Firm location choice and cities

We have seen a vast increase in the number of people residing in urbanised areas in the last two centuries. It rose from about 7.5 percent in 1800 to more than 50 percent nowadays. The number of urban megapolises is steadily rising: cities like New York, London, Tokyo, Mumbai and Rio de Janeiro become an increasingly common sight. Also in the Netherlands we observe that the biggest three cities in the Netherlands tend to have a surprisingly strong growth in the population in the last years (see article here).

The foremost question for urban economists, and economic geographers alike, is why cities exist and why they are still growing. This intellectual quest has been pursued for already more than a century by a wide variety of scholars. The great English economist Alfred Marshall argues that the most important reason why firms (and people) agglomerate is a reduction in transport costs. Firms can lower the costs of moving goods, people and ideas by agglomerating in an urban area.

More specifically, firms may locate near suppliers and customers to save shipping costs. In the nineteenth century many cities evolve around transport nodes like railway stations and waterways. For example, most of the industrial concentration in Rotterdam was due to the seaport.

Second, a large urban area often implies a large and diverse labour market. Large labour markets like Amsterdam and Rotterdam are offering a wide array of different jobs and give workers the opportunity to specialise. For specialised workers it is easier to switch between employers and for employers it is easier to find specialised workers.

A third source of so-called agglomeration economies is the exchange of ideas. Firms learn from each other and this increases the rate of innovation. A main example is Silicon Valley’s computer cluster where the ICT revolution started. It has been shown that employees in Silicon Valley often switch between jobs, which increases the likelihood that knowledge acquired in one firm is used in another.

It may be argued that agglomeration due to low transportation costs of goods is not so important anymore, as the costs of transporting physical goods have declined with more than 90 percent in the last century. Nevertheless, the transportation costs of moving people (commute time) and ideas are still high.

 All these agglomeration forces predict a positive relationship between density and productivity of firms. When firms are more productive at certain locations they can afford to pay higher rents. When agglomeration forces are still important, one expects to see high rents at locations that have high employment densities. Many of the most expensive office locations in the Netherlands, like the Amsterdam South-Axis, Rotterdam Weena and Schiphol, have very high employment densities. We have investigated the relationship between employment density and office rents in the Netherlands using a large dataset on rents of offices and industrial buildings, obtained from Strabo. The figure below shows that there is a (significant) positive relationship between commercial property values and density.


One may argue that this positive relationship between employment density (or: agglomeration) may be explained by other factors like the concentration of specific types of buildings of locations, place based policies or natural advantages. I therefore run several regressions with loads of control variables and use so-called instrumental variables. This should identify a causal link between employment density due to agglomeration forces and rents. I then find that  doubling of employment density leads to an increase in rents of about 10-13 percent.

What is interesting is that this effect is much stronger in dense areas and is about zero in rural areas. Many location based policies aim at attracting firms to deprived low density areas (think of the structural EU funds). My results, however, suggest that a euro invested in a rural areas is much less efficient than a dollar invested in a dense urban area, due to the positive externalities in the latter area.

What is more, I find that agglomeration economies are only important in the office market, rather than in the market for industrial buildings. This is not too surprising as industrial buildings are often located in low-density low-rent areas where agglomeration economies seem to be less important, whereas firms in offices likely rely much more on costly face-to-face contacts

Click here for the working paper

Click here for another paper on agglomeration economies