Economies of agglomeration

Economies of agglomeration

The term economies of agglomeration is used in urban economics to describe the benefits that firms obtain when locating near each other. It is related to the idea of economies of scale and network effects, in that the more related firms that are clustered together, the lower the cost of production (firms have competing multiple suppliers, greater specialization and division of labor result) and the greater the market that the firm can sell into. 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 form and grow to exploit economies of agglomeration.

There are of course also diseconomies of agglomeration. Additional competition drives down pricing 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 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 simplistic 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.


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, 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.


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 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 experience a lack of growth. The ways of maintaining a stable outcome for agglomeration economies is for clustering to create "knowledge spillovers" 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. Urbanization Economies will be discussed in another section, but for now let’s talk about localization economies. Localization Economies arise from many firms in the same industry locating in close proximity 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, 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 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. Let’s take a look at the sources of each of these economies more in depth:

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. 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.

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

See also

* Agglomeration
* Returns to scale
* Economies of scale

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