RIETI Report August 2017

Agglomeration benefits versus firm selection

Firms, on average, are more productive in larger cities, which is often attributed to agglomeration economies that are considered to generate benefits as positive externalities. However, recent theoretical studies have proposed another hypothesis of selection—less-productive firms being unable to survive in the market. Research has shown that larger markets bring about tougher selection, and, consequently, aggregate productivity in larger cities is higher than that in smaller cities, since only more-productive firms survive in larger markets. It is becoming increasingly necessary to distinguish whether higher productivity in larger cities is derived from agglomeration economies or firm selection. In the August issue of the RIETI Report, we present the column "Agglomeration benefits versus firm selection" by Fellow Keisuke Kondo.

Kondo first reviews the current quantile approach that tests for agglomeration economies and firm selection in spatial productivity differences. He applies this approach to the Japanese manufacturing sector for the period 1986-2013 and finds that agglomeration economies is a better explanation for the spatial productivity differences in the Japanese manufacturing sector, but that there is greater variation across different sectors. Furthermore, benefits from agglomeration economies in the Japanese manufacturing sector have decreased in the recent decade, suggesting that when regional economies are integrated more tightly as communication and transportation costs decrease, the productivity advantages of agglomeration also decrease. Finally, Kondo proposes further empirical studies and introduces his new Stata command, estquant, which he hopes other researchers will utilize.

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Agglomeration benefits versus firm selection

KONDO KeisukeFellow, RIETI

It is well known that firms, on average, are more productive in larger cities. Agglomeration economies are considered to generate benefits as positive externalities (e.g. Combes and Gobillon 2015). However, recent theoretical studies have proposed another hypothesis of selection. As introduced by Melitz (2003) in the international trade literature, selection is defined as less-productive firms being unable to survive in the market. Further introducing the endogenous markup, Melitz and Ottaviano (2008) showed that larger markets bring about tougher selection, and, consequently, aggregate productivity in larger cities is higher than that in smaller cities, since only more-productive firms survive in larger markets.

A crucial empirical concern is to examine whether higher productivity in larger cities derives from agglomeration economies or firm selection. The standard regression approach cannot distinguish productivity advantages of agglomeration economies from firm selection. Although urban economists have understood the productivity advantages of large cities as deriving from agglomeration economies, there may be different implications if stronger selection plays the key role. Thus, there is an increasing need to develop a new empirical methodology that can distinguish agglomeration from selection.

To read the full text
http://www.rieti.go.jp/en/columns/v01_0095.html

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