MODULE 1 UNIT 1
The productivity of cities
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Table of contents
1. Introduction
3
2. Location fundamentals
3
3. Internal and external returns to scale
3.1 Internal returns to scale
3.2 External returns to scale
3.2.1 Firms operating in the same sector
3.2.2 Firms operating in different sectors
6
7
7
7
7
4. Sources of agglomeration economies (Marshallian externalities)
4.1 Shared inputs (proximity of goods)
4.2 Labour market pooling (proximity of people)
4.3 Knowledge spillovers (proximity of ideas)
8
8
9
10
5. Visual representation
11
6. Conclusion
11
7. Bibliography
12
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Learning outcome:
LO2: Identify the productivity benefits of operating in larger and denser cities.
1. Introduction
If you look at a night-time satellite image of the earth, you can see the clustering of lights,
and thus development, in city centres. What drives this phenomenon? Why have cities
formed, and why do workers and firms cluster in cities?
Figure 1: Night-time satellite image of the earth. (Adapted from: NASA Earth Observatory, 2012)
The research undertaken by urban economists spans centuries and investigates the
reasons behind why cities form. By and large, cities form due to location fundamentals,
and workers and firms cluster in cities due to the benefits that cities provide (agglomeration
economies). These concepts will be further explored in this set of notes.
2. Location fundamentals
Cities develop as a result of location decisions by firms and workers (McDonald & McMillen,
2011). What drives these location decisions? The economics literature largely attributes
location decisions to transport costs, i.e. location decisions are driven by the cost of moving
goods and people over space (Glaeser & Kohlhase, 2003:2).
In the past, transport costs were very high. People travelled by foot and goods were
transported via water. The structure of cities and the places where they are located are
indicative of the high cost of transport. An example from Glaeser and Kohlhase (2003:3)
illustrates this:
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Of the 20 largest cities in America in 1900, seven were ocean ports where
rivers meet the sea (Boston, Providence, New York, Jersey City, Newark,
Baltimore, and San Francisco); five were ports where rivers meet the Great
Lakes (Milwaukee, Chicago, Detroit, Cleveland, and Buffalo); three were
on the Mississippi river (Minneapolis, St. Louis and New Orleans); three
were on the Ohio river (Louisville, Cincinnati and Pittsburgh); and the
remaining two were on east coast rivers, close to the Atlantic (Philadelphia
and Washington). America’s largest city, New York, was clearly its best
port.
Figure 2: Illustration of the 20 largest US cities in 1900 in relation to waterways.
Therefore, cities often first emerged due to geographical reasons, such as access to a
waterway, or access to minerals (e.g. gold). Weber (1929) proposed that firms locate
based largely on where they can minimise transport costs. He assumed that firms are
rational and would want to locate themselves where costs were minimised, thereby
maximising profits.
He also noted that firms producing products that lose weight during the production process
(such as coal, steel, or timber) would prefer to locate closer to the source of the raw
material than to the market in which they sell the product. This is because of the
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assumption that it is cheaper to transfer a product that weighs less. On the other hand,
industries such as breweries or bakeries would prefer to locate closer to the market, as the
cost of transporting their finished product is more than the cost of transporting the raw
material inputs.
Weber’s theory, referred to as classical location theory (CLT), emphasises firms incurring
the “least cost” (i.e. the lowest possible costs). The limitations of the model largely relate
to its assumptions. For example, while there can only be one least-cost location, there
might be many locations that are still profitable, and transport costs are not the only
consideration in deciding on a location. However, the theory is still useful in determining
the importance of transport costs as a driver behind a firm’s location decision.
Transport costs are reduced if firms and customers are close to each other. Production is
therefore cheaper, firms can make greater profits, and consumers can access cheaper
goods. This creates further incentive for more firms and consumers to locate in a city or
region. Figure 3 illustrates that the closer firms locate to the source of their inputs, and the
market, the lower the transport costs will be.
Figure 3: Illustration of classical location theory. (Adapted from: Weber, 1929)
Mohammed and Williamson (2004) found that transport costs decreased by approximately
90% between 1870 and 1930. Therefore, in more modern times, transport costs are less
of a compelling argument for concentration in cities. In addition, services (as opposed to
products) are becoming increasingly more important as an output for firms, and further
rationalisations are therefore needed to explain the existence of cities with regards to the
production of services. Figure 4 illustrates the findings of Ahlfeldt et al. (2020), showing
that the share of US gross domestic product (GDP) originating from manufacturing has
decreased since 1940, and the share of US GDP originating from prime services
(knowledge-based tradeable services) have increased.
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Figure 4: Time-series graph of the share of US GDP relating to prime services versus the share of
US GDP relating to manufacturing. (Adapted from: Ahlfeldt et al., 2020)
3. Internal and external returns to scale
Commercial activities tend to locate close to one another in order to take advantage of
external returns. Although internal and external returns contribute towards productivity,
internal returns are independent of co-location. Therefore, external returns lead to firms
locating close to each other. The concepts of internal and external returns to scale are
explored later in this section.
Note:
A firm has constant returns to scale when its output increases by the same amount as
its inputs. Increasing returns to scale occur when a firm’s output increases by more
than its inputs. Economies of scale occur when the average cost of production declines
as output increases.
When commercial activities locate closer together, it results in:
•
Greater competition for land (as many firms want to locate upon the same land),
with a resultant increase in land prices;
•
Workers locating closer together, resulting in congestion and higher residential
rents; and
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•
Higher wages to compensate workers for the downsides of living closer together in
cities.
Therefore, you would assume that, due to the increased wages and land costs, firms would
be less productive and, therefore, would choose not to locate together. This assumption is
based on the idea that all firms achieve constant returns to scale.
In order for firms to locate together, they must be more productive to compensate for these
downsides (costs), and that is exactly what has been observed – firms locating close to
each other achieve increasing returns to scale.
3.1 Internal returns to scale
Some firms experience economies of scale because they are large in size. These gains
are deemed to be internal to the firm. The economies still arise due to location – the firm
is located, at scale, in one location. Therefore, these benefits are connected to the fact that
this location has dense capital investment and population. However, the economies of
scale are location-specific (internal to the firm) and not place-specific (external to the firm).
3.2 External returns to scale
External returns to scale result when firms locate in the same area; these are referred to
as place-specific returns to scale. Agglomeration economies are the external benefits that
arise from firms and workers locating close to one another. Benefits can result when firms
in the same sector cluster together, but also when firms in different sectors cluster together.
These benefits are known as localisation economies and urbanisation economies,
respectively.
3.2.1 Firms operating in the same sector
Why would firms operating in the same sector get benefits from locating in the same place?
You might think that firms operating in the same sector would prefer to locate in different
areas, since they would then be able to create local monopolies (O’Sullivan, 2012).
However, firms in the same industries do cluster together in some instances. For example,
tech firms cluster in Silicon Valley, automobile producers in Detroit, and financial
institutions in London. The reasons for that relate largely to the benefits that are obtained
by locating in cities – agglomeration economies and, in this case, localisation economies.
Explore further:
The British Council published an article that discusses some of the benefits that firms
operating in the same sector obtain when they locate closer together.
3.2.2 Firms operating in different sectors
Why would firms serving different sectors of the market get benefits from locating in the
same place? There are various services that are related to production. For example, legal
services are required to transfer ownership of a property, and thus the legal profession and
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the real estate market intersect, and cities facilitate the communication and collaboration
between these two types of firms. Therefore, firms in different industries locate in the same
place due to the benefits that are obtained by locating in cities (Jacobs, 1969) –
agglomeration economies and, in this case, urbanisation economies.
4. Sources of agglomeration economies
(Marshallian externalities)
The previous section described types of agglomeration economies. This section explores
their sources.
Alfred Marshall (1920) proposed that firms and workers cluster in cities to reduce transport
costs and that transport costs encompass three aspects: the cost of moving goods, the
cost of moving people, and cost of moving ideas. Therefore, cities form in order to bring
goods, people, and ideas close to one another to gain economic benefits (i.e. to take
advantage of economies of scale).
Agglomeration minimises transport costs, as it is easier to communicate and exchange
goods and ideas with a firm or worker that is close by than with one that is further away
(Glaeser, 2010). One would think that, since transport and communication costs have
decreased, the importance of cities would also decline (Glaeser, 2010). However, this has
not been the case. Studies have found that around the world, a doubling of the population
density lead to an increase in productivity of between 2 and 4 percent (Ahfeldt &
Pietrostefani, 2019) (see Section 4.3 for further information on knowledge spillovers).
Furthermore, firms might choose a location based on natural advantages, such as access
to the coast. Ellison, Glaeser, and Kerr (2010) took this into account in a study assessing
whether industries locate together because of Marshallian externalities. They found strong
evidence to support that this was the case in the US manufacturing sector.
Marshall (1920) proposed that agglomeration economies occur due to three reasons:
shared inputs, labour market pooling, and knowledge spillovers.
Agglomeration:
To learn more about agglomeration economies download the article by Faggio et al.
(2020) titled “Tales of the city: what do agglomeration cases tell us about agglomeration
in general?” by accessing the downloads folder.
4.1 Shared inputs (proximity of goods)
Firms producing the same goods and services that locate closer together can make use of
the same suppliers for their inputs to production, resulting in lower costs. Conventional
inputs such as raw materials and labour are relatively cheap to transport (as seen in the
Weber model). Therefore, the goods that benefit most from locating in cities are
specialised, locally constrained inputs such as specialist legal services and software
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solutions. They have very high Weber transport costs and are only accessible by locating
in a city.
If firms locate in a city, then more than one firm can access the same services, thereby
sharing the costs (making the costs lower). For example, suppose a number of factories
need to use specialised equipment to test that their industrial components are operating
correctly. Instead of every firm making an expensive investment into this machinery, one
company can invest in the machinery and rent its services out to all the factories. This is
only feasible if all the manufacturing firms that need this testing performed locate close
together.
The same applies to indivisible inputs (inputs that cannot be reduced to smaller parts for
smaller outputs). Indivisible inputs have a high fixed cost relative to their marginal cost (the
extra cost needed to produce one more unit of output). Firms can more readily access
indivisible inputs by locating in a city, and, in doing so, the fixed costs are spread across
multiple parties.
An example of an indivisible input is mobile phone service infrastructure. Whether a mobile
service provider wishes to supply one minute of talk time to a customer or many minutes
of talk time to millions of customers, they will need the same infrastructure. Therefore, if
mobile phone operators locate together, they can make use of the same infrastructure,
reducing their cost per minute of talk time provided.
Figure 5: As the number of firms in a cluster increases, the actual cost to produce a product
decreases.
4.2 Labour market pooling (proximity of people)
People coming together (pooling) in a city results in an increased volume of the labour
market. This leads to many benefits:
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●
Searching for new workers is easier and cheaper in a larger pool, so workers can
be hired quickly, which reduces costs for firms.
●
Firms and workers can find better matches, which reduces the cost of training new
employees. For example, in Silicon Valley, a tech firm can find a suitably skilled
worker within the area, and similarly, a worker can find a tech company that
requires their skills without having to move. Therefore, labour acquisition costs are
lower in clusters, as workers have the opportunity to find a better-paying job if they
find an employer looking for exactly their skill profile.
●
Workers gain more when learning from each other, as they are exposed to people
with a wider variety of skills and experience.
O’Sullivan (2012) illustrates a pertinent example of the benefits of a labour pool in the US
film industry, located around the Hollywood area in California. One side of the labour pool
relates to the workers that are part of the production side of the industry (such as
cameramen, costume designers, set builders, etc.). The other relates to the actors, writers,
and directors. Each of these groups moves around from project to project. Therefore,
producers of films cluster together in Hollywood to take advantage of the presence of an
easily accessible and suitably skilled labour pool.
4.3 Knowledge spillovers (proximity of ideas)
An invention by one firm might lead to similar inventions being created by other firms, some
even improving on the original. Dense areas such as cities encourage innovation and
knowledge spillovers by allowing for the swapping of ideas that will ultimately result in the
development of new goods and services (or new ways of producing goods and services).
Cities provide access to knowledge based on people’s own experiences, which is not
necessarily written down or recorded (codified). Access to this knowledge leads to
innovation and increases productivity.
For example, Tom Wolfe (1983) notes how, in the 1960s, the Wagon Wheel in Silicon
Valley was a place where people would stop for after-work drinks and exchange ideas
about what they were working on at the time. Carlino (2001) finds that patent applications,
a proxy for innovation in cities, have increased substantially between the mid-1980s and
mid-1990s. He also noted that the source of the majority of granted patents were
metropolitan areas.
Knowledge is exchanged among firms in the same industry when they cluster in cities
(Glaeser et al., 1992). On the other hand, Jane Jacobs (1969) theorised that knowledge
spillovers result from the existence of firms in different industries in the same place. This
encourages the exchange of knowledge and ideas between people with different
experiences and viewpoints (Carlino, 2001).
Pause and reflect:
Can you think of an example of how agglomeration economies arise in your own, or a
nearby, city?
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5. Visual representation
Consider Figure 6, which summarises the concepts dealt with in Sections 3 and 4.
Figure 6: Types and sources of agglomeration economies.
6. Conclusion
These notes have explored some of the reasons why cities have formed and why workers
and firms cluster in cities. Cities mostly form due to location fundamentals, and workers
and firms cluster in cities due to agglomeration economies.
Location fundamentals relate, largely, to the cost of moving goods over space. Weber
(1929) theorised that firms will locate in the location that minimises transport costs.
Agglomeration economies arise because of both urbanisation and localisation economies,
and due to Marshallian externalities, which include shared inputs, labour market pooling,
and knowledge spillovers.
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Workers and firms that cluster together can share inputs to their production of goods and
services. They can also make use of the same labour pool and exchange knowledge and
ideas, resulting in cost savings and improved production processes (of both goods and
services). Furthermore, workers can benefit from locating close to one another by
exchanging ideas and thus driving innovation and productivity.
Complete the enrichment activity that follows to learn more about the relationship between
population and employment density, and productivity in cities. Then complete the practice
quiz to test your knowledge of the concepts covered in this unit.
7. Bibliography
Abel, J.R., Dey, I. & Gabe, T.M. 2010. Productivity and the density of human capital.
Available:
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr440.pdf
[2018, September 06].
Ahlfeldt, G.M. 2018. Regional and urban concentration forces [GY457 Lecture notes].
Department of Geography and Environment, The London School of Economics
and Political Science.
Ahlfeldt, G., Albers, T., & Behrens, K. 2020. Prime locations. [CED Discussion Paper
1725 ].
Ahlfeldt, G. & Pietrostefani, E. 2019. The economic effects of density: A synthesis.
Journal of Urban Economics. 111:93-107
Carlino, G.A. 2001. Knowledge spillovers: Cities’ role in the new economy. Business
Review. 7(Q4):17-26.
Ellison, G., Glaeser, E.L. & Kerr, W.R 2010. What causes industry agglomeration?
Evidence from coagglomeration patterns. American Economic Review. 100(3):
1195-1213.
Glaeser, E.L. Ed. 2010. Agglomeration economics. Chicago: University of Chicago Press.
Glaeser, E.L., Kallal, H.D., Scheinkman, J.A., & Shleifer, A. 1992. Growth in cities.
Journal of Political Economy. 100(6):1126-1152.
Glaeser, E.L. & Kohlhase, J.E. 2003. Cities, regions and the decline of transport costs.
National Bureau of Economic Research working paper 9886. Available:
http://www.nber.org/papers/w9886 [2018, August 30].
Jacobs, J. 1969. The economy of cities. New York: Random House.
Marshall, A. 1920. Principles of economics. London: Macmillan and Co.
McCann, P. 2013. Modern urban and regional economics. 2nd ed. Oxford: Oxford
University Press.
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McDonald, J.F. & McMillen, D.P. 2011. Urban economics and real estate: theory and
policy. 2nd ed. John Wiley & Sons.
Mohammed, S.I.S. & Williamson, J.G. 2004. Freight rates and productivity gains in British
tramp shipping 1869–1950. Explorations in Economic History. 41(2):172-203.
NASA Earth Observatory. 2012. Earth at night. Available:
https://earthobservatory.nasa.gov/Features/NightLights [2018, September 05].
O’Sullivan, A. 2012. Urban economics. 8th ed. New York: McGraw-Hill/Irwin.
Perloff, J.M. 2012. Microeconomics. 6th ed. Boston: Addison Wesley.
Weber, A. 1929. The theory of location of industries. Translated by Carl Joachim
Friedrich. Chicago: University of Chicago Press.
Wolfe, T. 1983. The tinkerings of Robert Noyce: how the sun rose on the Silicon
Valley. Available:
https://web.stanford.edu/class/e145/2007_fall/materials/noyce.html [2018, August
30].
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