Explaining urbanisation and localisation economies

Industrial diversity within cities leads to urban growth.

One of the biggest advantages of cities is that they help in generating agglomeration economies, that is, production is easier because more activity is going on nearby. This phenomenon is usually explained by spill-over effects or the generation of positive externalities in contexts of close proximity often found in cities. “Innovation and improvement occurring in one firm increases the productivity of the other firm without full competition”, occurs most dramatically in urban areas because of the presence of economic activities which have a higher value, and primarily because of the interdependence of economic activities.

However, economists have differed on what type of economic structure of cities, and therefore what form of positive externalities are crucial for the growth in cities, measured by growth of industries and growth of employment.

The forms of economic structure of cities are divided into two broad activities: a) localisation economies and b) urbanisation economies.

A localisation economy implies returns of scale that arise from having many firms of the same industry located in cities. And urbanisation economies lead to industrial growth and growth of employment in cities when people of several different kinds of industry are located together; that is, many firms of different industries are located in the same city. Both these ideas have important proponents. Handerson et al (1995) and the Marshall –Arrow – Romer (MAR) theorem, if applied in the contexts of cities, suggests that growth of industries and therefore of employment depends upon the concentration of an industry in a city. Contrarily, the urban historian Jane Jacobs has argues powerfully that it is industrial diversity which drives growth in cities.

Both, localisation and urbanisation economies can result in growth, and both have many notable examples of success, however, it is important to arrive at a statistically significant conclusion or understanding about what kinds of externalities, and what kinds of economic structure in cities has led to more growth, or which result in a higher chance of success. This is precisely what Glaeser et al seek to do. In their paper “Growth in cities”, by taking a “data set on the growth of large industries in 170 U.S cities between 1956 and 1987”, they argue that “local competition and urban variety, but not regional specialisation, encourage growth in industries. The evidence suggests that important knowledge spillovers occur between rather than within industries”. The paper therefore empirically confirms Jane Jacobs’ hypothesis. The paper states that “crucial externality in cities is cross-fertilization of ideas across different lines of work. New York grain and cotton merchants saw the need for national and international financial transactions, and so the financial service industry was born. In Jane Jacobs’ theory, industrial variety rather than specialisation is conducive to growth, because in diversified cities there is knowledge spillover of different ideas.”

But the question naturally arises: what is it about industrial diversification that leads to growth in cities? Or what is it about knowledge spillover of different ideas that lead to industrial and employment growth in cities? When an industry grows in a city, it leads to increased wages and increased employment, which further leads to increased demand and therefore a (generally) positive correlated growth of different industries in the city. However, parallel to the growth of specific industries in a city, industries which are interlinked begin sprouting up in cities. The example of the growth of the financial institutions in New York has already been mentioned. The intuition is the same: “knowledge transmission takes the form of adoption of an innovation by additional sectors”, or forms where links are further established.

Adhip Amin is a Research Associate at Takshashila Institution. Adhip tweets @AdhipAmin1.