URBAN ECONOMICS SPRING 2010 Location Agglomeration and Cities

URBAN ECONOMICS SPRING 2010

Location, Agglomeration and Cities

• We have learnt that cities exist because 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.

Agglomeration Economies • One of the central concepts in urban economics. • Meaning: Cost reductions occur because economic activities are located in one place. • Original idea: Alfred Marshall (1920) He never used agglomeration economies but instead used “localized industries”.

Agglomeration Economies • Marshall and the Marshallian-externality-based papers (Henderson 1974 and 1988, Carlino 1978, Stelting and al. 1994 among others), the micro-foundations of agglomeration stem from urban specialization through localized spillovers induced by firms operating in the same sector. • Jacobs and Jacobian-externality-based papers (Shefer 1973, Sveikaukas 1975, Segal 1976, Fogarty and Garofalo 1978, Moomaw 1981, and Tabuchi 1986 among others) emphasize on urban diversity fostering crossfertilization of ideas from various sectors.

Agglomeration Economies • Bertil Ohlin (1933) “Interregional and International Economics” • Provided most of what is now the standard system for classifying agglomeration economies. • Ohlin (1933) suggested that there are three main categories of agglomeration economies: 1. Economies of scale within the firm. 2. Localization economies, which are external to the individual firm and arise from the size of the local industry. 3. Urbanization economies, which are external to the local industry and arise from the local economy.

Categories of Agglomeration Economies 1. Economies of scale within the firm Economies of scale within a firm as an agglomeration economy may arise for a variety of reasons: • Spreading fixed cost over a larger output • Greater specialization and division of labour • Cost reductions through bulk purchases If there were no scale economies: Economy without cities Example: Feudal economy of medieval times

Categories of Agglomeration Economies 2. Localization economies external to the firm but internal to the industry: • They arise because of the size of the industry. • The larger the local industry gets the lower are the costs. As a results the industry gets larger.

Categories of Agglomeration Economies Industry grows Localization economies Costs of the firms decline

Categories of Agglomeration Economies • Firms in some industries have no interest to locate near other firms in the same industry. “Convenience goods” E. g. Grocery stores, drug stores, video rental stores, dentists, etc. • Firms in some industries have particular interest to locate near other firms in the same industry. “Shopping goods” : comparison shopping E. g. Auto dealers, furniture sellers, etc. This type of shopping behavior creates an incentive for businesses in an industry to cluster together because they can save on advertisig costs and costs of attracting customers.

Categories of Agglomeration Economies • Other forms of localization economies are created if there are economies of scale in the provision of inputs specific to the industry. • E. g. Labor: Some firms may need workers who have some specific training. Firms may train workers, themselves: Expensive. If there are enough firms in the local industry, someone may provide just these training services. Or, as Marshall said, if the local industry is large enough, the skills that are needed for the industry are just “in the air”. People in Los Angeles: movie business; Chicago: Finance

Categories of Agglomeration Economies • Economies of scale in other inputs: E. g. Legal services, management consulting, capital, computer services, etc. A lawyer can work more efficiently if he/she works only for one specific sector (finance, construction, etc. )

Categories of Agglomeration Economies 3. Urbanization economies external to the industry but internal to the local economy: • Urbanization economies are the cost reductions for an industry that arise from the size of the entire local economy. E. g. Shopping centers: Shoppers are able to buy many things in their lists in a single place. • Economies of scale exist in the provision of inputs that are not specific to the particular industry. E. g. General urban infrastructure/transportation facilities A larger urban area has a more convenient service.

Categories of Agglomeration Economies • Cultural and recereational amenities in large urban areas (Museums, theaters, music centers, sporting events, etc. ): These attract workers needed by the industry. • Some specific goods and services exist only in large urban areas: E. g. Patent attorney • There may be also diseconomies to urbanization: Congestion, pollution, social problems, competition for central locations drive up office rents and housing prices.

Empirical Evidence • Henderson (1986) studied 16 manufacturing industries in US urban areas. He found statistically significant localization economies in 8 of 16. • Primary metals, electrical machinery, non-electrical machinery, petroleum refining, apparel, wood products, pulp and paper products, food products. • He found out that localization economies die out once the local industry has reached some critical size. • Industries which did not exhibit localization economies: • Textiles, leather products, printing and publishing, furniture, chemicals, rubber and plastics, stone, clay and glass production.

Empirical Evidence • Coulibaly, Deichmann and Lall (2007) “Urbanization and Productivity: Evidence from the Turkish Provinces over the Period 1980 -2000” • The sector-by-sector estimations : Although the localization economies effect is negative for Non-metallic Mineral sector, and the urbanization economies is weak for some natural resource-based sectors such as Wood and Metal industries.

Static Theory of External Economies and Diseconomies

Static Theory of External Economies and Diseconomies • Logic: A person who is making an economic decision such as whether to produce more output, makes that decision on the basis of his own MC or MB. He ignores the costs and beneifts that affect others. • External economies or diseconomies

Static Theory of External Diseconomies • Scenerio: Two firms locating in the same region. • One of them at the upper side of the river, one at the down. • If the firm at the upper side wants to increase production by hiring more labor, this may lead to decline in the production of the firm at the down side. • External diseconomies: Reason? • Water pollution • Traffic congestion is another example.

Static Theory of External Diseconomies • Assumptions: Labor market is perfectly competitive at this area. • Hence, employment in the urban area will represent the size of the urban area. • Demand curve for labor • Supply curve for labor

Static Theory of External Economies • Localization economy: External to the firm but internal to the industry. • Assumptions: Industry is made up of large number of small competitive firms. • In long-run, output of this industry expands by adding more firms of this optimum size. • If there are localization economies specific to this industry, expansion of the industry through addition of another firm will lower the average costs of the other firms. • Hence, price level drops to this level.