $20,000 cost of purchasing allowances is less than the $25,000 it would have had to pay to reduce emissions by 50 tons. The total cost of the 100 ton emission reduction is $30,000— $10,000 for A and $20,000 for B—rather than the $40,000 cost for the uniform rollback policy. Under the new CAA, allowances are issued gratis to existing polluting utility units based on their “baseline” fuel use as measured by the annual average of 1985, 1986, and 1987 British thermal units (Btu) consumption. The basic Phase I allowances are calculated as 2.5 lb. SO, per 106Btu times the unit’s baseline, and the basic Phase II allowances for the larger, dirtier units are calculated as 1.2 lb. per 106Btu times the unit’s baseline, though allowance allocations are generally not larger than those required to meet historical emission rates. Table 2 shows the utility generating units affected in Phase I. All but the smallest units are affected in Phase II. The Table illustrates that although the Midwest receives a disproportionate share of the emission allowances, it also is likely to have greater control costs because greater emission reductions are needed in the Midwest to meet the allocated allowances (alternatively, the Midwest can buy or sell allowances and reduce emissions less or more, respectively.) The esti mates in Table 2 indicate that in Phase I, the Midwest receives 46 percent of the allowances but still must reduce emissions 43 percent (based on these allowances), compared with an average U.S. reduction requirement of 33 percent. In Phase II, the Midwest receives 28 percent of the allowances and must reduce emissions 65 per cent from the 1989 level, compared with a 41 percent U.S. average Phase II required reduction. Additional Phase I and II allowances are also distributed based on other considerations. In Phase I, a maximum of 3.5 million tons of SO, allowances are to be awarded to units installing scrubbers by 1997. These units can maintain their existing emissions for the first two years of Phase I and then after 1997, also receive ‘2-for1’ bonus allowances for emission reductions beyond those required by the 1.2 lb. per 106Btu limit. As the CAA plays out over time, it is ex pected that utilities will in fact choose to bank Phase I allowances for use in Phase II. This is partially connected with the relative concentra- ECONOMIC PERSPECTIVES TABLE 2 U.S. Phase 1affected units1 Midwest3 U.S. Phase II2 Midwest % o f U.S. % o f U.S. Num ber of generating units 261 137 52 1107 443 40 81 39 48 294 97 33 8.3 4.5 55 15.1 7.1 47 5.6 2.6 46 8.9 2.5 28 33 43 41 65 Capacity (th o u s a n d m eg a w a tts) S02 emissions (m illio n to n s ) so2 allowances (m illio n tons) Reduction needed to meet allowances (p e rc e n tf 'Phase 1affected units are listed by name in Table A of the 1990 Amendments; these are the larger, higher emitting units in the country. 2A few small units are not included. Illin o is , Michigan, Wisconsin, Indiana, Ohio, Minnesota, Iowa, and Missouri. "Required reduction based on no net trading of allowances outside the region. SOURCE: Argonne U tility Simulation Model for 1989. tion of coal production in the Midwest (see Figure 2). The incentives for installing FGD under the 1990 CAA Amendments along with pressure by mining interests in the Midwestern high sulfur coal producing states to scrub rather than switch to low sulfur coal, will result in banked allowances for use in Phase II. Another reason is that, assuming low sulfur coal prices are not bid up too high in Phase I, a unit may be able to switch fuels and achieve an emissions rate of less than 2.5 lb. per 106Btus. The banked emissions will lower the cost of complying with the more stringent rate effec tive in Phase II. For example, a utility could scrub those of its units that are the easiest to retrofit FGD and then bum low or medium sulfur coal in the remainder of its units, thereby banking allowances to cover any excess emissions in Phase II. Bonus allowances of 0.53 million tons per year are also pro vided in Phase II to be awarded to units with low capacity factors in the baseline years and to units FEDERAL RESERVE BANK OF CHICAGO which would be otherwise penalized because they were already low emitting units as of 1985. Any excess allowances can be traded or used in conjunction with new growth in coalfired generation. Utilities which contract for approved CCT may be awarded a four year Phase II extension. Figure 3 shows qualitatively the anticipat ed paths for emissions and allowances. Allow ance awards are the highest in 1995 and 1996 9 due to extensions for Phase I FGD. FIGURE 3 The allowances in 1997-1999 are Anticipated S 0 2emissions and allowances based primarily on an allowed 2.5 lb. per 106Btu emission rate ap q u a n tity o f S O 2 plied to the baseline fuel use for 110 affected plants in Phase I as defined in Table A of the 1990 CAA Amendments. The allowanc es in Phase II are based on 1.2 lb. per 106Btu or less, as applicable, with a four year extension for approved CCT. Hence, as illustrat ed in Figure 3, allowances are issued at a much higher rate early in the program. Although actual emissions will be decreasing over time, they will also decrease at a slower rate than allowances, which thereby implies an accumulation of allowance prices by facilitating the entry of banked allowances in Phase I and the using up speculators who are willing to bear some of the or depletion of these banked allowances in risks of risk averse utilities. Phase II (see Figure 4). The time at which Major uncertainties affecting allowance banked allowances are eventually used up (that prices include: future gas supply and deliveris, when the market regime switches to one of ability, success of renewable energy, effective annual market clearing) is denoted by T* in ness of demand side management programs Figures 3, 4, and 5. (DSM), recovery of the nuclear industry, CCT Hedging risks performance and future penetration, the extent The market price of allowances is expected of low sulfur coal reserves, future electricity to rise steadily over the course of Phase I and II demand growth, and regulatory risk. These through the middle of the next decade (see uncertainties all affect required coal-fired gen Figure 5). This is because (as illustrated in eration during Phase I and Phase II and hence Figure 4), there is expected to be an excess they effect the demand for allowances [see stock of allowances held and the only advantag Hanson (1991a and 1991b)]. The holding of es to holding allowances instead of acquiring allowances can be used to hedge against these them in the future as needed would be capital gains derived from an allowance price expected to rise or the holding of allowances for hedging against uncertainty in the escalation rate of allowance prices. The actual time path of prices will depend not only on technical eco nomic factors such as fuel switch ing costs, but also on the motiva tions of market participants. Risk aversion provides a possible mo tive for electric utilities to bank allowances, thereby increasing the current price of allowances. But forward contracts and futures mar kets for SO, allowances, such as those proposed by the Chicago Board of Trade, may also influence 10 ECONOMIC PERSPECTIVES FIGURE 5 Anticipated allowance price path with and without utility risk aversion Expected S 0 2 allowance price path NOTE: T*=year banked allowances are used up. uncertainties. By lowering costs and risks everyone can gain, including rate payers and utility shareholders. Electric utilities may consider hoarding more allowances than is prudent or installing more scrubbers than is cost effective when this behavior is sanctioned by their regulatory bodies (public utility commissions). However, if a formal market exists for allowances, it may be more difficult for public utility com missions to make regulations that inhibit elec tric utilities from making least cost abatement choices, since the existence of market prices makes the alternatives clear to the public and to all involved. Abatement cost functions and emission reduction The extent of emission re ductions in Phase I and Phase II will be a function of the market price for allowances. A firm can either reduce emissions using fuel switching or scrubbing, or use its allowances. The rule of thumb in economics is that it is cost effec tive to reduce emissions up to the point where marginal abatement costs equal the price of allowanc es. For example, if the marginal abatement cost is greater than the price of allowances at the Phase II basic emission rate of 1.2 lb. per 106Btu, it would be cheaper for the firm to increase emissions and buy allowances. Figure 6 illustrates the total abatement costs for SO, reduction by switching to lower sulfur coal or retrofitting a scrubber for a typical Midwest coal-fired power plant. As Figure 6 illustrates, scrubbing is typically more economical at high er reduction percentages. The slope of the total abatement cost curve is the marginal abatement cost (MAC). The firm can observe current allowance prices, PA, but it must forecast fu ture values for PA. The value of PA used by the firm for planning purposes is the slope of the tangent line (see Figure 6). As shown in the Figure, when the price of allowances is low (represented by the flatter line labeled PAa), the solution for emission reduction is shown as point (a) and fuel switching is used. When the price of allowances is higher in Phase II (repre sented by the steeper line labeled PAb), the solution is shown as point (b). In this case, the firm finds it economical to install a scrubber in Phase II. Allowances and coal market price path interaction Interestingly, marginal abatement costs (MAC) are, in theory, proportional to the low sulfur coal price premium, the additional amount paid for coal per unit reduction in sul fur content. Let PC(S) denote coal prices as a function of sulfur, where we define S in terms of the resulting lb. SO, per 106Btu emission rate. The MAC is just the extra price paid for lower sulfur coal from which it follows (adjust ing for a change in units): FEDERAL RESERVE BANK OF CHICAGO 11 (1) MAC = (-2,000 lb/ton) APC/AS. Since the condition PA = MAC provides the cost minimizing compliance strategy and emis sions reduction as a function of the allowance price, PA, then (2) PA =-2,000 APC/AS. Therefore, market equilibrium low sulfur coal prices are closely connected with market equi librium allowance prices. Bidding up allow ance prices is equivalent to bidding up the price premium on low sulfur coal. Hence, observing the sulfur price premiums in the coal market is a proxy for emission allowance prices. The o th e r title s o f th e 1 9 9 0 A m e n d m e n ts The EPA has already issued many of the detailed regulations implementing the various titles of the 1990 CAA Amendments, but many more regulations are still scheduled to be pro mulgated in the future. Interested parties are encouraged to comment on notices of prelimi nary regulations. This section provides a little more background on some of the other impor tant titles and issues in the new CAA. Ozone nonattainment areas Studies show that ozone damages materials and plants, contributes to urban smog, and is not healthy to breathe. Ozone is one of six common pollutants for which National Ambient Air Quality Standards (NAAQS) have been set under the authority of the earlier 1970 Clean Air Act. The other five common air pollutants are sulfur dioxide (SO,), nitrogen oxides (NOx), carbon monoxide (CO), particulate matter, and lead. Under the CAA, the U.S. is divided into Air Quality Control Regions, or airsheds, which are monitored and are deemed to be either in attainment or in nonattainment of the NAAQS for each of the six air pollutants. Considerable progress has been made in the last twenty years in bringing nonattainment areas into compli ance with NAAQS for all of the six air pollut ants except ozone. The 1990 CAA Amendments contain a tough new program designed to bring ozone nonattainment areas into attainment. In the 1990 Amendments, ozone nonattainment areas are to be classified as either extreme, severe, serious, moderate, or marginal. Los Angeles is 12 the only extreme nonattainment area. The areas likely to be designated as severe in the Midwest are the Chicago and Milwaukee met ropolitan statistical areas. The classification of an ozone nonattainment area determines the actions required under the 1990 CAA Amend ments and the schedule. Each of the states is required to submit a plan to bring nonattainment areas into compli ance over a scheduled number of years. These are called State Implementation Plans (SIPs). Any new sources resulting from economic growth in a nonattainment area, or the replace ment or modification of existing sources, re quires New Source Review. The emission rates for new sources in nonattainment areas are even more stringent than the usual new source per formance standards. Further, “offsets” must be obtained for new growth. An offset is a reduc tion in emissions, sometimes greater than l-for1, from another source. Various mobile source controls also apply in nonattainment areas. Prevention of significant deterioration The areas already in attainment, that is the clean air regions, are classified as Class I, II, or III, with Class I areas being the most deserving of clean air. National parks are all classified as Class I areas because of their scenic beauty. Air quality may be allowed to worsen in exist ing clean air areas, but only by a very small increment, as set out by EPA regulations. This is called the PSD increment. The State Imple mentation Plans (SIPs) are also required to maintain existing air quality. New sources in the region of a Class I area may require lower emission rates than the usual NSPS. Visibility and permitting The Acid Deposition Title IV may not reduce SO, sufficiently to achieve goals of improved visibility in national parks, such as the Grand Canyon in Arizona, Shenandoah National Park in Virginia, and other scenic areas. Title VIII of the 1990 Amendments requires that the federal government undertake a study to identify and evaluate possible sourc es of regional haze. Unfortunately, it appears that, because sulfates are carried over long distances rather than deposited locally, only a small percentage of the contribution to visibili ty impairment comes from local sources. Based on Argonne National Laboratory’s Ad vanced Statistical Trajectory Regional Air ECONOMIC PERSPECTIVES Pollution model (ASTRAP), relative contribu tions arriving at Great Smoky Mountain Na tional Park by source state are illustrated in Figure 7. The role and frequency with which sulfates contribute to visibility impairment are now being studied statistically. If more con trols are deemed to be needed, then consider ably greater SO, reduction costs will be in curred beyond the compliance costs already under Title IV. The reduction in visibility impairment cross cuts several of the regulatory controls in the CAA. The 1977 CAA Amendments set a national goal for no man-made visibility im pairment, with reasonable progress to be made toward this goal over time. The PSD program can be used to enforce further controls on emis sion sources. Alternatively, air quality related values, such as visibility and sensitive ecologi cal areas, can be protected through federal intervention in the state permitting process. Based on recent trends in rejecting new source permits and new regulations promulgated by the Department of the Interior, intervention by the Federal Land Manager to require more stringent emissions caps on existing sources is expected under the new permit program of the 1990 CAA Amendments. Industrial emissions of hazardous air pollutants The 1990 Amendments include a list of 189 potentially toxic industrial chemicals to be targeted for regulation. The EPA also has the authority to add to the list or modify it. A best technological approach has been adopted to regulate air toxic releases under the FEDERAL RESERVE BANK OF CHICAGO 1990 CAA Amendments, in contrast to the risk assessment requirements under Section 112 of the original CAA, which proved to be unworkable. The technological approach is called Maximum Achievable Control Technology (MACT). However, a firm may postpone the stringen cy of the MACT controls if it opts for early compliance. Hence, planning is required to make the best decision because if a firm waits and a stringent MACT is required, the cost may be much greater. After this pro gram is implemented, another wave of regulation is possible. Cost benefit studies will be commissioned by the EPA to see if future controls are warranted. Stratospheric ozone depletion and global warming Chlorofluorocarbons (CFCs) and similar bromine compounds are destroying ozone in the stratosphere and are also so-called “green house” gases. Recent scientific studies indicate a more rapid thinning of the stratospheric ozone layer than previously thought, which will, for example, increase the ultraviolet radiation from the sun that reaches the earth’s surface.1 Hence, more skin cancer cases are projected. The Montreal Protocol on ozone depleting substances calls for remedial steps to be taken by industrial countries. Title VI of the 1990 Amendments complies with the Montreal Pro tocol which calls for controlling both the chem icals themselves and products containing the chemicals. The production and sale of a list of chemicals and yet to be determined substitutes is to be regulated by the EPA. Hence, manufac turers will need to develop substitute chemicals and products including chemicals for use in automobile air conditioners and for cleaning fluids for electronic and photographic equip ment. The Administration’s position on control ling greenhouse gases is to reduce these emis sions when it is beneficial to do so based on criteria other than the effect on global warning. As a result, cost effective energy conservation is also encouraged to reduce greenhouse gas emissions. 13 Burdens and challenges: a general e q u ilib riu m m o d el Many of the burdens to individual firms complying with the new Clean Air Act Amend ments have been discussed here: increased expenditures for emission abatement or for related planning and administrative activities, loss of flexibility in industrial facility opera tions, the need to monitor emission releases, and the resulting burden of higher product prices or lower profits or wage payments. But the challenge facing industry is one that econo mists have trouble describing succinctly be cause it goes beyond the aforementioned bur dens. Emission control is just one of many challenges facing management and labor, who must also be concerned about marketing, prod uct quality, reliability, worker health and safe ty, labor productivity, cooperative manage ment, worker morale, supplier relationships, new product development, and shareholder profits. Industry must reduce emissions to comply with new regulations and at the same time increase product quality and lower costs. How this can all be done is perhaps a topic in management and organization. From a public standpoint, analysis must focus on how product prices and wage increases are impacted by an environmental regulation. At least in the short run, this reflects the notion that society can enjoy and benefit from a cleaner environment only at the expense of reduced income. In this section, it is suggested that the ex tent of these costs on the macroeconomy will depend heavily on the behavior of the real wage rate, that is, a wage adjusted for its power to purchase market goods. The economy may be aptly characterized by sticky wages if workers are reluctant to recognize that lower wages are the cost of a cleaner environment and, for ex ample, continue to negotiate for constant pur chasing power. A falling real wage can partly offset the abatement expenditures and full em ployment can be maintained. But if the real wage is sticky in the downward direction, then the economy will adjust to the new regulations at a greater total cost. Moreover, in a dynamic context, much of this magnified cost will fall on profits which could lower investment spend ing and new product development. Reasons to anticipate sticky nominal and/or real wages have recently been assessed by Robert Gordon (1990). Descriptions of economic behavior in terms of dynamic wage price spirals have been 14 used in numerous analyses such as the DRI quar terly model of the U.S. economy. Recent empir ical evidence has been presented by Mehra (1991). A simple model has been constructed to illustrate these relationships based on microeco nomic principles [see, for example, Varian (1984)]. For ease of exposition, the economy is divided into two industry sectors: Sector X, which creates pollution, and Sector Y which is assumed not to pollute. To obtain numerical results for illustration we assume that 1/3 of the labor force is employed in Sector X and 2/3 in Sector Y. The time horizon is short to medium term which means that technology and produc tion facilities are fixed but that sectorial output can be raised or lowered by hiring more or fewer workers. A marginal product of labor is assumed in which an n percent increase (decrease) in labor gives rise to a 1/2 n percent increase (de crease) in sectoral output. This marginal product of labor assumption defines the production possi bility frontier at full employment, as labor is shifted from one sector into the other. Under the environmental regulation, some output is used for real abatement expenditures. Abatement expenditures are assumed to be divid ed between heavy manufacturing equipment and materials purchases from Sector X and service and light equipment purchases from Sector Y. These abatement purchases are represented as intermediate goods described by interindustry flows. Substituting between these two abatement factors is allowed (that is, to minimize costs of regulation to the firm) and the feasible substitu tions are described by a Cobb-Douglas technolo gy. Abatement costs are taken to rise more than proportionally with reductions in emissions per unit of output in Sector X. Total abatement costs (TAC) using the price in Sector Y as the numeraire, is given by: (3) TAC = (P IP )X + Y ; where P and P are the prices of goods X and Y respectively, and Xa and Ya are the outputs of sector X and Y respectively, sold to sector X firms for pollution abatement. Hence, the sub script “a” refers to real resources used in emis sion control. It is often suggested that environ mental regulations create income and jobs and hence presumably have positive impacts on the economy. I agree with this position only in part. It is true that abatement expenditures, modeled ECONOMIC PERSPECTIVES here as TAC, also represent income earned by some business and that the production of abate ment goods, Xa and Ya, will employ workers. (In fact any output from sectors X or Y will employ workers.) The reason, however, that abatement expenditures (TAC) are a cost to the economy is that the skilled workers and other resources producing Xa and Y have an opportu nity cost; they could produce other valuable output for society. In a numerical example, we consider a new regulatory program with TAC equal to 20, which corresponds to the preliminary cost esti mate for the 1990 CAA Amendments cited earlier of $20 billion. This is 0.42 percent of national income, /, taken for illustration to be 4,800: (4) I/Py = (PJPJX + Y\ = (.8)2,000 + 3,200 = 4,800; where X and Y are the original equilibrium outputs assumed to be 2,000 and 3,200, respec tively (see Figure 8). The numerical values shown for income, 4,800, and the relative price ratio, 0.8, correspond to the consumer equilibri um point described by the consumers’ demand curve. The price elasticity of demand is as sumed to be -0.5, so that a 10 percent increase in the relative price of X, that is, PJPV, reduces the relative demand for X by 5 percent. The equilibrium point is illustrated in Figure 8. Another behavioral assumption of the model is profit maximization. In addition, firms in each sector are assumed to be price takers. Firms hire labor and produce output up to the point where the value of the marginal product of labor (MPL) equals the wage rate, W. For Sector Y we express this formally as: (5) MPl (L) = W/Py . In Sector X, expenditures for pollution abatement (TAC) per unit of output must be subtracted to obtain the net value marginal product of labor: (6) (PJP -TAC/X)MPl (LJ = W/P . These three relationships: 1) the produc tion function, 2) profit maximization, and 3) consumer equilibrium, define the model. It is a general equilibrium model in which sectoral prices, wages, outputs, and employment are all determined endogenously. The idea is to com pare the initial equilibrium point of the model (that is, without the environmental regulations) to the new general equilibrium solution which is reached subsequent to the environmental regulation.4 The distribution of income between labor and capital at the initial equilibrium can be calculated from the above assumptions, yield ing (7) (IIPJ = WL/P + n/Pv . We wish to examine changes in real in come, real labor income and real capital in come. The real values are the nominal values /, WL, and k deflated by a price deflator consis tent with consumer preferences. The rate of change in the price deflator is given by: (8) dP/P =1/3 dP IP + 2/3 dP IP , where the appropriate weights 1/3, 2/3 have been derived from the model. The “general equilibrium” results from the model are calculated for three policy scenarios which are based on differing assumptions about how flexibly the economy reacts to environ mental regulation: 1) full employment, in which the wage rate, W /P, decreases in re sponse to environmental controls, 2) a constant real wage based on the price deflator shown FEDERAL RESERVE BANK OF CHICAGO 15 TABLE 3 Illustrated direct and total effects of environmental policy Direct abatement cost Total change in real income* % Change in real labor income D o lla rs Change in real profits D o lla rs D o lla rs Full e m p lo y m e n t, lo w e r w age 20 -2 0 .0 -0.42 -14 .0 -0.4 2 -6 -0.4 2 0.0 C o n sta nt W /Py 20 -2 3 .3 -0.49 -16 .3 -0.4 9 -7 -0 .4 8 0.14 C o n sta nt real w age 20 -40.1 -0.84 -14 .0 -0.4 2 -2 6 -1.8 0 0.42 % D o lla rs % Addition to unemployment % in c lu d e s direct abatement cost. investment spending and delay the adoption of above, and 3) an intermediate case in which new competitive technology, thereby dampen W/Py is constant. In this intermediate case output in Sector Y is unchanged but some un ing economic growth. In a world characterized by stiff competition in most products, it may employment will arise from reductions in out put for Sector X. However, because the price not be possible for firms to simply raise prices of good X increases due to new abatement to partly offset abatement costs. Some observations can be made regarding expenditures, the constant value W/P will actually represent a decreasing real wage based regional impacts. It would appear that a region on the price deflator. In the case of a constant is better off if it produces more of good Y, such as services or light industrial products whose real wage, the result is even higher unemploy ment and a magnification of cost due to lost output under full employment expands, than a region which produces more of good X, which economic output. can be thought of as heavy manufacturing, Using these assumptions and numerical chemicals, refining, coal-fired power plants, values under the constant real wage case in mining, and materials processing. which labor attempts to maintain its real in come, the loss in national income is about double the loss in the full FIGURE 9 employment case. Under the full Illustration of the effects of regulation employment case the loss in na under a constant real wage tional income just equals the direct abatement cost (see Table 3). real output Further, with a constant real wage, 0.4 percentage points are added to the unemployment rate and real profits decrease about 2 percent, which represents an amplification effect: a direct cost of $20 reduces real profits by $26 and wages by $14 so that the constant real wage shifts the burden more onto capital income (see Table 3 and Figure 9). Of course, this framework accounts only for a “snapshot” estimate of costs to the economy. 1,970 1,980 1,990 2,000 2,010 2,020 real output As a matter of conjecture, in a 1 Production point with full employment. dynamic context, a more signifi 2 Production point with constant Y output. 3 Production point with constant real wage. cant burden would be expected to 4 Consumption point with constant real wage. develop if lower profits reduce 16 ECONOMIC PERSPECTIVES There are also regional implications regard ing goods consumed versus goods produced. Final goods consumed decline to the extent that they are displaced by the production of abate ment goods. And even if the national level of X does not decrease very much, there may be regional reallocations of production as some of the output from X goes into the abatement ex penditure activity. A regional goal to preserve regional income in heavy manufacturing areas like the Midwest will be to capture a large part of the market share for pollution abatement sales rather than importing these goods from other regions or from other countries. However, it should be noted that according to the model, even if a region maintains its share of abatement business in proportion to its original output from sector X, total national output from X is expected to decrease. A region would have to gain share in order to maintain its output. At the present time, the prospects for the U.S. or its industrial regions gaining share would be difficult in view of the strong market posi tions of other nations, particularly Germany and Japan, in the abatement equipment market. C onclusions It is unlikely that the announced costs of around $20 billion per year for the 1990 Clean Air Act Amendments will actually come to pass. Rather, costs are likely to be either higher or lower depending on how the economy adjusts; that is, either how it rises to the challenge, or on the other hand, how the burdens become magni fied. In the best case scenario, industry success fully plans to meet the requirements and tech nology is developed or adopted to meet emis sions requirements so that with continued in creases in labor productivity and economic growth and adaptation of thinking on the need to control emissions, there may be little public attention regarding an emissions control burden. This optimistic scenario largely reflects previ ous experiences with environmental legislation; many environmental programs have proven to be less costly than originally feared. The alternative, less positive scenario is one where planning is difficult because regula tory requirements remain uncertain, partly as a result of uncertainty as to environmental effects and partly due to the unpredictable outcomes of political wrangling over CAA implementations. The permitting process for industrial sources is long, detailed, inflexible, and uncertain. The goals of reducing urban ozone and cleaning up industrial waste and emissions remain as elu sive as they have been over the first twenty years of the Clean Air Act’s history. U.S. in dustry falls behind in developing and marketing new, more competitive, cleaner processes. Corporate funds available for investment in new or retrofitted facilities are low. In this negative scenario of lower economic growth, the distribution of income becomes more con tentious. Labor, not meeting its expectations for real standard of living growth, attempts to increase its real wage at a time when real envi ronmental control costs are rising. These mac roeconomic effects have been observed histori cally in the 1970s and 1980s, following the oil price shocks of 1974 and 1979 and the rising environmental clean up expenditures during these decades [for example, see Wilcoxen and Jorgenson (1990) and Hickman, Huntington, and Sweeney (1987)]. This, as was shown in our simple economic model, magnifies the direct abatement costs and thereby gives rise to additional lost output and slightly more unem ployment. The challenge is to promote com munication and cooperation among business leaders, scientists, engineers, and labor so that the worst case scenario involving high costs of a cleaner environment can be mitigated. FOOTNOTES 'The titles and sections under the original 1970 CAA and the 1977 Amendments are distinguished from the titles of the 1990 Amendments. For example, Title III of the 1970 CAA deals with administrative and miscellaneous matters, whereas Title III of the 1990 Amendments provides lan guage to replace Section 112 of the original CAA dealing with hazardous air pollutants from industry (see Box 1 for a listing of the major titles). authority of Title I of the original 1970 CAA in order to protect health and environmental values. 3Silver (1990), see Chapter 9. 4A paper describing the model in more detail is available from the author. 2National Ambient Air Quality Standards have been set for the six common pollutants shown in Box 2 under the FEDERAL RESERVE RANK OF CHICAGO 17 REFERENCES Fumento, M., “The hidden cost of regulation,” Investor’s Business Daily, March 9, 1992. gram as Amended in 1990, Morgan, Lewis & Bockius, 1990. Gordon, R.J., “What is new Keynesian eco nomics,” Journal of Economic Literature, Sep tember 1990, pp. 1115-1171. Silver, C., One Earth, One Future: OutChanging Global Environment, National Acad emy of Science, 1990. Hanson, D.A., “Forecasting the market for SO, emission allowances under uncertainty,” pre sented at EPRI’s Eighth Electric Utility Fore casting Symposium, Baltimore, October 1991a. U.S. Department of Energy, Clean Coal Tech nology: The New Coal Era, DOE/FE-0149, November 1989. _________________, “Two-period model of emission abatement and allowance banking under uncertainty,” Illinois Economic Associa tion, Chicago, October 1991b. Hickman, B.G., H.G. Huntington, and J.L. Sweeney, Macroeconomic Impacts of Energy Shocks, North-Holland, 1987. Kohout, E.J., et al., “Current emission trends for nitrogen oxides, sulfur dioxide, and volatile organic compounds by month and state: meth odology and results,” Argonne National Labo ratory Report, ANL/EAIS/TM-25, August 1990. Mehra, Y.P., “Wage growth and the inflation process: an empirical note,” The American Economic Review, September 1991, pp. 931 937. National Acid Precipitation Assessment Pro gram (NAPAP), 1990 Integrated Assessment Report, November 1991. Portney, P.R., “Policy watch: economics and the Clean Air Act,” Journal of Economic Per spectives, Vol. 4, No. 4, Fall 1990, pp. 173-181. Quarles J., and W.H. Lewis, Jr., The NEW Clean Air Act: A Guide to the Clean Air Pro 18 U.S. Environmental Protection Agency, Clean Air Act Amendments: Cost Compari sons, Office of Air and Radiation, January 1990a. ______________________________,The Clean Air Act Amendments of 1990, Summary Materials, November 1990b. ______________________________, National Air Pollutant Emission Estimates 1940 - 1990, EPA-450/4-91-026, November 1991. U. S. Congress, Senate, Project 88, Harness ing Market Forces to Protect our Environment: Initiatives for the New President, sponsored by Senator T.E. Wirth, Colorado, and Senator J. Heinz, Pennsylvania, December 1988. ______________________________, Project 88, Round II - Incentives for Action: Designing Market-Based Environmental Strategies, spon sored by Senator T.E. Wirth, Colorado, and Senator J. Heinz, Pennsylvnia, May 1991. Varian, H.R., Microeconomic Analysis, W.W. Norton, second edition, 1984. Wilcoxsen, P.J., and D.W. Jorgenson, “Envi ronmental regulation and U.S. economic growth,” Rand Journal of Economics, Vol 21, No. 22, 1990, pp. 314-340. ECONOMIC PERSPECTIVES Producer services: trends and prospects for the Seventh D istrict W illiam A . Testa Economic development strate gists in the Seventh District have tried to hitch their wag ons to the booming service sector as a means of replacing disappearing paychecks in manufacturing and agriculture. But not all services are capable of driving regional growth. Service sector jobs satisfying local consumer demand, such as dry cleaning and most retail sales, do not usually generate additional personal income. Accord ing to the so-called “export base” theory, goods and services sold afar generate income which, in turn, finances local income and spending on nonexport goods and services. In this way, the portion of regional growth that is generated by changes in external demand for the region’s exports is usefully identified for purposes of development policies. Accordingly, the re gion’s perspective correctly focuses on those service sectors that are driven by external de mand—that is, so-called “export sales.”1 In particular, producer services industries have been associated both with strong growth of late, and with external rather than local markets. Producer services are services sold to firms rather than to consumers and typically include accounting, management consulting, financial services, real estate, insurance, engineering, architecture, and credit reporting.2 The produc er services sector represents one of the most rapidly growing sectors as measured by the rate of job growth (see Table 1). Moreover, its growth has been consistently high over the past FEDERAL RESERVE BANK OF CHICAGO two decades, growing at an annual rate of 4.5 percent per year from 1969 to 1979, and 4.8 percent from 1979 to 1989. Given this robust growth, producer services appear to be a rich target for local and regional development policies. But the richness of the target may be to little avail without a deeper understanding of where and why producer ser vices are growing. Surely, not all regions will be attractive to all producer services industries; and not all industries will be attractive to re gions. What institutions and amenities are attractive to producer services industries? Are both urban and rural locales attractive? Do producer services industries sell beyond the boundaries of the local economy and, if so, which industries do so? In this article, I review current studies in order to shed light on these issues. Studies are reviewed which claim to measure a regional economy’s propensity to sell services beyond its own boundaries. Further, the article exam ines the tendency for producer services to favor locating in more urbanized areas rather than in less urbanized or rural areas, and how techno logical changes in personal computers and telecommunications technology may be chang ing the locational tendencies of producer serW illiam A. Testa is a senior regional econom ist and research officer at the Federal Reserve Bank of Chicago. The author thanks David R. Allardice, Andrew J. Krmenec, Richard H. M attoon, and Car olyn M cMullen for com ments, and gratefully ac knowledges the research assistance of Sonia Chung and David D. Weiss. 19 question to a greater degree, or because it produces the service with more labor and less capital Em ploym ent Annual grow th and land in comparison to other 1989 1969-79 1979-89 regions. Alternatively, its topog th o u s a n d s ( ------- p e r c e n t -------- ) raphy or climate may require greater local production and con Producer services 23,351 4.5 4.8 sumption of the service. For Business services 7,845 7.1 8.2 example, pest control services for FIRE 9,981 4.5 3.6 buildings are in greater demand in Legal services 1,258 5.8 6.0 hot humid climates such as Hous M em bership org. 1,644 -1.2 .5 ton or New Orleans, while snow 2,624 M iscellaneous* 6.4 3.9 removal services are demanded in Com m unication 1,340 2.3 .2 Buffalo. These problems aside, Electric, gas, and sanitary 1,004 1.9 2.1 differences in service employment 21,957 2.9 2.4 Retail trade across regions can be used to Wholesale trade 6,471 3.3 1.5 determine which regions export Transportation 3,988 1.3 1.6 services, to a reasonable order of Health 8,876 6.0 4.3 approximation.4 The most commonly used Government 1.4 20,355 1.0 measure for service export has All services (nongoods) 99,911 2.8 2.7 been a simple index of employ includes engineering, architecture, accounting, management, and ment concentration which looks at public relations services. SOURCE: Bureau of Economic Analysis. an industry’s share of total em ployment in a region. This share is put into index form by dividing vice firms. The final section summarizes the by the industry’s share of total employment in the nation: findings and discusses the overall prospects for producer services industries in the 1990s. (1) Index = (E../E , . ) / ( £ . / £ total,U S'* v 7 v IJ t o t a iy ' v i,U S TABLE 1 Can service e xp o rts spur a reg io n al econom y? Two types of studies support the idea that growth in services can independently spur a region’s economy. Both do so by suggesting that a significant proportion of a region’s ser vices are sold afar rather than locally, which implies that services growth need not be de rived from the growth in local goods produc tion. The first set of studies looks at the pro portion of a region’s services employment across industries. The observation that a re gion’s employment concentrates in a particular service industry, that is, that there is surplus labor employed in producing a service, sug gests that the region produces more than it needs and therefore exports the surplus.3 As pointed out by the authors themselves, this method and its variants are subject to error in their purported measurement. A region may display greater employment concentration, not because it exports the service afar, but because its population prefers to consume the service in 20 for service industry i and region j. For exam ple, if advertising employment in Chicago accounted for .5 percent of Chicago’s total employment, but only .25 percent of total em ployment in the nation, then advertising in Chicago would have an index number of 2. An index number greater than 1 suggests that the region produces a surplus in the service which is exported elsewhere. Accordingly, an index number of 1 would indicate little or no trade while an index number less than 1 would sug gest that the region imports the service. The idea of observing service specializa tion and export from employment concentration has been extended to service production within an urban hierarchy and, in particular, to the question of whether some services specialize in urban centers of roughly equal sizes and are exported downward to smaller areas [Gilmer, Keil, and Mack (1989)]. This technique has also been used to look at services trade within systems of large cities in a region in order to ECONOMIC PERSPECTIVES determine whether particular urban areas spe cialize in particular services, apart from and in addition to the export question [see Gilmer (1990)]. The employment concentrations of a sam pling of producer service industries are dis played in Table 2 for the metropolitan areas in Seventh District states. The strong propensity for producer service firms to favor large metro politan areas is evident; producer services tend to concentrate in the Chicago area, which ranks near the top both regionally and nationally. The largest metropolitan areas in the Seventh District—Chicago, Detroit, Indianapolis, Des Moines, and Milwaukee—display a tendency to export services.5 While an urban hierarchy is evident in the Seventh District, with services being exported from urban centers to hinterlands within the re gion, other observations also suggest that metro politan areas specialize in particular services, quite aside from the urban hierarchy. For exam ple, although Milwaukee is located only 90 miles from Chicago, a city with more than 3 times as many people, Milwaukee serves as an indepen dent purveyor and specialist in certain urban services such as advertising, consumer credit reporting, and accounting. Moreover, many small metropolitan areas rank close to or above the larger areas in particular services: Peoria and Cedar Rapids in advertising, Lansing and South Bend in consumer credit reporting, Sheboygan in TABLE 2 Index of employment concentration in business service industries (Top ranked Seventh District MS As, 1987) Advertising Index Rank Chicago, IL PMSA Cedar Rapids, IA MSA Milwaukee, Wl PMSA Peoria, IL MSA Detroit, Ml PMSA Elkhart-Goshen, IN MSA Ann Arbor, Ml PMSA Madison, Wl MSA Waterloo-Cedar Falls, IA MSA Kalamazoo, Ml MSA 2.89 2.32 1.99 1.82 1.76 1.38 1.37 1.33 1.20 1.19 5 6 9 11 12 28 30 31 43 45 Computer programming and data processing Index Rank Ann Arbor, Ml PMSA 2.44 Des Moines, IA MSA 2.33 Madison, Wl MSA 1.67 Cedar Rapids, IA MSA 1.51 Lafayette-West Lafayette, IN MSA 1.48 Chicago, IL PMSA 1.47 Detroit, Ml PMSA 1.18 Janesville-Beloit, Wl MSA 1.16 Champaign-Urbana-Rantoul,IL MSA 1.06 Milwaukee, Wl PMSA 1.06 Engineering, architecture. and surveying Ann Arbor, Ml PMSA Detroit, Ml PMSA Sheboygan, Wl MSA Cedar Rapids, IA MSA Madison, Wl MSA Green Bay, Wl MSA Jackson, Ml MSA Iowa City, IA MSA Chicago, IL PMSA Indianapolis, IN MSA FEDERAL RESERVE BANK OF CHICAGO Index 2.00 1.46 1.35 1.29 1.28 1.09 1.03 1.01 1.01 1.00 Consumer credit reporting Index Rank 1.87 1.66 1.61 1.35 1.34 1.28 1.20 1.17 1.13 1.09 21 34 38 51 53 65 76 81 86 94 Index Rank Lake County, IL PMSA Indianapolis, IN MSA Battle Creek, Ml MSA Chicago, IL PMSA Ann Arbor, Ml PMSA Grand Rapids, Ml MSA Cleveland, OH PMSA Fort Wayne, IN MSA Detroit, Ml PMSA Green Bay, Wl MSA 2.54 2.14 1.78 1.69 1.27 1.26 1.12 1.09 1.02 1.01 8 10 17 23 45 50 60 64 70 71 Rank Accounting, auditing. and bookkeeping Index Rank 14 40 49 55 57 81 91 96 98 100 Madison, Wl MSA Chicago, IL PMSA South Bend-Mishawaka, IN MSA Des Moines, IA MSA Grand Rapids, Ml MSA Milwaukee, Wl PMSA Aurora-Elgin, IL PMSA Kalamazoo, Ml MSA Indianapolis, IN MSA Detroit, Ml PMSA 1.66 1.50 1.48 1.41 1.32 1.26 1.20 1.12 1.09 1.04 11 16 18 25 36 42 54 67 74 83 16 17 35 41 43 44 56 59 67 70 Des Moines, IA MSA Lansing-East Lansing, Ml MSA Chicago, IL PMSA South Bend-Mishawaka, IN MSA Milwaukee, Wl PMSA Indianapolis, IN MSA Fort Wayne, IN MSA Green Bay, Wl MSA Kankakee, IL MSA Champaign-Urbana-Rantoul, IL MSA Management and public relations 21 engineering and architecture, Grand Rapids in accounting, and Battle Creek in management and public relations. Those smaller metropoli tan areas hosting major state universities such as Ann Arbor, Madison, and Champaign-Urbana figure prominently as service exporters. Computer programming, engineering, research, and testing labs draw heavily on university skilled labor and institutional capital. Direct observation of service exports A second group of analytical studies direct ly observes the sales transactions of service firms as exported outside the region. These studies have been conducted in particular re gions, with the assumption that the results could be applied to other regions. The pioneering work was conducted for the Puget Sound area of Washington state by William B. Beyers, Michael J Alvine, and Erik G. Johnsen (1985). The authors interviewed 2,000 firms in the services, utility, communication, FIRE (fi nance, insurance, and real estate), business, and professional services industries. The central finding was that a heretofore unrecognized proportion of service firms (55 percent) export ed more than 10 percent of their sales outside the area. All firms taken together exported more than 36 percent of sales outside the Puget Sound region, with healthy sales outside of the state as well. Other findings indicated a wide variation among industry types in the propensi ty to export services. Most individual indus tries tended to export between one-third and two-thirds outside the region; real estate and accounting tended to depend more heavily on local sales while R&D labs and transport ser vices tended to export more.6 Additional studies have been conducted as case studies of areas within the industrial Mid west [Goe (1990) and Porterfield and Pulver (1991)]. Such studies have corroborated the findings of the Beyers, et. al. study that produc er services are often exported. In addition, the subsequent studies offer many additional in sights into the geography of producer services sales such as the preferences of producer servic es export firms to locate in large metropolitan areas, rural areas, or in small to medium size metropolitan areas. U rb an ten d en c ie s Producer services have long displayed a marked preference for locating in urbanized 22 areas. By one recent study, 93.7 percent of producer service employment located in Metro politan Statistical Area (MSA) counties in the U.S., and 65.5 percent located in the largest 39 MSAs [O hUallachain and Reid (1991)]. This urban tendency also holds true with respect to the scale of establishment in larger versus smaller areas; that is, firm size increases with the size of the MSA [Krmenec and Cohn ( 1991 )].7 The reasons for more urbanized concentra tion may include gains from larger scale than is possible in urban locations. Demand for a service such as public relations or environmen tal law can be met at lower cost when the ser vice is provided to a large number of local clients. In addition, producer services inherent ly involve the transfer of information, either in person or through electronic transmission. The delivery of services through face-to-face com munication from a central place to a surround ing area economically provides such an ar rangement. Transportation from a central place outward through a spoke-like travel grid can minimize time. For example, recent studies have illustrated the importance of air travel access to service firms locating in large metro politan areas [Beyers, et. al. (1985)]. At the same time, a transportation grid can also effi ciently bring in service customers for face-toface meetings. These may be corporate cus tomers, wholesale buyers, or people attending conventions and similar meetings. A second set of reasons for urban concen tration are the gains of close proximity enjoyed by individual service industries, many of whom sell to one another and who presumably can shop for and/or deliver services at lower cost if they are located in the same urban area. Re portedly, producer services often sell to other service industries or the administrative arms of goods producing industries in a region [Goe (1990)]. Similar to the transportation benefits achieved by manufacturing industries from close proximity in years past (for example, apparel and textiles in New York City or more recently steel, machine tools, and autos in the Great Lakes region), service transactions in volving face-to-face contact may also benefit from location and interaction. Others have emphasized that “higher order” or “information intensive” service industries do benefit from strategic location, but the benefits do not neces ECONOMIC PERSPECTIVES sarily derive from direct interaction [O hUallachain and Reid (1991)]. Rather, a shared labor pool of creative and flexible workers may enable such firms to solve unforeseen and com plex problems as they arise. Rural prospects The revolution in electronic communica tion and information transmission has stirred the hopes and interests of rural areas in attract ing producer services firms. Indeed, advances in satellite communications, fiber optics, fac simile machines, and microwave technology have dramatically lowered costs and opened new vistas for communications in more remote locations. Anecdotal information such as Cit icorp’s siting of a credit card processing facility in South Dakota has created expectations in rural and smaller metropolitan areas of a decon centration of producer jobs. More general evidence of the developments in producer jobs is furnished by the recent study by O hUallachain and Reid, which reports that employ ment share of the nation’s producer services (SIC 73 and 89) increased from 3.6 to 6.3 per cent from 1976 to 1986. Gains were also re ported for small and intermediate metropolitan areas at the expense of the 39 largest MSAs. Despite this interest and evidence, the fundamental forces affecting the rural versus urban location decision are highly ambiguous; opportunities for rural development in producer services industries have possibly been oversold. While it is true that communications advances can allow some services to be delivered from less costly (and possibly more amenable) rural locations, the opposite is also sometimes true; communications advances also allow services to originate from urban sites and be delivered to rural locales more cheaply, as has been suggest ed by Kim, Conway, and Beyers (1990). These authors report little or no deconcentration of producer services down the urban hierarchy from 1974 to 1984. In another study conducted in rural Washington, the authors found that information technologies created nine jobs but eliminated eleven [Dillman, Beck, and Callan(1989)]. Some analysts also believe that many ser vice activities, especially those accounting for rapid growth in producer services industries such as management consulting and financial analysis, are becoming more sophisticated and skill intensive [Stanback and Noyelle (1982)]. FEDERAL RESERVE BANK OF CHICAGO But these types of activities—which involve information analysis and intepretation—require face-to-face meetings and interaction with associated industries. That is, communications are complementary to these activities rather than substitutes. Accordingly, rural locations will not tend to be a drawing card for such services. Air transportation represents another com plement rather than substitute for “higher or der” service activities. Airline deregulation has strengthened the producer services standing of those large metropolitan areas hosting major hub airports. Surveys attest to the importance of frequent and expansive air connections for both producer services and administrative es tablishments [see Testa (1992), Kim, Conway, and Beyer (1990), and Drennan (1989)]. In contrast, the near completion of the U.S. inter state highway system (along with supporting road networks) has tended to deconcentrate overland and distribution services. Analysts also observe a widening spatial “division of labor” or dichotomy arising from these relative advantages for centrally rather than rurally located service industries. Similar to the branching of routinized manufacturing production activities which has occurred in the U.S. from North to South and from urban to rural, service firms are unbundling the more routinized information processing activities such as data entry and claims processing to remote areas. Service firms do this in order to capitalize on lower cost labor where possible while retaining skilled service functions in larger metropolitan areas. Standardized and routinized service activities, so-called “back office” or “lower order” activities, are seen as most amenable to innovations in communica tions technologies. Information on the geography of services by type of activity tends to be scarce. One example has emerged from a recent survey of mortgage servicing firms and thrifts in the United States reported in American Banker. The results of the survey suggest that rural and small metropolitan areas have captured an inordinate share of routinized service activity. Grand Rapids, Michigan, and Gainesville, Georgia, ranked among the top locations in mortgage servicing. Troy, Michigan, Pasadena, Texas, and Fargo, North Dakota, were among top-ranking thrift locales.8 23 A promising research avenue to identify a rural/urban spatial divi sion of labor has been recently undertaken by Kassab and Porter field (1991). In examining business service industries and distribution industries in metropolitan and non metropolitan counties, the authors identify workers by their occupa tion as categorized by low skill or high skill using the Current Popula tion Survey. While results are preliminary at this time, the authors do find significant skill and occupa tional differences for the same industries in urban versus rural counties.9 If accurate, this rural/urban dichotomy between higher order and lower order producer services activities and occupations holds at least two potential draw backs for less urbanized areas. First, less skilled jobs tend to be lower paying so that, as a potential avenue for development, these jobs may be less desirable in their overall economic impact. The tendency has been for lower pay ing jobs to locate in less urbanized areas. Fig ure 1 shows average annual payroll per employ ee for four size classes of counties within the Seventh District.10 For producer services in aggregate, and for each individual category as well, a distinct and marked difference in payroll per employee can be seen for 1989. For servic es overall, compensation per em ployee in rural counties is approxi mately one-half that of the largest class of MS As in 1989 (see Figure 1). Perhaps even more convincing, a continuum of average payroll from higher paying (in large coun ties) to lower paying (in smaller counties) can be seen for each of the subcategories comprising pro ducer services. Over time, the same data source suggests that the payroll disparity between rural counties and MSAs has become more pro nounced in the Seventh District (see Figure 2). All of the subcategories of producer services industries, except auxiliaries, contributed to the total effect in which, for aggre gate services, the ratio of average 24 payroll per employee for the largest MSAs to the average for rural counties climbed from 1.56 in 1975 to 1.96 in 1989. Previous research has been conducted on payroll disparities between rural and urban counties in the upper Midwest states of Minne sota, Wisconsin, Illinois, Michigan, and Iowa by Porterfield and Pulver (1991). The results are notable in that, according to their survey of 18 producer services industries, few systematic differences in average annual payroll emerged between metropolitan areas, nonmetropolitan areas, and nonmetropolitan areas not adjacent to metropolitan areas. One explanation for the ECONOMIC PERSPECTIVES area economies, urban and rural alike, regardless apparent conflict in findings is that the Porterof their skill base, must struggle to re-invent field-Pulver study examined industries defined themselves and to encourage a flow of new jobs much more narrowly (for example, at the threeand activities to replace those that are fleeing. In digit SIC code level).11 This suggests that, this light, back office service jobs can be viewed when industry mix is taken into account, pay as a challenge rather than as a problem. One roll disparities may not be so profound. Either possibility would be to institute programs to way, many of the implications are the same for upgrade worker skills in order to preserve exist policy purposes. Whether it is the higher pay ing producer service jobs or to develop new ing industries or the higher paying activities of any industry that prefer urban locales, or both, industry activities. lower paying and lower skill jobs in rural areas Rural and urban e vid e n ce in th e are the result. S even th D is tric t A second concern about rural areas special Within the Seventh District states of Illinois, izing in back office operations is that standard Indiana, Michigan, Iowa, and Wisconsin, it ap ized jobs are often those that are the most tran pears that any change in the tendency for produc sitory. In contrast to nonstandard jobs involv er services to favor larger metropolitan areas is ing interpretative skills and face-to-face interac evolutionary rather revolutionary (see Table 3). tion, routinized jobs are most amenable to automation, thereby TABLE 3 leading to job base shrinkage. For example, there is a concern Concentration index of employment for the future of data entry jobs; (Seventh District) technological advances may All producer Auxiliary replace data entry workers with services establishm ents data scanning devices. Even if Change Change 1989 1974-89 1989 1974-89 mechanization is not the cause of worker displacement, low > 1 m illion 1.25 -0.01 1.61 0.17 skill jobs can be lost through 250,000 - 1 m illion 0.88 -0.07 0.09 0.53 migration. As many rural areas < 250,000 0.75 0.02 0.29 -0.16 have discovered from their ex Rural counties -0.04 0.04 0.51 -0.31 perience with branch plant man ufacturing jobs, the next stop in Finance, insurance, Business the geographic product cycle is real estate services (SIC 73) often cheaper overseas locations. Change Change 1989 1974-89 1989 1974-89 Recent news reports document the flight of routinized service > 1 m illion 1.15 -0.05 1.28 -0.05 jobs from the U.S. to other coun 250,000 - 1 m illion 0.97 0.11 0.88 0.15 tries. Insurance companies have < 250,000 0.82 0.07 0.80 0.07 set up claims offices in Ireland; Rural counties 0.66 0.01 0.34 0.01 airlines are processing tickets in Barbados; and book publishers Legal Miscellaneous services services (SIC 8 9 )* and data entry firms have moved Change Change keyboarding activities to Asia. 1989 1974-89 1989 1974-89 But of course, this concern does not mean that lower order > 1 m illion 1.27 0.15 1.50 0.31 producer service jobs are unde 250,000 - 1 m illion 0.81 -0.03 0.51 -0.39 sirable as targets for rural eco < 250,000 0.61 -0.13 0.56 -0.39 nomic development. The transi Rural counties 0.61 -0.33 0.21 -0.28 tory nature of employment is hardly confined to routinized ‘ Includes engineering, architecture, accounting, management, and public relations services. producer service employment. NOTE: Membership organizations (SIC 86) not shown. In today’s global economy, it SOURCE: U.S. Department of Commerce, Bureau of the Census, C ounty Business Patterns. may be easily argued that all FEDERAL RESERVE RANK OF CHICAGO 25 TABLE 4 Concentration index of employment in producer services industries (Selected MSAs, Seventh District) Chicago All prod, services Des Moines Detroit Indianapolis M ilw aukee 1974 1989 1974 1989 1974 1989 1974 1989 1974 1989 1.35 1.34 1.40 1.65 1.37 1.20 1.03 1.10 0.96 1.18 Auxiliaries 1.30 1.64 0.61 1.08 2.27 2.04 0.72 1.00 0.80 1.17 F.I.R.E. 1.37 1.30 2.14 2.45 0.97 0.90 1.34 1.18 0.99 1.16 Business (73) 1.59 1.35 1.16 1.21 1.21 1.25 .80 1.16 1.16 1.32 Legal 1.17 1.43 1.14 1.19 1.10 1.17 0.84 0.88 1.16 1.09 Membership org. 1.02 0.92 1.24 1.07 0.90 0.76 1.01 0.95 .96 0.92 Miscellaneous* 1.24 1.31 .96 1.33 2.34 1.14 0.98 0.75 1.50 N.A. •Includes engineering, architecture, accounting, management, and public relations services. SOURCE: U.S. Department of Commerce, Bureau of the Census, County Business Patterns. As measured by employment, producer services in aggregate remained some 25 percent more concentrated in the largest metropolitan areas (population greater than one million) in 1989. This concentration continued to diminish throughout metropolitan areas of smaller size until, for rural (nonMSA) counties, producer services employment share was 50 percent below the corresponding share of the five state region overall. A modest tendency for rural areas to become less concentrated in producer services can also be observed from 1974 to 1989, while small and medium sized metropolitan areas tended to gain concentration (see Table 3). Some of the gains in small and medium sized area specialization came at the expense of the largest tier of metro politan areas—those with populations greater than one million. Detroit and Chicago both reported a lower relative specialization in pro ducer services (see Table 4). C onclusions and o u tlo o k Producer services industries are becoming a more important part of the regional economic base. As producer services become increasingly specialized, so too have regions become more specialized in particular producer services. As a result, services are often sold from afar and can therefore correctly be considered as part of the regional “export base.” Technological and organizational advances in both communication and personal travel, including fiber optics net works and mega-hub airports, have facilitated the sale and delivery of specialized services from particular regions. 26 The successful development of producer services has become a much coveted prize for regions. For one reason, overall growth in producer services industries has been extremely robust throughout the 1970s and 1980s. How ever, during the recent U.S. economic slow down, overall employment in producer services also slowed owing to weakness in financial and real estate industries.12 So too, some ana lysts have speculated that long awaited gains in service sector productivity are now material izing (following capital investments during the early 1980s). If so, these productivity advances may be labor saving. But despite the recent slowdown in employment growth, not all pro ducer services industries are pulling back. For example, business services such as account ing and computer programming continue to expand, and producer services remains an active target of economic development in many regions. Not all regions have been successful in gamering growth in producer services but rath er, these industries remain concentrated in large urban areas. While existing evidence is not yet conclusive, it appears that advances in telecom munications and personal travel have only strengthened the hand of urban areas in hosting producer services and subsequently delivering producer services to peripheral areas. In the Seventh District states, payroll premiums for urban workers in producer services have appar ently increased in comparison to rural counties. As a counter trend, remote areas have succeed ed in attracting back office or lowered skilled ECONOMIC PERSPECTIVES producer services activities in many instances. As a matter of policy, such a trend should not necessarily be discouraged by rural areas. Such jobs may be quite valuable to rural labor mar kets and may lead to higher skilled jobs through either an active development policy such as worker training, or a natural evolution of sevice industry growth. FOOTNOTES 'The view that only goods and services that are sold afar are growth generating is not strictly true. Rather, it has been a useful paradigm in viewing the process of regional development. However, there is surely a remainder of growth and welfare which is internally generated. En hanced specialization and trade within regional boundaries can also increase the region’s welfare. Secondly, greater efficiency in providing local goods and services can in crease the region’s competitiveness and capacity to supply exports to other regions so that, indirectly, related nontraded job activities are also “growth-generating.” 2The definition of which industries comprised producer services varies from study to study. In fact, all of the industries make sales to both firms and to household consumers so that the classification “producer services” is somewhat of a misnomer. For a review of industry tenden cies to sell to both household and to business sectors over time, see Duchin (1988). 3See Mack and Keil (1986) for information on Indianapolis; Groshen (1987) on Ohio and neighboring states; Gilmer, Keil, and Mack (1989) on rural southeastern U.S.; Gilmer (1990) on major Texas cities; and Austrian and Zlatoper on Cleveland and large MSAs. 4Another possible reason for thinking that this measure is misleading is that the classification of service industries may be inexact. For example, a region may display an index of 1.0 for the advertising industry, suggesting no external trade in services. Nonetheless, the region may actually specialize in a particular ty p e of advertising which is exported while, in turn, another specific ty p e of advertis ing service is imported. The failure to reveal such trade and specialization lies with the insufficiently disaggregated classification scheme of the data. 5In constructing these indexes, we are comparing service employment share in the region to the overall nation. It should be noted that, because the overall region specializes in goods production—especially manufacturing—the metropolitan areas of the region will not rank as highly among the nation’s metropolitan areas. 6These figures are drawn from Table III-11 of the study, which refers to those 1,100 surveyed establishments report ing more than 10 percent export sales. 7See Goe (1990) and Porterfield and Pulver (1991). An earlier study by Stephen M. Smith (1984) surveyed 350 nonmanufacturing firms in nonmetropolitan areas of Wisconsin. The author reported 28.1 percent of sales outside of the town boundaries. 8Data provided by ADP Data Service division, New York, from its data base of the T h rift F in a n c ia l R e p o r t, as report ed in A m e ric a n B a n k e r, October 21, 1991. 9Kassab and Porterfield (1991). 10Data are drawn from C o u n ty B u s in e ss P a tte r n s , U.S. Bureau of the Census. Payroll employment reflects both part-time, full-time, and part-year employees. Employees are recorded for a single week in March of the year report ed. Only counties for which no disclosure problem existed were sampled. County classification reflects the population size of the MSA in 1988, rather than the population size of the county itself. Recent evidence by Kassab and Porterfield (1991) also finds sharp propensities for business service workers in rural areas to be employed part-time (often involuntarily), thereby lowering observed payrolls per employee. "The Porterfield-Pulver survey (1991) covered only a small subset of industries so that their results are not neces sarily in conflict with our own. Also, a methodological difference is that the Porterfield-Pulver study reported from data that was imputed or estimated for county areas. We prefer to sample only from rural counties in which there were no disclosure problems with the data. 12Strongin (1990). REFERENCES Austrian, Ziona, and Thomas J. Zlatoper, “The role of export services,” REI Review, Fall 1988, pp. 24-29. Beyers, William B., Michael J. Alvine, and Erik G. Johnsen, The Service Economy: Ex port of Services in the Central Puget Sound FEDERAL RESERVE BANK OF CHICAGO Area, Central Puget Sound Economic Develop ment District, Seattle, 1985. Dillman, Don A., Donald M. Beck, and John Callen, “Rural barriers to job creation remain even in today’s information age,” Rural Devel opment Perspectives, G: 1, 1989, pp. 21-27. 27 Drennan, Matthew P., “Information intensive industries in metropolitan areas of the U.S.,” Environment and Planning A, Vol. 21, 1989, pp. 1603-1618. Duchin, Faye, “Role of services in the U.S. economy,” in Bruce R. Guile and James Brian Quinn, eds., Technology in Services: Policies for Growth, Trade and Employment, National Academy Press, Washington D.C., 1988, pp. 76-98. Gilmer, Robert W., “Identifying service-sector exports from major Texas cities,” Economic Review, Federal Reserve Bank of Dallas, July 1990, pp. 1-15. Gilmer, Robert W., Stanley R. Keil and Richard S. Mack, “The service sector in a hierarchy of rural places: potential for export activity,” Land Economics, Vol. 65, No. 3, August 1989, pp. 217-227. Goe, W. R„ “Producer services, trade and the social division of labor,” Regional Studies, Vol. 24, No. 4, 1990, pp. 327-342. Groshen, Erica L., “Can services be a source of export-led growth? Evidence from the Fourth District,” Economic Review, Federal Reserve Bank of Cleveland, No. 3, 1987, pp. 2-15. Kassab, Cathy, and Shirley L. Porterfield, “The spatial allocation of labor in producer service industries,” paper presented at the Re gional Science Association Meetings, New Orleans, November 8, 1991. Keil, Stanley R., and Richard S. Mack, “Identifying growth in the service sector,” Growth and Change, Vol. 17, No. 4, 1986, pp. 1-10. Kirn, Thomas J., Richard S. Conway, Jr., and William B. Beyers, “Producer services development and the role of telecommunica tions: a case study in rural Washington,” Growth and Change, No. 4, 1990, pp. 33-50. Krmenec, Andrew J., and Roger Cohn, “Business services within a system of cities,” paper presented at the 22nd annual meeting of 28 the Mid-continent Regional Science Associa tion, Chicago, May 31, 1991. O hUallachain, Breandan, and Neil Reid, “The location and growth of business and pro fessional services in American metropolitan areas, 1976-86,” Annals of the Association of American Geographers, Vol. 81, No. 2, 1991, pp. 254-270. Porterfield, Shirley L., and Glen C. Pulver, “Service-producers: exports, impacts and loca tion,” International Regional Science Review, Vol. 14. No. 1, 1991, pp. 1-14. Smith, Stephen M., “Export orientation of nonmanufacturing businesses in nonmetropoli tan communities,” American Journal of Agri cultural Economics, May 1984, pp. 145-155. Stanback, Thomas M., Jr., and Thierry J. Noyelle, Cities in Transition, Allanheld, Osmun and Co., Totowa, N.J., 1982. Strongin, Steven, “Services also slow down,” Chicago Fed Letter, August 1990. Testa, William A., “Job flight and the airline industry: the economic impact of airports on Chicago and other metro areas,” Regional Eco nomic Issues, Federal Reserve Bank of Chica go, WP-92-1, 1992. Testa William A., and David D. Weiss, “Ser vice establishments of manufacturing compa nies, their role in understanding regional manu facturing output,” Regional Science Perspec tives, Vol. 21, No. 1, 1991, pp. 3-17. U.S. Department of Commerce, Bureau of the Census, 1981 Census of Service Industries, U.S. G.P.O., Washington, D.C., 1990. County Business Patterns (data base) Washing ton, D.C., various years. U.S. Department of Commerce, Bureau of Economic Analysis, Regional Employment Data Base, Washington, D.C., various years. ECONOMIC PERSPECTIVES ECONOMIC PERSPECTIVES BULK RATE Public Information Center Federal Reserve Bank of Chicago P.O. 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