A Simple Way to Understand How Your City’s Economy Works

Did you know that there’s no such thing as a state or provincial economy (or even a national economy for that matter)? Did you know that the economies of cities and regions are increasingly more relevant in the global economy? Most importantly, as a city leader, do you understand your local economy and your role in improving it across various metrics?

The reality is, when it comes to how our economic ecosystems work, there are a lot of misplaced assumptions that get in the way of effective policy and strategy development. Below is my attempt to simplify this topic using a model that will get you and your collaborators onto the same page. This will improve your effectiveness in working with your economic development team and hopefully make your community a better place to live, work and play.

Part 1 — The Container

The image above shows the basic, high-level model. It has three main parts:

• The container (or the economic ecosystem where wealth circulates and creates employment and other opportunities that lead to local household incomes)
• The faucet (or the means that new wealth or commerce enters the ecosystem)
• The drain (the economic leakages or how wealth leaves the ecosystem)

First, let’s look at the container itself:

In our model the container represents the city economy, or rather the container that the economy exists within (commerce circulates within it through human behaviours and business trade patterns).

Contrary to assumptions, it is very important to understand that the container does not mean the city jurisdiction (which is defined by political boundaries); rather, the container is defined by:

• Commutersheds (where people live relative to where they work)
• Human consumption behaviours (where people buy local goods and services or generally conduct their day to day life within)
• Local trade patterns (like where businesses and their suppliers are located)
• Natural geography (mountains, rivers and shorelines that create natural constraints on these behaviours and patterns)

We call the container the “ecosystem” because in many ways it behaves similar to ecology in that everything is interdependent with each other (no part of the ecosystem could thrive on its own without the other parts!).

More on the container later as we tie this together!

Part 2 — “The Faucet” and “the Drain”

Here are the other two high-level components and then some sub-components that I’ll explain below.

1. The Faucet (Wealth Creation). This represents where new wealth is created by entering the ecosystem. If a city economy isn’t creating new wealth, then it better be circulating existing wealth in very smart ways! Why? See #2:
2. The Drain (Economic Leakage). This reveals how wealth leaves the ecosystem. Obviously, if you leave the drain open without creating wealth, your ecosystem will dry up. In economic terms, we might call that a depressed economy.

Now let’s go a little deeper into these components, starting with the parts of the ecosystem.

Components in the Ecosystem

The legend above breaks down the key parts needed to create and maintain a 21st century city economy that is creating new opportunities for current and future residents.

There are the large, long-standing industries and employers — some of which may be at the root of why the community exists in its current location. These can be large in scale, like an automotive manufacturing facility, or small, like a collection of vessels and processing facilities that make up a fishing economy. These are shown in the model as the large trees. They provide the stability that the smaller enterprises within the community rely on.

There are the small, local service firms that primarily service the local economy. These are often called the secondary industries because they aren’t bringing new wealth into the ecosystem. Instead, they serve the local ecosystem (think of bookkeepers, hair salons, restaurants, machine shops and auto-repair shops and grocery stores). These are shown in our model as small flowers.

Then we have a third type of business organization: the start-up. These are demonstrated by bonsai trees because they are risky and without proper care and support, they will die (or some of them will fail fast as they determine that the business model or product is not viable). I’ve also included all forms of entrepreneurship here. The term ‘start-up’ mostly applies to technology companies with fast growth potential. And innovation, which similariliy to entrepreneurship, is risky and often fails to commercialize or achieve adequate financial returns.

Next we have the support organizations, shown as the garden tools. These are the networks of organizations that are trying to ensure various parts of the ecosystem are nurtured. They include chambers of commerce, immigrant support agencies, business improvement districts, and economic development agencies along with specialized services, such as those focused on supporting women entrepreneurs or working with minority-owned enterprises. In this model, I include post-secondary and other training institutions as well since they are developing the talent pool that often aligns to the opportunities within the ecosystem.

Then we have the capital market, shown in the model as watering cans. These are banks and lending institutions and also angel investors (those putting seed capital into very early-stage ventures, often before the business model itself has become obvious). This component also includes venture capital firms which inject growth capital into ventures that have potential to scale rapidly, often taking significant equity in the process.

Finally, the water represents money. Water is a useful metaphor in this model because even though plants within the ecosystem will absorb some of it, a lot of the water will ultimately drain away leaving the ecosystem dry until the next rainfall.

Deeper Level— The Faucet (or “Wealth Creation”)

Every community must have a means of local wealth generation. The primary way is through trade.

Domestic trade is achieved when your economic ecosystem is producing something of value to other ecosystems within your own province, state or country. This money received from those goods or services then circulates in the local ecosystem.

Foreign trade functions in the same way, except it involves ecosystems that are outside the country. This makes foreign trade slightly more difficult because you’re now dealing with different currencies, various trade barriers (like tariffs or increased shipping costs) and cultural norms and business practices that are less understood than your own (sometimes quality standards are out-of-sync as well). But increasing foreign trade is positive because it diversifies the revenue streams of your ecosystem, which makes you less vulnerable to disruptions and more stable through recessions. Conducting this trade in as low-carbon fashion as possible will be a necessary part of our economic future.

The impact of a “New $”: When a local product or service is “exported” (either through domestic or foreign trade), that money then enters the ecosystem and is circulated through a ripple-effect often referred to as a multiplier. As you get further from the centre of the circle, there is less circulating due to leakage. See next section to see how this happens.

You might notice something missing from the “wealth creation” part of this model and that is the role of monetary policy and instruments in creating new money. When the bank lends someone money to buy a home (for example), they are essentially allowing new money to enter the system that didn’t exist before (how much they are allowed to lend is part of the basis for centralized monetary policy since too much money in circulation would cause rapid inflation).

The reason I leave this out is simple: our model is far more concerned with how that household pays off the loan. To pay off the loan, the household needs income and this goes back to the model itself. An ecosystem without revenue sources will not have many loans getting approved in the first place. Therefore, the creation of money through monetary policy and lending instruments is a secondary factor here.

Deeper level— The Drain (or “Economic Leakage”)

The drain has three parts. These represent the three primary ways that money leaks out of the economic ecosystem.

Taxation — just like it sounds. Because regional economies are typically not nation-states (though Singapore is an example of one that is!), this means that a portion of the “revenues” are syphoned off by governments to run their mandates (from education to healthcare and beyond). However, since these services also benefit the local jurisdictions (local schools and hospitals!), a large portion of these leakages are actually returned back through transfers and investments and service delivery. Therefore this is not typically the largest area of concern when it comes to leakage. The exception would be when a jurisdiction is syphoning off too much money through taxation. This tax burden can cause your ecosystem to lose competitiveness relative to others, which can lead your wealth creation to defer to competitors instead. This means less local businesses, less local jobs, and furthermore less income for households to also contribute to the taxes needed for local services.

Savings — the second leakage area. Your initial reaction might be “wait, aren’t savings good?” and the answer is obviously yes. However, when it comes to an economic ecosystem, savings equates to money that is removed from the ecosystem. This means rather than supporting the local economy and creating economic benefits like jobs and taxation revenue, money is instead put into instruments like bonds or stocks. This equates to massive amounts of money that is removed from the system to support the activities of those firms that have public shares available — often multinationals like Google and Shell, rather than local circulation (imagine if we had more localized savings instruments!). However, like the first example, the savings are (eventually) returned to the system when people retire and live off of those savings. It’s sort of a delayed benefit if you will. *This assumes that the retiree stays in the community where they earned their income, which is often not the case.

Imports — the third and largest form of leakage. You may have seen examples within shop local campaigns where they point out “for every dollar spent at a local business, $X stays within the economy; but for every dollar spent at a chain store or online from an e-commerce giant, very little stays here”. This is true (though you could argue that a local chain store employs local people at least, which isn’t the case for e-commerce giants, other than a few local delivery jobs). This is why this area of leakage presents the most significant opportunities for interventions through what is referred to as import replacement. Local food suppliers, locally-owned services, like restaurants and even locally-owned manufacturing and production (and this includes non-profit owned enterprises and employee-owned enterprises) are all great examples.

However, in a modernized global economy, replacing all of your imports is not possible. A good demonstration of this is the piece of equipment you’re reading this on (computer, tablet or phone). The reason these technologies have become attainable for the average household is the economies of scale achieved by producing millions upon millions of units, and often in lower-cost jurisdictions like China. If you were to attempt to build an iPhone in your own jurisdiction it would end up costing $25,000 per unit (probably more than that actually, but you get the point).

This is why understanding the ecosystem within the global economy is so important. You need all the parts to make it work. You can slow the leakage, but you still need the faucet to create wealth and prosperity.

Micro, Meso, Macro — Tying Economies Together

You might be asking yourself “but what about people? Isn’t the economy just about people?”. The answer is wholeheartedly, “yes!”, this all stems from human behaviours, but as you rise out of micro and into meso and macro, it gets more complex.

Micro: Micro-economics is all about households. In fact, the word economy derives from two Greek words “oiko”, meaning house, and “nomy”, meaning management. So house management is the original definition of economy.

Households — regardless of their construct — have incomes and expenses, just like the container we examined above. Household prosperity should be the ultimate concern of any policymaker when it comes to economic development (and ensuring wealth distribution — increased equity across the economy — is perhaps the most overlooked area of economic policy and strategy).

Meso: The meso-level is really the inter-relationship or inter-dependence of multiple households in close proximity. In other words: a community, city or region. As I pointed out below, meso-economies are all about the behaviours and patterns (the economic container) rather than political boundaries (the jurisdictional container). This is why effective economic development strategies demand inter-jurisdictional collaboration through exploring how policies within one jurisdiction impact the ecosystem as a whole.

Macro: Sometimes we like to draw lines around things so we can understand them better. We do this with the economy by measuring the GDP (Gross Domestic Product) of countries, provinces and states. But, as I stated above, those are also arbitrary containers. Why? This is about behaviours and patterns. No person, household or business constrains their behaviours within only those geographic boundaries. This is why cities and regional economies are more relevant to understanding how the economy works than drawing a line around a vast geography (like a province or state) and measuring the sum of the parts.

This is also why I like to say that there is actually no such thing as a provincial or state-level economy nor a national economy. There are only regional economies and a constellation of these that make up the global economy (teaser…see below!). Most intervention policies do come from senior governments though (like monetary policy, banking regulations, social supports and trade agreements). However, I would argue more emphasis needs to be placed on how these policies can be strengthened by looking at various economic ecosystems that make up the national economy instead of applying blanket policies that attempt to impact them all at once.

The Global Economy: A Constellation of Ecosystems

In real life, the economy actually looks and behaves more like this. Take Canada, for example. Our land mass is the second largest of any country on earth, but the majority of our population (82%) live in urban areas. If you take just the 35 largest of these urban areas (called “Census Metropolitan Areas” in Canada), 72% of Canadians live in these and the top four alone contain 49% of the entire country’s jobs in advanced industries (more here).

So if this is the case, why do we revert to economic development policy that applies to entire nations, states or provinces? Instead, shouldn’t we take a more strategic look into these ecosystems and how they can be improved and better positioned for success within this global constellation?

Economic Development Strategy Explained

Using this model, economic development strategy could be summarized as “interventions that better strengthen and position your ecosystem within the global constellation in order to secure household prosperity and shared equity”.

You might not want to use this definition too widely though (because you’d have to explain what a constellation has to do with the economy or that an intervention isn’t referring to rehab). But using this approach we can dissect the range of typical economic development strategies to determine how they relate to the goals we want to achieve as city leaders. Here are some examples with links to deeper exploration:

Positioning & Planning:

• Regional SWOT Analysis
• Competitive Advantage Analysis (like using Location Quotients and how they are changing, or using Porter’s Five Forces to understand location advantage or disadvantage)
• Specialized Analysis (like assessing equity and access within the economy, or focusing on how a marginalized group is impacted by an issue, like women during the pandemic, for example)

Interventions & Strategies:

• FDI (Foreign Direct Investment) Attraction or Internationalization Strategy
• Business Retention and Expansion Programs
• Entrepreneurship Strategy & Innovation Strategy
• Clusters & Superclusters (Note: I don’t consider superclusters a local economic development strategy, but here in Canada it’s important to know what they are so you can leverage them)
• Place-Based Workforce Development
• Post-Disaster or Post-Crisis Economic Recovery (I’ve developed a whole set of resources specific to this here)

A new post-pandemic model:

• Post-Pandemic “RISE Model”: This stands for Resilient — Innovative — Sustainable — Equitable, four ingredients that must be combined in post-pandemic economic development strategies. Here’s my post on why.

So rather than overwhelming you with detailed descriptions of all of these economic development approaches and strategies (though links are provided for each), my overall point is that regardless of the direction you’d like your economy to go, understanding how it works — from how wealth is being created to where it leaks out and how it is circulated in between — is essential. Using the model and its components will help you understand the role economic development strategies play and how they can better help you achieve your community’s goals.

Dedication: This post is dedicated to the late Jane Jacobs whose book The Nature of Economies inspired me to use ecology as an analogy that could help simplify this concept.

Thanks for reading!