JOURNAL OF URBAN ECONOMICS 16, 91-104 (1984)

Economies of Scope and Economies

of Agglomeration’
G. S.GOLDSTEIN

Department of Economics, Northwestern University, Evanston, Illinois 60201

AND
T.J. GRONBERG
Department of Economics, Texas A & M University, College Station, Texas 77843

Received September 9,1982; revised January 26.1983

Agglomeration economies are economies external to the firm, and plant, but
internal to a particular location. In this paper the notion of agglomeration economies
is formally investigated. The implications of the concept for urban structure and
industrial organization are then traced. Under specified considerations, weak econo-
mies of agglomeration, as defined in this paper, are shown to be necessary for the
existence of an urban area.

1. INTRODUCTION
An urban agglomeration is a geographic concentration of economic
activity. The generally accepted economic basis for this agglomeration is
some form of scale economy, a notion that spatial proximity of activities
makes resources more efficient than if such activities are spatially dispersed.
The concept of economies of scale has been examined intensively from both
a theoretical and an empirical viewpoint, but not with completely satisfac-
tory results and not in a spatial context. (See Gold [3].) The agglomerative
economies concept, on the other hand, has not received the same attention.
There are basically three approaches to the scale concept underlying
agglomerative economies; economies internal to a firm at a given location,
which we shall label the company town; economies external to a firm at a
given location, but internal to an industry at that location, called localiza-
tion economies; and finally, economies external to both the firm and the
specific industry at a particular location, called urbanization economies.
Peat, Marwick, and Partners [13] and Henderson [5] discuss the latter two

‘We thank Jack Meyer, Ron Braeutigam, John Ledyard, Mike Marrese, Bruce Petersen, and
a referee for helpful comments.
91
0094-1190/84 $3.00
Copyright 0 19X4 hy Academic Press, Inc
All rights of reproduction in any form reserved.
92 GOLDSTEIN AND GRONBERG

concepts in detail. All three approaches imply that the benefit that firms
derive from operating in an urban environment is based on a scale concept,
One early example of this link between the functional structure of
industry and its geographic structure is provided by Stigler [17]. “Localiza-
tion is one method of increasing the economic size of an industry and
achieving the gains of specialization. The auxiliary and complementary
industries that must operate in intimate cooperation can seldom do so
effectively at a distance” [17, p. 1891. Stigler conjectures that geographic
dispersion is a luxury enjoyed by large industries, specifically those large
enough so that even small units of production can benefit from specializa-
tion. This reasoning suggestsone important cause of spatial agglomeration
which we pursue below, the incentive to reduce the costs of coordinating
closely linked activities.
An example of urbanization economies is specialized services in large
urban areas which do not exist in smaller areas. In a rural area, a
manufacturing firm which operates a fleet of trucks must have on hand its
own mechanics, or use local “general” mechanics. In a large urban area, the
firm can draw upon firms which specialize in maintenance of large trucks.
(See Isard [6].) W e will provide an alternative way of viewing agglomerative
economies, based on the theory of multiproduct firms as developed by
Panzar and Willig. We will argue that urban areas can be viewed as
“ vehicles” for spatial integration, in the same way that vertically integrated
firms gain efficiency from engaging in multioutput production. It is not
simply the scale of activity in the area that is important in our approach,
but the improvement in productive efficiency from placing related activities
at a common location.
We can distinguish our concept from the scale concepts by considering
the empirical implications of each approach. For localization economies, we
measure the scale factor using total employment or output in a given
industry, in a given urban area; for urbanization economies, we use total
population or employment of the entire city. Agglomerative economies
based on a multioutput concept cannot be measured with such aggregate
measuressince it is the presenceof a specific set of interrelated activities in a
given location that is the source of the efficiency gain. One possible measure
of agglomerative economies would then be the reduction in unit costs that
members of this set derive when they are in spatial proximity.
Our concept can also answer a question raised by Henderson [5] regard-
ing systemsof cities. “If resources are more efficient in one size city than in
another, then radically different size cities should not survive in a market-
oriented economy. Yet radically different size cities have always coexisted in
market economies” [5, p. 11.If one major source of agglomerative economies
is productive efficiency from locating specific sets of economic activities in
spatial proximity, then we can have a variety of city sizes and a variation in
 ECONOMIES OF AGGLOMERATION 93

the set of activities that takes place across cities. How large a city is and
what activities it contains depend on the particular set of interrelated
activities that operates within its boundaries.
Before we consider supporting empirical work, we note two other reasons
for agglomeration which do not fit neatly into the scheme outlined above.
Mills [9] argues that the most important aspect of agglomerative economies
“is statistical in nature, and is an application of the law of large numbers.
Sales of outputs and purchases of inputs fluctuate in many firms and
industries for random, seasonal, cyclical, and secular reasons. To the extent
that fluctuations are imperfectly correlated among employers, an urban area
with many employers can provide more nearly full employment of its labor
force than can an urban area with few employers” [9, p. 111.
Finally, there may be false price signals at small scales that lead more
firms to locate in a specific location than would do so in the absenceof this
“market failure.” This situation is analogous to congestion on an express-
way. The price paid for use of the urban infrastructure is not marginal social
cost, but the lower price, marginal private cost. The result is urban ag-
glomeration.
The approach to be presented formally includes the various scale con-
cepts, in addition to the multiproduct notion. The market failure idea could
be considered a special case of the multiproduct concept, in which private
costs of locating in an urban area do not reflect social costs. Mills’
suggestion, however, requires a dynamic context and is not dealt with in this
model.
2. EMPIRICAL SUPPORT FOR THE CONCEPT OF
AGGLOMERATIVE ECONOMIES
Lichtenberg’s study of the New York Metropolitan Region in the late
1950s is the classic case study of localization economies. He identified 87
industries “as dominated by external-economy factors of location and
which are relatively concentrated in the New York Metropolitan Region”
[6, p. 791. Most of these industries were related to the production of
clothing, in which proximity to buyers and suppliers was important.
Henderson [5] uses 1972 data for the United States and 1970 data for
southern Brazil to examine the nature and extent of scale economies in
manufacturing. He seeks to identify these scale economies as either urban-
ization or localization ones. Henderson’s empirical work is developed using
a constant returns to scale firm production function with a Hicks-neutral
external shift factor (which is a function of scale and technology measures
specific to an industry in an area). Henderson finds that in general, external
economies of scale are due to localization factors rather than urbanization
ones. Nothing, however, is revealed about the possible strength of a “multi-
product” basis for agglomeration when a Hicks-neutral shift factor is
94 GOLDSTEIN AND GRONBERG

employed. To examine this issue, specific interactions among firms have to

be modeled.2
Schmenner’s [16] comprehensive study of the manufacturing location
decisions in two areas, Cincinnati and New England, does reveal support
for the multiproduct concept. He found that almost 80% of the plants new
to the Cincinnati area were recently founded single-plant companies. These
new plants were in general small, simply organized; shared sites with one or
more tenants; “ tended to sell direct, do next to no off-site warehousing, and
use little nontruck transportation for shipping both supplies and output”
[16, pp. 4-116, 1171. They were, in addition: “more dependent on the
surrounding community than other plants;” “dependent on other manufac-
turers for ‘breaking in’ their production space;” and in general placed a
“higher average value on proximity to suppliers, customers, and special
services than other plants do” [16, pp. 4-117, 1211.Finally, a survey of the
headquarters of companies with plants in Cincinnati revealed that
“while . . . factors such as wage levels, taxes, and public services rank higher
than many factors with between a third and a half of the companies
considering them important influences to site selection, it is. . . factors such
as labor skills and proximity.. . to markets [supplies, and natural resources]
which are more universally appealed to in selecting sites” [16, pp. 4-1331.
Schmenner’s study makes a strong case for the importance of “multiprod-
uct” agglomerative economies in industrial location. Scale economies are
not the critical factors, but accessto related activities does seem to be.

3. VERTICAL INTEGRATION OF THE FIRM AND

AGGLOMERATIVE ECONOMIES
In our approach, urban areas can be considered “ vehicles” for the spatial
integration process. The parallel between this characterization of urban
areas and vertically integrated firms is striking. Vertical integration, in the
static sense, deals with the extent of coverage of the entire spectrum of
production and distribution stages by a single company. When a firm
becomes vertically integrated, it assumes activities previously handled

‘Moomaw [lo], reexamines two recent studies linking productivity and city size using
Hicks-neutral shift factors. He found that large American cities have substantial productivity
advantages which are much more important in their nonmanufacturing sectors. Harris and
Hopkins [4], who do examine interindustry effects, find that the basic chemical industry and the
iron and steel industry had the most influence on change in output in other industries. Basic
chemicals influenced the location of 11 other industries, six through transport costs, one as
major buyer and five because of the agglomeration effects of being a major supplier. [Iron and
Steel] influenced the location of 10 other industries. Other important influencing industries
are Agriculture, Paper, Rubber and Plastics, and Other Nonferrous Metals” [4, p. 921.
 ECONOMIES OF AGGLOMERATION 95

through a market transaction in which the firm participated as a customer

or a supplier. Scherer [15] and Williamson [19, 201 discuss a variety of
motives for vertical integration, including to reduce costs, enhance control
over the economic environment, ensure supplies of raw materials in times of
shortage, protect the user from price squeezeby monopolistic suppliers, gain
greater control over markets. In a world with incomplete information, there
is an opportunity cost of expending resourcesnecessaryto become informed
-a cost of using the price system.Williamson [19,20] argues that “rational”
firms have an incentive “to combine the interacting activities and substi-
tute an administrative solution for the defective market solution”
[19, p. 161.
Why, given the advantages of vertical integration and agglomeration, do
we not observe one big firm in one large urban area? With respect to the
firm, Williamson [19, 201suggeststhat size is limited by bounded rationality
“by which is meant bounds on the rate at which information can be
absorbed per unit of time, limits to the information storage capacity (in an
effective retrieval sense), and bounds on the processing ability of the
decision-maker” [19, p. 201. Stigler [17] in a similar vein, argues that the
organization of activities into one firm or many depends on the cost of
transactions within a firm relative to that cost between firms. With respect
to an urban area, as more and more firms compete for locations in the
urban area, they put pressure on the price of a scarce resource, accessible
land, land that has good access to both interregional and intraregional
modes of transportation. This drives up land rents, making the area less
attractive at the margin. Thus we observe some cases of large vertically
integrated firms in isolated locations, but there exist as well urban areas
with many firms related in some way through production or marketing, but
not under the same corporate umbrella. The critical factor distinguishing
these two possibilities is the minimum optimal scales of the separate
activities. If they “fit together” well in a single company (in a cost function
sense to be discussed below), then a single firm arises. If they “fit together”
well in a geographic sense, but not a corporate sense, then a multifirm
spatial agglomeration results. A plant located in a rural area might hold
larger inventories of inputs to avoid the effects of interruptions in supply
patterns. This entails larger warehouse facilities. By moving to an urban
area the plant can use the “urban warehouse,” cutting back on its warehouse
needs because its proximity to suppliers means that supply interruptions,
due to transportation problems, for example, are less likely to be a problem.
In this case there is both a scale aspect and a coordination aspect to
agglomerative economies. The more important is spatial proximity to re-
lated firms for informating processing and coordination relative to “urban
warehouse” needs, the more important is the multiproduct aspect of ag-
glomerative economies. Both the Schmenner and the Peat, Marwick studies
96 GOLDSTEIN AND GRONBERG

provide evidence of the importance of this “coordinating” factor. On the

pecuniary side, by locating near suppliers the firm realizes a lower delivered
price for its inputs. (This is the essenceof the classic Koopmans-Beckman
model of firm location [S].)
That spatial and nonspatial integration are intimately related phenomena
seems clear. We wish to establish that the formal basis for both of these
integration processesis found in the concept of economies of scope. Panzar
and Willig [lo] coined the term “economies of scope” to describe the
situation in which it is less costly to combine two or more product lines in
one firm than to produce them separately. Scope economies can refer to
horizontal or vertical integration. Panzar and Willig prove two propositions.
The first proposition characterizes the conditions which lead to the forma-
tion of multiproduct firms in perfectly competitive markets. Economies of
scope are the driving force in the existence of such firms.3 Proposition two
shows there are economies of scope in the operations of a firm that produces
its own stream of services from a quasi-public input and utilizes them for
the production of more than one output. Basically the existence of a
sharable input, such as a warehouse, allows the firm to produce two or more
product lines at less than the total costs of producing these commodities
separately. If such services could be efficiently allocated by a market, then
economies of scope would disappear.
The Panzar-Willig framework serves as our point of departure.4 In the
analysis to follow we extend the notion of scope economies to space, and in
so doing analyze formally agglomerative economies.

3Teece [18] points out that scope economies indicate that joint production must occur, but
that “joint” production can be obtained using contracts as well as managerial hierarchies.
Whether the one is more efficient than the other is basically an empirical question which turns
on transactions costs. Stigler [17] makes a similar point.
41n a related paper, Chipman [2] developed the concept of “parametric external economies
of scale,” a concept which can be related to agglomerative economies. He distinguished the
entrepreneur’s notion of his production function, the subjective production function, from the
actual or objective production function. Each entrepreneur believes “that his firm is operating
under constant returns to scale, and any departures from this assumed output-factor
relationship are interpreted by him as brought about by a perturbation in his unit-homoge-
neous production function even if such departures are caused in part by changes in his own
level of output. Such shifts are, in turn, assumed to be governed by the level of output in the
industry” [2, p. 3491.Chipman argues that this last assumption could be relaxed to make such
shifts a function of employment in other industries. This would cover agglomerative economies.
Our approach will not rely on a distinction between a subjective and an objective production
function. We will restrict firms by making assumptions about economies of scope, about
operating costs about which the firm is fully infmed. Using a Chipman-type model, we would
find that the market would not necessarily produce spatial agglomeration since the firms would
not perceive the effect of such spatial agglomerations on their production function.
 ECONOMIES OF AGGLOMERATION 97

4. ECONOMIES OF SCOPE AND

MULTIPRODUCT-MULTIFIRM CITIES
Economies of scope with respect to spaceis our concept of agglomerative
economies. Agglomerative economies exist when it is less costly to combine
two or more product lines in one urban area (but not necessarily one Jim)
than to produce them in different urban areas.
More formally, using the notation of Panzar and Willig, let N =
{1,2,... n } denote the set of products under study with respective quanti-
ties y = (yi... y,). Let y, denote the n vector whose elements are set equal
tothoseofyforiEScNandOfori~S.LetR={1,2...z}denotethe
potential locations available for production. The function C( y,‘, wr) denotes
the cost of producing only the products in the subset s at location r, by a
single multiproduct firm at the quantities indicated by the vector y. w’ is the
vector of factor prices at r. C( *, 0) is the usual multiproduct minimum cost
function.
Let T= {r,,... T,} denote a nontrivial partition of S c N, that is,
uq=S,qOI;.=0fori#j,7j#0,andI>l.
DEFINITION. There are economies of agglomeration at r and at factor
prices w with respect to the partition T if

where 1 < 1, z and c qc8 = y,! .

i=l r=l i=l r

(1)
In Table 1 we summarize the notation to be used. For example, C( y,‘, w)
represents the cost function of a multiproduct firm which locates all
production activities at site r. This firm benefits from both economies of
scope and economies of agglomeration. At the other extreme,

i i c(q;,,w), cq-;;=yp
r=l i=l r

represents the total cost of producing the products in the subset S when
those products are produced at more than one location by more than one
firm. There are both diseconomies of scope and diseconomies of agglomera-
tion. Finally, in order to concentrate on interindustry effects, we assume w
to be uniform over space. There are no initial differences in the relative
attractiveness of various sites. The only factor that can make one site more
or less attractive than another to a particular firm is the presence or absence
of other firms.
98 GOLDSTEIN AND GRONBERG

TABLE 1
Cost of Production under Various Assumptions

Economies of scope Diseconomies of scope

Economies of
agglomeration

Diseconomies of
agglomeration

For the multiproduct firm we write

wherel<lrzandzqG,=y,,.
r

(14

To rule out an urban area with only multiproduct firms, we must assume
diseconomies of scope in the Panzar-Willig sense,that is, that

i C(YG,Y 4 < C(Y,‘,U).

i=l

Weak economies of agglomeration exist if the inequality in (1) is weak

rather than strict, and diseconomies of agglomeration exist if the inequality
is reversed.5
‘This formulation is rather general. It includes economies from locating different activities in
one place, but as written-the economies could be due to spatial economies of scale rather than
spatial cost complementarities across products. This is the case of the company town. An
example is provided in the table. Consider two products, a and b, and two locations, 1 and 2,
y0 is the total output of a; yh, of b. In this example, if the total costs of producing y, and yh
are lower in case 3 than in case 1, this is consistent with, but does not establish the existence of,
agglomerative economies due to spatial cost complementarities. If case 3 provides no cost
savings over case 2 then clearly the cost savings are due to spatial scale economies rather than
economies of scope. The spatial reorganization of production is such that all of y, is produced
at one location, and all of y,, is produced at one location. The fact that y, and yh may be
produced at a single location is irrelevant. We wish to distinguish spatial economies of scale
from economiesof agglomeration due to cost complementarities. Define J?, = (0,O y, 0,O)
for all i E S c N. For ease of exposition assume that there are at least as many locations
available as products. C, E s c p,( j’, w) then represents the total cost of producing the products
 ECONOMIES OF AGGLOMERATION 99

We can now relate economies of scope and economies of agglomeration

to the existence of urban areas. For simplicity we assume(1) that consumers
are distributed uniformly over space and (2) that firms use mill pricing.
Urban area refers to a spatial concentration of firms.
PROPOSITION 1. (i) Economies of agglomeration and economies of scope at
prevailing factor prices with respect to the specialization partition T =
{l, 2,. . . n } are suficient for the existence of urban areas with multiproduct
firms in competitive equilibrium and (ii) weak economies of agglomeration with
respect to all partitions of at least one nontrivial S c N are necessary for such
existence of an urban area. We demonstrate Proposition (i)a that economies of
agglomeration without economies of scope but with two added assumptions,
namely that (1) all firms are fully aware of all gains from certain location
patterns and (2) that the costs of agreeing to a mutually satisfactory location
are less than the cost savings from agglomeration, are sufficient for the
existence of urban areas with only single-product-jirms. In other words, there
are multiproduct urban areas made up of firms each producing a single
product.
Proof (i) Suppose the contrary; that is, that equilibrium involves only
single-product firms randomly distributed over space, each earning zero
profits. Then a geographic and corporate merger of n price-taking firms,
each specializing in a different product, would lower their total costs and
yield positive profit. Hence, firms would have a profit and the hypothesized
industry configuration could not be a competitive equilibrium.
(i)a What if we assume diseconomies of scope and continue to maintain
economies of agglomeration. Suppose again, an equilibrium with only

in the subset s, if full advantage is taken of spatial economies of scale, but not spatial cost
complementarities.
We can say that economies of agglomeration are due to spatial cost complementarities and
not spatial scale economies if (1) holds and in addition if

Spatial Arrangement of Production”

Case 1 Case 2 Case 3

Production at 1 (c.h, eyb) (YmO) (VWY/J

Production at 2 ((1 - c)Y,,(~ - e)yb) (0, Yh) (O>O)

‘0 < c. e < 1.
100 GOLDSTEIN AND GRONBERG

single-product firms randomly distributed over space, each earning profits.

Given our current assumption about w, that it does not vary over space,the
incentive for individual firms to relocate in a Pareto-optimal fashion, that is
to exhaust economies of agglomeration, depends on the availability of
information about potential agglomeration economies and the transactions
cost of coordinating movement to the same location. If all firms are fully
aware of the gains from certain location patterns, and if these firms can
agree on specific locations to capture these economies at a cost less than the
cost-savings to be realized, urban areaswith single-product firms will result.
Firms do not have an incentive to merge in the traditional sense,but they
do have an incentive to merge geographically.
It is important to add, however, that unless all firms earn positive gains
from agglomeration, it will be necessary for those firms who gain to
compensate or bribe those who suffer or realize no cost savings from the
spatial realignment. As long as the transactions costs involved in this
process do not absorb the gains from agglomeration, the market will create
an urban area with single-product firms. This is an important assumption,
since it will be in the interest of each firm that gains from agglomeration to
contribute as little as possible to the pool used to compensate or bribe the
firms who lose or simply gain zero.
(ii) Assume an urban area in which the product set S was produced in
competitive equilibrium and there were economies of scope and disecono-
mies of agglomeration with respect to the nontrivial partition of S,
{ Ti . . . T, }. Each multiproduct firm could geographically disperse its facili-
ties producing Tl through T, at different locations and earn positive profit at
the equilibrium prices p, since

O= CPiYl - c(Ys’) < 3 where cq;, = yT,.

s r

Following Panzar and Willig, if there did not exist at least one subset of N
containing two or more products, which was invulnerable to such fragmen-
tation, no multiproduct urban areas could exist in competitive equilibrium.
A similar argument holds for the case of diseconomies of scope.
We have now established the consequencesof the presence or absenceof
economies of agglomeration for the spatial arrangement of firms in competi-
tive equilibrium.‘j The source of these economies, input sharing, can now be
examined.

6We have said nothing about the existence of either spatial or nonspatial monopoly. The
approach developed can shed light on this issue. What is necessary is a more precise
specification of the relationship between the spatial structure of demand and the spatial
structure of costs.
 ECONOMIES OF AGGLOMERATION 101

5. SHARED INPUTS AND ECONOMIES OF

AGGLOMERATION
Panzar and Willig [lo], using an abstract duality approach, have proven
that sharable inputs are both necessaryand sufficient for economies of scope
between product sets. In their more concrete model of input sharing, Panzar
and Willig [ll] point out that if the services of the quasi-public (sharable)
input
could be efficiently allocated by a market, then both the economies of scope and the
need for horizontal integration over the final products in the set N would disappear
[12, p. 2711.

It is, however, the existence of a sharable input provided at a specific

location by the market that provides a strong motivation for spatial integra-
tion. This sharable input could be private storage facilities, machine repair
shops, training centers for skills, and so forth. The firm always has the
option of providing such resources for itself, and, in fact, the scale of some
firms may make sharing a less cost-effective technique than self-provision.
In the latter case, we would have economies of scope, but not necessarily
economies of agglomeration,
In the case of space, sharable factors, also provide a basis for agglomera-
tion. If we consider storage facilities, training centers, and so forth, we are
dealing with localization economies or urbanization economies. The shar-
able input could, however, be unrelated to scale factors. It could be the
coordinating factor discussed above, a factor which does not rely on the
scale of activities but on the presenceof related activities in close proximity.
We will call the sharable factor “coordination.”
PROPOSITION 2. For any nontrivial partition of N over space, there are
economies of agglomeration if and only if the cost of producing the resources to
be shared by other is strictly subadditive over space, in the relevant range.
Proof. (i) Consider sufficiency first. Assume single-product firms are
randomly distributed over space, each having economic relationships with
firms distributed across various urban markets. By assumption, the cost of
coordination is strictly subadditive over space. This means that by locating
all firms in one area we lower the total cost of coordinating activities and
therefore of all goods together. This is the definition of economies of
agglomeration.
(ii) Consider necessity. Assume the cost of coordinating activities services
is superadditive (or not subadditive) over space. Assume single-product
firms are randomly distributed over space, each having economic relation-
ships with firms distributed across various urban markets. Relocate all firms
in the same area. By assumption the cost of coordinating activities is
superadditive (or not subadditive). This implies that the costs of coordina-
102 GOLDSTEIN AND GRONBERG

tion will increase (or not change) and therefore the cost of producing all
goods together will increase (or not change). Therefore, superadditivity (or
not subadditivity) of the cost of producing the shared resource is incompati-
ble with economies of agglomeration.

6. SPATIAL VARIATION IN PRICES

To this point, w has been assumeduniform over space,implying that any
incentive for spatial agglomeration comes from production externalities. If
we index w with respect to location, then we incorporate further incentives
or disincentives for spatial agglomeration. A specific locational pattern of w
must be imposed, however. If, for example, we argue that in larger urban
areas there is a wider variety of labor specialities available than in smaller
areas, this by itself will not reveal whether these labor specialties are
associated with higher or lower prices in larger areas. We must also specify
the relative demand for such services. What we can say is the obvious. If
higher input prices are associated with larger urban areas, then these costs
must be weighed against the incentives for spatial agglomeration and may
lead to less agglomeration than would be expected in the case of spatially
uniform w. A general model, however, including factor supply over space is
needed to explain the spatial variation in w.

7. THE SCOPE OF THE FIRM AND THE SCOPE OF THE

URBAN AREA
We can now employ the propositions developed to provide insight into
the industrial structure of urban areas. From Proposition 2 there are
economies of agglomeration if firms can make use of a “sharable factor” at
a specific location. Proposition 1 shows, that there need not be multiproduct
firms to take advantage of this “sharable factor” at a specific location.
If we are talking about urbanization economies, then the sharable factor
can be produced by government, ports or railroad depots, for example. It
can also be produced in the private sector, warehouses for example. This is
also true with respect to localization economies. Further, there is no reason
to expect that the private market suppliers of such services cannot charge
different users different prices thus enabling the market to efficiently allo-
cate these services.
Using Propositions 1 and 2 we explain the location of relatively small
manufacturing firms in the central business districts of cities and in in-
dustrial parks. These firms share the common facilities of the specific
locations, such as easy accessto interregional and intraregional modes of
transportation. Relatively large firms which can fill up a complete truck
transport on their own, or which have their own railroad siding, are not tied
to the “sharable” factors.
 ECONOMIES OF AGGLOMERATION 103

A further source of cost-savings from location in large urban areas comes

from the vertical integration literature. This argument combines the multi-
product argument with the scale argument. Williamson [(19, 20)] argued
that firms operating in markets with small numbers of firms are exposed to
the hazards of recontracting and high switching costs. Vertical integration
attenuates these costs. Using our approach we suggestthat location in urban
areas, generally large numbers markets, provides an alternative to vertical
integration. Large urban areas with publicly provided utilities, a multiplicity
of supply sources, and marketing outlets reduce the uncertainties of operat-
ing in a small numbers market. Consequently, the cost functions of firms
locating in such areas tend to be lower than those of firms operating outside
major “agglomerations.”
There are implications for the sustainability of monopoly literature as
well. Baumol and Willig [l] define an entry barrier as “anything that
requires an expenditure by a new entrant into an industry, but that imposes
no equivalent cost upon an incumbent” [l, p. 4081. Consider a product
which involves a considerable variety of closely related activities. This
implies that if one firm does not monopolize all stages of activity, then
resources have been expended in searching out and setting up relationships
among the separate cooperating firms. In the terminology of Baumol and
Willig, these are sunk costs, “funds already committed and.. . already
exposed to whatever perils participation in the industry requires” [l, p. 4181.
Such costs contribute to entry barriers, which can give rise to monopoly
profits. The argument proceeds by considering the use of artificial barriers,
such as advertising, to sustain monopoly profits.
When we consider this problem in a spatial context, we can link the sunk
costs discussed above to the spatial structure of industry, using the multi-
product notion of agglomerative economies. More specifically, if we pos-
tulate economies of agglomeration, economies due to the savings from not
having to expend resources in searching out cooperating firms, then the
locational decisions of firms eliminate a category of sunk costs. If this was
the critical category of sunk costs contributing to entry barriers, then spatial
decisions of firms have made a monopoly situation untenable. The scope of
the enterprise and the industrial structure or urban areas are not indepen-
dent phenomena.

8. SUMMARY
By taking account of both the spatial production and organizational costs
of operating a firm, we have developed a foundation for the economics of
agglomeration. We have, moreover, indicated that multiproduct urban areas
do not necessarily involve multiproduct firms. Clearly vertical and horizon-
tal integration in the traditional industrial organization, that is, where the
104 GOLDSTEIN AND GRONBERG

focus is on the firm, are strongly linked to the location strategy of the firm,
that is, where the focus is the urban area.
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