EconPort - Why Cities Exist and How They Have Formed

In order to understand why cities exist we must first consider a world without cities. For there to be a place with no cities there must be equal productivity, constant returns to scale in production, and constant returns to scale in exchange. Equal productivity allows each person to be responsible for his or her self and there is no specialization in any one area thus there is no need for a city to develop.

The next thing necessary for there to be no cities is for there to be constant returns to scale in production. So if production is subject to economies of scale, then households will be more likely to involve a trading firm when trading their products. This is because trading firms will have the ability to effectively trade with lower transaction costs than if the household were to do it themselves.

The last necessary condition for cities to not exist is constant returns to scale in exchange. If there are scale economies in exchange then two households will link together and exchange the products in which they have a comparative advantage.

Once all three of these conditions are changed, a trading city will emerge. Different firms locate in different areas based on what type of transport costs they have. Most firms will choose to locate in a trading city because the benefits outweigh the costs. In a trading city a firm has access to a large customer base, good access to foreign markets, and a large labor pool. This outweighs the fact that in a city there are higher rents and the firms must pay their workers higher wages. There are two different types of transaction costs that affect where a firm will locate. Some firms have inputs that are cheaper to transport in the beginning than at the end and this is called material-oriented. When they focus on outputs this is called market-oriented and the companies will locate where the final product will be.

Let’s take away equal productivity first and see where that leaves us. If there are two regions that are not equally productive then it can be assumed that one area may be better in producing one or more products than the other region. This is called comparative advantage. If one region has a comparative advantage then it is more beneficial to produce that item and trade for another item that another region may have a comparative advantage in producing. To learn more about comparative advantage and trade visit the production possibilities section.

Considering constant returns to scale in production once more we can assume that production is subject to economies of scale. So, if a household were to specialize in one specific thing, then the inputs would be indivisible such as machines and workers could specialize in certain tasks thus leading to a higher productivity and lower costs all around.

The last condition for there to be no cities is to have constant returns to scale in exchange. Households can link together and directly trade, however with economies of scale in exchange trading firms will emerge because they ultimately have lower transaction costs.

Therefore, it can be seen that cities exist because it is beneficial to produce what you are good at and use trading firms to lower costs and trade with other cities that may specialize in something else. Because of this trading effect and the fact the firms cluster, larger cities will develop with a central business district.

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