of scale arise as firms and infrastructure operate at scale. There is evidence that provision of infrastructure is much cheaper, per person, in dense urban areas than dispersed rural ones.<sup>5</sup> The other driver is a set of **_agglomeration economies_** that are generated by close and intense economic interaction. These arise through several different mechanisms. Thick labor markets enable better matching of workers to firms’ skill requirements. Better communication between firms and their customers and suppliers enables knowledge spillovers, better product design and timely production. A larger local market enables development of a larger network or more specialized suppliers. Fundamentally, larger and denser markets allow for both scale and specialization.

A good example is given by specialist workers or suppliers. The larger the market the more likely it is to be worthwhile for an individual to specialize and hone skills in producing a particular good or service. The presence of highly specialized skills will raise overall productivity. The specialist will be paid for the product or service supplied but, depending on market conditions, is unlikely to capture the full benefit created.<sup>6</sup> Since the benefit is split between the supplier and her customers there is a positive externality. And this creates a positive feedback – more firms will be attracted to the place to receive the benefit, growing the market, further increasing the returns to specialization, and so on. This is the classic process of cluster formation.

The benefits of proximity are a force for increasing returns, but proximity also has **_costs_** , particularly in the urban context, creating a force for decreasing returns. Clustering of firms increases commuting costs for workers who may have to travel far to employment centers such as the central business district. These costs are exacerbated by congestion – a negative externality – and other costs of close urban living. Land becomes the scarce factor and housing consumption (floor-space per household) is reduced. However, it is important to note that high land rents and land prices are not a real cost; they are a transfer payment from occupants of land to its owners, so do not use up real resources (as does time in commuting).

Location choices – be they by firms or by households – are typically major decisions, with large sunk costs and, if structures are being built, creating long-lived assets. **_Expectations_** of future returns are therefore critical, and agglomeration economies mean that the returns to investing in a place depend on who else is (or is expected to be) there. This in turn creates a **_first-mover problem_** : no one wants to move to a new place while uncertain about its future development. There is inertia

> 5 For example, estimates contained in Foster and Briceno-Garmendia (2010) suggest that the per capita capital cost of providing a package of utilities and infrastructure may be five times higher in a low-density city than a highdensity city, and ten times higher in rural areas (Foster and Briceno-Garmendia 2010, Table 5.6).

> 6  The supplier will capture the full benefit only if able to perfectly price discriminate.  Otherwise, the customer will also receive some consumer / user surplus on the introduction of a new product.  This observation is central to the wide range of economic models in which the number and variety of goods and services offered is endogenous (following Dixit and Stiglitz 1977).

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