An Evaluation Of Agglomeration Economics

“There are a number of advantages that may be enjoyed by firms who locate near other firms. These advantages are known as agglomeration economics or external economies of scale.” (Helsley 2003) These advantages are known as external because they do not arise from the company itself, but from the external environment. Similar businesses that locate close to each other can produce more efficiently and at a lower cost due to their ability to specialize, access to resources, decrease in transportation and access to knowledge and information.

Two examples of areas that have benefited from the agglomerating of economies are the oil and gas industry in Alberta and the Auto industry in Detroit. These industries arose in their specific locations for different reasons but both share the common conditions of economies of scale and agglomeration economics. Both of these industries take advantage of the locations by producing more efficiently and maximizing profits.

The Oil Industry in Alberta

The most renowned oil discovery in Alberta that really propelled the industry was made by Imperial Oil 1n 1947 when they struck oil near Leduc. (ucalgary.ca) Oil was however discovered in Alberta much before then. In the 1910’s a farmer at Okotoks discovered gas and then later in the 1930’s oil was discovered beneath the gas fields. Because of these two discoveries international oil companies began operations in Alberta, and in 1923 and 1939 Imperial Oil and British America Oil built refineries in Calgary. In 1938 the Alberta government set up the Alberta Energy Conservation Board in 1938, this led the way for Calgary’s development of being the main administration center for the oil and gas industry in Alberta. These early discoveries helped turn Alberta from one of the poorest provinces in the Nation into the multibillion dollar empire that it is today. The reason that the oil and gas industry settled in Alberta was because of geographic location, this is where the bulk of the oil and gas in the county resides. Because this industry is based on extraction and processing of a raw resource it needed to locate where the resource is. However government policy has also helped shape the industry. Government policy, both at the provincial and federal levels have impacted the oil and gas economy. Like I previously mentioned the provincial government in 1938 set of the AECB and this chose Calgary as the main administrative head for the industry. More recently other government programs have also helped shape the industry by opening up markets and access to labor, NAFTA is an example of this.

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Once the industry starts growing it creates many positive externalities that fuel the feedback loop which in turn grows the economy some more. There are now several areas of the province that have specialized even further and are now seeing their own agglomeration economics some examples of this are the oil and gas headquarters in downtown Calgary and Alberta’s Industrial Heartland north east of Edmonton. This area consists of many companies specializing in the petro chemical industry. These companies locating in close proximity greatly reduces their pipe line costs because they can all share one major pipeline and then just build minor lines to each of their plants. In Calgary having so many companies in close proximity greatly increases the speed to which communications and knowledge can be transferred and it also greatly reduces search costs for firms looking for skilled labor. Having the oil industry focused in Alberta has also helped in greatly expanding research and training programs for the industry. Much of this has been developed out of necessity because extraction is becoming more and more difficult and companies need to specialize further and further, directional drilling and the oil sands are examples of this.

The oil industry has grown into one of the most influential sectors in the county, and has left Alberta, with its newly found financial security to be admired. There are many factors such as a stable government, government programs and incentives and new knowledge and technologies that have all helped shape the industry into what it now is. However it is impossible to try and over look the obvious fact that the industry is located where it is because of access to the valuable resource beneath Alberta’s soils. Alberta has been able to create this powerful agglomerated economy because of the simple fact that the province contains massive reserves whether they be shallow gas or the Oil Sands of Fort McMurray.

Detroit’s Auto Industry

Detroit or “Motown” is the leading Vehicle manufacturer in the United States. It was not always this way however. The first gas powered automobile was manufactured is Springfield Massachusetts in 1896. The first automobile to be built in Detroit was manufactured by Olds in 1899. But by 1904 42% of automobiles were built in Detroit and then by 1914 this number rose to 78%. (McDonald 2007) From 1900 to 1930 the population of Detroit grew rapidly from 305 000 to 1 837 000 people this was greatly related to the fact that by 1929 the Auto Mobile industry in Detroit was the largest industry in the Country. In 1909 there were over 200 automobile manufacturers in the United States this number however dropped rapidly until it was basically just the three based out of Detroit; General Motors, Ford and Chrysler. There are a few other factors that some have contributed to the successes of Detroit, such as the fact that Detroit is a major shipping port and this would give them access to cheap transportation of raw resources, parts and markets. While geographic location may have played a minor role in the Auto industry in Detroit it is widely recognized that it is not a key element in Detroit’s success. (Klepper 2001) The main reason is just the fact of Agglomeration Economics. Early automobile manufacturers were set up all over the county, the ones that became the most successful just happened to be the ones that were setup in close proximity.

Detroit already had a shipping industry which meant that there was already skilled mechanics that knew gas engines, this gave the auto industry access to these skills. There was also already manufacturers in place that could build engines and parts. Because there were so many manufacturers in close proximity this is were people began moving to find work, because with so many companies close together it created the highest odds of finding a job. There was also spill over knowledge that other companies could learn from, such as Henry Fords famous invention the assembly line. This greatly decreased cost and speed up the time in which an auto could be manufactured. In 1910 it is said that the assembly line lowered the cost to produce one Model T from $780 – $360. (McDonlad) Once the other manufactures in Detroit saw the great success of this they soon implemented assembly lines.

2

There are many benefits to businesses that relocate to a place where there is an agglomerating economy. The most obvious advantage is economies of scale. When an industry grows large enough companies start to specialize. When a market is large enough and companies start to specialize then costs are reduced. In the auto industry if there are part manufacturers and that is all they specialize in then the auto manufactures may be able to buy products such as bearings for less than they could produce them internally. Or for say the oil industry there might be some sort of drilling problem and a company needs a special piece of machinery, it doesn’t make since for them to buy it for just one problem but there is probably another company that has specialized in that piece of machinery so it is cheaper just to hire them. Production costs are also greatly reduced in an agglomerated economy because of a reduction in transportation costs, both of people and material. In the case of the Industrial Heartland they can all share pipeline costs instead of having to all build their own, this greatly reduces costs. As well if there is enough industry located in an area it also may become more economical to have a rail line put in. As well it makes more sense to have refineries built in Alberta because this is where the oil production is so it saves on shipping raw resources. As well in both instances it greatly reduces on the cost of the transfer of knowledge. When an automobile company has a great new idea or a production technique and you are located near them, then the likely hood of finding out about the idea and benefiting from it is much higher. As well in either instance if you have a problem and need help there is probably someone close to you that has had experience dealing with that issue, or there might be specialized think tanks set up for the industry. When you are working in an area that is very technical it is important to have access to the best minds and new technology. As well when you have all of this knowledge and experience at your finger tips it doesn’t feel as if you’re alone, you are working under years of past experience that has greatly reduced the risk for your business in the industry. In this case there is a major advantage compared to someone opening a business far away from the major area of influence.

As well as there being benefits to the business and industry as a hole there are also advantages of agglomerated economies for employees. For instance if you were looking for a job in an automobile factory, you would prefer to go to a city where that are 5 factories then go to a city with only one, your chances of successfully finding a job increase if there are more possible positions. As well when there are more jobs in an area an employee can pick and choose and find the position that most closely matches his or her skill set and desires. If there are more jobs this also increase opportunities for an employee to leave and go and work for the competitor this causes employers to have to increase pay or working conditions in order to retain their employees. There are other positive externalities along with this, once workers start to concentrate in an area then other amenities such as restaurants and shopping malls will follow.

Agglomeration, however, may have a few drawbacks. It may cause an area to become to undiversified, such as Alberta we just recently witnessed that a drop in the price of oil causes a relapse in the entire province. Or for Michigan a drop in Auto production has caused a collapse in almost the entire city. Since 2000 there has been a decline of over a half million jobs in Detroit this has left vast areas of the city vacant and there is even entire office buildings in Detroit’s downtown which have been left vacant. As well there is a term called “dissagglomeration” (Fritzgerald 200) In this instance a region becomes so successful that it loses its cost savings appeal. An example of this is when it becomes so competitive in an area that it drives real estate prices so high that it becomes no longer economical to locate in that area. This has become evident for many workers in Alberta, housing prices have skyrocketed in areas such as Calgary’s downtown and employees now have to make major commutes. As well along with booming business and successful employees comes the proliferation of crime and human density increases and congestion.

3

In respect to the two examples of agglomeration used above they have affected their respective regions differently. Alberta’s oil patch is booming along with this there is an abundance of well paying jobs. We have seen an increase in the number of engineers and other educated students want to enter this field, however we have seen an even larger number of students either drop out of high school or go straight from high school to the oil industry because education is not needed in order to get a well paying job. So, over all there seems to have been a decline in the importance of a post secondary education. There has also been an increase in movement of Canada’s uneducated into Alberta to find jobs. The population density in Alberta has drastically increased due to the Oil industry and this has brought problems such as pollution with it. However, even though there are some drawbacks the Oil and gas Industry definitely needs to be attributed to the financial success and national importance of Alberta.

In Detroit however it seems to be a different story. Historically the affects would seem to have been the same, Detroit was highly successful attracted a lot of employees and would have been extremely nationally important because it was contributing so much to the economy. Now however Detroit seems to be dying. The reason for this is the slowdown in the Auto industry. The crash of the Auto industry cannot be linked to agglomeration, the crash of Detroit however can be partly. Because of agglomeration Detroit did not diversify its economy very well the Auto sector seemed too powerful and lucrative to worry, now however with the slow down, we are seeing massive layoffs and vacant homes.

Part 2

1

This clustering of businesses would be considered examples of agglomeration economies. However I feel that not to the same extent, because they would not experience as many benefits as the agglomeration of an entire industry. They do however reduce some costs and have some added benefits. By clustering business can better monitor market trends, monitor their competition, as well they may be able to cluster in terms of safety and to help watch and guard each others merchandise and lots. The big benefit though is that a multiple of stores can better attract customers then a single store off by itself. By clustering consumers can spend less on transportation and they will be more inclined to visit the area with the most stores for shopping ease. Because of the scale there are some benefits that I feel they do not get to experience, such as a decrease in start up costs and a decrease in raw material costs. Two examples of this type of agglomeration would be the Auto Mile in Wetaskiwin Alberta;

A – Toyota City

B – Pioneer Chrylser Jeep

D – Schwabs Chevrolet

F – Denham Ford Sales

G – Spruce View Motors

H – Union Motors

As well as bars along the “red mile” in Calgary, 17th ave sw;

Left to Right:

Morgans Pub

Mugs Restauraunt

Beckham’s Pub

Watchman’s Delivery

Red Mile Creamery & Desserts

Melrose Café & Bar

Ship & Anchor Pub

Bob the Fish Tavern

Rose & Crown Pub

The Auto Mile in Wetaskiwin is well known and is recognized by its own Advertisement “Cars cost less in Wetaskiwin”. This shows that the area is not just known for a single dealership, it is known because there is many dealerships together and that attracts business. As well it is the same for the Red Mile customers want to go and walk down 17th ave because there is a lot of pubs and restaurants. Because there is a variety it attracts more customers then if there were just one business, even though when there are many businesses they will have to compete for business.

2

Harold Hotellings model is based mostly on transportation costs and price. Rather than positive externalities of being side by side. Hotelling assumes that customers choose were to purchase their product based on the cost of the good plus transportation, add these together and pick the less expensive. Because of this firms will set up in the same central location to maximize exposure and avoid being placed between two other stores and getting squeezed out. According to Hotelling firms choose their location based strictly on maximizing the amount of people in their area relative to the competition. Two examples of this are Fast Food restaurants and gas stations. In both these cases competitors either tend to be side by or across the street from each other. So even though in both of these cases it is the firms locating close to one another it is for very different reasons. In the Hotelling theory firms cluster for competitive reasons and in agglomeration economics they cluster for the economic benefits and economies of scale.

3

Benefitting from clustering or not is most likely a case by case scenario. It will not be the same for all types of industries and will need to be calculated on a case by case basis. No matter what the case, competition will increase by clustering and this should lower prices. In the Hotteling model the decreased prices are offset by the increased customer base that clustering creates so it all depends on whether or not this does indeed offset the reduced prices. Agglomeration economies on the other hand benefit from reduced costs, greater people, information etc. In agglomeration economics the benefits are always supposedly positive otherwise they would not hold true and business would relocate to be close to one another. The Hotelling model is based on competiveness where as agglomeration economics are based on maximizing benefit.

4

I believe that whether or not firms cluster and how they benefit from it or not is largely dependent on what level of the economy they are in and what type of good. It would seem that manufacturing level firms would benefit from clustering through agglomeration economics. These are the firms such as oil and gas refineries and automobile manufacturing. They have highly substitutable products and they do not market to the end consumer, and therefore would greatly benefit from the reduced costs. Where as an industry like the clothing stores market directly to the end consumer and therefore benefit from increased exposure and differentiation and therefore benefit from clustering through the Hotelling model. The areas within a city where this type of clustering occurs are normally very high traffic areas with lots of people.

In terms of agglomeration economics I do not feel that a large anchor tenant is required, these businesses are generally not looking for attention they are just wanting to produce at a low cost. Where as in an area with clusters of consumer goods stores, an anchor tenant may be helpful. But I do not know if it would be necessary. If for instance a large store may not need to be in a cluster, they might attract enough attention by themselves and people will travel, where as if you a minor store then you probably would need to be a cluster to attract business to your store.