The term economies of agglomeration is used in urban economics to describe the benefits that firms obtain by locating near each other ('agglomerating'). This concept relates to the idea of economies of scale and network effects. Simply put, as more firms in related fields of business cluster together, their costs of production may decline significantly (firms have competing multiple suppliers, greater specialization and division of labor result). Even when competing firms in the same sector cluster, there may be advantages because the cluster attracts more suppliers and customers than a single firm could achieve alone. Cities form and grow to exploit economies of agglomeration.
The term 'diseconomies of agglomeration' refers to the opposite case. Additional competition drives down pricing power. For example, spatially concentrated growth in automobile-oriented fields may create problems of crowding and traffic congestion. It is this tension between economies and diseconomies that allows cities to grow while keeping them from becoming too large.
Agglomeration economies are closely associated with economies of scale and the network effects mentioned above. It is important to understand that a positive outcome of agglomeration economies will only be achieved if the benefits outweigh the disadvantages. The ultimate end to agglomeration economies is the formation and growth of a city. The processes and factors contributing to the formation and growth of cities are considered here in the types of economies that are formed, their sources that are the contributing factor, network linkages, and the advantages and disadvantages that may or may not occur in the growth and formation of cities.
In simple terms, the basic concept of agglomeration economies is that production is facilitated when there is a clustering of economic activity. Although this may be true, the reality is that the existence of agglomeration economies is central to the explanation of how cities increase in size and population, which places this phenomenon on a larger scale. This concentration of economic activity in cities is the reason for their existence, and they can persist and grow throughout time only if their advantages outweigh the disadvantages. It is significant to understand why these advantages allow for the persistence of cities.