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The Basics of the Assumption Approach

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The Basics of the Assumption Approach

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- Assigns activities to the Basic and Non-basic sectors on the basis of assumed sales patterns for different types of industries.
- Sectors typically assigned to the Basic sector:
--Manufacturing--State/Federal Government --Agriculture, Forestry, Fishing--Hotels/Lodging --Mining

- Sectors typically assigned to the Non-Basic sector: --Retail Trade--Local Government --Wholesale Trade--Services --Transportation, Comm, Util--Construction
- The choice of allocation to Basic versus Non-Basic gets back to the question: Where are the dollars coming from that support this industry?
- ALL local employment in each of these industries is assigned to either of these sectors. For example, every manufacturing job is considered a Basic job.

Evaluating the Assumption Approach

- The major advantages to the Assumption Approach include: --Easy to do --Widely used for certain industries --A good first step in the analysis
- The major disadvantages: --Generates substantial errors --Nearly every industry serves both local and non-local needs --The relative proportion of an industry that serves a non-local need can change over time and is different at larger geographic levels (as an area grows, the proportion of local sales grows for most industries)
- Overall evaluation: “Although inadequate as a general basic sector estimation procedure, the assumption technique is appropriate for segments of the economy that clearly serve local or non-local markets.” (p. 128)

The Basics of the Location Quotient Technique

- Location quotients compare the local share of a given industry to the share of that industry for a larger area. This concept measures the relative specialization and concentration of an industry in the local economy compared to the larger area (usually the nation).
- The location quotient is defined as the ratio of an industry’s share of the local economy to the industry’s share of the national economy.
- The formula:LQi = eit/eTt
Eit/ETtwhere:eit=Local employment in sector i at time teTt = Total local employment at time t

Eit= National employment in sector i at time tETt = Total national employment at time t

- Three values are possible:
1) Industries with LQ’s = 1 (Self-Sufficiency)

2) Industries with LQ’s < 1 (Net Importer)

3) Industries with LQ’s > 1 (Net Exporter)

Evaluating Calculated LQ Values

- When LQ = 1 (Self-Sufficiency)
--In this situation, a given industry’s share of the local economy is the same as the share of that industry in the national economy.

--Local production is assumed to be just sufficient to meet local demand, so all of the employment in this industry is considered Non-Basic.

- When LQ < 1 (Net Imports)
--In this situation, a given industry’s share of the local economy is less than the share of that industry in the national economy.

--Local production is assumed to be insufficient to meet local demand, so all of this employment is considered Non-Basic.

- When LQ > 1 (Net Exports)
--In this situation, a given industry’s share of the local economy is greater than the share of that industry in the national economy.

--Local employment is concentrated in these industries (relative to the nation) and is therefore assumed to exceed local demand and any excess production is exported.

--With an LQ > 1, that proportion of the industry that accounts for this excess production is considered Basic Employment.

Calculating a Location Quotientfor Florida’s Entertainment Industry

Calculating a Location Quotientfor Florida’s Information Industry

Calculating Basic Employment with LQ Values

- We must remember that an LQ >1 does not mean that all employment in that industry is basic, only that proportion of the industry that is responsible for the excess production is basic.
- To calculate the basic employment when the LQ > 1, the formula is: (p. 132)Basic Employment = [(eit/ Eit) - (eTt/ETt)] * Eit

- For example, let’s assume that the LQ for Entertainment = 1.489 Local Emp in Ent = 141,335 (eit ) Tot Local Emp = 6,217,386 (eTt ) National Emp in Ent = 1,741,497 (Eit)Tot National Emp =114,064,976 (ETt)
- The Basic employment for this industry is then:Basic= [(Loc Emp Ent/Nat Emp Ent) - (Tot Local/Tot National)] * Nat Emp Ent= [(141,335/1,741,497) - (6,217,386/114,064,976)] * 1,741,497= (0.08116 - 0.05451) * 1,741,497= 46,411Non-Basic for FP = Total i - Basic i or (141,335 - 46,411) = 94,924

Evaluating the LQ Technique

- The major advantages to the Location Quotient Technique include: --More sensitive/responsive than the Assumption Approach --Compares the local economy to a larger economy --Can be combined with the Assumption Approach for even more control in determining basic vs. non-basic employment
- The major disadvantages: --More complex --Still may generate substantial errors --Major assumptions to the method
Overall evaluation --By far the most popular method for studying the local economy, Location Quotients offer a nice balance of control and complexity to the analyst.

--However, the analyst must be careful not to interpret the LQ’s blindly.

--In addition, a number of refinements can be utilized to minimize the impacts of the assumptions underlying this technique.

Combining the Assumption and LQ Approaches

Refinements to the Location Quotient Approach

Consumption

Production

bi = [(ei / Ei) - (et / Et)] Ei

- At its heart, basic employment is assumed to be a function of the difference between supply (production) and demand (consumption).
- However, this equation makes several assumptions about production and consumption that require some attention.

Productivity Adjustment

- One of the major assumptions of the Location Quotient Technique is that labor productivity is the same for local workers and national workers. For example, local construction workers manufacture homes at the same rate as the average national construction worker.
- If Local Productivity is higher than National Productivity (LP > NP), then the equation will underestimate the regional share of national production and underestimate basic employment.
- If Local Productivity is lower than National Productivity (LP < NP), then the equation will overestimate the regional share of national production and overestimate basic employment.
- To correct for this we can use a ratio of regional value added to national value added.
Basic Employment = [vi(eit/ Eit) - (eTt/ETt)] * Eit/vi

- Value added data is only available at the state level and only for two industrial sectors; Construction and Manufacturing. Also, we must use a State rate as a proxy for local productivity.

Productivity Adjustment Calculation

- We have productivity data for States and the United States for two major industries: Construction and Manufacturing
Value Added By Industry Division: United States and Florida 1992

ConstructionManufacturingUnited States$134,617,817$1,709,180,300,000Florida $12,025,405 $37,933,600,000

- Note 1: Because we don’t have local value added data (county level) we assume that the local area (Bay County) has the same level of productivity as the state.
- Note 2: We calculate Value Added on a per employee basis.
- The formula to do so is:
State Value Addedit/State Employmentit

US Value Addedit/US Employmentit

- Therefore in addition to our Value Added data, we also need the Total Number of Employees in each of these industries for the state and the United States.

Vi=

Productivity Adjustment Example

- In this example, Georgia’s Value Added per employee in construction is greater than that of the United States.
- When incorporated into the LQ formula this adjustment will increase Basic employment because Georgia’s workers generatemore output per employee than the nation’s and the state therefore hasmore output to export.

Consumption Adjustment

- A second major assumption of the LQ Technique is that Regional Consumption is equal to National Consumption; there is no variation in consumption patterns across space.
- We know this to be false. For example, Florida does not consume (purchase) snow skiing equipment at the same rate as cold weather places like New Hampshire or Colorado.
- If Local Consumption is greater than National Consumption, then we will underestimate local consumption and we will overestimate basic employment (because more goods are consumed locally and not exported).
- Unfortunately, consumption data are not readily available, so we must use indirect measures to address this.
- Two options:
1) Population Ratio Adjustment

Basic Employment = [(eit/ Eit) - (pt/Pt)] * Eit

2) Total Personal Income Adjustment

Basic Employment = [(eit/ Eit) - (yt/Yt)] * Eit

- The Personal Income Adjustment is considered more desirable because income is a better proxy for consumption than employment or number of residents.

Export Adjustment

- The LQ Technique assumes that there are no net national exports or imports; Production = Consumption. However, this is very rarely the case and, in fact, the U.S. currently imports many more goods than it exports.
- If there are net national imports then Consumption > Production and the technique will understate the local share of national consumption and overstate basic employment.
- If there are net national exports then Consumption < Production and the technique will overstate the local share of national consumption and understate basic employment.
- The adjustment to address this is the calculation of employment that is tied to national consumption (a Proportion Domestic) by industry.
Proportion Domestic = (Total Emp - Export Emp)/ Total Emp

- Then, we apply this adjustment to our basic employment formula:
Basic Employment = [(eit/ Eit) - di (eTt/ETt)] * Eit

- This adjustment can never exceed 1.0. This adjustment always reduces consumption, thereby always increasing basic employment. (We do not factor in Imports.)

Crosshauling Adjustment

- Crosshauling is the importing of goods in an export sector. The LQ Approach assumes that there is no crosshauling of goods between the local and national areas.
- For example, there is a brewery in town that produces 1% of the nation’s beer and the local area consumes 1% of the nation’s beer. The technique assumes the local brewery accounts entirely for this 1% consumption. Clearly, however, there is “Crosshauling” as the local brewery exports a sizable amount of their product and local vendors import other beers to sell locally.
- There is also the question of product mix. Few areas have industries across the entire range of a given industrial sector. Some goods must be imported and, invariably, some goods are exported.
- The solution to these problems: “The effects of crosshauling can be reduced by using more refined industrial categories…” (p. 143)
- By using more disaggregated data (three and four digit NAICS codes) you can better account for these problems. Disaggregated data can more accurately identify export activity.

The LQ Adjustments Combined

- The combined adjustments formula is
bit = [ vi (eit/Eit) - di (yt/Yt)] Eit/vi

- Because these adjustments generally increase the number of basic sector jobs, you should apply this formula to every industrial sector, except those that have been dealt with by the Assumption Approach (like Local Government (NB) Fed/State Government (B), and Hotels and Lodging (B)).
- In addition, to be more accurate, the analysis should be done at least at the three digit NAICS level.

Equal

ProductivityAdjustment

EqualConsumptionAdjustment

National ExportsAdjustment

The Major LQ Equations

- LQi = eit/eTt
Eit/ETtwhere:eit=Local employment in sector i at time teTt = Total local employment at time t

Eit= National employment in sector i at time tETt = Total national employment at time t

- To calculate the basic employment when the LQ > 1, the formula is: (p. 132)
bit = [(eit/ Eit) - (eTt/ETt)] * Eit

- The combined adjustments formula:
bit = [ vi (eit/Eit) - di (yt/Yt)] Eit/vi

Equal

ProductivityAdjustment

EqualConsumptionAdjustment

National ExportsAdjustment