Chapter 3 Why do Firms Cluster Together

1
Chapter 3 Why do Firms Cluster Together?
2
Puzzling Feature of Urban AreasWhy Do Similar
Firms Locate Together?

• Disadvantages of Clustering of Similar Firms
• Must compete with other firms for customers,
  workers
• 4 Possible Advantages of Clustering of Firms
• Sharing suppliers of intermediate inputs
• Sharing a pool of labor
• Labor matching
• Sharing information
• Because we OBSERVE clustering of similar firms in
  cities must mean that, at least in some cases,
  the advantages outweigh the disadvantages

3
Internal and External Economies of Scale

• Internal Economies of Scale
• Where cost/unit ? as output of firm ?
• External Economies of Scale
• Where cost /unit ? as output of other firms ?
• Localization Economies
• Source of external economies of scale from
  locating near similar firms in the same industry

4
Sharing Input Suppliers

• Firms will benefit from clustering around a
  common input supplier if
• Input demand for individual firm not large enough
  to exploit scale economies in producing input
• Example dressmakers around button factory
• Transportation costs for input are relatively
  high
• Input is bulky, fragile, or perishable
• Example chicken processor locating near chicken
  houses
• Frequent face-to-face contact between buyer and
  seller of input is necessary
• Example corporate headquarters around
  advertising firms

5
Intermediate Input Costs

• If there are either
• Scale economies in production of inputs, or
• Sufficient demand generated to allow for
  varieties in production of inputs
• Firms benefit from locating in clusters around
  suppliers
• Why?
• Lower cost per unit
• Lower cost in product changeover and product
  modification

6
Examples of Clustering due to Scale Economies in
Intermediate Inputs

• Corporate Headquarters
• Have need for frequent contact with advertising
  agencies, consultants, legal specialists
• High Tech Firms
• Need specialized electronics
• Access to testing companies
• Newspapers publishers
• Need services of illustrators, free-lance
  reporters
• Typically, firms more likely to cluster around
  input suppliers when
• Demand for product or service is diffiicult to
  predict, or
• Nature of product or service changes frequently

7
Local Example, FIB

• Fulton Industrial Blvd.(FIB) produces a variety
  of products
• Alcoa siding (injection molding)
• Aircraft parts manuf.
• Engine Rebuilding
• Key inputs
• Tool and die services
• Warehousing and shipping (UPS hub)

8
Sharing a Labor PoolVarying Demand for Labor

• Firms will have incentive to locate near other
  firms that hire same type of labor when there is
  uncertainty about
• Quantity of labor it will hire in future
• Particular skills it will need in workers in
  future
• Uncertainty of demand for products ?
• Uncertainty of demand for workers ?
• Workers changing jobs frequently

9
Pooling Labor

• Assume 2 states of the world (H L), with equal
  probability of occurring.
• The isolated firm faces an inelastic labor supply
  of 12 workers.
• The same firm in a cluster would face a perfectly
  elastic labor supply.
• We assume workers are free to re-locate between
  sites, but do not commute between sites.
• What is the difference in expected profits
  between the two sites?
• From the firms standpoint, what are the
  incentives derived from labor pooling? Cluster?
  Or, no cluster?

P48
P147
P3
P48
10
Examples of Industries Benefiting from Labor
Pooling

• Computer Industry
• Pharmaceutical Bio Tech Industry
• Television Industry
• In general, firms are more likely to benefit from
  clustering due to labor pooling when
• Quantity of labor demanded is diffiicult to
  forecast because demand for product fluctuates
  over time
• Types of labor demanded are difficult to forecast
  because nature of product changes over time

11
Example (local-ish)

• Independent medical practices often cluster
  around big regional hospitals (for more than one
  reason, but)
• Insurance specialists (fill out and file
  insurance)
• Labs
• Technicians

12
Why Computer Firms Benefit from Clustering
Through Labor Pooling

• Changes in technology, product innovation ?
• high degree of uncertainty of demand for
  products ?
• uncertainty of demand for labor ?
• substantial benefits from labor pooling ?
• high concentration of computer firms in Silicon
  Valley

13
Why Pharmaceutical, Biotech Firms Benefit from
Clustering Labor Pooling

• New product development is time consuming,
• requires very specialized labor
• Testing of new products, FDA approval ?
• high degree of uncertainty for success of new
  products ?
• uncertainty of demand for labor to produce
  products ?
• substantial benefits from labor pooling ?
• high concentration of firms in California,
  Boston area, Research Triangle, NC

14
Why Television Firms Benefit from Clustering
Through Labor Pooling

• Unpredictability of success of individual
  programs,
• uncertainty of offerings by rival networks ?
• high degree of uncertainty of demand for
  programs ?
• uncertainty of demand for actors, technicians ?
• substantial benefits from labor pooling ?
• high concentration of firms in Hollywood, New
  York

15
Clustering of Firms Makes it Easier for Workers
to Switch Jobs Because

• Workers have lower job search costs because
• Information about job openings is spread
  informally and quickly
• Many prospective employers are located nearby
• This means
• Lower search costs for workers ?
• lower wage costs for firms

16
Expected Income of Workers
17
Labor Market Matchingin Isolated Location
18
Labor Market Matchingin Industry Cluster
19
Skills Matching
Each worker has an address on the unit
circle. Training costs increase with distance
between skill requirements and skill type. As we
add more workers with potentially different
skills, and More firms with potentially
different requirements, the distance between F
and W decreases. Clusters support more labor
skill types and more industry skill
demandsgtgtgtbetter matches
The mismatch decreases as the number of firms and
worker skill sets increases.
20
Labor Matching

• Uncertainty of future demand also ? uncertainty
  in type of labor needed
• Clustering of firms ?
• larger pool of labor with different skills ?
• better chance of filling future labor needs ?
• higher productivity of labor
• Also, because job search costs are lower (recall
  from before), its easier for employees to change
  jobs to find their best fit.

21
Sharing InformationKnowledge Spillovers

• Firms also benefit from clustering through
  sharing of information, ideas
• Formally
• Seminars at local universities
• Conferences held locally
• Informally
• Conversations during lunch, golf, soccer matches
• Example computer firms in Silicon Valley

22
Costs of Clustering

• The main cost of clustering is the loss in market
  dominance.
• When firms cluster they share a market
• The cost of transportation increases for people
  located at the fringe of the NOW larger market
  area around the cluster.
• Consumers obey the law of demandhigher prices
  (via transport costs) means the quantity demanded
  falls.

23
Costs of Clustering
Suppose Firm E moved to where C is locateda new
cluster is formed. Now, CE split 2/3rd of the
market. But, for these folks, transport costs
just went up, so they demand less. Prices must
fall by AT LEAST enough to overcome the longer
travel costs
24
External Economies of Scale and/or Agglomeration
Economies

• External Economies of Scale
• Where cost/unit ? as output of other firms ?
• Localization Economies INDUSTRY SPECIFIC
• where cost/unit ? as output of other firms in
  same industry ?
• Urbanization Economies AFFECTS ALL INDUSTRIES IN
  CITY
• where cost/unit ? as output of firms in other
  industries ?

25
Reasons for Urbanization Economies

• As total output of urban area increases,
  individual firms also benefit from
• Scale economies in shared intermediate inputs
• Business support services such as banking,
  insurance, advertising develop
• More/better public services such as schools,
  police fire protection, highways
• Labor pooling in workers whose skills not
  industry specific
• Clerical, managerial, maintenance, etc.
• Sharing information
• Knowledge spillovers that are not industry
  specific
• General technology transfers (e.g., Blackberry,
  internet access, etc.)

26
Differences in City Size

• Clustering of firms ?
• Different size cities due to differences in
• Localization economies
• Urbanization economies
• Goods produced for local consumption

27
How Localization Economies ?Cities of Different
Size

• Disadvantages of Clustering of Similar Firms
• Must compete with other firms for customers,
  workers
• Possible Advantages of Clustering of Firms
• Sharing suppliers of intermediate inputs
• Sharing a pool of labor
• Sharing information
• Observed clustering of similar firms in cities
  must mean that advantages outweigh disadvantages
• However, degree to which advantages outweighs
  disadvantages varies by industry

28
For example

• 3 industries that benefit from clustering of
  firms
• Each industry employs 120 workers
• Industry L has strong localization economies ?
• All 120 workers located in 1 city
• Industry M has medium localization economies ? 60
  workers located in 2 cities
• Industry S has weak localization economies ?
• 30 workers located in 4 cities

29
How Urbanization Economies ?Cities of Different
Size

• Firms in industries with strong urbanization
  economies are attracted to large urban areas
• Assume
• Largest city attracts firms that benefit most
  from urbanization economies ?
• Employment in largest city ? by 80 employees
• Medium size cities attracts firms that benefit
  less from urbanization economies ?
• Employment in 2 medium cities ? by 20 employees
• Small cities are too small to attract firms that
  benefit from urbanization economies ?
• Employment in smallest cities stays same
• ? Urbanization economies exaggerates differences
  in city size initiated by localization economies

30
Goods Produced for Local Consumption ?
Differences in City Size

• Small cities produce goods services for local
  consumption with large per capita demand relative
  to scale economies
• Examples
• Grocery store, gas station, doctors office,
  barber shop, bank
• Larger cities produce goods services for local
  consumption feasible in smaller cities plus
  others with small demand relative to scale
  economies
• Examples
• Hardware store, most fast-food chains, general
  hospital, Wal-Mart, bowling alley
• Largest cities produce goods and services for
  local consumption feasible in larger cities plus
  others with very small demand relative to scale
  economies
• Examples
• Bloomingdales, opera, professional sports,
  specialty hospital, fine dining, etc

31
Production of Goods and Services for Local
Consumption ? Local Employment

• Assume
• Small city 1 export job generates 1.0 local
  jobs
• Medium city 1 export job generates 1.5 local
  jobs
• Large city 1 export job generates 2.0 local
  jobs

32
Variations in City Size
33
City Sizelets look again
34
Agglomeration Economies in MarketingShopping
Externalities

• Shopping Externalities
• when sales of one store are affected by location
  of other stores
• Examples
• Shoe store moves next to mens clothing store ?
• sales of both stores ?
• Target moves next to Publix ?
• sales of both stores ?

35
Types of Products that Generate Shopping
Externalities

• Imperfect Substitutes
• goods that are similar but not identical
• Examples
• Audi versus BMW
• Taco Bell versus KFC
• Perry Ellis versus Giorgio Armani
• Complementary Goods
• goods that are different but purchased together
• Examples
• Movie theatres and restaurants
• Tattoo parlors and bars and bail bondsmen
• Hooters and racing tires stores

36
Retail Cluster (Centers)

• Clustering of sellers of imperfect substitutes ?
• shopping costs for consumers?? ?
• total sales ? relative to sales at separate
  locations
• Explains clustering of auto dealers,
  electronics stores, etc.
• Clustering of sellers of complementary goods ?
• net price (including shopping costs) of
  complement?? ?
• demand and sales for related goods ?
• Explains malls, origin of term one-stop
  shopping