Labor Market Density and Increasing Returns to Scale: How Strong is the Evidence?

Abstract

Models of economic geography posit that the density of economic activity has two effects that oppose each other in equilibrium: decreasing returns to productive activities due to congestion effects and increasing returns that result from information spillovers and local demand externalities. In an influential paper, Ciccone and Hall (1996) looked at the effect of county level labor market concentration on per-worker Gross State Product in a cross section of US States, and observed that on net, the increasing returns/agglomeration effect dominates. We extend their analysis and re-examine the relationship between density and productivity across industries and over both states and time. Through careful identification of the source and nature of productivity shocks, we show that the evidence for agglomeration effects is indeed quite robust, even within industries, providing evidence for the presence of Marshallian externalities. As for the balance of agglomeration and congestion effects found in previous literature, what we call net increasing returns to scale, the evidence is much weaker.