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One of the major subfields of urban economics, economies of agglomeration (or agglomeration effects), explains, in broad terms, how urban agglomeration occurs in locations where cost savings can naturally arise.^[1] This term is most often discussed in terms of economic firm productivity. However, agglomeration effects also explain some social phenomena, such as large proportions of the population being clustered in cities and major urban centers.^[2][3] Similar to economies of scale, the costs and benefits of agglomerating increase the larger the agglomerated urban cluster becomes.^[4][5] Several prominent examples of where agglomeration has brought together firms of a specific industry are: Silicon Valley and Los Angeles being hubs of technology and entertainment, respectively, in California, United States along with London, United Kingdom, being a hub of finance.^[1]

Economies of agglomeration have some advantages. As more firms in related fields of business cluster together, their production costs tend to decline significantly (firms have multiple competing suppliers; greater specialization and division of labor). Even when competing firms in the same sector cluster, there may be advantages because the cluster attracts more suppliers and customers than a single firm could achieve alone. Cities form and grow to exploit economies of agglomeration.

Diseconomies of agglomeration are the opposite. For example, spatially concentrated growth in automobile-oriented fields may create problems of crowding and traffic congestion. The tension between economies and diseconomies allows cities to grow but keeps them from becoming too large.

At the foundational level, proximity—especially to other facilities and suppliers—is a driving force behind economic growth and is one explanation for why agglomeration effects are so evident in major urban centers.^[2][6] While the concentration of economic activity in cities has a positive effect on their development and growth, cities, in turn, help foster economic activity by accommodating population growth, driving wage increases, and facilitating technological change.^[7]

When firms form clusters of economic activity, particular development strategies flow into and throughout this area of economic activity. This helps accumulate information and the flow of new and innovative ideas among firms to achieve what economists call increasing returns to scale. Increasing returns to scale are internal economies of scale for a firm and may allow for establishing more of the same firm outside the area or region. Economies of scale external to a firm result from spatial proximity and are called agglomeration economies of scale. Agglomeration economies can be seen as the external condition for companies and the internal condition for the region.

Increasing returns to scale, according to Beckmann, is integral to understanding why urban centers form. These increasing returns to scale "give rise to [urban systems]," capturing "the trade-off between transportation costs and economies of scale".^[7] Agglomeration economies exist when production is cheaper because of this clustering of economic activity. As a result of this clustering, it becomes possible to establish other businesses that may take advantage of these economies without joining any big organization. This process may help to urbanize areas as well.

Benefits arise from the spatial agglomeration of physical capital, companies, consumers, and workers:^[8]

• Low transport costs: Physical proximity to other firms and centers of production can minimize costs associated with transportation. While this may have been the case for many manufacturing firms in the United States, Glaeser and Gottlieb argue that reducing transportation costs is more important for firms producing services.^[9] Moreover, other studies have shown that when negative externalities like pollution are taken into account, agglomerated city centers are more likely to be dispersed over a larger geographical area rather than be confined to a single, metropolis-like urban region.^[10]
• Geographic advantages: A longstanding theory in urban economic literature is that firms (and cities) are likely to agglomerate where there are natural geographic advantages, which would give these firms both comparative and cost advantages over their competitors.^[1] Ellison and Glaeser argue that while this may be true for firms whose location decisions are highly sensitive to cost differences or geographic locations, such as the wine industry, they find that only 20% of geographic agglomeration effects in the United States can be explained by "natural" cost advantages.^[1]
• Labor pooling and matching: Agglomerating effects, such as an increase in population and therefore, human capital, arguably help improve matching within the economy, e.g. employees with employers, suppliers with buyers, and so on.^[2] Moreover, massive urban areas like cities, which contain a multitude of industries in a localized area, can help firms offset their reaction to shocks more efficiently by 'pooling' labor resources together.^[2]
• Knowledge spillovers: the accumulation of knowledge and human capital in concentrated areas like major urban centers can contribute to the sharing of production technologies (i.e., know-how) between firms. Econometric analysis by Liang and Goetz showed that agglomeration effects account for technology-intensive industries benefiting from Jacobs-type knowledge spillovers.^[11] Furthermore, agglomerated centres of production, like cities, also facilitate learning—that is, knowledge generation, diffusion, and accumulation—on a larger scale than smaller economic regions.^[5]

While the existence of cities can only persist if the advantages outweigh the disadvantages, poorly planned agglomerations may also lead to negative externalities like traffic congestion (lack of walkability and public transport) or pollution (lack of environmental protection laws). These adverse effects can cause diseconomies of scale.^[12] Another source of agglomeration diseconomies—higher crowding and increased waiting time—can be observed in disciplines or industries that are characterized by constrained access to relevant production facilities or resources.^[13] As stated above, these factors are what decrease the pricing power of firms because of the many competitors in the area, as well as a shortage of labor and a lack of flexibility among firms for the laborers abound. Large cities experience these problems, and this tension between agglomeration economies and agglomeration dis-economies may contribute to the area's growth, control the growth of the area, or cause the area to experience a lack of growth.

The economies of agglomeration have also been shown to increase inequality both within urban areas and between urban and rural areas.^[14] The Oxford development economist Paul Collier proposed that the gains of agglomeration should be taxed as rents, which leads to behavior-distorting rent-seeking (Henry George theorem). This would be ethical and efficient in that gains would be better aligned with deserts, and rent-seeking would be curbed. Collier recommended a tax calculated by combining high-income and metropolitan locations, which can then be redistributed to other cities that have been hard hit by agglomeration.^[15]

The disadvantages of agglomerations are to be mentioned:^[8]

• For the environment: The high level of economic agglomeration is probably the cause of environmental pollution,^[16] including air pollution, water pollution, land pollution, etc. One example is the economic agglomeration in the Yangtze River Delta region in China. Because of the concentration of individuals and industry, the serious air pollution in the Yangtze River Delta has not only caused some extreme weather problems but has also increased some diseases.^[17] Adjusting the city’s spatial structure can alleviate environmental problems and release environmental pressures.^[18] Energy consumption is another environmental problem. The agglomeration of the economy led to a rapid increase in population and industries, which caused serious energy problems.^[19] It also resulted in pollution and raised the demands for more advanced production technology.^[20]
• Economic: Economic agglomeration can create some economic benefits but also tends to widen the disparity between rich areas and poor areas and increase interregional inequality.^[21] Interregional inequality cannot be prevented because it is a necessary stage during economic development. The serious inequality problem even causes issues of social instability and political uncertainty.^[22] Governments need to improve equality by doing activities such as investing in human capital and innovation.^[23] Economic agglomeration may also affect rural areas. The over-agglomeration in the city would affect agricultural production and cause unemployment problems.^[24]
• For society: Economic agglomeration has also caused social problems. First, the increased population has led to high land prices. To reduce the inequality problem, governments may tax the land in the agglomeration area, increasing the land price. Second, the agglomeration of the economy also creates a high demand for infrastructure. It is important to coordinate the public goods problem, find the best volume of public contribution, and prevent poor or overburdened infrastructure.^[25]
• For companies: Economic agglomeration would cause fierce competitive pressure. Competition can reduce the market price, motivating companies to innovate and increase production efficiency.^[26] However, over-competition would hinder companies' development and innovation, and would also generate some social problems.^{[citation needed]}

Two types of economies are considered large-scale and have external economies of scale: localization and urbanization economies. Localization economies arise from many firms in the same industry located close to each other. There are three benefits of localization economies: The first is the benefit of labor pooling, which is the accessibility that firms have to a variety of skilled laborers, which in turn provides employment opportunities for the laborers. The second benefit is the development of industries due to the increasing returns to scale in intermediate inputs for a product. The third benefit is the relative ease of communication and exchange of supplies, laborers, and innovative ideas due to the proximity among firms.

While localization and urbanization economies and their benefits are crucial to sustaining agglomeration economies and cities, it is important to understand the long-term result of the function of agglomeration economies, which relates to the core-periphery model. The core-periphery model features an amount of economic activity in one main area surrounded by a remote area of less dense activity. The concentration of this economic activity in one area (usually a city center) allows for the growth and expansion of activity into other and surrounding areas because of the cost-minimizing location decisions of firms within these agglomeration economies to sustain high productivity and advantages, which therefore allow them to grow outside of the city (core) and into the periphery. A small decrease in the fixed cost of production can increase the range of locations for further establishment of firms, leading to loss of concentration in the city and possibly the development of a new city outside the original city where agglomeration and increasing returns to scale existed.

If localization economies were the main factor contributing to why cities exist with the exclusion of urbanization economies, then it would make sense for each firm in the same industry to form its city. However, in a more realistic sense, cities are more complex than that, which is why the combination of localization and urbanization economies forms large cities.^{[citation needed]}

From the localization of firms, labor market pooling emerges. Large populations of skilled laborers enter the area and can exchange knowledge, ideas, and information. The more firms there are in this area, the greater the competition is to obtain workers, resulting in higher wages for the workers. However, the fewer firms there are and the more workers there are at a location the lower the wages for those workers will be.

The second contribution to localization economies is the access to specialized goods and services provided for clustering firms. This access to specialized goods and services is known as an intermediate input. It provides increasing returns on scale for each of the firms located within that area because of the proximity to available sources needed for production. If intermediate inputs are tradable, a core-periphery notion will have many firms located near each other to be closer to their required sources. If there are tradable resources and services nearby but no related industries in the same area, then in that case, there are no networking linkages, which makes it difficult for all firms in the area to obtain resources and increase production. The decreased transportation costs associated with the clustering of firms lead to an increase in the likelihood of a core-periphery pattern; the result will be that more intermediate inputs will be focused at the core and, therefore, will attract more firms in related industries.

The third source relating to localization economies is technological spillovers. One final advantage of this source is that clustering in specific fields leads to quicker diffusion or adoption of ideas. For production to be at its maximum and for firms to sell their products, they require some feasible access to capital markets. New forms of technology can create problems and involve risk; the clustering of firms creates an advantage to reduce the uncertainty and complications involved with using new technology through information flow. The capital flow and technology industry are concentrated within specific areas, and therefore, it is to the advantage of the firm to locate near these areas. This technological impact, specifically in the communications field, will provide and dismiss the barrier between firms in the same industry located further away and nearby, leading to a greater concentration of information flow and economic production and activity. Furthermore, technological spillovers may be more beneficial to smaller cities in terms of their growth than larger cities because of the existing informational networks that already helped them form and grow.

• Brueckner, Jan. "Lectures in Urban Economics." 2011. The MIT Press
• O'Flaherty, Brendan. City Economics. Cambridge, MA; London. 2005. Harvard University Press
• Coe, Neil M., Kelly, Philip F., and Yeung, Henry W.C. Economic Geography: A Contemporary Introduction. Malden, MA; Oxford, UK; Victoria, Australia. 2007. Blackwell Publishing
• Bogart, William Thomas. The Economics of Cities and Suburbs. Upper Saddle River, New Jersey. 1998. Prentice Hall
• Strange, William C., 2008, "urban agglomeration," The New Palgrave Dictionary of Economics, 2nd ed. Abstract.
• Venables, Anthony, 2008. "New Economic geography," The New Palgrave Dictionary of Economics, 2nd ed . Abstract.

• Rosenthal, Stuart S., and William C. Strange. 2020. "How Close Is Close? The Spatial Reach of Agglomeration Economies." Journal of Economic Perspectives, 34 (3): 27–49.