The productivity-enhancing effects of industrial agglomeration have attracted great attention in policy circles. For instance, the French government spent

Theoretical analysis
Partly for consistency with earlier product-quality representations, we extend Berry’s (1994) logit demand framework by introducing a product quality dimension to the firm’s strategic decision-making. Quality is defined as a demand shifter that boosts consumer willingness to pay. If one good is perceived to be of higher quality than another, its demand is greater even if the two have the same price.

In our study, product quality is varied through a suitable adjustment in the firm’s marginal and fixed costs. Antoniades (2015) argues that research and development (R&D) investment – affecting the firm’s fixed expenses – is the key ingredient to the kind of innovation that upgrades quality. By contrast, Fan et al. (2015) reason that it is an intensive use of inputs, and hence a high marginal-cost that is responsible for output quality growth.

We find that since agglomeration economies – modelled as the productivity-enhancing externalities – reduce marginal costs and lift marginal products, and since each additional production dollar affords more inputs, urban firms will market both more and better-quality outputs than rural firms. Stated differently, agglomeration economies boost firms’ profits directly by improving productivity, and indirectly by improving product quality (Figure 1).

Figure 1. Agglomeration economies and profits





Product quality also has important implications for the measurement of agglomeration economy benefits. Earlier studies, as part of efforts to predict the effectiveness of policies that attract agglomeration, have often examined their impacts on total factor productivity (TFP). However, if quality upgrading requires increased input use, TFP underestimates agglomeration benefits because it does not count the benefits’ contributions to quality enhancement. To put this differently, TFP-based empirical evidence of agglomeration economies is underestimated if firms place a high priority on quality enhancement.

Empirical analysis
The theoretical finding that product quality improves with market size motivates us to empirically explore the relationship between regional market size and quality improvement. In doing so, we follow Khandelwal (2010) to estimate product quality at each plant, employing plant-product-level data in Japanese manufacturing.

The Census of Manufactures, published by Japan’s Ministry of Economy, Trade and Industry (METI), is the primary data source in this study. Using its microdata, we construct a panel of individual plant-products from 1994 through to 2007. As for market size variables, following earlier studies of agglomeration, we consider two types of externalities: localisation economies, and urbanisation economies. A firm’s localisation economies are the productivity-enhancing externalities it enjoys arising from the spatial concentration of firms in its own industry, and its urbanisation economies are the economies it enjoys arising from the concentration of all firms in the region.

By regressing the estimated product quality on variables reflecting regional market size, we find statistically significant evidence that urbanisation economies enhance product quality. Quantitatively, agglomeration quality impacts are quite large: one third to one half of the observed quality variation is explained by agglomeration economies. Moreover, the agglomeration impacts are more pronounced for small and medium-sized firms, suggesting that they are more dependent on local economic conditions than their larger counterparts. These results are robust to simultaneity bias – arising from the decisions of firms already producing a high-quality good to relocate into a city – between market size and unobserved economic shocks on plant-product quality (Picard and Okubo 2012).

Together with the finding that urbanisation economies have positive and statistically significant impacts on a product’s market share, our empirical evidence suggests that both product quality and market share rise with market size.

Conclusion
We find that policies to attract new firms to a market area can have very strong product-quality implications. New arrivals to an urban area have an incentive to allocate their received agglomeration benefits to quality as well as productivity. This extra benefit can provide an extra incentive to agglomerate, intensifying the benefits enjoyed by the market incumbents, and reinforcing the positive externality feedback.

To improve the effectiveness of agglomeration subsidies, policymakers need to pay greater attention to the kind of industries they wish to attract. In those in which quality improvement requires increased input use, TFP underestimates agglomeration benefits by ignoring the incentives it provides to improve quality. So long as they are based solely on entrants’ likely TFP gains, agglomeration subsidies therefore will be biased toward industries in which quality is not a principal concern. Geographic market policies will underperform until cognisant of agglomeration’s quality dimension, allowing a proper balance between the quality and productivity factors that maximise overall competitiveness.

Editors' note: The main research on which this column is based appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan.

References
Amiti, M, and A Khandelwal (2013), “Import competition and quality upgrading”, Review of Economics and Statistics, 95: 476–490.

Antoniades, A (2015), “Heterogeneous firms, quality, and trade”, Journal of International Economics, 95: 263–273.

Berry, S (1994), “Estimating discrete-choice models of product differentiation”, RAND Journal of Economics, 25: 242–262.

Fan, H, Y Li, and S Yeaple (2015), “Trade liberalization, quality, and export prices”, Review of Economics and Statistics, 97: 1033–1051.

Hayakawa, K, T Matsuura, and S Takii (2015), “Does trade liberalization boost quality upgrading? Evidence from Indonesian plant-product level data”, IDE Discussion Paper, No.540.

Khandelwal, A (2010), “The long and short (of) quality ladders”, Review of Economic Studies, 77: 1450–1476.

Martin, P, T Mayer, and F Mayneris (2011), “Spatial concentration and plant-level productivity in France”, Journal of Urban Economics, 69: 182–195.

Nishimura, J, and H Okamuro (2011), “R&D productivity and the organization of cluster policy: An empirical evaluation of the Industrial Cluster Project in Japan”, Journal of Technology Transfer, 36: 117–144.

Picard, P M, and T Okubo (2012), “Firms’ locations under demand heterogeneity”, Regional Science and Urban Economics, 42: 961–974.

Saito, H, and M Gopinath (2009), “Plants’ self-selection, agglomeration economies and regional productivity in Chile”, Journal of Economic Geography, 9: 539–558.

Saito, H, and T Matsuura (2016), “Agglomeration Economies, Productivity, and Quality Upgrading”, RIETI Discussion Paper, 16-E-085.

Timmer, M, A Erumban, B Los, R Stehrer, and G de Vries (2014), “Slicing up global value chains”, Journal of Economic Perspectives, 28: 99–118.

World Bank (2009), World Development Report 2009: Reshaping Economic Geography, Washington, DC: The World Bank

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