The cost of living crisis is continuing to make headlines around the world, with rents rising and many being priced out of areas they’d like to live in. The cost of everyday items like groceries, gas, and utility bills add to the sense that living in a major city is becoming increasingly burdensome.

While this article certainly can’t solve the cost of living crisis, it can provide an answer to that question of why cities are so expensive. Let’s dive in.

“Agglomeration economies” are the backbone of urbanization

Often, businesses thrive in one particular location. Historically, cities have been founded near waterways, coasts, or major transport links. When businesses are situated in a place where they can thrive — for example shipping companies being located near a natural harbor or waterway — their profits increase. Their demand for intermediate goods increases, and they hire more workers.

This makes it more attractive for other companies — say, steel companies, textile factories, or other exporting firms — to locate near (in this example) the shipping companies. This can result in increased efficiency, reduced costs, and increased profit margins for all firms involved. There are also positive externalities from industries being located in the same place, as natural knowledge spillovers can occur between innovators and industry experts.

In economics, we call these efficiencies and savings “agglomeration economies”. As more and more firms congregate into one area, agglomeration economies are realized, even if those firms don’t belong to the same industry.

This agglomeration phenomenon happens naturally even in the modern world, relatively divorced from geographical features. A great example is Silicon Valley. Once a few major software firms located in San Francisco, agglomeration economies took off and ensured that the city (and surrounding area) became one of the world’s great producers of software. As more and more software development occurred there, it became very easy for software firms to find quality laborers in that region.

Agglomeration economies can happen more broadly than just for a single industry, too. When it comes to building a city in the first place, the mere presence of additional laborers and industries makes it easier to launch a new business in that area regardless of industry. And, increasing density can increase productivity itself. For example, Cem Özgüzel in a 2020 OECD paper estimated that increasing the size of UK cities by 10% would result in a 1% increase in productivity.

Thus, as a region attracts more activity, the supply of and demand for jobs located in that area increases. This causes more people to migrate there, which increases the demand for everyday goods and services that can provide food, clothing, schooling, entertainment, etc. for the growing labor force. This is all related to the cost of living that we see in major cities today.

As a city grows, the price of its land spikes

As a burgeoning city develops, the price of real estate, and thus rents, grows. Land is scarce when so many people and businesses want to operate in a close vicinity, and this mismatch between supply and demand raises land prices, a perfect example of one of the classic lessons in economics.

The increased value and price of land is reflected in a few different ways. Businesses face higher rents for the factories, plants and office buildings they occupy, or for the land they want to build on. Housing developers face higher costs and must make higher revenues out of the residential buildings they erect, and these costs get passed on to individuals as higher rents.

Rent is one of the major costs of living, also for laborers, which means that as rents rise, labor costs (i.e., wages) increase. This in turn pressures businesses to increase their prices as their costs rise yet again. Further, the smaller “everyday” businesses that laborers rely on for their standard of living — the café down the street, for instance — must raise their prices as well, in order to keep up with their own business costs.

Increased costs are passed on to the consumer

This feedback loop is perhaps the greatest reason why bigger cities tend to be more expensive than other areas. Businesses can only increase production or efficiency by so much, and at a certain point their margins begin to squeeze tightly. At the same time, laborers struggle to make ends meet between the rising costs of their everyday lives, from clothing, food, or a haircut, and with wages that can seem stagnant.

This process should sound familiar — inflation is defined as a general increase in prices over time. However, while urbanization can (often indirectly) contribute to inflation, urban areas may not necessarily have higher rates of inflation than rural areas (in fact, the US Fed found the opposite was true in the USA post-COVID). Rather, urban areas have a higher baseline cost of living due to their density. And, when prices rise due to urban development, rural areas that share the same currency can be affected too.

There are additional factors beyond increasing costs that can cause cities to be particularly expensive. One of the most important is the availability of housing relative to demand.

Lack of housing contributes to a decline in affordability

While every city is different, for many, a lack of affordability is exacerbated by a lack of housing. People flock to cities, and often this means that there isn’t quite enough housing to go around. The pace of new construction often lags behind the pace of migration, even when good policies and incentives are in place.

It’s no surprise that a lack of supply increases prices for the good being demanded. Indeed, in April 2026, Christian Hilber in a report for the UK’s Institute for Fiscal Studies found that “[housing] supply constraints are important for explaining prices and rents”. As cities grow, a lack of housing supply can cause rents to skyrocket, worsening affordability for everyone.

A lack of housing supply can come about for many reasons. Sometimes, the process to approve new construction is lengthy and onerous. Current residents may vote against new developments (the so-called “not in my backyard”, or NIMBY, problem). Local authorities may lack incentives to support new residential construction, especially if they either do not directly benefit from the increased tax base or if commercial construction is more attractive.

Regardless of the root cause, urban areas tend to experience less affordable housing and a lack of enough new housing units, especially if underlying causes are not addressed over time.

Other contributing issues

Another important aspect of high costs of living can be unequal distributions of wealth. If the majority of the productive economy’s profits are being concentrated in the hands of relatively few, everyday laborers face the higher costs that increased commerce and concentration bring, but reap little of the rewards. Naturally, this means that affordability issues can be felt asymmetrically across a population. In extreme cases, this can even contribute to a decline in growth, as one recent study suggests.

Increasing regulations and higher taxation can also increase the cost of living by imposing additional costs on businesses, further pressuring profit margins. Of course, regulations and taxes also help to protect consumers and introduce services like public transit, but too much taxation and too many regulations can worsen affordability issues.

Finally, speculation, especially in real estate, can also worsen the cost of living. When investors buy homes but allow them to sit vacant as investment properties, it artificially reduces the supply of housing and can increase the price of housing, contributing to the high cost of urban living.

How to solve an increased cost of living

It’s impossible to apply a one-size-fits-all solution to high costs of living in cities. And it would be unreasonable to think that living in cities ought to be as cheap as living in the countryside.

Still, most of the solutions likely involve effective policies to address underlying causes. This could include policies that promote increasing housing supply, changing onerous processes or taking action to reduce business expenses, and ensuring that all of a city’s limited land is used efficiently.

Understanding a particular city’s underlying challenges and designing an effective solution is easier said than done. Still, solving these complicated problems is part of the joy of being an economist!

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