Agglomeration Economies

By clustering in close proximity to one another, firms can lower their production costs and raise profits. This process is enormously important to many forms of production and is titled agglomeration economies—that is, the benefits derived from grouping together. By forming dense webs of production and embedding themselves within them, firms usually can produce more efficiently and profitably.

Agglomeration economies take several forms. Production linkages accrue to firms locating near producers that manufacture their inputs. By clustering, transportation and assembly costs are reduced. Service linkages occur when enough firms locate in one area to avail themselves of specialized support services. For example, the advertising industry in New York is concentrated within a short distance of Madison Avenue, investment banks form a dense wad in southern Manhattan, and film companies agglomerate in Hollywood. By locating near one another, firms can acquire up-to-date information on the latest trends in their sector, technological changes, shifts in policies and markets, clients, hires, and new products and processes, and they can keep an eye on the competition. Marketing linkages occur when a cluster of similar firms is large enough to attract specialized distribution services. The small firms of the garment industry in New York City have collectively attracted advertising agencies, showrooms, buyer listings, and other aspects of product distribution that deal exclusively with the garment trade. Firms within the cluster have a cost advantage over isolated firms, which must acquire these benefits for themselves.

Agglomeration economies may be temporary, are found to different extents in different industries, and may be offset through various forms of economic, technological, and geographic change. Typically, agglomeration economies reflect firms’ need for close interaction with clients and suppliers, often on a face-to-face basis. Thus, they are most pronounced in vertically disintegrated types of production, in which firms have many linkages “upstream” and “downstream” in the production process. (In contrast, vertically integrated firms, with relatively few external linkages, are less dependent on agglomeration.) Firms in markets with low degrees of uncertainty (usually due to slow rates of technical change, the market structure, or the regulatory environment), in contrast, are less dependent on agglomeration to minimize costs and maximize profits. As firms grow, they often become more vertically integrated and more capital intensive, have fewer external linkages, and come to substitute economies of scale for agglomeration economies.

Because agglomeration economies provide powerful incentives for firms to locate in close proximity to one another, they are most heavily manifested in large metropolitan areas. The prime motivation behind the agglomeration of firms in metropolitan regions is the ready access they offer to clients, suppliers, and ancillary services, most of which is accomplished through face-to-face interaction. Often, personal relationships of trust and reputation are of paramount significance. Agglomeration thus maximizes access to information, much of which is tacit, irregular, and non-standardized, and helps firms minimize uncertainty. Firms in these locations have an advantage, within limits, over similar firms in rural areas. Cities provide the markets, specialized labor forces and services, utilities, and transportation connections required by manufacturing. Urbanization economies, therefore, are a combination of production, service, and marketing linkages concentrated at a particular location. Agglomeration forms the basis for the comparative advantage of cities in forms of production, which typically consist of relatively labor-intensive, vertically disintegrated firms in highly competitive markets with high degrees of uncertainty and change.

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