Magazine article Business Review (Federal Reserve Bank of Philadelphia)

Three Keys to the City: Resources, Agglomeration Economies, and Sorting

Magazine article Business Review (Federal Reserve Bank of Philadelphia)

Three Keys to the City: Resources, Agglomeration Economies, and Sorting

Article excerpt

Although metropolitan areas account for only 16 percent of the total land area in the United States, they contain almost 80 percent of the nation's population and nearly 85 percent of its jobs. This high degree of spatial concentration of people and jobs leads to congestion costs, such as increased traffic and pollution, and higher housing costs. To offset these congestion costs, workers must receive higher wages, and higher wages increase firms' costs.


So why do firms continue to produce in cities where the cost of doing business is so high? Economists offer three main explanations. (1) The first explanation is that cities developed and grew because of some valuable natural advantage, such as a source of raw materials or a port that allowed businesses to save on transportation costs. For example, because of its access to a deep harbor and because of its central location, Philadelphia was the largest and most important trading and merchant center in North America during the nation's colonial period.

But, as Satyajit Chatterjee points out in an earlier Business Review article, a natural advantage, such as a harbor, was not the main reason for Philadelphia's subsequent growth into the fourth largest metropolitan area in the country. As colonial Philadelphia grew, the resulting concentration of people and jobs led to efficiency gains and cost savings for firms, efficiency and savings that arose from being close to suppliers, workers, customers, and even competitors. This second reason for cost savings in cities is referred to as agglomeration economies. Finally, as Joseph Gyourko points out, the early growth of Philadelphia was aided by its large and relatively highly skilled labor force. The presence of a talented and flexible labor force made it feasible for entrepreneurs to start new businesses in Philadelphia. This third reason for the growth of cities is called sorting: A disproportionate share of highly skilled (more productive) workers choose to live in large cities, making big cities more productive than small ones. Other things equal, firms will have little incentive to move if congestion costs are balanced by the benefits of a natural advantage, agglomeration economies, and sorting.

At one time, economists tended to lump together the advantages of sorting and the advantages associated with urban agglomeration economies into a single measure. However, more recently, economists have examined how important each of the three reasons is in accounting for city productivity. Knowledge about the relative importance of each of the reasons is important to policymakers, too. If agglomeration economies kick in once a city reaches a critical size, urban planners might want to pursue policies that help a city reach that size. There is also mounting evidence that agglomeration economies depend on a city's ability to attract and retain high-skill workers. Edward Glaeser and Matthew Resseger find that agglomeration economies are much stronger in cities where workers are relatively highly skilled. Given the evidence that a high concentration of skilled workers enhances city productivity, policymakers may want to consider policies that attract and retain highly skilled people.

In this article I will look at recent developments in measuring each of the sources of city productivity and discuss the policy implications of this research.


A location may attract households and firms because of the presence of valuable natural resources, such as petroleum, coal, lumber, or minerals, and proximity to a navigable river or a port. Although the availability of resources and other natural advantages varies from place to place, a diversity of resources cannot be the main reason for the existence of cities. According to Edward Glaeser and Janet Kohlhase, "The cost of moving a ton by rail has declined in real terms by more than 90 percent since the late 19th century and the rise in trucking has been even more dramatic. …

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