Optimal cities with indivisibility in production and interactions between firms

Abstract

A fundamental question in urban economics is why cities exist. We show that we can obtain agglomeration economies simply by combining the exchange of intermediate inputs with indivisibility in production. In our model, interactions between firms are market transactions and do not represent externalities in the usual sense. Combining them with indivisibility, however, creates locational externalities. The optimal allocation requires Pigouvian subsidies to firms, and the externality version of the Henry George theorem holds in our model. We also obtain conditions for a monocentric configuration and perform comparative statics exercises.