CHAPTER 3 (Part 2)
Why Firms Cluster?
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3. Improving Skills Matching
The third type of agglomeration economy is related to the
matching of workers and jobs.
• Workers and firms are not always perfectly matched. Skill
mismatches require expensive worker training to better match
workers with jobs.
• Key assumptions of classic model of labor matching include:
– Economies of scale in production: Because of scale economies in
production, each firm will hire more than one worker so skill matching is
important.
– Firm skill requirements: Each firm requires unique set of skills.
– Variation in worker skills: Each worker has unique set of skills.
– Training cost: There is cost for closing the gap between the worker’s
skills and the skills required by a firm.
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3. Improving Skills Matching (cont.)
• The formula below illustrates the agglomeration economies
associated with improved matching of workers and firms as a
city’s workforce grows. In general, if the number of workers in
the city is n, the average skills mismatch (m) is calculated as:
The average skills mismatch (m) = 1/[2(n ‒ 1)]
• As n increases, the skills mismatch decreases.
• Ex; If n = 4, then m = 1/(2*3) = 1/6 and if n = 6, then 1/(2*5) =
1/10
• When the skills mismatch decreases the training costs
decreases which contribute to economies of scale.
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3. Improving Skills Matching (cont.)
• The increase in firms clusters attracts more workers which
decreases mismatches and training costs, which increases
workers net wage.
• The higher net wage provides an incentive for workers to move
to live in large numbers in cities.
• The presence of a large workforce attracts firms that compete
for workers.
• As the urban economy grow the attraction between firms and
workers also grow because both firms and workers benefit from
better skill matching.
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4. Sharing Knowledge
The fourth agglomeration economy involves the benefits of
sharing knowledge and promoting innovation.
• Physical proximity facilitates the exchange of knowledge
between people, leading to new ideas.
• If one man starts a new idea, it is taken up by others and
combined with suggestions of their own; and thus it becomes
the source of new ideas.
• The sharing of knowledge provides an incentive for firms to
cluster as innovation leads to lower costs and higher profit.
• Knowledge spillovers could occur within an industry
(localization economies), but the spillovers often cross industry
boundaries (urbanization economies).
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4. Sharing Knowledge (cont.)
• As per research summarized by Carlton and Kerr (2015),
knowledge spillovers cause firms to cluster and increase the
number of firms in a city.
• The studies drew the following additional conclusions:
– The largest knowledge spillovers occur in the most innovative
industries.
– Knowledge spillovers are more prevalent in industries with small,
competitive firms.
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Agglomeration Economies and
The development of cities
The four agglomeration economies generate localization
economies and urbanization economies which means firms in
same industry will have incentive to locate close to one another
(cluster) and also firms of different industries also will have
incentive to locate close to one another, which contribute to the
development of large, diverse cities.
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Benefits of Urban Size
In addition to the four types of agglomeration economies the
growth of an urban economy (City) provide three other reasons
for firms to cluster in urban cities.
• Joint labor supply: A larger city with diverse industries provide
better job opportunities for two-earner households (family)
which provide the labor market in the city with variety of skills.
• Learning: A larger city provides a wider variety of role models
for workers so it attracts workers looking for learning
opportunities which increases the human capital.
• Social interactions: A larger city will generate better matching
of hobbies and social interests which attracts more people
(workers, and businesses).
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The Impact of Firms Clusters
Research in the last few decades provides evidence that the
clustering of firms in cities increases worker productivity,
promotes the development of new production facilities, and
increases employment.
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Equilibrium Size of a Cluster
• Agglomeration economies generate external benefits that
provide an incentive for firms to cluster.
• The clustering of firms increases total employment in the
cluster.
• The increase in the number of workers in a cluster increases the
density and the cost of living in the city over time which
increases wages which increases production cost generating
agglomeration diseconomies that offset the reduction in
production cost generated by agglomeration economies.
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Equilibrium vs. Efficient Cluster Size
Profit and Cluster Size
Equilibrium
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Equilibrium vs. Efficient Cluster Size
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