By Morris A. Davis, Jonas D. M. Fisher and Toni M. Whited
The authors construct a dynamic general equilibrium model of cities and use it to estimate the effect of local agglomeration on per capita consumption growth. Agglomeration affects growth through the density of economic activity: higher production per unit of land raises local productivity. Firms take productivity as given; produce using a technology that has constant returns in developed land, capital, and labor; and accumulate land and capital. If land prices are rising, as they are empirically, firms economize on land. This behavior increases density and contributes to growth. They use a panel of U.S. cities and our model’s predicted relationship among wages, output prices, housing rents, and labor quality to estimate the net effect of agglomeration on local wages. The impact of agglomeration on the level of wages is estimated to be 2 percent. Combined with their model and observed increases in land prices, this estimate implies that agglomeration raises per capita consumption growth by 10 percent.
This paper fits in a new line of research that tries to understand cities and agglomeration effects using dynamic general equilibrium models. The basis here is the good old Lucas-Prescott island model, the model is used to study the impact of agglomeration on prices (land, labor, goods). Would this explain why Tokyo and New York City are so expensive?