by Rizal, K*

In 1991, Krugman, a Guru in economics, developed a formal model on agglomeration economies. In short, by co-locating in the same place, firms can take advantage of a bigger market and gain efficiency by exploiting economies of scale. The idea of agglomeration economies, in fact, has been around since Alfred Marshall introduced it back in 1890. Similar idea of cumulative causation, coined by Gunnar Myrdal in 1957, was also popular in the 1950s and 1960s.

In general, the literature distinguishes two forms of agglomeration economies: Localization (Marshall, 1890) and Urbanization Economies (Jacob, 1979). Urbanization economies accrue to firms if they locate in large, diverse cities, while localization economies accrue to firms if they locate in cities specialized in the industries they are active in.

Advantages of locating in large cities are the availability of a large, diverse labor pool, a large number of different suppliers and customers and between industry knowledge spillovers. The advantages for firms to locate in specialized cities are the availability of a large pool of specialized labor and related suppliers and customers. Specialized cities, however,  may result in more limited knowledge spillovers (Marshall, 2014, 1890).

In terms of its dynamic externalities, Glaeser et al. (1992) distinguish three types of agglomeration, which are Marshall-Arrow-Romer (MAR) externalities, Jacobs’ externalities, and Porter’s externalities. MAR, Jacobs and Porter’s externalities are commonly referred as specialization, diversity, and competition externalities respectively.

The key distinction of those three externalities is laid on the nature of knowledge spillovers within agglomeration. Specialization concept stresses on intra-industry knowledge spillovers, diversity emphasizes on inter-industry knowledge spillovers, while competition underlines the role of competition in knowledge spillovers. Beaudry and Schiffauerova (2009) summarize the effects of dynamic externalities on knowledge spillovers in following Table.

The dynamics of knowledge spillovers

So, what do cities actually do for firms? Duranton and Puga (2004) summarize it into three words of sharing, matching, and learning. Cities share specialized input, suppliers and skilled labor. Cities also match suppliers to customers and workers with jobs. Most importantly, cities allow learning process and knowledge spillovers to occur.

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