• Firms produce at lower costs by locating near one another (clustering) => positive externality, external economies of scale

• Localization economies - external effects confined to firms in same industry ("intra-industry external economies")

• Urbanization economies - external effects cross industry boundaries ("inter-industry external economies")

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1.  Reasons for agglomeration economies

a. Sharing intermediate inputs

• Costs reduced if firms share an intermediate input supplier

• Conditions needed:

(1)  Economies of scale for production of intermediate input

• Economies of scale in intermediate inputs because of indivisible inputs and specialized labor

• Demand by a single firm too small to exploit economies of scale in production

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(2)  Face time

• Inputs not standardized

• Requires face-to-face interaction  between producer of intermediate input and producer of final good

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Ex. - Dressmakers (buttons), movie industry (props), theater (costumes), high-technology firms (electronic components), trading firms (repair services), urbanization economics (banking, insurance, accounting, legal services)

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b. Tapping a common labor pool

• Cost of labor is reduced if firms can share a pool of labor

• Particularly the case if demand for final product is constant over time, but demand per firm varies from one period to another

Ex. - Television programs

• Unsuccessful firms fire workers, successful ones hire workers

• Cost of switching firms reduced in a cluster compared to an isolated firm

(1)  Reduced search costs

• Higher density of information about job opportunities

• Less time traveling from one prospective employer to another

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(2)  Reduced relocation costs

• Don't have to spend money to move

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• Since labor market is more stable in a cluster compared to an isolated firm, wage will be lower

Ex. - Movie industry

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c. Skills matching

• Workers and firms not always perfectly matched

• Costly to train workers to meet job requirements

Ex. - Software firm (computer programmers)

• Workers in large cities closer in match to firms' skills needs

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(1)  Small city

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(2)  Large city

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• Average skills mismatch = m = 1 / [2 (n - 1)]

• Lower training costs if city is larger

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d. Knowledge spillovers

• Information and ideas more easily exchanged

• Formal and informal networks

• Diverse backgrounds, interaction=> innovation

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2. Marketing - shopping externalities

• Sales of one store affected by the location of others.

a. Imperfect substitutes

• Goods similar but not identical => comparison shopping required

Ex. - Car districts, Akihabara (Tokyo)

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• Cluster of imperfect substitutes decreases cost of comparison shopping, attracts customers, boosts demand

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b. Complementary goods

• Purchased on same trip - "one-stop shopping"

Ex. -

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3.  Other benefits of urban size

a.  Joint labor supply

• Two worker households benefit

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b.  Learning opportunities

• Urban area has more and wider variety of learning opportunities

• Attractive because of higher wages

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c.  Social opportunities

• More likely to find a match in terms of interests

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4.  Equilibrium size of a cluster

a.  Agglomeration diseconomies

• Increased employment leads to higher wages

- Increased population density raises housing costs

- Increased land area increases commuting time and costs

- Workers want increased wages as compensation

• Increased wages partially offset agglomeration economies

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b.  Equilibrium vs. efficient cluster size

• Firms will enter as long as profit exceeds amount made in isolated case

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• Equilibrium number of firms greater than the efficient level

• Firms ignore both positive and negative external effects

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5.  Empirical evidence and examples

a.  Agglomeration economies, million dollar plants

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b. Knowledge spillovers

(1)  Largest knowledge spillovers occur in the most innovative industries

(2)  Knowledge spillovers are highly localized, petering out over a distance of a few miles

(3)  Knowledge spillovers are more prevalent in industry clusters with small, competitive firms vs. clusters dominated by a few firms

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c.  Single-industry clusters

• Localization economies can lead to large clusters of firms producing the same product

Ex.- Socks in Datang, PRC

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• Location quotient = % of local employment in industry / % of national employment in industry

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Product	Metropolitan Area	2015 Employment	Location Quotient
Software Publishers	Seattle, WA San Francisco, CA San Jose, CA Atlanta, GA Madison, WI	53,800 20,700 16,900 12,300 8,900	12.3 3.9 6.91 2.16 10.17
Motion Pictures and Video	Los Angeles, CA New York, NY New Orleans, LA Bridgeport, CT	106,800 35,500 2,900 2,300	11.74 2.48 3.33 3.3
Sound Recording	New York, NY Los Angeles, CA Nashville, TN	3,076 2,718 1,936	2.94 4.09 19.23
Insurance Claims	Los Angeles, CA Atlanta, GA Las Vegas, NV	3,257 2,382 1,030	1.86 2.43 3.04
Investment Banking and Securities	New York, NY Chicago, IL Bridgeport, CT	53,888 8,381 3,782	5.71 1.52 8.42
Shipbuilding and Repairing	Virginia Beach, VA Mobile, AL	26,232 5,645	59.61 49.15
Ophthamalic Good	Los Angeles, CA Rochester, NY Dallas, TX Tampa, FL	2,953 1,924 1,837 1,355	2.82 29.63 2.28 6.73
Aerospace Products	Seattle, WA Los Angeles, CA Dallas, TX Wichita, KS St. Louis, MO	91,424 49,934 32,121 28,062 16,228	12.67 2.48 2.79 27.52 3.57

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d.  Corporate headquarters and functional specialization

• Corporate headquarters locate in cities to take advantage of urbanization economies, particularly sharing intermediate inputs - accounting, legal, advertising

Ex. - New York City (70 of Fortune 500), Bay Area (35)

• Large cities increasingly specialized in managerial functions, smaller cities becoming more specialized in production

• Innovations in telecommunications make it easier to manage production at a distance from headquarters

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e.  Nursery cities and the product cycle

• Nursery cities - large diverse cities that provide a nurturing environment for early product design and development

• Diverse cities foster new ideas and experimentation

• Production more efficient in specialized cities due to localization economies

• Design and development in diverse cities, then move to specialized cities

• Most likely for highly innovative industries

Ex. - R&D, pharmaceuticals and cosmetics, IT, business services, printing and publishing, aerospace equipment, electronic equipment

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