When do cities specialize in production?

When do cities specialize in production and when do they diversify? What determines the size and number of cities in an economy? These questions are addressed in a general equilibrium model of a closed economy consisting of a system of circular cities. The economy produces two final manufacturing goods with the use of labor and two groups of non-traded differentiated intermediate services. These two manufacturing goods are traded within the system at a positive transportation cost. The specialization of cities is due to the desire of the manufacturing industries to use a variety of product-specific differentiated intermediate services in production. This is because the larger the variety of services in the city the higher is the productivity of the manufacturing industries. Diversification is due to higher intercity transportation costs. The model presented generates two possible equilibrium configurations: (i) pure specialization, where each city in the economy specializes in the production of one group of differentiated services and one manufacturing good; and (ii) pure diversification, where all cities in the economy produce both groups of differentiated services and both manufacturing goods. The conditions under which each configuration emerges are identified. These conditions depend on the tradeoff between scale economy resulting from specialization and the saving in inter-city transportation costs in the case of diversification. Then some comparative static results, on stable equilibrium, are presented.