CHAPTER 4Scale Economies and Agglomeration T he most celebrated example in eco- nomics is perhaps the simplest. On the fi rst page of The Wealth of Nations, published in 1776, Adam Smith wrote of the benefi ts of dividing labor to make pins. A single unskilled worker with- out the benefi t of machines might make fewer than 20 pins in a day. But in a pin factory that Smith visited, 10 workers, who divided among themselves the 18 operations involved in making a pin, were produc- ing 48,000 pins a day. Rather than strug- gling to produce just a few pins a day, each worker was turning out almost 5,000. Later in Smiths classic work are two important qualifi ers: the gains from dividing labor are limited by market size, and not all activities exhibit increasing returns to scale. The ability to transport products wid- ens the market, so cities are located near the most natural and effi cient of transport systemswaterways. Places blessed with this natural infrastructure often do well, while other places must bide their time. As Smith wrote, There are in Africa none of those great inlets, such as the Baltic and Adriatic seas in Europe, the Mediterranean and Euxine seas in both Europe and Asia, and the gulphs of Arabia, Persia, India, Bengal, and Siam in Asia, to carry maritime commerce into the interior parts of that great continent: and the great rivers of Africa are at too great a distance from one another to give occasion to any considerable inland navigation.1 Besides, not all activities exhibit scale economies, and some do not need large markets to thrive. Subsistence farming is one such occupation, fruitfully carried out in villages. But such trades as manufactur- ing and commerce can be carried out only in bigger settlements, because they require access to both workers and customers. Caveats notwithstanding, the benefi ts of producing large quantities in a single plant or place have increased as transport costs have fallen in the two centuries since Smith visited the pin factory. Those who doubt the awesome potential of scale economies and how access to world markets helps exploit them should visit Dongguan, a city half- way between Guangzhou and Shenzhen in Southeast China. Until the 1980s it was a collection of sleepy villages in Chinas Pearl River delta. Since then it has rushed head- long into the world of increasing returns (see box 4.1). Every year, millions of peo- ple in the developing world enter this new realm and the implications, for them and for policy makers, are nothing short of revolutionary. This chapter summarizes the experience of entrepreneurs over the last two centuries in exploiting economies of scale in produc- tion. It focuses on “agglomeration econo- mies,” whose exploitation requires locating in areas densely populated by other produc- ers. It next provides a brief synopsis of about two decades of work by economists seeking to understand these scale economies work that has diminished the disconnect between research and the real world, and that yields valuable policy insights. It then assesses whether policy makers in the devel- oping world have been learning from this experience and analysis. 126 WDR09_10_Ch04.indd 126WDR09_10_Ch04.indd 12610/8/08 2:11:46 PM10/8/08 2:11:46 PM Scale Economies and Agglomeration 127 BOX 4.1 Scale economies in an almost unreal world: the story of Dongguan, China In 1978 what today is the city of Dong- guan in China s Guangdong province was but a collection of villages and small towns spread over 2,500 square kilome- ters on the Pearl River, midway between Guangzhou to the north and Shenzhen and Hong Kong, China, to the south. The area s population of 400,000 relied on fi shing and farming andthough not the poorest in Chinawas not especially prosperous. Today Dongguan is home to about 7 million people. More than 5 million of its residents are migrants who work in the thousands of factories that dot the city, churning out a wide range of products in such huge volumes that recent media accounts have assigned Dongguan the label of “factory of the world.” Dong- guan s economy has grown at more than 20 percent annually since 1980, and in 2004 its gross domestic product (GDP) was about $14 billiongreater than Iceland s. If one includes only registered urban residents (as in offi cial statistics), Dongguan s GDP per capita of $9,000 in 2004 made it the wealthiest city in China. Even if the city s fl oating population of migrant workers is included, its GDP per capita in 2004 was still more than $2,000. Dongguan s development since the 1970s, and particularly in the last decade, exemplifi es (perhaps in exaggerated fashion) the economic forces shaping East Asia s middle-income economies (see the table below). Location and favorable factor prices undoubtedly spurred Dongguan s early growth. For the fi rst decade and a half after China s reforms began, small and medium enterprises from both Hong Kong, China, and Taiwan, China, were attracted t