The research estimates the effects of agglomeration economy for 47 Japanese prefectures. We adopt a newly developed panel model with spatially correlated error components and use a socioeconomic dataset containing data across 47 spatial units from 1990 to 2012 and not previously analysed. The endogeneity issue between dependent and independent variables is also properly considered. While controlling for the variation of labour efficiency, the empirical results show that a doubling of employment density increases labour productivity by 4.52%, and agglomeration economy does play a significant role in boosting labour productivity.