Localization, Urbanization and Agglomeration Economies

2. Localization, Urbanization and Agglomeration Economies

3. 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.

4. Hencewereachedtwosorts of smallcities: • 1. Smalltradingcentreswith a fewfirms at a marketplace • 2. Smallfactorycitywithallworkersemployed in a singlefactory • But, in reality, wehavemostlylargecitieswithdiversecollections of economicactivity. • Whentheoutput of onefirmincreases, theproductioncost of anotherfirmmaydecraese. Thismeansfirmsmayexperience” externaleconomies of scale”.

5. 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.

6. Keyconcepts of agglomerationeconomies: • Localizationeconomiesandindustryclusters 2. Urbanizationeconomies

7. Localizationeconomiesandindustryclusters A puzzlingfeature of the urban economy is thetendency of firmsproducingthesameproducttolocateclosetooneanother (E.g. Furnitureproducers). Whatarethecosts of locatingclosetoeachother? Discuss…. Thismeansthatthereshould be subtlebenefitsfromclusteringtodominatethecosts. Theexternaleconomiescreatedduetoclustering is called “localizationeconomies”. Thismeans, costsavingsoccuronlyforlocalfirms (firms in thecluster).

8. 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.

9. a) Inputdemand of an individualfirms is not largeenoughtoexploitthescaleeconomies in theproduction of theintermediategood. b) Transportationcostsarerelativelyhigh. Proximitytotheinputsupplier is importantif • Theintermediateinput is bulky, fragile, ormust be deliveredquickly. • Iffacetofacecontactbetweenbuyerand seller is necessary.

10. E.g. Firms producing high-tech products. Demand for the products of such firms is uncertain. Instead of producing all of their components, these firms purchase electronic parts from the firms that can exploit scale economies in producing those parts. They sometimes test those components. Hence, proximity is important. The firms can interact suppliers in the design and fabrication of components. In order to facilitate frequent face time, firms should locate close to their suppliers.

11. 2. Sharing a laborpool: i) Varyingdemandforlabor: Localizationeconomiesmayresultfromtheuncertaintyandvariability in demandforlabor. If a firm is uncertainabout: • Quantity of workers it willhire or • Skills of itsworkforce; It’llprefertolocatearoundotherfirmsanddrawfrom a commonpool.

12. Supposethatthefirm is operating at an industrywhoseproductionprocessandproductdemandschangerapidly. E.g. Computerindustry. Duetothoseuncertainties, a firmmay be successfulthisyear but unsuccessfulthenextyear. Hence, sometimesthefirmwillneedmore sometimeslessworkers.

13. Switch cost: Cost of finding a job in another city if the worker does not work at a firm in an industry cluster.

14. Inequilibrium, workerswill be indifferentworking in theclusterorisolated site. • At whatwage in clustertheywill be indifferent? • Inthecluster, a $16 income is a surething. Hence, it’llmakeworkersindifferentbetweenclusterandisolated site. • However, firmswillprefertheclusterwithabovewages, since thelaborpoolprovidesfirmsexternaleconomy (lowerswitchingcoststranslateintolowerwagesforallfirms in thecluster).

15. Benefits and costs of labor pooling 30 10 120 30 20 10 80 120 160 Isolated firm Firm in an industry cluster

16. ii) Matching: A firmmayhaveuncertaintyaboutthefuturedemandforitsoutputandfutureproductiontechnology. Futuremayrequiredifferentlaborskills. A largelaborpoolaroundthefirm in an industryclusterprovidesbenefitstofirm. How?

17. 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. • In isolated location, if firm discovers next year that 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.

18. 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.

19. 3. Sharinginformation: Knowledgespillovers This is thethirdsource of localizationeconomies. A cluster of firms in thesameindustrypromotesinnovationbybringingtogetherpeopleproducingsimilargoodswithsimilarproductiontechnologies. Alfred Marshall (1920) “….ifonemanstarts a new idea, it is takenupbyothersandcombinedwithsuggestion of theirownandthus it becomesthesource of newideas.” Opportunitytoexchangeideasoccurs in bothformalandinformalsettings: Work (workshop) orplay(jogging, eating, etc. Talkshop). E.g. Siliconvalley Knowledgespilloversarestrongest in industrieswithmanysmall, competitivefirms (RosenthalandStrange, 2000).

20. 2.Urbanizationeconomiesandindustryclusters This is thesecondtype of externalscaleeconomies. Itoccursifproductioncost of an individualfirmdecreases as the total output of the urban areaincreases. Itsdifferencesfromthelocalizationeconomies: • Urbanizationeconomiesresultfromthescale of theentire urban economy. • Urbanizationeconomiesgeneratebenefitsforfirmsthroughoutthecity not justforfirms in a particularindustry. • Urbanizationeconomiesoccur at themetropolitanlevelratherthantheindustrylevel.

21. However, urbanizationeconomiesariseforthesamereasonswithlocatizationeconomies. Such as: • Intermediateinputs: Firmsfromdifferentindustriessharesuppliers of intermediateinputsallowingthereealization of scaleeconomies in banking, insurance, realestate, hotels, public service, transportation, etc. • Laborpooling: Workers in a decliningindustry can easilyswitchto a growingindustry. • Sharinginformation: Knowledgespilloversacrossdifferentindustriesleadtoinnovation in productdesignandproductionmethods.