Bouvard, Matthieu, de Motta, Adolfo and Titman, Sheridan (2024) Should Cities Diversify? City Risk and Industrial Policy. TSE Working Paper, n. 24-1538, Toulouse

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Abstract

We explore the diversification of an urban economy where the labor specialization choices of its residents determine the city’s exposure to sectoral shocks. The presence of demand-driven externalities introduces the possibility of city-wide coordination failures. Residents, when making their specialization choices, do not account for the costs of these coordination failures, and as a result, the equilibrium level of diversification is ineÿcient. The optimal policies that address these externalities depend on the city’s economic condition, with prosperous urban economies deriving a greater benefit from fostering diversification. Thus, the paper rationalizes the widespread industrial policies that in some cases promote diversifying, while in others, specializing a city’s economy.