Urban Agglomeration Economies and You: Making sense of Urban Economics and understanding why it matters

November 4, 2014 Published by
Post Categories: HSS Blog

It was with great sadness that our firm recently said goodbye to one of our employees after they had been with us for over two years, leaving to work closer to home. While they loved the firm, its people and its clients, and looked forward to coming into work every day, they had often recited horror stories about their commute to us every morning. After living in London and Woodstock for the past five years, I had been noticing that traffic in the Toronto area was getting worse and worse every year. But I couldn’t have imagined how terrible my co-worker’s commute was until I took a trip up to a client in Newmarket. What I saw heading up Highway 404, thankfully against traffic, was a solid column of cars snarled in a “routine” 20-kilometre traffic jam. I did not even need to get caught in the mess to understand my co-worker’s frustration; an hour and a half would easily be spent driving each way from Davis Drive to Sheppard Avenue, a trip which should only take half an hour. That would be three hours a day to complete a one-hour round trip, which in turn translates into ten hours per week- a full work day.

All across the GTA, hundreds of thousands of desperate commuters are exposed to this sort of frustration every day. And they are not necessarily drivers: many transit users complain about the system’s overall inefficiency; its constant delays; the increasing crowding of transit infrastructure; and rising costs. Everyone is affected. But surprisingly few, it seems, stop to think of the impact that urban traffic congestion has on their quality of life and their businesses’ bottom line. In a 3-part series, I will be looking at why these issues plague our lives and how they affect your business. In the first segment, presented this week, I will give a very basic explanation of urban economics and the reasons for the existence of cities. In Segment 2, I’ll look at the causes and effects of traffic congestion in urban economies, with a focus on Toronto. Finally in Segment 3, we will look at solutions to the congestion problem and talk about funding them.

URBAN ECONOMY CRASH COURSE

So before starting on a “traveling in the city is awful” rant, it is best to begin by describing the raison d’être of cities, which will explain why congestion exists. Urban economics can be an extremely complex area of study, well beyond the scope of this blog post, but we can simplify it to a tradeoff between efficiencies, or “scale economies”, and inefficiencies, known as “diseconomies of scale”. Think of scale economies as the cost advantages your business can achieve by spreading fixed costs over a larger production output. You may, for example, outsource HR functions to a specialized firm, which is able to provide HR solutions at a much lower cost because it is able to spread its fixed personnel and capital costs over a huge number of clients. By taking advantage of scale economies from another firm, your business may be able to achieve the exact same results as you would get in-house, for less money. Urban agglomeration economies are an application of this idea; they are the cost advantages multiple firms can take advantage of by locating close together in one area.

SCALE ECONOMIES- IT’S BETTER TOGETHER

Cities form because businesses and people cluster together in order to take advantage of locational advantages. Occasionally, similar firms will locate in the same area due to the proximity of inputs; consider nickel mining operations in Sudbury, Ontario, or pulp and paper operations in Trois-Rivières, Quebec. However, location is often a question of costs and capital. Some inputs used by businesses are “lumpy”, meaning they cannot be scaled down for smaller operations. To counteract this, we often see similar competing firms locating close to one another in a cluster, sharing indivisible inputs in order to reduce their production costs. This is a simple form of urban agglomeration, referred to as “localization economies”. Consider the area around San Jose, California; technology firms cluster together to share inputs (both capital and labour) as well as ideas, which results in a large industry concentration within the same area. Something similar, albeit on a smaller and less pronounced scale, can be seen in the cluster of software firms around Ottawa. Urbanization economies are the next step above basic localization economies. Rather than occurring across a single industry, urbanization economies cross industry boundaries and can help increase efficiency and reduce costs for all firms in an urban area.

In large cities such as Toronto, dissimilar businesses will cluster together in order to share firms that provide business service inputs. These may include marketing firms, accounting firms, law firms, or even HR firms like the example I mentioned earlier. Hogg, Shain & Scheck itself is an example of this shared service input; we serve a wide variety of clients across a broad spectrum of industries. The provision of our expertise at a competitive price to so many different clients is made possible by urbanization economies.

Another important component of urbanization economies are the social and networking opportunities that come with living in a large, diverse urban area. As more people come together, it is more likely that there will be a critical mass of groups with similar interests. You may find more clients who you can easily identify with and who may be more appreciative of your services. You may find it easier to make friends with people who share your passions in Toronto than in, say, Woodstock. You may find more businesses selling things that you are interested in. The benefits of face time are extremely important in understanding why so many businesses crowd together; you want to be close to potential customers and to the experts who help run your business.

SO, CAN CITIES GROW INDEFINITELY?

It is easy to see the self-reinforcing effects of urbanization economies; after all, who wouldn’t want to be a part of an urban area where you can reduce your input costs, gain access to a larger market, and overall lead a happier life? Left to their own devices, without limitations, the largest cities would actually continue to grow at the expense of outlying areas, until the entire world resided within a handful of massive metropolitan areas. Of course, we know that this isn’t the case. Everything ultimately comes down to administration and transportation costs.

DISECONOMIES OF SCALE- HOLDING OUR CITIES BACK

We know the effects of urbanization economies draw in a huge number of people. While this is obviously positive for business, it also generates congestion, as people and goods must physically move around within an urban centre in order to reach their market. Cities may attract enough people and grow up to a point where the costs imposed on them by congestion outweigh the benefits of urbanization economies. In short, diseconomies of scale are the mounting costs imposed on people and business as an urban area grows, and eventually becomes too large.

These inefficiencies impose costs on business. For example, if you run a manufacturing business that depends on a Just In Time inventory system, you may find the delays brought about by congestion negatively impact productivity. If your workers travel between multiple locations and have to spend more time doing so, regardless of what your per-kilometer reimbursement policy is, you will have an overall less productive workforce if employees spend most of their time stuck in traffic.

Speaking of employees, workers also have costs imposed on them by congestion, manifesting in lost productivity or lost leisure time. Routine congestion may also cause frustration amongst your employees; people who have to give up leisure, sleep or gainful employment are more likely to come to work in a bad mood, and will generally be less productive. These high costs imposed on workers by long commute times in congested areas provide a disincentive to finding the perfect job. Workers respond by settling for jobs with inferior “fit” that just happen to be closer to home. When this happens, your business cannot take full advantage of specialization and knowledge spillovers because, through no choice of its own, it is physically limited to candidates within a certain commuting distance. This negates the whole point of setting up shop in an urban area to begin with; you can no longer fully take advantage of worker specialization and shared inputs. What we see is transport network inefficiency breeding labour market inefficiency!

Diseconomies of scale extend beyond transport networks; cities will become increasingly expensive to run as we need increasingly complex bureaucracies to control them. Eventually the cost of running the municipal government outpaces the benefits we receive.

BIG, INEFFICIENT, AND CHOKING ON CONGESTION

Neoclassical economists will tell you that once diseconomies of scale become sufficiently severe, people will move away, and the city will shrink back to a more efficient size. That would be fine, and it makes sense. If Toronto became too costly a place to do business, we should see a lot of companies moving out and locating back office operations in lower-cost centres like Winnipeg, London and Ottawa, while preserving high-value added operations that require face time in Toronto. But research actually suggests that cities have a tendency to remain artificially large rather than shrinking to an appropriate size. This implies that we all live in massive, inefficient urban areas that cause us more grief than they are actually worth. Which leads to an interesting question: have you ever thought about why your business must be located in Toronto? Is there an advantage to moving elsewhere? You may be concerned with working within the framework that you’re given, as are thousands of other owners and managers. This is why such a question is rarely asked, and why Toronto perhaps remains bigger than it should.

Next time, we’ll take a closer look at inefficiencies in transportation, particularly in Toronto.