The reasons for Detroit’s decline are numerous. Most reporters inevitably talk about the demise of the city’s auto industry. The recent failure of large companies like General Motors and Chrysler, and the trend to move production to countries like Mexico, have undermined what was once one of the most important sources of employment for the city. As far as the auto industry goes, the decline is probably worse than some people realize. But, the more general cause of Detroit’s deterioration is a loss of trade.

To understand the impact of the decline of Detroit’s auto industry we should think about the “geography of trade.” This is the stuff that Paul Krugman won the 2008 Nobel prize for. One approach is to consider external economies of scale. In economics, we say there exist economies of scale if an increase in production brings about a decline in average cost. Causes of this decline in average costs can be caused by forces particular to some firm or forces that affect all firms — the former are internal and the latter are external. What kind of things bring about external economies of scale?

Some industries require relatively specific capital inputs, meaning, for instance, machinery that is only useful for the production of cars. Because these inputs are so specific, manufacturers of these inputs will probably be relatively scarce, implying that car factories have to spend time and money searching for suppliers, and they have to move that equipment over some distance. If auto factories consolidate in a general geographic area, however, these suppliers can also relocate to this area, making it cheaper to search for competing input sellers. Consolidated geographic organization also allows for greater specialization, because one firm can specialize, say, in designing car computer chips and then outsource production to a nearby factory. If we approach this from an Austrian angle and think of a structure of production made up of several stages, the external benefits of geographic consolidation will accrue to the entire supply chain, ultimately reducing average costs for most involved firms; Several of these firms also require relatively specialized labor. Suppose a firm sets up shop in San Diego, attracting some pool of applicants. If a rival firm enters the industry in Japan, it may find it difficult to find the workers it needs, since these will also be attracted to San Diego. If the Japanese firm finds that sales are good and they want to increase employment they may find an insufficient labor pool in Japan. To better compete for specialized labor it makes sense to manufacture where your competitors are, so that skilled labor can better move from one firm to another. This also allows firm, even if unintentionally, to coordinate fluctuations in employment: if one firm is doing poorly and another is doing well, the latter can attract labor from the former; There’s also a learning curve. Production of advance goods often requires specialized knowledge, and this kind of knowledge can also improve the production process. Where industry is highly concentrated, there can be “knowledge spillovers.” Usually, textbook examples are things like reverse engineering and the informal exchange of information, such as when employees of different firms interact, for example. But, there are also formal exchanges of information. For example, it’s becoming more popular for large firms to organize what are called knowledge management systems (KMS’) between them and their suppliers, where they not only coordinate orders, but they also share production techniques and other information that makes production less costly and more efficient.

We saw this form of concentration in Detroit. Truth be told, the auto industry in Detroit has been falling off the world map for quite some time. It faces direct competition from East Asian car companies, and production is simply cheaper elsewhere, since high unionization increased the price of Detroit auto labor above this pool’s marginal productivity. Auto factory employment peaked sometime during the 1950s or ’60s, but since then has been gradually falling. The economies of scale theory also works in reverse: as firms leave an area, remaining firms lose the externalized benefits of industry concentration. The 2007–09 financial crisis and the related output contraction was the final nail in the coffin, especially given the bankruptcies of General Motors and Chrysler. But, it’s not just General Motors and Chrysler who are impacted, but also the various suppliers and the many industries, in general, that depend on the large auto firms for their existence.

The concentration of the auto industry was a very important factor behind the rise of Detroit after the Second World War. The auto industry remained one of the city’s most important industries up until this recession. The $24.9 billion bailout of General Motors and Chrysler underscored the companies’ importance to the city. But, the city put too much emphasis on the industry. When the decline started it responded by trying to protect auto jobs as much as possible, and much of this was accomplished through the unions. Rather than allow global trade forces to take their toll, and allow for a restructuring of the city, Detroit, in a sense, decided to place all its eggs in one basket. It invested in a dying industry (in that city, at least), but you can only avoid market forces for so long.

One way to make the loss of an industry less catastrophic is to diversify an area’s economy. Detroit, to some extent, has diversified. Kane Farabaugh writes that healthcare and casino gaming have become important alternative employers. But, these employers are clearly insufficient to restore the city’s tax base and end the gradual stream of emigrants. Automobile firms earn most of their income by exporting their product. That is, most of, for example, General Motor’s sales are outside of Detroit. When an export-oriented industry gives out because of a erosion of is customer base, it either has to be replaced by another export-oriented industry or the income has to be made up by an increase in local demand.

Detroit’s general problem isn’t the dying car manufacturers there, but the gradual collapse of local demand. This phenomenon probably has multiple causes. Walter Williams blames the “White Flight,” or the emigration of Detroit’s wealthier white population because of changes in the tax code in the 1980s. By doing this, the city’s government not just ran off an important source of local consumer demand, but also an important source of local investment. We know that ultimately all incomes are sourced to production; by pushing producers out, you inevitably shrink local incomes. Detroit also has a significant crime problem, and has one of the worst education systems in the United States. It’s probably safe to argue that Detroit has been suffering from a shrinking pool of human capital. The city’s productive capability has severely eroded over the past three to four decades.

Trade is what brings people together. People are interested in moving to places where they can sell their produce. Laborers are interested in selling their labor, and they can only sell it if there is a demand for it. If you put a clamp on production, you put a clamp on trade, and ultimately you limit the employability of the city’s population. A city without trade — without employment opportunities — is an unattractive one, so it should come to no surprise that Detroit has been declining.This is also why the city has put so much effort in saving its auto industry. The auto industry was seen as a representative of Detroit’s more glorious past. The city chose to try to restore its former glory, instead of starting from scratch again and just open the area up to new trade activity. It has turned out to be a failed gamble.

Detroit isn’t the first city to suffer from cycles in trade activity: this kind of phenomenon occurred fairly frequently in older times, when political institutions were more extractive. Cities can be strangled by bureaucracy. The inducement for trade can be eliminated if a government is particularly insistent. Detroit’s city government was one such bureaucracy and the people of Detroit have paid the price. Given how deep a hole Detroit has dug for itself, something as radical as Patrick Barron’s proposal would be a worthwhile experiment. Short of that, though, the city’s government needs to focus on deregulation, deunionization, reducing the tax burden, and, more generally, making the area more attractive for production and trade. Otherwise, Detroit will continue to deteriorate.