The Industry choice

Alex Martelli aleaxit at
Mon Jan 3 00:08:25 CET 2005

Bulba! <bulba at> wrote:

> True. I have a bit of interest in economics, so I've seen e.g.
> this example - why is it that foreign branches of companies
> tend to cluster themselves in one city or country (e.g.

It's not just _foreign_ companies -- regional clustering of all kinds of
business activities is a much more widespread phenomenon.  Although I'm
not sure he was the first to research the subject, Tjalling Koopmans, as
part of his lifework on normative economics for which he won the Nobel
Prize 30 years ago, published a crucial essay on the subject about 50
years ago (sorry, can't recall the exact date!) focusing on
_indivisibilities_, leading for example to transportation costs, and to
increasing returns with increasing scale.  Today, Paul Krugman is
probably the best-known name in this specific field (he's also a
well-known popularizer and polemist, but his specifically-scientific
work in economics has mostly remained in this field).

> China right now)? According to standard economics it should
> not happen - what's the point of getting into this overpriced
> city if elsewhere in this country you can find just as good
> conditions for business. 

Because you can't.  "Standard" economics, in the sense of what you might
have studied in college 25 years ago if that was your major, is quite
able to account for that if you treat spatial variables as exogenous to
the model; Krugman's breakthroughs (and most following work, from what I
can tell -- but economics is just a hobby for me, so I hardly have time
to keep up with the literature, sigh!) have to do with making them

Exogenous is fine if you're looking at the decision a single firm, the
N+1 - th to set up shop in (say) a city, faces, given decisions already
taken by other N firms in the same sector.

The firm's production processes have inputs and outputs, coming from
other firms and (generally, with the exception of the last "layer" of
retailers etc) going to other firms.  Say that the main potential buyers
for your firm's products are firms X, Y and Z, whose locations all
"happen to be" (that's the "exogenous" part) in the Q quarter of town.
So, all your competitors have their locations in or near Q, too.  Where
are you going to set up your location?   Rents are higher in Q than
somewhere out in the boondocks -- but being in Q has obvious advantages:
your salespeople will be very well-placed to shuttle between X, Y, Z and
your offices, often with your designers along so they can impress the
buyers or get their specs for competitive bidding, etc, etc.  At some
points, the competition for rents in quarter Q will start driving some
experimenters elsewhere, but they may not necessarily thrive in those
other locations.  If, whatever industry you're in, you can strongly
benefit from working closely with customers, then quarter Q will be
where many firms making the same products end up (supply-side

Now consider a new company Z set up to compete with X, Y and Z.  Where
will THEY set up shop?  Quarter Q has the strong advantage of offering
many experienced suppliers nearby -- and in many industries there are
benefits in working closely with suppliers, too (even just to easily
have them compete hard for your business...).  So, there are easily
appreciated exogenous models to explain demand-side clustering, too.

That's how you end up with a Holliwood, a Silicon Valley, a Milan (for
high-quality fashion and industrial design), even, say, on a lesser
scale, a Valenza Po or an Arezzo for jewelry.  Ancient European cities
offer a zillion examples, with streets and quarters named after the
trades or professions that were most clustered there -- of course, there
are many other auxiliary factors related to the fact that people often
_like_ to associate with others of the same trade (according to Adam
Smith, generally to plot some damage to the general public;-), but
supply-side and demand-side, at least for a simpler exogenous model, are

Say that it's the 18th century (after the corporations' power to stop
"foreign" competition from nearby towns had basically waned), you're a
hat-maker from Firenze, and for whatever reason you need to move
yourself and your business to Bologna.  If all the best hat-makers'
workshops and shops are clustered around Piazza dell'Orologio, where are
YOU going to set up shop?  Rents in that piazza are high, BUT - that's
where people who want to buy new hats will come strolling to look at the
displays, compare prices, and generally shop.  That's close to where
felt-makers are, since they sell to other hat-makers.  Should your
business soon flourish, so you'll need to hire a worker, that's where
you can soon meet all the local workers, relaxing with a glass of wine
at the local osteria after work, and start getting acquainted with
everybody, etc, etc...

Risk avoidance is quite a secondary issue here (except if you introduce
in your model an aspect of imperfect-information, in which case,
following on the decisions made by locals who may be presumed to have
better information than you is an excellent strategy).  Nor is there any
"agency problem" (managers acting for their interests and against the
interest of owners), not a _hint_ of it, in fact -- the hatmaker acting
on his own behalf is perfectly rational and obviously has no agency

So, I believe that introducing agency problems to explain clustering is
quite redundant and distracting from what is an interesting sub-field of
(quite-standard, by now) economics.

There are quite a few other sub-fields of economics where agency
problems, and specifically the ones connected with risk avoidance, have
far stronger explicatory power.  So, I disagree with your choice of


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