URBAN ECONOMICS

1. URBAN ECONOMICS SPRING 2011

2. Location, Agglomeration and Cities

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. 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”.

7. Agglomeration Economies Marshall and the Marshallian-externality-based papers (Henderson 1974and 1988, Carlino 1978, Stelting and al. 1994 among others): The micro-foundations ofagglomeration stem from urban specialization through localized spillovers induced byfirms operating in the same sector.

8. 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 crossfertilizationof ideas from various sectors.

9. Agglomeration Economies • Bertil Ohlin (1933) “InterregionalandInternationalEconomics” • Providedmost of what is nowthestandardsystemforclassifyingagglomerationeconomies. • Ohlin (1933) suggestedthattherearethreemaincategories of agglomerationeconomies: • Economies of scalewithinthefirm. • Localizationeconomies, whichareexternaltotheindividualfirmandarisefromthe size of thelocalindustry. • Urbanizationeconomies, whichareexternaltothelocalindustryandarisefromthelocaleconomy.

10. Keyconcepts of agglomerationeconomies: • Localizationeconomiesandindustryclusters 2. Urbanizationeconomies

11. Localizationeconomiesandindustryclusters 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”. Thismeans, costsavingsoccuronlyforlocalfirms (firms in thecluster).

12. Firms in someindustrieshave no interesttolocatenearotherfirms in thesameindustry. “Conveniencegoods” E.g. Grocerystores, drugstores, video rentalstores, dentists, etc. • Firms in someindustrieshaveparticularinteresttolocatenearotherfirms in thesameindustry. “Shoppinggoods” : comparisonshopping E.g. Autodealers, furnituresellers, etc. Thistype of shoppingbehaviorcreates an incentiveforbusinesses in an industrytoclustertogetherbecausethey can save on advertisigcostsandcosts of attractingcustomers.

13. 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.

14. a) Input demand of an individual firm is not large enough to exploit the scale economies in the production of the intermediate good. b) Transportationcostsarerelativelyhigh. Proximitytotheinputsupplier is importantif • Theintermediateinput is bulky, fragile, ormust be deliveredquickly. • Iffacetofacecontactbetweenbuyerand seller is necessary.

15. 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.

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

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

18. 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).

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

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

21. 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.

22. 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.

23. 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. Silicon valley, Hollywood Knowledgespilloversarestrongest in industrieswithmanysmall, competitivefirms (RosenthalandStrange, 2000).

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

25. However, urbanizationeconomiesariseforthesamereasonswithlocatizationeconomies. Such as: • 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. • Laborpooling: Workers in a decliningindustry can easilyswitchto a growingindustry. • Sharing information: Knowledge spillovers across different industries lead to innovation in product design and production methods.