3. Agglomeration
In this section, we provide a brief overview of the empirical evidence for the existence of agglomeration economies overseas, as well as a discussion of the key theoretical underpinnings.
3.1 Introduction
A fundamental driver of city growth is that the clustering of people and economic activity in larger, denser urban agglomerations generates higher levels of productivity and higher returns to businesses and workers. The benefits of concentrating economic activity in urban areas are widely evident in the "growth of cities, in the formation of clusters of related businesses and the growth of industrial regions".9
Agglomeration theory supports the role of Auckland in achieving New Zealand's economic transformation. In particular, the productivity effects of agglomerated activity may provide stimulus needed to achieve the goals associated with economic transformation. The benefits of agglomeration were first formalised by Alfred Marshall in the late 19th century. The roots of agglomeration theory can be traced back to Adam Smith's much earlier observations around the role of specialisation and the division of labour in promoting economic growth through productivity gains.10
Agglomeration theory argues that the congregation of businesses and workers is caused by the existence of positive externalities that are generated through close spatial proximity, and that, when combined with increased specialisation, this serves to "raise the efficiency of firms".11
The externalities underpinning agglomeration economies have been seen to work at three different levels:12
- Internal scale economies (firm level) are the efficiency gains that occur within a firm as the overall scale of production is increased (this is not a focus of this paper, but has been widely considered by organisational theorists, as well as transaction cost and institutional economists).
- Localisation economies (industry level) describe the benefits that occur through increased scale, when firms within a particular industry choose to co-locate in an area. In essence the scale economy is external to the firm, but internal to the industry.
- Urbanisation economies (city level) describe the benefits that arise from the co-location of firms in large urban areas. The benefits are not concentrated at the industry level, and refer to, for example, the concentration of people, common infrastructure, an available and diverse labour force and market size.
With these broad agglomerative forms in mind, we now examine the empirical evidence for the existence of agglomeration economies, before examining the nature of agglomeration externalities in greater detail.
3.2 Empirical Analyses of the Existence of Agglomeration Effects
Empirical studies strongly support the existence of a positive relationship between increased employment scale or employment density and productivity.13 Table 3.1 highlights a selection of studies that have sought to assess the relationship between density or scale, and productivity.
Table 3.1 Estimates of Agglomeration Economies from Changes in Scale & Density14
| Author |
Unit of Analysis |
Dependent Variable |
Independent Variable |
Elasticity |
Aaberg15
|
Swedish cities |
Productivity |
City size (population) |
0.02 |
Nakamura16
|
Japanese cities |
Productivity |
City size (population) |
0.03 |
Henderson17
|
Brazilian cities |
Productivity |
Industry size (employment) |
0.11 |
Ciccone & Hall18
|
US states |
Productivity |
Employment density
|
0.06 |
Ciccone19
|
EU regions |
Productivity |
Employment density |
0.05 |
In all the studies noted in Table 3.1, wages are taken as a proxy for productivity.20
The first three studies listed scale as the independent variable, while employment density was deployed in the latter two studies. For the purposes of this paper, we are particularly interested in the relationship between the density of economic activity and productivity.
A recent study suggests that, for UK cities, doubling the economic density of a city is likely to result in an increase in productivity of around 4%.21 Moreover, in a widely cited study of US states, Ciccone & Hall found that employment density is positively related to productivity, in that doubling employment density increases average labour productivity by 6%.22 Ciccone repeated this analysis for five European countries, showing that, by doubling employment density, average labour productivity increases by 5%.23
It should be noted however, that a large majority of the studies that have set out to measure the effects of agglomeration on productivity, have been conducted with respect to manufacturing industries only.24
Behind the positive relationships between scale or density and productivity however, what sources and processes are at play?
3.3 Externalities and Mechanisms
Marshall's classification of externalities helps to explain the effects of agglomeration on productivity, and provides a more detailed explanation as to why the concentration of activities in urban areas is economically advantageous (externalities may otherwise be referred to as the sources of agglomeration).25
Three externalities were outlined by Marshall:
- Input-output linkages promoting more efficient provision of intermediate inputs to firms in greater variety and at lower cost. Here a "concentration of producers using particular inputs allows increased specialisation and greater economies of scale in the production of inputs".26
- Larger labour markets. With increased urban size, deeper labour markets are likely to arise. This "may allow greater specialisation in human capital, by reducing the risks to workers of firm specific employment shocks. Similarly it will be easier for firms to find new employees, should current employees quit".27
- Technological or knowledge spillovers between firms. In this regard, agglomeration facilitates faster communication and transfer of information across firms and other institutions such as universities and research think tanks.28
The three externalities outlined by Marshall have been bolstered by a series of empirical studies:
- Input-Output Linkages – Holmes found a positive relationship between vertical disintegration of the supply chain and industrial concentration, demonstrating the sharing of inputs as a source of agglomeration economies.29
- Labour Markets – Baumgardner showed that physicians perform a narrower range of activities in larger markets, providing support for the notion that agglomeration helps to foster specialisation.30 Dumais, Ellison & Glaeser found that industries with similar labour mixes obtain the greatest benefits from concentration through matching.31 Other authors have focused on risk. For instance, Simon found that industry diversification in cities reduces workers exposure to industry-specific shocks, as workers can apply their skills in other industries if necessary.32 Where a city is sectorally specialised on the other hand, workers will require a wage premium for taking on the risks associated with industry collapse.33
- Knowledge – Jaffe, Trajtenberg & Henderson studied the impact of spatial form on innovation.34 Using patent citations as their proxy for knowledge spillovers, they found that such citations were highly spatially concentrated. Audretsch and Feldman examined the concentration of product innovation in the United States.35 They found that industries with higher R&D rates and higher shares of skilled labour are more concentrated. They interpret their results as being evidence of the importance of the tacit transmission of knowledge. Other authors pick up on the disproportionate number of skilled workers in cities, emphasising that "workers are the primary vehicle of knowledge spillovers".36
While there is supporting evidence for all three Marshallian externalities, the strongest evidence is for the advantages of a deeper labour market.37 Rosenthal & Strange also remark that identifying knowledge spillovers is particularly difficult given the lack of systematic evidence, such as a data trail.38
Duranton & Puga consider that an awareness of sharing, matching and learning mechanisms helps to provide a more comprehensive understanding of the sources of agglomeration economies.39 The authors note, that only by "studying what gives rise to urban agglomeration economies – rather than merely stating that they exist – that we gain real insight into why there are cities".40
The mechanisms are as follows:
- Sharing, which refers to "indivisible facilities" (e.g. machinery with high fixed costs that few firms would buy individually), the "gains from a wider variety of input suppliers that can be sustained by a larger final-goods industry", the "gains from the narrower specialisation that can be sustained with larger production, and risks".41
- Matching, which refers to an ability to improve quality (e.g. improving the match between the skills demanded by business and the skills available in the workforce) and alleviate "hold-up problems".42
- Learning, which refers to the "generation", "diffusion" and "accumulation of knowledge".43
The three mechanisms will generate different agglomeration effects for each of the three Marshallian externalities, resulting in a range of "welfare and policy implications".44 Developing a better understanding of how the mechanisms work, is therefore crucial.
The agglomeration literature is a complex area that is still evolving. Until one can link agglomeration benefits with the precise mechanisms and externalities more concretely, this evolution is likely to continue.
3.4 Limits to Agglomeration Effects
A number of costs (diseconomies) to agglomeration exist. They include:
- Congestion.
- Pollution.
- Loss of urban amenity (such as open space).
The diseconomies act as counter forces to employment concentration, and, at some level of activity, ultimately threaten to suppress increases in agglomeration benefits.
Congestion costs are often prominent in dense urban forms. As the user costs of, for example, transport within a city increase, the effective density of people and jobs that are accessible to the economy of that area becomes limited. This factor puts a cap on the potential for further growth, although other factors may act to limit urban expansion.
3.5 Intervention: Transport Investment
To address congestion issues and relieve the constraints that these impose, transport investment is a crucial intervention that enables further benefits from concentration to be achieved.45 Simply put, a reduction in transport costs, through improved transport infrastructure or improved delivery of transport services, creates an opportunity to improve accessibility, which in turn increases employment density, giving rise to increased productivity.
Research has indicated that: "accessible cities with efficient transport systems had higher productivity than more dispersed places".46 Understanding these issues and linkages is critical to gaining a true understanding of the benefits of urban transport projects. This requires going beyond traditional economic transport evaluation techniques.
For Graham, agglomeration effects will be an important component in any assessment of transport investment benefits.47 This is because a change in the level of transport infrastructure in an area will alter the effective density of people and jobs that are accessible to the economy. This has implications for productivity and efficiency.
In summary, significant economic gains may be made from transport infrastructure investments, which will improve access into areas that have high employment densities and display a strong agglomeration-productivity relationship.
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