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.

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 clustersA 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 ifi) 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 ori) 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)+(20-8)(1/2)=16

Industry Cluster

16 0 ½ 16 (1/2)+(16-0)(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

10

120

30

2010

80 120 160

Isolated firmFirm 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 Industry Cluster

Type 1 2 3 4 5 1 2 3 4 5

Actual types x x x x

Output produced

4 5 6 5 4 6 5 6 5 6

•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.

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: 4.80Expected 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.

Isolated Location Industry Cluster

Type 1 2 3 4 5 1 2 3 4 5

Actual types x x x x

Output produced

4 5 6 5 4 6 5 6 5 6

3. Sharing information: Knowledge spilloversThis 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 clustersThis 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.