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Lecture notes, lectures 3 - why do firms cluster

Regional and Urban Economics (Universidad Carlos III de Madrid)

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WHY DO FIRMS CLUSTER?

1. Why do firms locate close to one another?

In this chapter we are studying agglomerations economies, the economic forces
that cause firms to locate close to one another in clusters. The forces acting on firms in
a single industry together are called localization economies, indicating that they are
local to a particular industry. When agglomeration economies cross industry boundaries,
they are called urbanization economies. The idea is that the presence of firms in one
industry attracts firms in other industries. Urbanization economies lead to the
development of large, diverse cities.
Firms cluster to:
• Share intermediate inputs
• Share a labor pool
• Get better matches of workers and labor tasks
• Share knowledge

2. The European Cluster Observatory

The European Cluster Observatory identifies regional clusters in the EU-27,
Iceland, Israel, Norway, Switzerland and Turkey. To data, the Observatory has identifies
more than 2000 regional clusters, assigning one star for each of the following criteria:
• Employment size in a particular industry cluster within a region
• Degree of specialization within the region
• Cluster focus on employment within a region
155 clusters register three stars (8%), 524 two stars (25%), and 1338 one star
(67%).

3. Clustering to share Intermediate Inputs.

Some competing firms locate close to one another to share a firm that supplies an
intermediate input. Let's consider the production of high-fashion dresses. Firms have to
be small and nimble so as to react quickly to changes in fashion and output.
Intermediate goods they need, need to be produced according to scale economies in
order to reduce price as the quantity increases. Face time is recquired to produce
buttons, thus a dressmaker must be located close to its button supplier. The firms may
also incur in a cost of modigying the button. Therefore, dressmakers share a button-
maker and cluster to facilitate face time.

4. Self-Reinforcing Effects cause industry clusters

When agglomeration economies are strong enough to offset the cost of clustering,
firms will form industry clusters, causing the development of specialized cities.
If we take into account the tradeoffs associated with clusters, we can observe
that benefits may emerge from localization economies that reduce the cost of the
intermediate inputs. However, competitions for workers increases labor cost and wages
paid are higher. If we calculate profits depending on the number of firms in the cluster,
there will be a point in which profits for the initial firm are the same as when it was an
isolated firms. Computing the profit gap, the difference between the profit of a firm in
a cluster and an isolated firm, we realise that it is zero for a one firm cluster and it is
also zero when it reaches a determined number of firms. This means that firms will be
joining the cluster as long as their profit gap is positive, that is, as long as the cluster
location is more profitable than the isolated location.

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5. Sharing a labor pool

In an environment of rapidly changing demand – for instance, softwares or TV
programmes -, unsuccessful firms will be firing workers at the same time that successful
firms are hiring them. A cluster of firms facilitates the transfer of workers from
unsuccessful firms to successful ones.
The key notion of sharing a labor pool is that the boom-bust process occurs at the
level of the firm, not the industry: the total demand at the industry level is constant,
but the demand for each firm varies from year to year. For each firm, there are two
possibilities, high demand or low demand) and each outcome is equally likely.

6. Labor matching
In a typical economic model of a labor market, we assume that workers and firms
are matched perfectly. Each firms can hire workers who have precisely the skills the firm
requires. In real world, workers and firms are not always perfectly matched, and
mismatches require costly worker training so as to eliminate skills gap. A large city can
improve the matching of workers and firms in the untidy real world, decreasing training
costs and increasing productivity.

7. Knowledge spillovers
This type of agglomeration economy comes from sharing knowledge and ideas
among firms in an industry.Innovations are proptly discussed, improved and adopted.
There is ample evidence that knowledge spillovers cause firm clustering:
• It is more important for industries with small, competitive firms.
• Spillovers are more important in idea industries.
• Most innovative industries are the most likely to cluster.
• Spillovers have range of a few miles.

8. Evidence of location economies

If there are localization economies, we expect industry clusters to generate
higher productivity, more births, and more rapid emplyment growth.

9. Urbanization Economies
Urbanization economies -defined as agglomeration economies that cross industry
boundaries- cause firms of different industries to locate close to one another. The ersult
is the development of large, diverse cities. The four agglomeration economies that
generate localization economies also generate urbanization economies. For example,
different industries use business services, hotels or transportations services. In
additiong, firms share public infraestructure such as highways, transit systems, ports and
universities.
Corporate Headquarter and Functional Specialization
Corporations locate their headquarters in cities to exploit urbanization
economies. Corporations cluster to share firms that provide business services.
In the last several decades, there has been a fundamental shift in the
specialization of cities. Large cities have become increasingly specialized in managerial
functions, while small cities have become more specialized in production.
Knowledge Spillovers
The essential feature of knowledge spillovers is that physical proximity facilitates
the exchange of knowledge between people, leading to new ideas. The ideas lead to
new products as well as new ways to produce old products. Knowledge spillovers often
cross industry boundaries.

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1r. Other benefits of Urban size

Urbanization economies generate higher productivity and lower production costs.
Moreover, there are other benefits that increase the relative attractiveness of large
cities and increase the supply of labor to big cities.
Joint labor supply
Large cities offer better employment opportunities for two-earner families in
different sectors. The role of cities in resolving the issue of joint labor supply started in
the 1800s when mining and metal-processing firms located close to textile firms, and
each firm benefited from the presence of the other. More recently, “power couples” are
concentrated in large cities, where they are more likely to find good employment
matches for both workers.
Learning opportunities
Human capital is defined by the increase as the knowledge and skill acquired by
workers in formal education, work experience, and social interaction. A larger city
provides a wider variety of role models to learn from by imitation for workers so it
attracts workers looking for learning opportunities. The benefits of urban learning
translate into higher wages everywhere.
Social opportunities
People enjoy interacting with one another, and a larger city provides more
opportunities for social interactions. In a model of social-interest matching, a larger city
will generate better interest matches, with each network achieving a tighter range of
social interests.

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