Location theory: Technology and Agglomeration Economies
Studies of the effects of spillovers, external economies, or agglomeration economies on FDI location choices date back to Alfred Marshall (1920). Agglomeration economies are benefits that accrue to firms that locate in geographically concentrated areas or ‘‘clusters’’ such as Silicon Valley.
Several types of benefits can arise when firms collocate. First, a geographically concentrated cluster of activity in a particular sector creates a specialized pool of skilled labor that can lower a firm’s search and training costs. Second, due to labor mobility and social networks, firms can potentially gain some knowledge about the proprietary technology and processes of their competitors. At the same time, of course, firms also risk losing some of their own proprietary knowledge in this context. Third, specialized suppliers often locate near clusters, again, lowering firms’ costs and giving firmsmore choice in make-or-buy decisions. Fourth, when clusters exist, firms and states oftenmake significant investments in infrastructure development such as building roads, upgrading airports, and improving local universities. These features of industrial clusters create an environment where firms can potentially reap benefits larger than their direct costs.
The existence of spillovers and their influence on the location decisions of MNCs has been a controversial topic that has received considerable attention fromacademic researchers. Since spillovers are nearly impossible to measure, their very existence is controversial. Firms in the same sectors often do tend to locate in clusters. Some researchers take this empirical fact as prima facie evidence for the existence of agglomeration economies. However, Head, Ries, and Swenson (1995) point out that clusters could exist for many reasons that have nothing to do with spillovers. Firms might collocate for economic reasons such as the local presence of factors of production or strategic reasons such as the ability to better monitor competitors. Local governmentswanting to attract high-quality jobs might offer subsidies to firms in particular industries.Thus the fact that firms do cluster is not, in itself, evidence of spillovers.
Another controversy in the literature on agglomeration economies is the question of what, if any, effect they have on the production cost of firms and hence firms’ decisions to collocate. If knowledge spillovers exist, why would a leading-edge firm risk locating close to competitors that could free-ride on its investments in proprietary technology? Similarly, clusters often do eventually result in crowding. After experiencing rapid growth, the Silicon Valley area became such a high-cost location for land and labor that many firms wanting to move there were ultimately priced out of the market. Crowding should eventually increase the production costs of all firms, including early entrants into the cluster.
Spillovers of knowledge have a less straightforward effect onfirms’ costs in the sense that some firms might gain and others might lose. By focusing on micro mechanisms such as buyer-supplier relationships between firms, recent research allows us to better understand which firms would benefit from knowledge spillovers. Since firms do tend to collocate, and since proprietary technology is so important to firms, further research in this area will help us better understand the complex links between spillovers, production costs, and FDI location decisions.