Economies of agglomeration

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One of the major subfields of urban economics, economies of agglomeration (or agglomeration effects), explains, in broad terms, how urban agglomeration occurs in locations where cost savings can naturally arise. [1] This term is most often discussed in terms of economic firm productivity. However, agglomeration effects also explain some social phenomena, such as large proportions of the population being clustered in cities and major urban centers. [2] [3] Similar to economies of scale, the costs and benefits of agglomerating increase the larger the agglomerated urban cluster becomes. [4] [5] Several prominent examples of where agglomeration has brought together firms of a specific industry are: Silicon Valley and Los Angeles being hubs of technology and entertainment, respectively, in California, United States along with London, United Kingdom, being a hub of finance. [1]

Economies of agglomeration have some advantages. As more firms in related fields of business cluster together, their production costs tend to decline significantly (firms have multiple competing suppliers; greater specialization and division of labor). Even when competing firms in the same sector cluster, there may be advantages because the cluster attracts more suppliers and customers than a single firm could achieve alone. Cities form and grow to exploit economies of agglomeration.

Diseconomies of agglomeration are the opposite. For example, spatially concentrated growth in automobile-oriented fields may create problems of crowding and traffic congestion. The tension between economies and diseconomies allows cities to grow but keeps them from becoming too large.

At the foundational level, proximity—especially to other facilities and suppliers—is a driving force behind economic growth and is one explanation for why agglomeration effects are so evident in major urban centers. [2] [6] While the concentration of economic activity in cities has a positive effect on their development and growth, cities, in turn, help foster economic activity by accommodating population growth, driving wage increases, and facilitating technological change. [7]

Advantages of agglomeration

When firms form clusters of economic activity, particular development strategies flow into 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 for 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 called agglomeration economies of scale. Agglomeration economies can be seen as the external condition for companies and the internal condition for the region.

Increasing returns to scale, according to Beckmann, is integral to understanding why urban centers form. These increasing returns to scale "give rise to [urban systems]," capturing "the trade-off between transportation costs and economies of scale". [7] 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: [8]

Disadvantages of agglomeration

While the existence of cities can only persist if the advantages outweigh the disadvantages, poorly planned agglomerations may also lead to negative externalities like traffic congestion (lack of walkability and public transport) or pollution (lack of environmental protection laws). These adverse effects can cause diseconomies of scale. [12] 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. [13] 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 a lack of flexibility among firms for 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. [14] The Oxford development economist Paul Collier proposed that the gains of agglomeration should be taxed as rents, which leads to behavior-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 recommended 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. [15]

The disadvantages of agglomerations are to be mentioned: [8]

Types of economies

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 located close to each other. There are three benefits 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 opportunities for the laborers. The second benefit is the development of industries due to the increasing returns to scale in intermediate inputs for a product. The third benefit is the relative ease of communication and exchange of supplies, laborers, and innovative ideas due to the proximity among firms.

Core-periphery model

While localization and urbanization economies and their benefits 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.[ citation needed ]

Source of economies

From the localization of firms, labor market pooling emerges. 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 wages for those workers will be.

The second contribution to localization economies is the access to specialized goods and services provided for clustering firms. This access to specialized goods and services is known as an intermediate input. It provides increasing returns on 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. If there are tradable resources and services nearby but no related industries in the same area, then in that case, there are no networking linkages, which 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 for firms to sell their products, they 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 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 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 terms of their growth than larger cities because of the existing informational networks that already helped them form and grow.

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