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The term economies of agglomeration is used in urban economics to describe the benefits that firms obtain by locating near each other ('agglomerating'). This concept relates to the idea of economies of scale and network effects. Simply put, as more firms in related fields of business cluster together, their costs of production may decline significantly (firms have competing multiple suppliers, greater specialization and division of labor result). 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.
The term 'diseconomies of agglomeration' refers to the opposite case. Additional competition drives down pricing power. For example, spatially concentrated growth in automobile-oriented fields may create problems of crowding and traffic congestion. It is this tension between economies and diseconomies that allows cities to grow while keeping them from becoming too large.
Agglomeration economies are closely associated with economies of scale and the network effects mentioned above. It is important to understand that a positive outcome of agglomeration economies will only be achieved if the benefits outweigh the disadvantages. The ultimate end to agglomeration economies is the formation and growth of a city. The processes and factors contributing to the formation and growth of cities 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 simple 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 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 their existence, 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 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 take advantage of these economies without joining any big organization. This process may help to urbanize areas as well.
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 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 toe 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 cause the area to 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.
There are two types of economies that are considered large-scale and external economies of scale; localization and urbanization economies. Localization economies arise from many firms in the same industry located close 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 and exchange of supplies, laborers and innovative ideas due to the proximity among firms.
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 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.
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.
Achieving economies of agglomeration is the reason many U.S. state governments redistribute income from their affluent suburbs to poorer urban localities. This is often achieved through grants to local governments according to criteria that favor low-income communities. Suburbanites benefit from this redistribution because many work in and enjoy visiting city centers that would not be sustainable on their own tax revenues. For example, cities that cannot afford to provide adequate fire and police protection or schools are not places where businesses want to locate, and thus they cannot maximize the agglomeration effect without this type of income redistribution.