Economies of agglomeration

When firms form clusters of economic activity, particular development strategies flow in and throughout this area of economic activity. This helps accumulate information and the flow of new and innovative ideas among firms to achieve what economists call increasing returns to scale. Increasing returns to scale are internal economies of scale to a firm, and may allow for establishing more of the same firm outside the area or region. Economies of scale external to a firm result from spatial proximity and are referred to as agglomeration economies of scale. Agglomeration economies can be seen as the external condition for companies and internal condition for the region.

Increasing returns to scale, according to Beckmann, is integral to understanding why urban centres form. These increasing returns to scale "give rise to [urban systems]", capturing "the trade-off between transportation costs and economies of scale".[6] Agglomeration economies exist when production is cheaper because of this clustering of economic activity. As a result of this clustering, it becomes possible to establish other businesses that may take advantage of these economies without joining any big organization. This process may help to urbanize areas as well.

Benefits arise from the spatial agglomeration of physical capital, companies, consumers and workers:[7]

• Low transport costs: physical proximity to other firms and centres of production can minimise costs associated with transportation. While this may have been the case for many manufacturing firms in the United States, Glaeser and Gottlieb argue that reducing transportation costs is more important for firms producing services.[8] Moreover, other studies have shown that when negative externalities like pollution are taken into account, agglomerated city centres are more likely to be dispersed over a larger geographical area rather than be confined to a single, metropolis-like urban region.[9]
• Geographic advantages: A longstanding theory in urban economic literature is that firms (and cities) are likely to agglomerate where there are natural geographic advantages, which would give these firms both comparative and cost advantages over their competitors.[1] Ellison and Glaeser argue that while this may be true for firms whose location decisions are highly sensitive to cost differences or geographic locations, such as the wine industry, they find that only 20% of geographic agglomeration effects in the United States can be explained by "natural" cost advantages.[1]
• Labour pooling and matching: agglomerating effects, such as an increase in population and therefore human capital, arguably help improve matching within the economy, e.g. employees with employers, suppliers with buyers, and so on.[2] Moreover, massive urban areas like cities, which contain a multitude of industries in a localised area, can help firms offset their reaction to shocks more efficiently by 'pooling' labour resources together.[2]
• Knowledge spillovers: the accumulation of knowledge and human capital in concentrated areas like major urban centres can contribute to the sharing of production technologies (i.e. know-how) between firms. Econometric analysis by Liang and Goetz showed that agglomeration effects account for technology-intensive industries benefitting from Jacobs-type knowledge spillovers.[10] Furthermore, agglomerated centres of production, like cities, also facilitate learning – that is, knowledge generation, diffusion, and accumulation – on a larger scale than smaller economic regions.[4]

While the existence of cities can only persist if the advantages outweigh the disadvantages, agglomeration would also lead to traffic congestion, pollution and other negative externalities caused by the clustering of a population of firms and people, these adverse effects will cause the diseconomies of scale.[11] Another source of agglomeration diseconomies—higher crowding and increased waiting time—can be observed in disciplines or industries that are characterized by constrained access to relevant production facilities or resources.[12] As stated above, these factors are what decrease the pricing power of firms because of the many competitors in the area as well as a shortage of labor and lack of flexibility among firms to the laborers abound. Large cities experience these problems, and this tension between agglomeration economies and agglomeration dis-economies may contribute to the area's growth, control the growth of the area, or cause the area to experience a lack of growth.

The economies of agglomeration have also been shown to increase inequality both within urban areas, and between urban and rural areas.[13] The Oxford development economist Paul Collier has proposed that the gains of agglomeration should be taxed as rents, which leads to behaviour-distorting rent-seeking (Henry George theorem). This would be ethical and efficient in that gains would be better aligned with deserts, and rent-seeking would be curbed. Collier recommends a tax calculated by combining high-income and metropolitan locations, which can then be redistributed to other cities that have been hard hit by agglomeration.[14]

The disadvantages of agglomerations are to be mentioned:[7]

• For the environment: The high level of agglomeration of economic is probably caused the pollution,[15] including air pollution, water pollution, land pollution, etc. One example is the economic agglomeration in the Yangtze River Delta region in China. Because of the concentration of individuals and industry, the serious air pollution in the Yangtze River Delta has not only caused some extreme weather problems but also increased some diseases.[16] Adjusting the city’s spatial structure can alleviate environmental problems and release the environmental pressures.[17] Energy consumption is another environmental problem. The agglomeration of the economy leads to a rapid increase in population and industries, which caused serious energy problems.[18] It would also cause some pollution and provide higher requirements for production technology.[19]
• For economic: Economic agglomeration can create some economic benefits but also tend to widen the disparity between rich areas and poor areas and increase interregional inequality.[20] Interregional inequality cannot be prevented because it is a necessary stage during economic development. The serious inequality problem even causes the issue of social instability and political uncertainty.[21] The government needs to provide some politics to improve equality, such as investing in human capital and innovation.[22] Economic agglomeration may also affect rural areas. The over-agglomeration in the city would affect agricultural production and cause unemployment problems.[23]
• For society: Economic agglomeration also caused some social problems. First, the increased population led to high land prices. To reduce the inequality problem, the government may tax the land in the agglomeration area, increasing the land price. Second, the agglomeration of the economy also has a high demand for infrastructure. It is important to coordinate the public goods problem, found the best volume of public contribution, and prevent poor or overburdened infrastructure.[24]
• For companies: Economic agglomeration would cause fierce competitive pressure. Competition can reduce the market price, motivating companies to innovate and increasing production efficiency.[25] However, over-competition would hinder companies' development and innovation, and also generate some social problems.

Two types of economies are considered large-scale and have external economies of scale; localization and urbanization economies. Localization economies arise from many firms in the same industry locate close to each other. There are three sources of localization economies: The first is the benefits of labor pooling which is the accessibility that firms have to a variety of skilled laborers, which in turn provides employment opportunity for the laborers. The second benefit is the development of industries due to the increasing returns to scale in intermediate inputs for a product, and the third source is the relative ease of communication and exchange of supplies, laborers, and innovative ideas due to the proximity among firms.

While localization and urbanization economies and their sources, are crucial to sustaining agglomeration economies and cities, it is important to understand the long-term result of the function of agglomeration economies, which relates to the core-periphery model. The core-periphery model features an amount of economic activity in one main area surrounded by a remote area of less dense activity. The concentration of this economic activity in one area (usually a city center) allows for the growth and expansion of activity into other and surrounding areas because of the cost-minimizing location decisions of firms within these agglomeration economies to sustain high productivity and advantages which therefore allow them to grow outside of the city (core) and into the periphery. A small decrease in the fixed cost of production can increase the range of locations for further establishment of firms leading to loss of concentration in the city and possibly the development of a new city outside the original city where agglomeration and increasing returns to scale existed.

If localization economies were the main factor contributing to why cities exist with the exclusion of urbanization economies, then it would make sense for each firm in the same industry to form its city. However, in a more realistic sense,, cities are more complex than that, which is why the combination of localization and urbanization economies forms large cities.

From the localization of firms emerges labor market pooling. Large populations of skilled laborers enter the area and can exchange knowledge, ideas, and information. The more firms there are in this area, the greater the competition is to obtain workers, resulting in higher wages for the workers. However, the fewer firms there are and the more workers there are at a location the lower the wage for those workers.

The second contribution towards localization economies is the access to specialized goods and services provided for the clustering firms. This access to specialized goods and services is known as intermediate inputs. It provides increasing returns to scale for each of the firms located within that area because of the proximity to available sources needed for production. If intermediate inputs are tradable, a core-periphery notion will have many firms located near each other to be closer to their required sources. Suppose there are tradable resources and services nearby but no related industries in the same area. In that case, there are no networking linkages and therefore makes it difficult for all firms in the area to obtain resources and increase production. The decreased transportation costs associated with the clustering of firms lead to an increase in the likelihood of a core-periphery pattern; the result will be that more intermediate inputs will be focused at the core and, therefore, will attract more firms in related industries.

The third source relating to localization economies is technological spillovers. One final advantage of this source is that clustering in specific fields leads to quicker diffusion or adoption of ideas. For production to be at its maximum and sell its products, firms require some feasible access to capital markets. New forms of technology can create problems and involve risk; the clustering of firms creates an advantage to reduce the uncertainty and complications involved with using new technology through information flow. The capital flow and technology industry is concentrated within specific areas, and therefore, it is to the advantage of the firm to locate near these areas. This technological impact, specifically in the communications field, will provide and dismiss the barrier between firms in the same industry located further away and nearby, leading to a greater concentration of information flow and economic production and activity. Furthermore, technological spillovers may be more beneficial to smaller cities in their growth than larger cities because of the existing informational networks that already helped them form and grow.

• Brueckner, Jan. "Lectures in Urban Economics." 2011. The MIT Press
• O'Flaherty, Brendan. City Economics. Cambridge, Massachusetts. London, England. 2005. Harvard University Press
• Coe, Neil M., Kelly, Philip F., Yeung, Henry W.C. Economic Geography: A Contemporary Introduction.' Malden, Massachusetts. Oxford, United Kingdom. Victoria, Australia. 2007. Blackwell Publishing
• Bogart, William Thomas. The Economics of Cities and Suburbs. Upper Saddle River, New Jersey. 1998. Prentice Hall
• Strange, William C., 2008, "urban agglomeration," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
• Venables, Anthony, 2008. "new economic geography," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.

• Rosenthal, Stuart S., and William C. Strange. 2020. "How Close Is Close? The Spatial Reach of Agglomeration Economies." Journal of Economic Perspectives, 34 (3): 27-49.