THE MICRO-EMPIRICS URBANIZATION OF AGGLOMERATION ECONOMIES 3

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2 2 S. S. ROSENTHAL AND W. C. STRANGE A Companion to Urban Economics Edited by Richard J. Arnott, Daniel P. McMillen Copyright 2006 by Blackwell Publishing Ltd Urbanization The essays in part I deal with different facets of urbanization. The Concise Oxford Dictionary defines urbanization as rendering urban or removing the rural character of a district. In everyday usage, the term connotes the dynamic process whereby a district undergoes the transformation from being rural to being urban. The term is here used somewhat more broadly. Urban economists define a city as a spatial concentration of economic activity. Accordingly, urbanization covers description of the spatial pattern of economic activity over space, and explanation of that pattern as well as of the evolution of that pattern. Imagine an economy on a large, homogeneous plain in which transportation is costly and in which all firms produce under constant or decreasing returns to scale. Such an economy exhibits a uniform distribution of economic activity over space. Since each household produces everything it consumes in its own backyard, we may refer to such an economy as a backyard economy. There are no benefits from spatially concentrating economic activity but there are costs, in particular transportation costs. While an uneven distribution of resources over space gives rise to a nonuniform distribution of economic activity over space, this factor can explain only a fraction of the high degree of spatial concentration of economic activity observed in today s service- and knowledge-based economies. There is broad agreement among economists that at the present time the dominating trade-off determining the spatial structure of economic activity is between transport costs and increasing returns to scale in production. Consider an economy that produces a single good in factories that exhibit increasing returns to scale and are operated by separate firms. If transport costs are high and the degree of increasing returns to scale small, market areas the area to which a single factory distributes its output are small, while if transport costs are low and the degree of increasing returns to scale large, market areas are large. In such an economy, each firm will recognize that it has market power within its market area and that the size of its market area depends on the pricing policy of the firms whose market areas border on its own, as well as its own pricing policy. Spatial competition theory describes how the economy s equilibrium is determined, taking into

3 THE MICRO-EMPIRICS URBANIZATION OF AGGLOMERATION ECONOMIES 3 account the strategic or game-theoretic interplay between firms. Now add another good, so that there are now two industries. If firms in the two industries operate completely independently, there will be an overlapping pattern of market areas, with the firms in the one industry having larger market areas than those in the other. But the two sets of firms do not operate independently. For one thing, a firm in industry A likely uses the output of the closest firm in industry B in its production process, and vice versa. This by itself gives the two firms an incentive to locate closer to one another than they otherwise would, so as to reduce transportation costs. But the firms would then have to compete more intensively for the land and labor in their common market area, which would give the two firms an incentive to locate further from one another than they otherwise would. One can imagine adding more industries to the model, and getting a rich pattern of industrial location, with each firm in some industries operating in its own specialized city and each firm in other industries co-locating with firms from other industries. Such a model would be empirically unrealistic in two important respects. First, firms within a particular industry would be spatially dispersed, whereas in fact firms within the same industry are often spatially concentrated. Second, firms would tend to be large, to exploit scale economies in production. That may have been the case in economies in which manufacturing predominated, but not is not the situation today. Economists have reconciled theory and observation by developing models in which economies of scale operate at the level not of the individual factory but of an industry within a city (localization economies) or of the city (urbanization economies). Since these economies of scale operate externally to the individual firm, they are referred to as external economies of scale. And since, by hypothesis, they form the basis for today s large urban agglomerations, they are also referred to as agglomeration economies. Each firm faces a horizontal average cost curve, but the level of the cost curve falls as the size of the industry city, or simply city, in which it is located increases. Rapid progress has been made in measuring the various sources of external economies of scale that have been hypothesized. The earlier work measured localization economies (by industry) and urbanization economies, aiming partly to determine which are more important. More recent work, which makes use of very detailed microdatabases, recognizes that the magnitude of the costreducing benefits a firm receives from another firm being located nearby depends on the distance between the two firms, and attempts to measure the rate at which these benefits fall off or attenuate with distance. This is just one of the strands of empirical literature that have developed out of the new economic geography, which was mentioned in the introduction. Volume 4 of the North-Holland Handbook series, entitled Cities and Geography (Henderson & Thisse 2004) provides an up-to-date review of this burgeoning literature; and the Economics of Agglomeration, by Masahisa Fujita and Jacques-François Thisse (2002), provides an overview of the current state of theory on the subject. Two essays in this part treat facets of the recent empirical work on external economies of scale, The Micro- Empirics of Agglomeration Economies, by Stuart Rosenthal and William Strange, and Human Capital Externalities in Cities: Identification and Policy Issues, by Gilles Duranton.

4 4 S. S. ROSENTHAL URBANIZATION AND W. C. STRANGE Urbanization, in the more colloquial usage of the word, is the topic of the other two essays in this part. An outstanding debate in the urbanization literature is what spurred development of the first cities, all of which appeared in today s Middle East. Many explanations have been put forward, though none has been modeled with precision. Animal husbandry and the domestication of wild grains permitted a nonnomadic, sedentary lifestyle, and presumably incremental technical progress in agriculture in due course made feasible an agricultural surplus that could be used to feed city dwellers. But since agriculture per se is not characterized by increasing returns to scale, on a large homogeneous plain these developments would lead to more efficient agricultural production but not cities. Even though most of the cities developed alongside rivers, transport costs would have been high. There must therefore have been some sizeable source of economies of scale to give rise to cities rather than scattered settlements. Various sources have been suggested: defense, offense, religious public goods, political administration, marketplaces, grain storage, hydraulic infrastructure (e.g., irrigation and the control of flooding), education (for writing and adding), and culture. In The First Cities, Arthur O Sullivan discusses what light current archaeological evidence casts on the debate. The broad history of urbanization in Western Europe since the beginning of the Industrial Revolution should be familiar to all readers; Bairoch (1988) provides a particularly magisterial account. Though it has distinct phases, the picture it paints is of a seemingly inexorable rise in urbanization, population, and prosperity. We should not, however, forget the sobering experience of the Dark Ages, when Western Europe retrogressed: the splendor that was once Rome crumbled into disrepair and became overgrown in weeds; population fell, with the vast majority living in isolated subsistence agricultural communities; trade dried up; and most of the glorious intellectual achievements of Ancient Greece were lost some forever, some for a millennium, until they reentered Europe from North Africa via Spain in the late Middle Ages. Outside Western Europe, modern urbanization has been compressed in time. Except in centrally planned economies, which were able to resist market forces, it seems that the qualitative process of urban development has been much the same everywhere. Despite this, huge disparities in income and wealth remain between the less developed countries, particularly those in Africa, and developed countries. Stephen Malpezzi s essay, Cross-Country Patterns of Urban Development, documents both the similarities in process and the disparities in outcomes. The aim of the Companion is not to give a comprehensive review of the literature but, rather, to provide a collection of stimulating and challenging essays to supplement available textbooks. Nevertheless, we regret that some important branches of the literature have not been covered, and one in particular, the description of spatial structure. We need to describe spatial structure well before we can explain it well. Most description of spatial structure is based on data collected for administrative units wards, school districts, zip codes, cities, metropolitan areas, regions, and countries. Such data are much better than no data, but we could do so much better using modern technology. Put a thin sliver of an onion ring under a microscope, and gradually increase the level of resolution. At

5 THE MICRO-EMPIRICS URBANIZATION OF AGGLOMERATION ECONOMIES 5 some levels of resolution, there is a blur, but at other levels a visual structure emerges, and the pattern of this structure is different at different levels of resolution. The situation for the spatial distribution of economic activity is analogous. Census microdata can now be obtained at the block level, and modern satellite imaging collects spatial data down to the resolution of a meter. So we could perform the microscope exercise on spatial economic data, except of course at a considerably larger scale. In principle, we could infer much about the forces shaping the spatial structure of economic activity by identifying the levels of resolution at which well-defined structure is observed and by describing the structure at these levels of resolution. To do the latter, we need to describe spatial structure, which is the job of spatial statistics. The field of spatial statistics has been developing rapidly, with urban economists contributing greatly to the work done by econometricians and geographers. Bibliography Bairoch, P. 1988: Cities and Economic Development. Chicago: The University of Chicago Press. Henderson, J. V. and Thisse, J.-F. (eds.) 2004: Handbook of Regional and Urban Economics, vol. 4: Cities and Geography. Amsterdam: North-Holland. Fujita, M. and Thisse, J.-F. 2002: Economics of Agglomeration: Cities, Industrial Location, and Regional Growth. Cambridge, UK: Cambridge University Press.

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