How Location Clusters Affect Innovation

Innovation is thought to come easily for companies in a high-tech cluster such as Silicon Valley, where firms in related businesses colocate. In a cluster, reasoned economist Alfred Marshall some 80 years ago, “the mysteries of the trade become no mysteries; but are, as it were, in the air, and children learn many of them unconsciously.” So, as theorists who continue Marshall's line of inquiry like to propound, technology is so pervasive in a cluster that surely clustered companies must have an easier time innovating than their competitors in the hinterlands, right?

Maybe not, say the authors of a February 2002 working paper, who measured the relationship between clustering and innovation on U.S. software firms and found unexpected results. “I thought that firms would try to free-ride,” says co-author Brent Beal, assistant professor at Louisiana State University's E.J. Ourso College of Business Administration. It's thought that within clusters, there is a collective pool of knowledge that companies can tap by hiring from local firms or simply socializing with their brethren's employees. So Beal and his co-author Javier Gimeno, associate professor at INSEAD, expected clustered firms to spend less per employee on R&D, because they would garner some tacit knowledge simply by breathing the air. The clustered firm's employees and suppliers would bring knowledge to the table that nonclus-tered firms would need R&D investment to realize.

That pattern of R&D expenditure did-n't exist. Instead, the authors found that clustered firms launched fewer products for their R&D bucks. “[Clustering] didn't have much effect on the amount spent on R&D, but there is a negative impact on innovative output, which is counterintuitive,” says Beal.

Beal and Gimeno's research tracked 56 firms that primarily sold prepackaged software from 1982 to 1998 and determined the degree to which they were “agglomerated” (as the authors called clustering), by counting software firms at the county level. Beal and Gimeno are revising the paper, “Geographic Agglomeration, Knowledge Spillovers and Competitive Evolution,” which emerged from Beal's Ph.D. dissertation at Texas A&M University, for submission to the Academy of Management Journal after having presented it at the Academy of Management's 2001 annual conference.

There is another surprise in the data. Although the study finds that innovative output declined for clustered firms, revenue per employee was higher. That is, the few products that clustered firms introduced did better in the marketplace. Isolated firms, in fact, brought in $68,000 less per employee in sales each year than clustered firms, according to the study. That's a big drop-off considering the sample's average of $280,000 in sales per employee.

How could this be? One explanation the authors offer is that the clustered firms do get a free-ride on knowledge spillovers — the pervasive pool of knowledge in the cluster. But the spillovers are not of a technical nature; they're of a marketing nature. So clustered firms don't gain an advantage in new technological innovations; rather they get an edge in finding markets and customers and in tailoring products for them.

In part, this could be a function of the nature of the software industry. “The tacitness of the [technical] knowledge is not as relevant. You can access the newest software technologies wherever you are,” says Gimeno. Thus, the technologies are not geographically bound. The information that is more tacit, or harder to codify, is market information — knowledge of industry trends, market niches and customer needs might be signifigantly easier to acquire when a firm is focused in a cluster.

So how can nonclustered firms compensate for their lack of proximity to tacit information and remain competitive? “They need to be particularly careful about developing innovation that is based on their own assessment of the market,” says Gimeno. “Nonagglomerated firms may be able to provide more breakthrough innovations. But the dark side is that they are more likely to mistime entry into markets or be unaware of the attractive markets that are emerging.”