To offset these 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. First, cities developed and grew because of some natural advantage, such as a port. Second, as cities grew, the resulting concentration of people and jobs led to efficiency gains and cost savings for firms, creating agglomeration economies. Finally, the presence of a talented and flexible labor force made it feasible for entrepreneurs to start new businesses. This third reason for the growth of cities is called sorting. In this article, Jerry Carlino looks at recent developments in measuring each of the sources of city productivity and discusses the policy implications of this research.

This article appeared in the Third Quarter 2011 edition of Business Review.

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