6.1Agglomeration Economies

According to neoclassical theory, there are decreasing returns to all inputs, such as capital and labor. Therefore, the marginal product of labor at any location should decrease as the density of workers increases, where density is defined as the number of workers per acre. Because wages are determined by the value of the marginal product, a worker located in a denser area with lower marginal product would have an incentive to move to a less dense area where his/her marginal product and wage would be higher. In equilibrium, all workers would be evenly distributed across all locations in a given county, state or country.

In reality however, population tends to be concentrated at nodes of different sizes, both within countries and around the world. Looking at a map representing the distribution of the population around the world, Krugman (1991) noticed that the neoclassical theory of decreasing returns to density seemed to be in contradiction with reality. Many authors have attempted to justify the existence of cities and other population clusters by noting the existence of externalities and increasing returns to scale to population density (Sveikauskas (1975), Henderson (1986) and Krugman (1995)). Their arguments that the externalities identified as agglomeration, localization and urbanization economies should arise with employment concentration, are persuasive.