RIETI Report April 21, 2023

Industry agglomeration and location choice of productive firms: The role of product markets in adverse selection

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This bi-weekly newsletter will keep you updated with the recent columns, event information and research results by RIETI fellows and other leading economists in Japan and around the world.

In this edition, we present topics related to industry agglomeration and location choice of productive firms. René Belderbos, Professor of Strategy at KU Leuven and his team analyzed the location decisions of Japanese multi-plant firms and found that agglomeration effects exist when firms compete for different foreign markets but adverse selection occurs when firms face direct rivals in the product market.

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Editors of RIETI Report (Facebook: @en.RIETI / Twitter: @RIETIenglish / URL: https://www.rieti.go.jp/en/)

This month's featured article

Industry agglomeration and location choice of productive firms: The role of product markets in adverse selection

René BELDERBOSProfessor of Strategy at KU Leuven

FUKAO KyojiFaculty Fellow, RIETI

IKEUCHI KentaSenior Fellow (Policy Economist), RIETI

KIM YoungGakProfessor, School of Economics at Senshu University

KWON Hyeog UgFaculty Fellow, RIETI

More productive firms may choose to locate in industry clusters in order to benefit from agglomeration externalities. However, negative sorting and adverse selection effects are also possible. This column studies the location decisions of Japanese multi-plant firms in order to disentangle these effects. Agglomeration effects are present when firms compete for different, or dispersed, foreign markets. On the other hand, adverse selection occurs when firms face direct rivals in the product market. It suggests there is a need for policies that provide incentives to attract highly productive firms to industrial clusters.

Recent empirical studies show that firms located in industry clusters tend to be more productive (e.g. Andersson et al. 2019, Rosenthal and Strange 2020, Lavoratori and Castellani 2021). Two competing explanations have been put forward for this correlation. The first and predominant explanation is the notion of Marshallian agglomeration externalities, which contends that firms can enjoy positive externalities stemming from geographic industry clustering. Externalities can occur on the supply side in the form of the availability of specialised factors of production and on the demand side through reduced search costs for customers and heightened local industry demand. That these possible externalities motivate firms to choose locations where similar establishments are clustered has been supported by theoretical models (e.g. Krugman 1991) and empirical work (e.g. Belderbos et al. 2021).

A second explanation is the selection effect associated with the increased competition within clusters. Collocation leads to tougher competition, forcing the exit of weaker firms with lower productivity. Moreover, more productive firms may benefit more from agglomeration, leading to a positive sorting effect, with more productive firms self-selecting into high-density clusters (Baldwin and Okubo 2006). However, this conjecture has received less substantive support in empirical research. In fact, instead of positive selection effects, negative effects are also conceivable. When productive firms locate in industry agglomerations, they run the risk that their innovative technologies and organisational and process skills could be copied by collocated rival firms. Less productive firms, in contrast, have less to lose. Such asymmetry in knowledge spillovers due to productivity differences suggests a process of negative sorting (adverse selection) in which firms with relatively weaker (rather than stronger) productivity are more likely to locate within industry clusters.

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