Quarter 4, 1998
by Jed David Kolko

In the long run, local industries play a key role in a region's economic character and prospects for growth. Advantages (or disadvantages) conferred by industrial patterns can persist for decades, even centuries. And new technologies and industries are likely to be born near the older industries that inspired them.

Traditionally, local concentrations were in manufacturing industries; increasingly, they are in services. Manufacturing now accounts for only 19 percent of New England's private nonfarm employment, down from 30 percent twenty years ago. Services, both business services (such as advertising, management consulting, software and data processing, finance, and insurance) and consumer services (such as entertainment, education, and health care) account for 46 per- cent of all jobs. Together, they grew at more than 4 percent per year between 1977 and 1995, both nationally and in New England. Services employment in New England is particularly concentrated in its larger, urban areas. Hartford is the Insurance City, while Boston is the locus of mutual funds and universities.

Many worry that New England's reliance on service industries leaves the region dependent on low-wage, dead-end jobs. They also worry that many of the "better" service jobs, such as in consulting or financial services, will eventually go the way of manufacturing, moving from larger to smaller cities, and then to rural areas, as new communications technologies allow firms to leave costly urban locations, yet stay in touch with clients.

But for many service jobs, pay is relatively high. The U.S. average hourly wage in business services, $12.30, was comparable to that of manufacturing; the average wage in consumer services, $10.58, exceeded that in retail trade.

Moreover, there are good economic reasons why service industries cluster in large cities. Locating near each other facilitates the face-to-face exchange of information and knowledge, creates specialized labor markets, and takes advantage of large consumer markets. Business services, to a greater degree than manufacturing, depend on skilled workers, who are disproportionately found in cities. Business services require relatively little land and so can better manage urban rents. And, perhaps most important, business services tend to "co-agglomerate." They buy from each other as well as sell to manufacturing firms. Thus, the presence of other business services in big cities discourages any one industry from moving away.

SERVICES IN NEW ENGLAND

"Made in New England" used to mean shoes and computers; now it means services, especially business services. Finance, insurance, and education are all overrepresented in New England. With 7,300 people working in mutual funds and asset management and another 23,000 in investment advisory services, New England accounts for 31 and 19 percent of total U.S. employment in these industries, respectively, even though it has only 5.6 percent of all U.S. jobs. Insurance, which employs an additional 155,000, is also concentrated in New England, although increasingly less so. And, "Made in New England" also means consumer services — almost three times as many universities, libraries, and museums are in New England as one would expect if these services simply mirrored the distribution of the population.

As in the nation, New England's services tend to be concentrated in the largest cities. In Suffolk County, Massachusetts, which includes Boston, 35 percent of the workforce is in business services, nearly twice the national average of 18 percent. Other business services centers are also located in urban, densely populated areas: Hartford; the counties next to Boston (Middlesex and Norfolk); and the portion of Connecticut nearest New York City (Fairfield County). Consumer services tend to be more evenly distributed, with the only significant New England concentrations in Boston and in Newport, Rhode Island. Boston, like many big cities, is a center for entertainment and for social services; Newport is a center for tourism.

And, both nationally and in New England, particular cities tend to specialize in particular services. For example, Boston specializes in mutual funds and other financial services. Its finance industry, which has grown 9 percent a year over the past two decades, is New England's most highly concentrated service industry, more concentrated than the better-known cluster of insurance companies in Hartford.

Hartford's insurance industry is the region's second major service specialty, and it spans a range of products, including life insurance, medical insurance, fire/marine/casualty insurance, and pension funds, all concentrated there. Hartford has lost some of its importance as an insurance center, however, with industry employment up an average of only 0.7 percent per year over the past two decades, as compared to 1.7 percent per year nationally.

Cambridge, Massachusetts, and neighboring towns focus on universities, the region's third major cluster. In this area (Middlesex County) are Harvard, MIT, Tufts, Brandeis, and Boston College. The concentration spills over into Boston, with Northeastern, Boston University, Suffolk University, and the University of Massachusetts-Boston. This specialty in education has also fostered the development of two related clusters: computer and data processing services, and research and testing services. These industries still maintain close relationships to universities, both serving and being served by them.

WHY ARE SERVICES CONCENTRATED?

Service industry concentrations are, on average, younger than manufacturing concentrations, in part because the prominence of services is a relatively modern phenomenon. But New England's three major service concentrations have histories that rival the best-known manufacturing concentrations. All three began in the city where they remain focused today.

The American mutual fund industry started in Boston, as wealthy local investors (who had made their fortunes in manufacturing and trade) sought new ways to invest their money productively while spreading risk. The first fund was the Massachusetts Investment Trust, founded in 1924; today, Fidelity, Putnam, and Scudder are the largest firms in Boston's best-known service industry. The Hartford insurance industry began even earlier, in the late eighteenth century. Local merchants insured each other's overseas trading expeditions by sharing their profits and losses. These informal arrangements eventually grew into large insurance companies, starting with the Hartford Fire Insurance Company in 1810. Other major Hartford insurers, including Aetna, Connecticut General, and Travelers, were founded in the early and middle 1800s.

The region's cluster of universities, centered around Cambridge, Massachusetts, has an even older heritage, perhaps the oldest of any industry in the country. Harvard University was founded in 1636 and remained the nation's only university for decades. Even as population shifted west, Harvard maintained its position among the nation's most prestigious colleges, and other universities were established in Cambridge and surrounding towns, including Tufts (1852), MIT (1861), and Brandeis (1948).

Universities encouraged the development of other service industries. The computer and data processing industry, anchored in Cambridge by Lotus, began near MIT, and countless smaller firms were started by MIT graduates and faculty. Commercial research and testing services congregated near MIT and in Harvard Square, reflecting the role that universities played in their success.

So, history, even happenstance, matters. But, why did these industries continue to cluster? First, firms locate near each other in order to share ideas and information face to face. These "intellectual spillovers" are the products of formal meetings and spontaneous encounters. Particularly in growing and rapidly innovating industries, nothing can replace the happy hour at the local pub or the unplanned brainstorming at the gym or on the golf course. Every high-tech industry has its tale of the brilliant idea that began with a doodle on a cocktail napkin. To benefit from intellectual spillovers, firms need to be close enough to guarantee regular face-to-face contact, say, in the downtown area or even in a part of a city.

Firms also locate near each other to have access to an industry-specific labor force. Called "labor pooling," this works best if firms in an industry do not expect to do poorly at the same time. In that case, more firms in an area mean a reduction in the overall volatility of labor demand. Workers benefit from lower unemployment rates. Firms benefit by having a dependable supply of specialized labor when demand increases. To benefit from labor pooling, firms need to be close enough to share the same labor market, perhaps within the same metro area or county, but not necessarily in the same neighborhood or town.

So, why aren't service industries completely concentrated? Why isn't every insurance firm in Hartford and every mutual fund in Boston? Just as there are reasons to cluster, there are opposing forces that cause firms to disperse. First, services are often consumed in person and cannot be transported. This is most obviously true for consumer services, such as doctor's visits and haircuts. But many business services, such as advertising and legal services, also depend on regular personal contact for making deals and delivering products. In that case, the cost of "shipping" a consultant or lawyer is high enough that markets stay local.

Second, the high land prices that can result when many businesses want to locate in the same area may ultimately provide an incentive for firms to disperse. Most industries are relatively small, so clustering has only a small effect on local land prices. But large, geographically concentrated industries can drive land costs high enough so that some of the firms move away — witness the movement of some financial firms from Wall Street across the river to New Jersey and into Connecticut.

The overall level of geographic concentration of an industry depends on the relative advantages and disadvantages to clustering. Mutual funds and insurance companies tend to operate in a national market; the disadvantages of concentration are slight, and the result is strong concentrations in Boston and Hartford.

But finance and insurance are exceptions. Service industries tend to be less geographically concentrated than manufacturing industries. Measured at the county level, business services are only half as concentrated as manufacturing; consumer services are one-sixth as concentrated. In part, this is because manufactured goods tend to be sold nationally, and prices that firms charge do not depend on whether competitors are nearby. Also, manufacturers often locate near essential raw materials (like wineries in California or cigarette makers in North Carolina). Since services rarely depend on raw materials, they don't have the same incentive to cluster.

WHY ARE BUSINESS SERVICES CONCENTRATED IN LARGE CITIES?

Not only are business services concentrated in cities, but also the larger the city, the more prevalent are business services. While 8 percent of the nation's rural employment is engaged in business services, 22 percent of its large-city employment can be found there. Even as manufacturing has left, service employment in large cities has remained strong.

First, services tend to use less land than manufacturing. Manufacturing firms often require bulky machinery and single-story production lines. (Try building a car in a skyscraper.) But services tend to rely more on labor and less on capital equipment and, therefore, need less land per employee or per dollar of output. Banks, insurance companies, and even schools can operate comfortably in high-rise buildings that economize on land. They can sit in very close physical proximity (even on top of each other) and so have the potential for being very concentrated geographically. In economic terms, this means that service industries are more likely to outbid manufacturing industries for land, where land is most scarce — in large cities.

Second, service firms hire more educated workers than do manufacturing firms. More than one-third of consumer service employees and 42 percent of business service employees have completed four or more years of college (as compared to 20 percent of manufacturing workers). Since the average education level is higher in larger cities, service firms are more likely to locate there.

The third reason is subtler. Business services have great potential for co-agglomeration, — the tendency to locate near other industries. Business service firms serve firms in other industries, including other business service industries — every big bank needs advertising, and every advertising firm needs a bank account. The potential for co-agglomeration is less intrinsic to consumer services (i.e., schools don't teach museums; they teach individuals) and to manufacturing.

Since business service industries tend to locate near each other, then any cluster of business services represents significant employment. Workers need to be clothed, fed, and entertained, so business services eventually attract consumer services and retail firms. Thus, not only do cities attract business services; but a cluster of business services also makes a city.

CONCLUSION

The fortunes of cities, like the fortunes of industries, rise and fall. American cities that depended on manufacturing have fallen on hard times, as manufacturing employment has declined and is less and less likely to be found in urban areas. Many of the nation's largest cities, including Boston and New York, are almost entirely service economies. Other cities, like Lowell, Massachusetts, are trying to reinvent themselves with new investment and service-sector employment.

Relying on the service sector is, of course, no guarantee that a city's good times will continue. While Boston is gaining more of the nation's financial services, Hartford is losing some of its share of the insurance industry. Still, modern cities are about services — in fact, the best economic definition of a city is that it is a diverse collection of service industries.

Over the longer run, service industry concentrations are persistent. Those in New England stretch back three centuries, and they are here for good economic reasons. These reasons may grow even stronger if information technology transforms formerly local service industries into national ones and New England's service concentrations grow. Cities that depend on service industries instead of manufacturing need not fear the future.

On the Street
As any urban shopper knows, retail stores selling similar products tend to cluster. These concentrations are most apparent at the street or neighborhood level. Some are spread out in suburban locales, like the "Automile" on Route 1 southwest of Boston, or the tile stores around Watertown, Massachusetts. Others are clumped within walking distance, such as the dozen furniture stores along Massachusetts Avenue in Cambridge, or the Jewelers Building in Boston's Downtown Crossing.

Why do retail firms locate near each other, even when proximity puts pressure on firms to compete on price? Probably because their customers like to compare goods, particularly when the goods are specialized (like furniture, tile, or jewelry). A retail establishment might expect to dramatically increase its flow of customers by setting up shop nearby similar stores. This might more than make up for any tendency to lower prices to meet the local competition. These "shopping externalities" depend on similar retail stores being in close proximity — either within walking distance or a short drive.

But since retail businesses tend to serve the local market, they tend not to be more concentrated in one city than in another. Consumer services, in general, and retailing, in particular, are a relatively constant fraction of employment everywhere. Across the Boston metropolitan area, for example, there are about as many car dealers, tile stores, furniture stores, and jewelers as in other big cities.