What Factors Make Up Agglomeration Economies?

Identifying and analyzing those advantages that may accrue to firms located in close juxtaposition to other similar and related firms, rather than being located in isolation, is one way to account for the agglomeration phenomenon. The concept of agglomeration economies (or localization economies) refers to these advantages. The basic understanding of this concept was in place already a century ago. Thus, Alfred Marshall identified already in 1890 three different mechanisms – related to interfirm linkage, labor skills, and knowledge spillover that are still more or less valid. A few decades later location theorists like Alfred Weber added a fourth, pointing to cost savings derived from shared infrastructure.

Beginning with the latter, there are benefits to be gained from the possibility for agglomerated firms to share the cost for certain collective resources between several firms. This applies in particular to the cost of installing proper infrastructures (roads, sewage, electricity, and broadband networks) and institutions (education and legal systems). It need not be just a matter of cost savings, however. When an agglomeration of similar or related firms is established, there is also a potential to adjust the local infrastructure, the education system, and other types of collective goods after the needs of this particular industry.

Second, firms in agglomerations can reduce their transport and transaction costs as interfirm transactions and shipments are simplified when the distance between firms is negligible. The customer firm that can place an order with a supplier located down the street will gain an advantage in relation to a competitor that has to travel long distances to see its supplier or, alternatively, place the order by means of some communications system and then wait for the shipment to take place. Reduced transaction costs for co located trading partners may be the shorthand for this second mechanism. Third, agglomeration makes for the development of a local labor market for specialized skills. The establishment of a local pool of skilled labor has been proposed as a major element of the localization economies ever since Alfred Marshall more than a century ago wrote so elegantly about the advantages of being located in an industrial district:

Again, in all but the earliest stages of economic devel opment a localized industry gains a great advantage from the fact that it offers a constant market for skill. Em ployers are apt to resort to any place where they are likely to find a good choice of workers with the special skill which they require; while men seeking employment naturally go places where there are many employers who need such skill as theirs and where therefore it is likely to find a good market. (Marshall, 1890/1916: 271)

Thus, it can theoretically be argued that local labor markets function better, from the point of view of both firms and employees, if there are several similar and related firms around. Well functioning markets for specialized labor skills can thus be added to the list of localization economies.

Fourth, an agglomeration of related firms forms the basis of a local milieu that may facilitate knowledge spillovers and stimulate various forms of learning and adaptation. This is the aspect of industry agglomeration that has attracted the bulk of research interest since the early 1990s. The general argument is that agglomerations tend to trigger processes that create not only dynamism and flexibility in general, but also learning and innovation. In such milieus, chances are greater that an individual firm gets in touch with actors that have developed or been early adopters of new technology. The flow of industry related information and knowledge is generally more abundant to the advantage of all firms involved. A local culture with specific norms, values, and institutions (formal and informal) makes it possible to transfer also more tacit forms of knowledge from one actor to another. Thus, agglomeration may also promote localized learning and knowledge spillovers between firms.

To sum up: spatial proximity between similar and related firms does make easier not just interfirm trans actions in general, but in particular those interactions and knowledge spillovers which form the basis for innovation and learning. The generation of well functioning labor markets for specialized skills does also contribute both to efficiency and knowledge creation. Institutional and infrastructural factors add further to making location in an agglomeration beneficial for the individual firm.