On the productivity advantage of cities

Abstract

Agglomeration externalities are the key factor explaining the existence of cities and their size. However, while the various micro foundations of agglomeration externalities stress the importance of total factor productivity (TFP), the empirical evidence on agglomeration externalities rests on measures obtained using firm revenue or value-added as a measure of firm output: revenue-based TFP (TFP-R). This article uses data on French manufacturing firms’ revenue, quantity, and prices to estimate TFP and TFP-R and decompose the latter into various elements. Our analysis suggests that the revenue productivity advantage of denser areas is mainly driven by higher prices charged rather than differences in TFP. At the same time, firms in denser areas are able to sell higher quantities and generate higher revenues, despite higher prices. These and other results we document suggest that firms in denser areas are able to charge higher prices because they sell higher demand/quality products. In this respect, two key elements related to this capacity to sell more at higher prices are the degree of vertical differentiation and trade cost, with products characterized by higher vertical differentiation and/or lower trade costs featuring stronger patterns and driving overall results.