ABSTRACT
Intermediate industries of an economy have recently come into focus. These industries are, for instance, essential in numerous recent models dealing with what is sometimes called the economics of cities or the economics of agglomeration (Fujita and Thisse, 2002). The set-up in these types of models is usually such that the production function of the final industry exhibits increasing returns in the number of intermediate inputs. This is achieved by using the monopolistic competition model developed by Dixit and Stiglitz (1977) with a conventional CES aggregator over the varieties of the intermediate industry. In this manner, the performance of the final industry depends on the performance of the intermediate industry (which operates under a monopolistic competitive regime). One of the advantages of this modeling structure is that it makes it possible to show that the final industry, in the aggregate, experiences increasing returns in the labor force of a region.1 Thus, it allows for an explanation of the relationship between ‘size’ and productivity, which in itself is an explanation of why we observe cities. Furthermore, in the cluster literature the formation of a set of specialized input suppliers located in the neighborhood of a localized industry is used as an explanation of why firms localize in the first place. Specifically, this is one of Marshall’s (1920) three famous reasons for co-location, the other two being a pooled labor market and information spillovers. Holmes (1995) presents empirical support of this effect. The author finds that establishments located in areas where there are many other establishments in the same industry tend to use more purchased inputs than establishments located in areas with less establishments in the same industry.
