2025 Reports

Granular Origins of Agglomeration

Kikuchi, Shinnosuke; O’Connor, Daniel G.

A few large firms dominate many local labor markets. How does that granularity affect the geography of economic activity and optimal place-based policy? To answer this question, we propose a new economic geography model featuring granular firms subject to idiosyncratic shocks. We show that average wages increase with the size of the local labor market due to that granularity, and we derive the optimal place-based policy. Using Japanese administrative data on manufacturing, we estimate our model and provide evidence consistent with our mechanism. Our mechanism implies that the smallest commuting zones have an elasticity of wages to population of 0.005. In large markets like Tokyo, the elasticity is around 0.001. Enacting optimal place-based industrial and wage policy would increase the number of people in the smallest cities, but the effect on the number of firms depends on firm conduct.