6.1.1Definition of Agglomeration Economies

Agglomeration economies are one of the main determinants of spatial productivity variation. They are related to economies of scale, which play an essential role in productivity growth. Agglomeration economies reduce average costs of a product in the long run, resulting from an expansion of some activity. There are different kinds of scale economies, and the literature has not always been clear on how to label them. Bogart (1998) presents a well-defined approach to the problem. Figure 6.1 helps inform the following discussion. There are two kinds of economies of scale: internal, which result from an expansion wholly within a given economic unit (a firm, an industry, a city, a state, a region), and external economies of scale, which result from an expansion in the size of a group of economic units (firms in an industry, industries in a region, and so on). Internal economies arise from the expansion of, say, a single firm and may be attributed to declines in costs from technological, managerial, financial or risk-spreading sources. External economies of scale or externalities, arise from the expansion in the size of the industry, even if the firm’s size remains constant, and could be positive or negative. For instance, spatial proximity of firms to each other could result in positive externalities, referred to as agglomeration economies, or negative externalities or agglomeration diseconomies, which could result from congestion, pollution and other sources. Finally, agglomeration economies are of two types: localization economies and urbanization economies. Localization economies arise when a firm benefits from being near other related firms in the same industry. There are three sources of localization economies. The first is the benefit from labor pooling, i.e. the reduction in labor search costs from both the availability of a high-skilled labor force for the demand side of the labor market, and a variety of employment opportunities for the supply side of the labor market.

Figure 6.1Description of Various Types of Economies of Scale

The second source of localization economies is reduced costs of intermediate inputs for a given product when economies of scale are realized in the intermediate input industries. Finally, proximity contributing to better communication and faster spreading of innovation are the last sources of localization economies. On the other hand, urbanization economies arise when firms are located in a large city, even if these firms do not belong to the same industry. These urbanization economies come from three sources: access to a large market, access to a variety of specialized services available only in large cities, and potential for cross-industry spillovers of knowledge and technology.