URBAN ECONOMICS SPRING 2011 Location Agglomeration and Cities

URBAN ECONOMICS SPRING 2011

Location, Agglomeration and Cities

• 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.

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-externalitybased 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.

Agglomeration Economies Jacobs and Jacobian-externality-based papers (Shefer 1973, Sveikaukas 1975, Segal 1976, Fogarty and Garofalo 1978, Moomaw 1981, and Tabuchi 1986 among others) emphasize urban diversity fostering cross fertilization 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.

• 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). This means that there should be significant 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).

• 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.

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 firm 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.

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) 20 8 ½ 20 (1/2)+(208)(1/2)=16 Industry Cluster 16 0 ½ 16 (1/2)+(160)(1/2)=16 Isolated site 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. • 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 even with higher 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 4 3 Industry Cluster 4 5 x 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: Labor productivity • In isolated location, if firm discovers that for the next year 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 4 3 Industry Cluster 4 5 x 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, Hollywood 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 realization 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.