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

Q3 2011

Business Review — Metropolitan areas in the U.S. 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 and higher housing costs.

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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