Does Location Really Matter?

For innovation-based companies, being located in an industry cluster has long been thought to enhance long-term financial prospects. This research suggests otherwise.

by Matt Palmquist
Title: Agglomeration Economies and Firm Performance: The Case of Industry Clusters (Subscription or fee required.)
Authors: Sal Kukalis (California State University at Long Beach)
Publisher: Journal of Management, vol. 36, no. 2
Date Published: March 2010

It is generally believed that industry clusters — geographic concentrations of companies and institutions in a specific field — play an important part in facilitating the development and long-term prospects of innovative industries. The semiconductor industry in Silicon Valley, Hollywood’s movie business, and the pharmaceutical industry in New Jersey and Massachusetts are three prominent examples of such clusters. Some of the most commonly cited benefits of these regional arrangements are better collaboration between firms; lower production costs, such as those incurred when infrastructure and service resources are shared between firms; access to a skilled labor pool; and knowledge spillovers as a result of “informal socializations” among employees from different firms.

But do these clustering benefits necessarily benefit firms financially? And can outsiders hope to compete against firms that are entrenched in developed industry clusters? To answer these questions, the author looked at the financial advantages, and costs, that clusters provided for firms throughout the life cycle of two innovative industries — semiconductors and pharmaceuticals. He examined 31 years of data on 194 publicly traded companies, which enabled him to see how clustered and nonclustered firms performed at various points in an industry’s life cycle. Surprisingly, the author found no clear evidence that clusters enhance a firm’s financial performance. Even early adopters in a cluster failed to outperform their more isolated counterparts. And late in an industry’s life cycle or during periods of economic contraction, the nonclustered firms outperformed their clustered rivals in both return on assets and return on sales, the author found.

In addition, firms within a cluster have less of an advantage when an industry gets overcrowded with competitors than those that are geographically dispersed. The author proposes several explanations for these seemingly counterintuitive results. One argument is that when an industry reaches its saturation point, too many companies are competing for the same resources in the same region, resulting in, for example, not enough talent in the area to keep up with demand. This can kill off weaker firms and prevent new firms from getting off the ground, especially when the goods produced in the cluster are similar and are sold locally. High exit barriers may also discourage firms from relocating when negative cluster effects begin to outweigh positive ones; substantial costs can be involved in switching locations and finding the necessary resources in a new area. Finally, the author postulates that the information age, with all its communications innovations, may have made geographic proximity to others
less important for innovation-based industries.

Bottom Line: Although analysts have long maintained that geographic proximity can help companies within the same industry prosper, clustering has little impact on a company’s bottom line.

Author Profile:
Matt Palmquist was a founding staff writer and is currently a contributing editor at Miller-McCune magazine. Formerly, he was an award-winning feature writer for the San Francisco–based SF Weekly.