Product Quality and Market Size∗

Urban economists generally understand cities to balance negative externalities of congestion against the positive effects of agglomeration on productivity and consumers (Henderson, 1969). It is commonly assumed that that agglomeration promotes product variety. Here we explore a related but distinct effect on consumers, the effect of agglomeration (or city size) on product quality. This question is interesting in itself and also because high quality products may provide a source of attraction to productive residents (Jacobs 1961) (Glaeser, Kolko, and Saez 2001). Recent theoretical developments in industrial organization provide an invaluable framework for thinking about the relationship between product quality and market size. In a series of important books and articles, Shaked and Sutton (e.g. Shaked and Sutton (1987) and Sutton (1991)) have sought to explain the circumstances in which markets remain concentrated as they grow large. In particular, Shaked and Sutton show that in industries where quality is produced mainly through outlays on fixed costs, then as markets grow large, at least one firm will have an incentive to invest in quality. Because