Localization,
Urbanization
and
Agglomeration Economies
• We have learnt that cities exist beacuse some
activities are subject to economies of scale.
• Scale economies in transportation: Trading
cities
• Scale economies in production: Factory cities
• In both cases, an increase in firm’s output
decreases its average production cost.
• Scale economies are internal to the firm.
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•
•
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Hence we reached two sorts of small cities:
1. Small trading centres with a few firms at a
marketplace
2. Small factory city with all workers employed
in a single factory
But, in reality, we have mostly large cities with
diverse collections of economic activity.
When the output of one firm increases, the
production cost of another firm may decraese.
This means firms may experience” external
economies of scale”.
• These are positive spillovers.
• They cause firms to cluster in cities leading to
large agglomerations of output. External
economies increase labor productivity. Wages
are also high in large cities to compansate for
higher commuting costs.
• Key concepts of agglomeration economies:
1. Localization economies and industry clusters
2. Urbanization economies
1. Localization economies and industry clusters
A puzzling feature of the urban economy is the
tendency of firms producing the same product to
locate close to one another (E.g. Furniture
producers).
What are the costs of locating close to each other?
Discuss….
This means that there should be subtle benefits
from clustering to dominate the costs.
The external economies created due to clustering is
called “localization economies”. This means, cost
savings occur only for local firms (firms in the
cluster).
In our analysis we will focus on a firm’s decision
between locating in an industry cluster or at an
isolated site.
Assumption: Firms export their goods outside
the city.
Benefits of clustering:
1. Sharing input suppliers: Firms will cluster
around a common input supplier if two
conditions are satisfied.
• a) Input demand of an individual firms is not
large enough to exploit the scale economies in
the production of the intermediate good.
b) Transportation costs are relatively high.
Proximity to the input supplier is important if
i) The intermediate input is bulky, fragile, or
must be delivered quickly.
ii) If face to face contact between buyer and
seller is necessary.
E.g. Firms producing high-tech products.
Demand for the products of such firms is uncertain.
Instead of producing all of their components, these firms
purchase electronic parts from the firms that can exploit
scale economies in producing those parts. They
sometimes test those components. Hence, proximity is
important. The firms can interact suppliers in the design
and fabrication of components. In order to facilitate
frequent face time, firms should locate close to their
suppliers.
2. Sharing a labor pool:
i) Varying demand for labor: Localization economies may result
from the uncertainty and variability in demand for labor.
If a firm is uncertain about:
i) Quantity of workers it will hire
or
i) Skills of its workforce;
It’ll prefer to locate around other firms and draw from a
common pool.
Suppose that the firm is operating at an industry whose
production process and product demands change
rapidly. E.g. Computer industry.
Due to those uncertainties, a firm may be successful
this year but unsuccessful the next year. Hence,
sometimes the firm will need more
sometimes less workers.
Wage (USD)
Switch Cost
(USD)
Probability of
switch
Expected net
income (USD)
Isolated site
20
8
½
20 (1/2)+(208)(1/2)=16
Industry
Cluster
16
0
½
16 (1/2)+(160)(1/2)=16
Switch cost: Cost of finding a job in another city if the worker
does not work at a firm in an industry cluster.
• In equilibrium, workers will be indifferent working
in the cluster or isolated site.
• At what wage in cluster they will be indifferent?
• In the cluster, a $16 income is a sure thing.
Hence, it’ll make workers indifferent between
cluster and isolated site.
• However, firms will prefer the cluster with above
wages, since the labor pool provides firms
external economy (lower switching costs
translate into lower wages for all firms in the
cluster).
Benefits and costs of labor pooling
30
30
10
20
10
120
Isolated firm
80
120 160
Firm in an industry
cluster
ii) Matching:
A firm may have uncertainty about the future
demand for its output and future production
technology.
Future may require different labor skills.
A large labor pool around the firm in an industry
cluster provides benefits to firm.
How?
Isolated Location
Type
1
2
Actual types
Output
produced
3
Industry Cluster
4
5
x
4
5
6
1
2
x
5
4
6
3
4
x
5
6
5
x
5
•Industry cluster has a greater variability of labor skills
since it has more workers.
•Isolated location has a single type of labor (type 3).
•Output per worker depends on the match between the
actual and ideal type of worker.
•In isolated location, if firm discovers next year that its
ideal labor type is 3, it will be a perfect match. Output per
worker will be $6.
•What if it decides that ideal is 1 but has to hire 3? Then,
the worker will produce only an output of $4.
6
Isolated Location
Type
1
2
Actual types
Output
produced
3
Industry Cluster
4
5
x
4
5
6
1
2
x
5
4
6
3
4
x
5
6
x
5
Since a firm does not know its ideal type, it can only calculate its
expected output.
Expected output of a firm in an isolated site: 4.80
Expected output of a firm in an industry cluster: 5.60
Why? In an industry cluster, number and variability of workers are
high. Hence, firm is more likely to match skills.
Clustering increases productivity by providing a better match
between workers and firms.
5
6
3. Sharing information: Knowledge spillovers
This is the third source of localization economies.
A cluster of firms in the same industry promotes innovation by
bringing together people producing similar goods with similar
production technologies.
Alfred Marshall (1920) “….if one man starts a new idea, it is
taken up by others and combined with suggestion of their
own and thus it becomes the source of new ideas.”
Opportunity to exchange ideas occurs in both formal and
informal settings: Work (workshop) or play(jogging, eating,
etc. Talkshop). E.g. Silicon valley
Knowledge spillovers are strongest in industries with many
small, competitive firms (Rosenthal and Strange, 2000).
2.Urbanization economies and industry clusters
This is the second type of external scale economies.
It occurs if production cost of an individual firm
decreases as the total output of the urban area
increases.
Its differences from the localization economies:
1. Urbanization economies result from the scale of
the entire urban economy.
2. Urbanization economies generate benefits for
firms throughout the city not just for firms in a
particular industry.
3. Urbanization economies occur at the
metropolitan level rather than the industry level.
• However, urbanization economies arise for the
same reasons with locatization economies. Such
as:
1. Intermediate inputs: Firms from different
industries share suppliers of intermediate inputs
allowing the reealization of scale economies in
banking, insurance, real estate, hotels, public
service, transportation, etc.
2. Labor pooling: Workers in a declining industry
can easily switch to a growing industry.
3. Sharing information: Knowledge spillovers
across different industries lead to innovation in
product design and production methods.