Should Cities Diversify? City Risk and Industrial Policy

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.