Economies of agglomeration

Economies of agglomeration

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The term economies of agglomeration is used in urban economics
Urban economics
Urban economics is broadly the economic study of urban areas; as such, it involves using the tools of economics to analyze urban issues such as crime, education, public transit, housing, and local government finance...

 to describe the benefits that firms obtain when locating near each other ('agglomerating'). This concept relates to the idea of economies of scale
Economies of scale
Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...

 and network effect
Network effect
In economics and business, a network effect is the effect that one user of a good or service has on the value of that product to other people. When network effect is present, the value of a product or service is dependent on the number of others using it.The classic example is the telephone...

s. Simply put, as more firms in related industries cluster together, costs of production may decline significantly (firms have competing multiple suppliers, greater specialization and division of labor result). Even when multiple firms in the same sector (competitors) cluster, there may be advantages because that cluster attracts more suppliers and customers than a single firm could alone. Cities
City
A city is a relatively large and permanent settlement. Although there is no agreement on how a city is distinguished from a town within general English language meanings, many cities have a particular administrative, legal, or historical status based on local law.For example, in the U.S...

 form and grow to exploit economies of agglomeration.

Diseconomies of agglomeration refers to the opposite case. Additional competition drives down pricing
Pricing
Pricing is the process of determining what a company will receive in exchange for its products. Pricing factors are manufacturing cost, market place, competition, market condition, and quality of product. Pricing is also a key variable in microeconomic price allocation theory. Pricing is a...

 power. Large cities attract problems of crowding and congestion. It is this tension between economies and diseconomies that allows cities to grow, but keeps them from becoming too large.

Agglomeration economies are most closely associated with economies of scale
Economies of scale
Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...

 and these network effects as stated above. It is important to understand the possible ultimate outcome of agglomeration economies, only if the benefits outweigh the disadvantages. The ultimate end to agglomeration economies is the formation and growth of a city. However, there are processes involved and factors that must contribute to the formation and growth of cities. These are considered here in the types of economies that are formed, their sources that are the contributing factor, network linkages, and the advantages and disadvantages that may or may not occur in the growth and formation of cities.

In simple terms, the basic concept of Agglomeration Economies is that production is facilitated when there is a clustering of economic activity. Although this may be true, the reality of it is that the existence of agglomeration economies is central to the explanation of how cities increase in size and population; which places this phenomenon on a larger scale. This concentration of economic activity in cities is the reason for the existence of them and they can persist and grow throughout time, only if their advantages outweigh the disadvantages. It is significant to understand why these advantages allow for the persistence of cities.

Advantages


When firms form clusters of economic activity, there are particular development strategies that flow in and throughout this area of economic activity. This helps to accumulate information flow of new and innovative ideas among firms for the achievement of what economists call increasing returns to scale. With the establishment of a firm, there is always a fixed or average cost of production for the firm based on (supplies needed, labor, capital, rent etc.) for the production of the firm. When this average cost of production falls as the result of the increased total output of a product, here indicates a presence of economies of scale; increasing returns to scale and economies of scale may be used interchangeably.

Increasing returns to scale or economies of scale
Economies of scale
Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...

, is internal to a firm and may allow for the establishment of more of the same firm outside the area or region. Economies of scale external to a firm are the result of spatial proximity and are referred to as agglomeration economies of scale. Agglomeration economies may be external to a firm but internal to a region. It is important to note that these increasing returns to scale are a major contributing factor to the growth of cities. Agglomeration economies exist when production is cheaper because of this clustering of economic activity. As a result of this clustering it allows for the establishment of other businesses to take advantage without joining any big organization.
It helps to urbanize areas as well.

Disadvantages


Referring back to the growth of cities and that the existence of them can only persist if the advantages outweigh the disadvantages, it is important to know that agglomeration
Agglomeration
In the study of human settlements, an urban agglomeration is an extended city or town area comprising the built-up area of a central place and any suburbs linked by continuous urban area. In France, INSEE the French Statistical Institute, translate it as "Unité urbaine" which means continuous...

 economies may also lead to congestion, pollution and other negative externalities caused by the clustering of a population of firms and people and that this may lead to diseconomies of scale. 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 move their laborers around. Large cities experience these problems, and it is this tension between agglomeration economies and agglomeration diseconomies that may contribute to the growth of the area, control the growth of the area, or cause the area to experience a lack of growth. The ways of maintaining a stable outcome for agglomeration economies is for clustering to create "knowledge spillover
Knowledge spillover
Knowledge spillover is an exchange of ideas among individuals. In knowledge management economics, a knowledge spillover is a non-rival knowledge market externality that has a spillover effect of stimulating technological improvements in a neighbor through one's own innovation...

s" that prevail over these negative externalities.

Types of economies


There are two types of economies that are considered large-scale and external economies of scale; localization and urbanization economies. Localization economies arise from many firms in the same industry locating close to each other. There are three sources of localization economies: the first is the benefit 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.

Core-periphery model


Whilst localization and urbanization economies as well as 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
Core-periphery
Core-periphery theory is based on the notion that as one region or state expands in economic prosperity, it must engulf regions nearby to ensure ongoing economic and political success. The area of high growth or former high growth becomes known as the core, and the neighboring area is the periphery...

 model. The core-periphery model basically 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 sustaining 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 the 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.

In a nutshell, 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 their own city. However, in a more realistic sense cities are more complex than that; which is the reason for the combination of localization and urbanization economies to form large cities.

Source of economies


From the localization of firms emerges labor market pooling. Large populations of skilled laborers enter the area and are able to exchange knowledge, ideas, and information. The more firms there are in this area, the greater the competition is to obtain workers and therefore results 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 becomes 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 are known as intermediate inputs and 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, there forms a core-periphery notion that will have many firms locate near each other to be closer to their needed sources. If there are tradable resources and services nearby but no related industries in the same area, 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 clustering of firms leads to the increase in likelihood to a core-periphery pattern; where the result of this will be 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
Knowledge spillover
Knowledge spillover is an exchange of ideas among individuals. In knowledge management economics, a knowledge spillover is a non-rival knowledge market externality that has a spillover effect of stimulating technological improvements in a neighbor through one's own innovation...

. One final advantage of this source is that clustering in specific fields leads to quicker diffusion of ideas or adoption of ideas. In order for production to be at its maximum and sell their products, firms require some sort of 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 amount of uncertainty and complications involved with the use of new technology through information flow. The industry of capital flow and technology are 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 as well as nearby which would lead 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 in larger cities that already helped them to form and grow.

Basis for state redistribution from suburbs to cities


Economies of agglomeration is the reason many U.S. state governments redistribute income from its affluent suburbs to poorer urban localities. This is often achieved through grants to local governments according to a criteria that favor low-income communities. Suburbanites benefit from this redistribution because many work and enjoy visiting city centers that would not be sustainable on their own tax revenues. Cities that cant afford to provide adequate fire and police protection or schools are not places where businesses will want to locate and thus cannot maximize the agglomeration effect.

Sources and further reading

  • 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
    The New Palgrave Dictionary of Economics
    The New Palgrave Dictionary of Economics , 2nd Edition, is an eight-volume reference work, edited by Steven N. Durlauf and Lawrence E. Blume. It contains 5.8 million words and spans 7,680 pages with 1,872 articles. Included are 1057 new articles and, from earlier, 80 essays that are designated as...

    , 2nd Edition. Abstract.
  • Venables, Anthony
    Anthony Venables
    Anthony J. Venables, CBE, born April 25, 1953, is a British economist and the BP Professor of Economics at the University of Oxford.Venables is known as one of the pioneers of New Economic Geography...

    , 2008. "new economic geography," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.

See also


  • Agglomeration
    Agglomeration
    In the study of human settlements, an urban agglomeration is an extended city or town area comprising the built-up area of a central place and any suburbs linked by continuous urban area. In France, INSEE the French Statistical Institute, translate it as "Unité urbaine" which means continuous...

  • Returns to scale
    Returns to scale
    In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable...


  • Economies of scale
    Economies of scale
    Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...

  • Gains from trade
    Gains from trade
    Gains from trade in economics refers to net benefits to agents from allowing an increase in voluntary trading with each other. In technical terms, it is the increase of consumer surplus plus producer surplus from lower tariffs or otherwise liberalizing trade...


  • Cluster effect
    Cluster effect
    The cluster effect is the effect of buyers and sellers of a particular good or service congregating in a certain place and hence inducing other buyers and sellers to relocate there as well.- The Silicon Valley case :...

  • Cluster initiative

  • Business cluster
    Business cluster
    A business cluster is a geographic concentration of interconnected businesses, suppliers, and associated institutions in a particular field. Clusters are considered to increase the productivity with which companies can compete, nationally and globally. In urban studies, the term agglomeration is used...

  • Hotelling's law
    Hotelling's law
    Hotelling's law is an observation in economics that in many markets it is rational for producers to make their products as similar as possible. This is also referred to as the principle of minimum differentiation as well as Hotelling's "linear city model"...