Economies of agglomeration


Economies of agglomeration or agglomeration effects are cost savings arising from urban agglomeration, a major topic of urban economics. One aspect of agglomeration is that firms are often located near to each other. This concept relates to the idea of economies of scale and network effects.
As more firms in related fields of business cluster together, their costs of production may decline significantly. 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. It is the tension between economies and diseconomies that allows cities to grow but keeps them from becoming too large.
The basic concept of agglomeration economies is that production is facilitated when there is a clustering of economic activity. The existence of agglomeration economies is central to the explanation of how cities increase in size and population, which places the phenomenon on a larger scale. The concentration of economic activity in cities is one reason for their development and growth.

Advantages of agglomeration

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 and the flow of new and innovative ideas among firms for the achievement of what economists call increasing returns to scale.
Increasing returns to scale, and economies of scale, are 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 becomes possible to establish other businesses which 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:
While the existence of cities can only persist if the advantages outweigh the disadvantages, agglomeration may also lead to traffic 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. 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. 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 the laborers abound. Large cities experience these problems, and it is this tension between agglomeration economies and agglomeration dis-economies that may contribute to the growth of the area, control the growth of the area, or cause the area to experience a lack of growth.
The economies of agglomeration has also been shown to increase inequality both within urban areas, and between urban and rural areas. The Oxford development economist Paul Collier has proposed that the gains of agglomeration should be taxed as rents which lead to behaviour-distorting rent-seeking. This would be both ethical and efficient, in that gains would be better aligned with deserts and rent-seeking would be curbed. Collier recommends a tax calculated by combining high income and metropolitan location, which can then be redistributed to other cities which have been hard hit by agglomeration.
The disadvantages of agglomerations are to be mentioned:
There are two types of economies that are considered large-scale and have external economies of scale; localization and urbanization economies. Localization economies arise from many firms in the same industry locate close to each other. There are three sources of localization economies: The first is the benefits 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 and exchange of 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 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 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 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.