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2. The Art and Technology of Economic Clustering

Published onMar 26, 2020
2. The Art and Technology of Economic Clustering
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Consider Silicon Valley technology, Florentine Renaissance art, Hollywood movies, Burgundy wine, Detroit automobiles, Paris fashion, Swiss watches, or Madison Avenue advertising. Throughout history and into the modern era, certain regions rise to become world-renowned centers for a particular industry or skill. These regional economic booms attract workers, entrepreneurs, investment, companies, political interest, and intellectual capital. Economists, historians, and business school academics give these special regions names such as economic clusters, industrial clusters, agglomerations, and industrial districts. More pointedly, Perroux1 referred to them as “growth poles,” while Hirschman2 called them “growth centers.” Politicians, regional boosters, and business executives eagerly seek the economic and financial benefits of clusters.

Silicon Valley may be the “poster child” of clusters, but many regions have grown and prospered by becoming clusters of various industries. Why do these clusters form and how can governments encourage their formation to bring economic prosperity? To help understand the answers, this chapter examines one very old and one new cluster—one brought beauty and also technology into being; and the other brought technology and also beauty.


Florence: The Silicon Valley of the Renaissance

In the annals of art, the names Michelangelo, Leonardo da Vinci, Donatello, Botticelli, Giotto, and della Robbia rank high. These artists, and dozens of others, share a common thread. All came from or worked in Florence during the fourteenth through sixteenth centuries, when that wealthy Tuscan city became a cluster for artistic endeavors of all kinds. Similarly, in the annals of technology, the names Intel, Hewlett-Packard, Oracle, Google, Apple, Cisco, and Facebook rank high. These companies also share a common thread: they arose in Silicon Valley during the late twentieth and early twenty-first centuries when this northern California region became a cluster of high-technology endeavors of all kinds. The experience of Florence, like the experience of Silicon Valley half a millennium later, shows how a concentration of resources, knowledge, innovation, and culture can create a positive feedback loop leading to long-lived economic booms in industries as diverse as art and technology.

Riding the Economic Boom

Wealth drove the rise of the Florentine art scene. Major works of art required both time and manpower. Some projects, such as Ghiberti’s twenty-eight gilded-bronze panels on the north doors of Battistero di San Giovanni in the Piazza del Duomo, took the artist and his workers some twenty-one years to complete. Artists’ workshops supported not only the master and his family but also upward of dozens of apprentices, journeymen, and itinerant artists. Artists also required a range of high-cost materials such as multiton blocks of marble and large castings of bronze, as well as rare imported ingredients such as vivid dyes, mineral pigments, and specialized oils. For example, the exquisitely blue ultramarine pigment created from lapis lazuli imported from Afghanistan was as expensive as gold.3 Florentine painters actually belonged to the same guild as doctors and pharmacists because these artists bought so many of their compounds from apothecaries.

Florence’s initial wealth came from international trade in the city’s exquisite textiles.4 Growing international trade called for logistics expertise and for capital to cover the high costs of raw materials, labor of craftsmen, shipping, and protection of goods. Florentine firms became multinational organizations with branch operations in key cities across Europe and the Mediterranean.

The city’s wealth led to growing interest in, and increasing ability to pay for, art in religious, public, and private lives. Florence became a Mecca for artists creating frescos, oil paintings, ceramics, marbles, and bronzes—and Florence became an arts cluster.

Like Florence, Silicon Valley arose in a time of growing prosperity and expanding knowledge. The Valley became a cluster for electronics and computing in the post–World War II decades of the Baby Boom. New electronics technologies from WWII and successive waves of inventions such as the transistor, the silicon integrated circuit, digital computers, Internet networking, the World Wide Web, and social media drove successive waves of entrepreneurship in Silicon Valley.

As with the varied artistic media of Florence, the stars of Silicon Valley worked their arts in multiple technological media, too. Silicon Valley companies pioneered key areas such as electronics and computer hardware (HP, Fairchild, Intel, Apple), storage (Seagate, Quantum, Maxtor), networking (Cisco, Juniper Networks), database systems (Oracle, Sybase), Internet applications (eBay, Google, Yahoo), and social media and entertainment (YouTube, Pixar, Electronic Arts, Facebook). A groundswell of computerization started in military applications and business, spread to the rising middle class of developed countries, and then became deeply embedded in even the most mundane consumer appliances. The world went from a time in which urban legend has it that Thomas Watson, head of IBM, said in 1943: “I think there is a world market for maybe five computers”5 to a time when there are more than five computers per living person.


Innovations

Silicon Valley is dedicated to and almost synonymous with technological innovation. The innovations in the valley include new ideas in the realms of mathematics, materials, and advances tied to the human world. Mathematical innovations came in the form of new computer languages (such as SQL and Java) and innumerable mathematical constructs related to digital logic circuits and computer algorithms. Of course, Silicon Valley derives its name from the material used to make semiconductors, which replaced germanium. In 1961, Fairchild Semiconductor Inc. built a circuit with four transistors on a single silicon wafer, thus creating the first silicon integrated circuit.6 By September 2009, Intel CEO Paul Otellini introduced the twenty-two-nanometer 3D Tri-Gate chip family, with three billion transistors packed into an area the size of a fingernail.7

The entire history of chip making is a story of companies learning how to paint ever smaller and faster circuits onto a silicon canvas. On average, Silicon Valley found a succession of innovations to double the number of transistors on a chip about every 1½ to 2 years for the last five decades. Valley companies accomplished this pace of improvement through advanced materials, new manufacturing technologies, and new software-based chip design methods.

Florentine Art Innovations

Florentine artists introduced many new innovations in materials and forms that fueled the explosion of artistic output. These include the introduction of perspective, anatomy, new materials, and combinations of these innovations:

Linear Perspective
Florentines pioneered the development of linear perspective in art, starting with Ghiberti, Brunelleschi, and Masaccio in the early 1400s.8 Prior to these developments, many paintings had a flat quality, with figures sized by importance; pre-Renaissance artists rendered a foreground crowd of adoring worshippers as small figures with an over-sized Madonna and Jesus in the background. The artistic innovation of perspective brought the science of optics to art. Ghiberti developed and wrote about his notions of perspective and applied these ideas to the rendering of objects in drawings, paintings, and bronzes like his famous Baptistery doors.9

The introduction of linear perspective led to significant changes in methods and results, with Masaccio producing some of the first major art works rendered in proper perspective. Artists learned mathematical and geometrical methods for properly creating the vanishing points and foreshortened shapes in a perspective view. They also crafted images with the proper proportioning and positioning of figures in the foreground and background. The advent and acceptance of these new techniques would make Florence a leading region of art education as artists flocked to the city to learn the techniques.10

Natural Figures: Anatomy
Renaissance Florence also brought a new interest in more lifelike compositions and representations of people. The artists worked at understanding the articulation of the joints and the delineation of muscles and tendons to convey effort and strain. This pursuit of knowledge includes Leonardo da Vinci’s controversial studies of human anatomy, with his explorations of internal organs by dissecting corpses.11 Florentine artists helped popularize portraits, landscapes, and nudes as art shifted from strictly religious themes to more secular images. The result was a change from static, standing figures to more dynamic compositions with the figures caught off-balance in mid-motion. Overall, Florentine artists innovated by representing what the eye saw in real life rather than presenting an idealized or stylized image.

Materials
Florentine artists also innovated with the materials they used. For example, sometime before 1445, Luca della Robbia refined a formula for opaque-white tin-oxide glaze and firing methods that converted dull, fracture-prone terracotta sculpture into especially lustrous, durable, marble-white works of art.12 Adding other metal oxides (cobalt for blue, antimony for yellow, manganese for purplish-brown) enabled della Robbia to create vivid colors that made his pieces much favored by the Medicis and others.13 Florentine merchants exported della Robbia’s works across Europe and his workshop grew to include an extended family and a large volume of production of polychrome terracotta pieces of all shapes and sizes. As a result of his success, in 1471, della Robbia was elected president of the Florentine Guild of Sculptors.14

Financial Innovations

Talented painters, sculptors, and other artists needed one crucial ingredient for success—money; the same ingredient that budding hardware and software entrepreneurs required 500 years later to fuel the high-technology boom of the late twentieth century. And the rise of both Renaissance Florence and Silicon Valley involved financial innovations that fueled the respective arts and IT waves.

Florentine Finance
At least two Florentine financial innovations enabled the accumulation of wealth in Florence. The first was the use of double-entry accounting among Florentine merchants and banks, starting sometime just before 1300.15 The new method let the Florentines track the interplay of revenues, costs, assets, and debts in a way that reduced errors. Proper accounting let them track the profits from individual ventures, which aided management of the inherently complex transactions of international trading firms. The success of Giovanni di Bicci de’ Medici, founder of the Medici bank in the late 1300s, spawned a dynasty that would effectively dominate Florentine politics from 1415 through 1737.

For the second financial innovation, Florence broke with Christian prohibitions on usury to semilegalize interest-bearing loans in 1403. On one hand, the move prompted outrage in parts of Europe. Leaders in some key trading locations, most notably Martin “the Humane”—King of Aragón, Valencia and Sardinia—expelled the free-wheeling Florentine bankers.16 Yet the expulsions didn’t change the financial need for money in global trade, or the desires of investors to find a return on their capital. Florence enjoyed a significant influx of money; even the pope put his money in the Medici bank.

By the mid-fifteenth century, Florence was a leading European financial center. And it wasn’t just the Medicis who made Florence so wealthy. Some eighty banks arose in Florence, making the city a major source of capital during the Renaissance,17 much like Silicon Valley venture firms did in California 500 years later. The Medicis and other Florentine bankers had outposts in important cities throughout Europe such as London, Bruges, Lyon, and Geneva, as well as branches in large Italian cities such as Rome, Venice, Pisa, and Milan.18 So powerful was Florence as a financial and merchant trading center that its currency, the florin, became an international standard.19 The florin lived on as a name given to various coins minted in a dozen lands ranging from Britain to the Netherlands, Hungary, and New Zealand.

Venture Capital in Silicon Valley
Silicon Valley also rode a wave of financial innovation: the rise of the venture capital firms as a new type of financial institution that aggregates the money of private investors and invests in highly speculative new ventures such as high-technology startups. The venture capitalists of Silicon Valley are the patrons of modern times. While entrepreneurs supply the inspirational ideas, the venture capitalists supply the money as well as some guidance to bring those ideas to life. In this way, one might say that the top VC firms are the Medicis of Silicon Valley. Entrepreneurs aggressively court these top-flight investors because attention and investment from one of these major firms all but guarantees a steady supply of funding and support for a new startup.

The waves of technological inventions starting in the second half of the twentieth century earned prodigious profits for technology companies and their venture capitalist investors. Sand Hill Road, connecting El Camino Real and Interstate 280, became a minicluster of venture capitalists, including leading firms such as Kleiner, Perkins, Caufield & Byers (KPCB), Sequoia Capital, Battery Ventures, Draper Fisher Jurvetson (DFJ), and scores of others. These companies provided the money, advice and support to entrepreneurs, leading to several eye-popping returns for their investors. For example, KPCB paid $4 million in 1994 for about 25 percent of Netscape and probably made close to a $1 billion from Netscape’s IPO and its subsequent $4 billion acquisition by America Online. An investment of $8 million in Cerent returned around $2 billion when the optical equipment maker was sold to Cisco Systems for $6.9 billion in August 1999. The same year, KPCB teamed with Sequoia Capital to invest $25 million for 20 percent of Google; as of October 2010 Google’s market capitalization was about $200 billion. Other successful investments of KPCB include Amazon.com, AOL, Compaq, Electronic Arts, Flextronics, Genentech, Intuit, Lotus Development, Sun Microsystems, and many others. As of 2011, over 150 of the 475 KPCB-backed companies had gone public since 1972.

New companies lived on venture capital, and existing companies accumulated deep pools of cash from sales of their highly profitable high-tech products. During the dot-com boom, venture-backed start-ups went public to raise billions of dollars in additional capital that repaid the early investors. As a result of the widespread and deep use of stock options to attract talented, risk-taking employees, Silicon Valley created instant millionaires among the employees who were attracted to and then helped build the firms that went public. This created the seeds for the next generation of entrepreneurs and venture capitalists and excited the imagination of budding entrepreneurs the world over, many of whom immigrated to the valley to start new companies.

The Role of Patrons
The Medicis may have been patrons extraordinaire and strong political leaders for much of the Renaissance, but they were really only the most famous tip of the patronage iceberg in Florence. Development of Florence’s art cluster both predated the Medici’s rise and survived the volatile political fates of that most famous arts-loving family. Other wealthy Florentine families, such as Strozzi, Ricci, Macchiavelli, Brancacci, Canigiani, Frescobaldi, and Pucci, commissioned artistic works such as frescos and altarpieces for family chapels, sculptures for gardens and villas, polychrome terra-cotta reliefs for interiors and exteriors of buildings, and family portraits.20 Wealthy patrons and guilds competed to upstage each other in the latest and greatest works of art, fueling increasing commissions that attracted even more artists in a mechanism similar to the technology boom of 1995–2001 and another beginning in 2009 in Silicon Valley. The density of wealthy patrons attracted a density of artistic ideas and the density of new ideas in art, in turn, attracted the interests of wealthy patrons, fueling the positive feedback that resulted in the timeless works of art that characterized the place and the period.

Just as leading venture capital firms took an active role in managing the start-up companies they funded, Florentine patrons actively directed work of artists, rather than passively financing art production. Patrons made specific demands, which suggest an awareness of artists’ materials, an interest in artistic design, and a desire for personal promotion through art. For example, when Florentine banker Giovanni Tornabuoni commissioned Domenico Ghirlandaio (Michelangelo’s teacher) for new frescos in the chancel of Santa Maria Novella in 1485, the banker specified in the contract the saints, scenes, the amount of gold to be used, and the quality level of the blue pigment.21


Labor, Education, and the Flow of Knowledge

Without various formal and informal methods for education and knowledge transfer, artistic innovations would have remained the idiosyncrasies of individual Florence artists. Likewise, without Silicon Valley’s free flow of ideas and tacit knowledge transfer among software engineers and chip designers, many of today’s household technology companies would not have succeeded.

Florentine Guilds and Improvement Processes

Florence illustrates how the organization of labor and training encouraged economic cluster development through both knowledge sharing and productivity improvement. Three facets of Florentine society—the workshop system, trade guilds, and access to art—drove the city’s economic rise as an art cluster and the aggregation there of artistic endeavors.

Artists have long practiced imitation as means of developing new skills and new methods. More than just a form of flattery, the intentional studying, sketching, and copying of other artists’ works enabled an artist to learn new skills. Art historians can readily trace the sharing of artistic knowledge in the works of the artists. Compositions, techniques of line, shading, coloring, and the execution of particular details (e.g., the folds of drapery) provide a code to the influences on a given artist over time. Surviving letters and records attest to the times when artists met, befriended, and studied other artists. Given a timeline of an artist’s oeuvre, historians can even detect when artists gained particular ideas from particular colleagues.

Florentine artists’ workshops were rarely the quiet havens of inspiration for solitary artists. Instead, they were bustling factories (and schools) for art production. Florentine artists used a workshop system in which boys or young men started as apprentices in the workshops of established master artists.22

The workshop system of training enshrined copying as a key skill, which aided the subsequent flow of knowledge. Artists-in-training copied their master’s style because they were expected to augment the productivity of their master. Only after the young artists achieved mastery could they leave the workshop, seek their own commissions, and develop their own style. Nor did artists stop learning from each other when they reached mastery. Learning was sometimes mutual between two masters, not just unidirectional from master to apprentice. In the early 1500s, for example, Raphael befriended Fra Bartolomeo.23 Raphael helped the older Bartolomeo learn perspective, and Bartolomeo helped Raphael in coloring and handling of drapery—a joint venture by any other name.

Artistic knowledge also moved across fields when artists started life as apprentices in one field and then moved to another. For example, della Robbia started as a jeweler’s apprentice but then moved into sculpting marble and glazed terracotta reliefs. Brunelleschi, Botticelli, Ghiberti, Ghirlandaio, and Verrocchio all started as apprentice goldsmiths.24 Many of the more famous Renaissance artists (e.g., Michelangelo and Verrocchio) produced both paintings and sculptures. This spillover between forms enhanced all the artistic disciplines. Five hundred years later another genius—in Silicon Valley—led the development of the personal computer, the graphic user interface, the mobile music industry, advanced wireless communications devices, and computerized animated movies.

Knowledge also moved across the artists’ workshops owing to an additional formal structure: the guild system. Florentine guilds were formed by groups of independent craftsmen, merchants, or business owners in a given industry, creating centers of knowledge-sharing among guild members. For some periods of the Renaissance, painters belonged to the guild of doctors and apothecaries, while sculptors were affiliated with the guild of sculptors and architects, which was part of the stone-working guild.25 Many of the more famous and multitalented artists often aligned with the prestigious goldsmiths guild, which was, at times, part of the silk guild.

Silicon Valley Culture

Burning Man is an annual event held in the Black Rock Desert in northern Nevada. It is a free-for-all week-long unstructured “happening” celebrating self-expression and community participation based on self-reliance without commercial interventions. In many ways, it symbolizes the culture of Silicon Valley, especially during its early technology boom days.

This culture can be characterized by openness and networking, leading to efficient deal making. One can find a lot of information on the Web sites and blogs of Silicon Valley entrepreneurs. They understand that great ideas require a dedicated team that shares their vision, and that such openness will attract top engineers as well as smart and helpful investors. In a book comparing Silicon Valley to Boston’s Route 128, AnnaLee Saxenian26 argues that networking—the “face-to-face shop talk and gossip of workers in bars and restaurants, at trade association meetings and in more formal business-sharing arrangements”—allows people to quickly recognize and adjust to the fast-changing high-technology environment. Both the openness and the networking lead to fast deal making and a stream of new companies.

Students, Defectors, and Job Hoppers

Whereas Renaissance artists had little formal education, the workers and entrepreneurs of Silicon Valley come from a tradition of intensive formal education, usually in engineering or the sciences, and often involving advanced degrees. Stanford, San Jose State, UC Berkeley, and more than a dozen other universities produce highly skilled workers for the valley. And in attracting top technology talent from around the world, Silicon Valley also harvests the cream of the crop of national and international name-brand schools. But education in Silicon Valley doesn’t stop with a formal degree. As with the Florentine workshop system, Silicon Valley workers continue their education while on the job.

Silicon Valley also has some unusual dynamics in workers’ relationships with companies. From the very beginning of Silicon Valley, innovation spilled out of companies as employees quit one company to found their own companies, in a mechanism similar to apprentice artists leaving their master’s shop to open their own in Florence. For example, William Shockley literally brought silicon to Silicon Valley when he left Bell Labs in New Jersey in 1953 to form the Shockley Semiconductor Laboratory in Mountain View, California, to develop silicon-based transistors. He picked the southern end of San Francisco Bay because of its pleasant climate and the proximity of Stanford University as well as his aging mother. In a pattern that would repeat itself many times in the valley, eight young engineers, who would become known as “the traitorous eight,” defected from Shockley’s company in 1957 to form Fairchild Semiconductor. In 1968, two of the “traitorous eight”—Robert Noyce and Gordon Moore—would leave Fairchild to found Intel and still other Fairchild employees would leave to form National Semiconductor and AMD.

In addition to this pattern of defectors founding new companies, Silicon Valley workers job-hop much more frequently than do high-level employees in other industries. These hops occur as engineers look for more exciting opportunities in other companies or when companies stagnate or fail. In the roiling entrepreneurial environment of Silicon Valley, people can learn by failing and have no stigma attached to them. These entrepreneurs and engineers carry all the knowledge gained from the failure to their next venture or employer.

Competitive Geeks
If Florentines celebrated art and artists, Silicon Valley celebrated technology and geeks. Silicon Valley bred a culture tied to engineers’ joy of problem solving and an intrinsic love of new technology. By and large, it was engineers and technologists, not business and marketing people, who started firms in Silicon Valley. Stories such as Bill Hewlett and Dave Packard’s founding of HP in a garage in Palo Alto epitomized the area’s engineering-focused, build-a-prototype, start-up culture. This culture attracted engineers and geeks who loved cool technology and all it that could do. These geeks wanted to be the next HP, Intel, Apple, or Google by creating the next great thing.

This focus on technological performance meant that Silicon Valley has always had rivalries in the same way that Florentine artists’ shops competed for great new commissions and patronage. And these rivalries spurred innovation, attracting more talent and more money in a positive feedback loop that contributed to the growth of the cluster.

Fresh Ideas Bring Fresh Talent

Renaissance Florence was filled with exciting small- and medium-sized businesses that defined the core of the economy. The Ponte Vecchio Bridge, alone, hosted forty-four goldsmiths’ shops. Each artist’s workshop was, in fact, a small business. The growth of the Florentine economy and the success of many of these workshops fueled the creation of new businesses.

An Influx of Artists
Some of the growth in new workshop business came from an influx of outsiders. Florence attracted artists from around Italy, including Raphael, Pietro Perugino, and Piero della Francesca, as well as artists from around Europe such as the Flemish-born Giovanni Stradano (Jan Van der Straat). For example, Raphael (Raffaello Sanzio da Urbino) was born in Urbino and apprenticed in Urbino and Perugia throughout his teens. He moved to Florence in 1504 and spent four years studying Florentine methods, which significantly influenced all his subsequent works. 27

Commercial opportunities and money also attracted talent. For example, Pietro Perugino (from Perugia, Umbria), seems to have been attracted to Florence by the availability of commissioned work. He opened a workshop in Florence and appears to have spent more than a dozen years (1486–1499) working on commissions for Florentines. 28

A Silicon Gold-Rush
As with Florence, and similar to the 1849 California Gold Rush, the opportunities of Silicon Valley attracted people, money, and attention from outside the region. More than half of the companies founded in Silicon Valley in recent decades included a foreign-born founder. Prominent companies with foreign-born founders or cofounders include Google, Yahoo, Sun Microsystems, YouTube, eBay, and PayPal. And just as Florence attracted non-Florentine artists to set up second workshops in Florence, Silicon Valley also attracted existing non–Silicon Valley companies to form divisions or research centers to tap into the valley’s deep pools of knowledge and innovation. Thus, beginning in the 1950s, New York–based IBM created a research center and disk drive manufacturing operation in Silicon Valley that developed the first disk drives and the SQL database language. And Rochester, NY–based Xerox created its famed Palo Alto Research Center in 1970.


The Commonalities of Clusters

Although separated by 500 years and representing seemingly opposite ends of the arts and sciences spectrum of human accomplishments, the Florence and Silicon Valley clusters share many common characteristics. It has long been observed that industries tend to be geographically “clustered.” Some well-known clusters were mentioned in the introduction to this chapter, including the concentration of information technology firms in Silicon Valley, California, and their counterparts along Route 128 outside Boston, Massachusetts. Other well-known examples include casinos in Las Vegas, Nevada; film production in Hollywood, California; life science companies in Medicon Valley (extending from Eastern Denmark to Western Sweden); cork products in Portugal; household furniture in High Point, North Carolina; finance and investment banking in and around Manhattan; and computer chips in Taiwan.

In addition, certain corporate functions tend to be clustered. Examples include biotechnology research and development centers in Cambridge, Massachusetts; garment and shoe design in Northern Italy; corporate innovation centers in Silicon Valley; and corporate planning and marketing in Zurich and Geneva.

This agglomeration of firms, or corporate functions, that draw economic advantages from their geographic proximity to others in the same industry or stage of value addition is a phenomenon that was originally observed and explained by the British economist Alfred Marshall in his classic 1920 work, Principles of Economics.29 Marshall hypothesized that the development of industrial complexes implies the existence of positive externalities of colocation. He attributed such externalities to three main forces: (i) knowledge sharing and spillover among the colocated firms; (ii) development of a specialized and efficient supplier base, and (iii) development of local labor pools with specialized skills.30

In the 1950s and 1960s, Walter Isard developed some of the most compelling models of industrial agglomeration, laying the foundation for and leading the (new at the time) discipline of regional science. He suggested several ways to analyze “industrial complexes,” or clusters, arguing that such methods can contribute to the understanding of regional growth and development.31,32

Michael Porter expanded on Marshal’s hypothesis and Isard’s work in a landmark 1998 paper,33 providing a detailed framework for cluster analysis, as well as many more examples of clusters in various industries. His paper focuses on the competitive advantages and the increased innovation offered by clusters. He suggests that clusters affect competition by (i) increasing the productivity of the co-located companies, (ii) increasing the pace of innovation, and (iii) stimulating the formation of new businesses.

Type of Relationships among Cluster Members

The two major types of interfirm relationships that contribute to the success of clusters can be defined as “vertical” and “horizontal.”

Vertical Relationships
Vertical relationships are links between trading partners. Trading partner relationships are important because the lion’s share of value most nonservice businesses offer to their customers is obtained through procurement of parts and services from suppliers. On the procurement side, commercial enterprises interact with a network of material and parts suppliers and an array of service providers. On the sales side, they interact with distributors, customers, and other service providers. Managing these relationships is of prime importance, especially as firms move away from vertical integration and increasingly outsource many functions and stages of production. The ultimate examples of vertical clusters are those created by a single “channel master,” such as “Toyota City” in the Aichi prefecture, or the cluster of aviation suppliers servicing Boeing in Everett, Washington. As an example of the wide economic effect of such a channel master, consider the impact of the BMW plant in Greer, South Carolina. It employs 5,000 workers directly and supports over 23,000 jobs in the state, because many BMW suppliers decided to colocate around Greer.34

An example of a cluster driven mainly by the availability of a specialized labor pool is the Dalian, China, high-technology cluster, which primarily serves Japanese companies. Because of Japan’s colonization of Manchuria from 1931 to 1945, the area, including Dalian, has a large pool of Japanese-speaking workers. This led Japanese companies to set up operations in Dalian, hiring local engineers at less than one-third of the cost of Japanese engineers.35 Dalian, for its part, started teaching Japanese as a second language in schools, thereby accelerating the trend.

Horizontal Relationships
Horizontal relationships are between firms at the same stage of production, such as automobile manufacturing plants in Detroit, Michigan, or film studios in Hollywood, California. These firms both compete and cooperate with each other along dimensions that benefit them. Horizontal relationships also exist between functions in firms of the same or different industries. Thus, human resources, legal, procurement, finance, and supply chain management functions may collaborate across companies and industries.

The presence of many qualified customers is both the effect and the cause of urban concentrations of businesses offering goods and services similar to each other. When hairdressers in Boston talk about working on “The Street,” they do not mean Wall Street, but rather Newbury Street in the Back Bay of Boston, which is home to dozens of women’s beauty salons along the eight blocks between Arlington Steet and Massachusetts Avenue. Similarly, there are hundreds of jewelry shops right next to each other in the four blocks of Liberato Street in Buenos Aires between Avenue Corrientes and Avenue de Mayo. And there are hundreds of merchants of knock-off goods in the Museum Market and the Yu Garden market in Shanghai.36 Such agglomerations are clearly not driven by supply side considerations but by demand; customers understand that such clustering means competitive prices, high quality, and availability—and the foot traffic leads more businesses of that type to settle in the cluster.

Naturally, most clusters include both vertical and horizontal types of relationships. Thus, Detroit and its vicinity is composed not only of many automotive plants but also a legion of suppliers and subsuppliers’ plants, as well as educational institutions and a large employee pool. Similarly, Hollywood includes major studios but also a myriad of technical and artistic suppliers, as well as the professional human resources necessary to bring films to life.

Clusters grow as a result of “positive feedback” or “reciprocal reinforcement” forces. As more companies of a certain type (or certain corporate functions) move in, more suppliers and customers move in, making the cluster even more attractive. Furthermore, as the cluster grows, its influence with government grows, affecting further infrastructure investments as well as advantageous regulations, attracting—again—even more companies.


Why Cluster?

In many ways, the existence of clusters today is surprising. In the past, such agglomerations enabled communications. Consequently, one can understand the success of clusters like the Incense Route along the Horn of Africa; carpet-weaving in North-West Persia; glass-blowing in Phoenicia; and the obsidian industry of Teotihuacán, Mexico—all of which were important to perfecting the local state of the art and therefore key to economic growth. What is not intuitive is why such agglomerations still persist today, when we already have efficient supply chain management processes and advanced global communication technologies.

In many ways, Tom Friedman’s bestseller The World Is Flat37 popularized the idea that globalization means The End of Geography38 and The Death of Distance,39 as earlier authors argued. Yet—even in today’s world of efficient global supply chains, instant communication, electronic worldwide financial industry, free flowing knowledge, and enhanced human mobility—over half the world’s population now lives in urban areas,40 and that portion is increasing. Commensurate with this trend, the economic leadership of megacities has become more pronounced.41

Urban areas are obvious clusters of human activity, leading to superior economic performance. The agglomeration of people and businesses means that it is economical to develop the many levels of infrastructure needed for enhanced economic performance, including the physical layer (roads and bridges, water and sewage systems, etc.); the energy system (power generation and transmission); and the myriad of services, basic and advanced, that urban areas provide (emergency, health, mobility, entertainment, cultural, educational, etc.).

Cluster Advantages

Industrial clusters form because they yield certain advantages, as noted by many economists. Some of these advantages include trust between cluster inhabitants, tacit knowledge exchange, a collaborative environment, the support for research and educational institutions, and the availability of a supply base.

Trust
By their geographical colocation, cluster inhabitants are subject to the same cultural environment, language, customs, and legal regime. Common experiences make it easier to develop trust among organizations and people, leading to lower transaction costs between firms, whether they are trading partners or horizontal collaborators/competitors. In most cases, this trust is based on relationships forged outside the work environment. Thus, Hollywood, Wall Street, and Silicon Valley are famous for their deal-making ability, based on deal participants’ reputations and familiarity, giving them a competitive advantage over outsiders.

Tacit Knowledge Exchange
As systems and services become more complex, much of the knowledge associated with their development and operations cannot be codified in something as simple as an email attachment sent to a supplier. Tacit knowledge exchange requires discussions over specifications with a supplier; exchanging benchmarking information with a competitor; or supporting a customer—all made easier, faster, less expensive, and more effective when conducted within a cluster, particularly using face-to-face and chance meetings. This holds for both vertical and horizontal corporate relationships. A related phenomenon is knowledge spillover. As Rodríguez-Posea and Crescenzi argue: “the process of knowledge accumulation gives rise to spillovers that could benefit a whole set of potential (intended or unintended) beneficiaries.”42 Much of this knowledge exchange takes place informally, between programmers, traders, technicians, and growers, depending on the type of cluster involved. Knowledge spillover is characterized by chance interactions among individual contributors, unlike deal making or formal benchmarking.

Collaboration
The concentration of firms in the same industry, with their similar needs and concerns, gives natural rise to joint activities. These activities include lobbying for the provision of infrastructure, regulatory relief, incentives, and other government largess; development of and participation in organizations dedicated to cluster development, such as chambers of commerce; establishment of cluster-focused procurement strategies, leading to lower costs and higher quality for all members; engagement in cluster-specific marketing and branding activities; and so on. Such collaborative activities are conducted based on both horizontal and vertical relationships between firms in the cluster. Porter referred to the organizations through which such activities take place as institutions for collaboration (IFCs)43, which can be either formal or informal.

Research and Education
The strength of engineering and computer science at Stanford University and biotechnology and engineering at MIT mean that companies located in Silicon Valley and “Bio-Cambridge” have access to state-of-the-art research and have a steady supply of educated employees. In addition, faculty and students can work in their laboratories on real problems using actual data. Such symbiotic relationships between universities and industry clusters are not limited to the information technology or biotechnology industries. For example, Sonoma Valley sports the Wine Business Institute in Sonoma State University, and the nearby University of California-Davis offers, arguably, the leading program in the United States for viticulture and enology. The relationship between universities teaching special skills and the neighboring commercial communities engaged in those skills is not dissimilar to the role of Florence’s apprentice system that trained generations of Renaissance artists.

Many clusters support vocational education and training both to increase the supply of employees and to upgrade capabilities. While online training and education is an option, it is still not as effective as a classroom where students can learn as much from each other as from the instructors, and where they can interact with executives from various cluster firms, sharing their wisdom and interacting with students in a way that no webinar can yet match.

Supply Base
As mentioned by Marshall in 1920, clusters attract suppliers who see advantages in locating next to their customers. Even in today’s environment, the opportunities for unstructured and chance interaction with customers, the opportunities to learn where their business is heading. and the opportunities to forge strong, trusting and collaborative relationships with customers are very important when firms make location decisions. From the customers’ point of view, a strong supplier base with multiple suppliers bodes well for competitive pricing and supplier innovation, which are crucial for competitiveness.

One of the most important consequences of these advantages is that clusters can be very productive and efficient in spawning various new activities. The most significant of those activities may be innovation and the formation of new companies that can use the cluster resources to go to market, grow, and scale. But the existence of cluster expertise, knowhow, money and relationships does not only manifest itself in new companies. The entire movie industry is based on numerous experts—individuals and companies—coming together for a project, namely making a movie. These individuals include writers, producers, animators, cinematographers, editors, musicians, wardrobe designers, makeup artists, actors, sound engineers, special effect producers, and many others. Having all the required ingredients in Hollywood makes it easier to put together the required ensemble for a movie production. Similarly, it is easier to launch a new mutual fund in Boston or a sophisticated financial product on Wall Street. The presence of expertise and support functions enables and supports the innovation process, whether performed within a company or by forming new ones.

Making Clusters Work
Despite what some economists and academics argue,44 governments do have a role in cluster formation and development. Even Silicon Valley, the high point of entrepreneurship, was helped by defense spending on technology around the Bay Area during and after WWII, and government grants were instrumental in funding research and development in the higher education institutions in the area. The influence of the public sector can be direct or oblique.

“State-Sponsored” Clusters
Some clusters have a strong “state-sponsored” heritage or origin, usually from military spending or government research laboratories.45 For example, the telemarketing cluster in Omaha, Nebraska, owes much to the decision by the United States Air Force to locate the Strategic Air Command (SAC) there. Charged with a key role in the country’s nuclear deterrence strategy, SAC had the first fiber optic telecommunications installation in the United States because fiber-optics are immune to the electromagnetic pulse generated by nuclear explosions. This government work gave the Omaha-based contractor, Kiewit Corporation, much experience in the new technology. The contractor went on to build private fiber networks, starting in Omaha and expanding to include the first nationwide fiber-optic network. With growing local experience in telecommunications and the ultralow cost, per call, of carrying calls on fiber, Omaha became a cluster for call centers. As of 2011, six fiber optic networks converged in the city; twenty-three corporate call centers there answer twenty million calls per day.

Cluster-Enabling Infrastructure
Governments provide a range of infrastructure and services that enable any economic system, and in particular free enterprise, to exist in the first place. Thus, physical infrastructure, regulatory frameworks, patent laws and law enforcement institutions, trade agreements, as well as an array of social, medical, educational, and other services are the cornerstone of any economic system. Naturally, governments can do more or less to help businesses succeed. To this end, global analyses such as the World Economic Forum’s Global Competitiveness Report46 or the World Bank’s Ease of Doing Business Index47 provide rankings of countries along business-relevant dimensions related to the ease of doing business in the countries studied.

Education and Research
Education and research, invariably with government backing, aid cluster development by enhancing a skilled workforce, developing new knowledge, and creating a source of entrepreneurs.

Advanced education in a cluster encourages entrepreneurship. More than 80 percent of the scientists from California research institutions who started their own biotechnology firms did so in California.48 Similarly, a Kauffman Foundation study credited MIT-spawned companies with employing more than a million workers in Massachusetts alone.49 Thus, education creates a positive feedback loop in which graduates of a given university stay in that locality, either joining local firms or starting new businesses in the university’s strongest fields of study. These entrepreneurial alumni then support their alma maters, fund research, and support employee education.

Culture
Local culture shapes economic behaviors such as risk-taking, cooperation, and information sharing, all of which are also important to clustering. As mentioned on page 37, cultural differences between Boston’s Route 128 and Silicon Valley’s high-technology clusters—especially differences in openness and tolerance of failure—have been cited to explain the greater success of the California cluster.50 Similarly, Baltimore hasn’t developed a strong biotechnology cluster (despite Johns Hopkins’s prominent position among the nation’s leading medical research institutions) because, some suggest, of a persistent culture unwelcoming of entrepreneurship.51

I had an experience that may explain one facet of the effects of “culture.” During 2002 and 2003, I was on faculty sabbatical at Cambridge University in the UK as part of the Cambridge-MIT Institute (CMI). CMI was funded by the UK government with the express goal of increasing entrepreneurship output of UK university research. MIT, with its long tradition in this area—MIT has spawned over 25,800 active companies employing more than 3.3 million people and generating worldwide annual revenues of $2 trillion52—seemed to be the perfect partner.

While conducting my own research (unrelated to the subject of entrepreneurship), I had discussions with dozens of government, academic, and business leaders in the UK on the subject of entrepreneurial culture. As a five-time entrepreneur myself, I had firsthand knowledge and experience in this area. It became clear to me that, at the time, one of the impediments to a higher rate of business formation in the UK could not be cured by work done at Cambridge University, nor at any other British university. In many ways, it was the attitude toward failed entrepreneurs that was the barrier. Among US venture capitalists, executives, and academics, a failed enterprise tends to be seen as evidence the entrepreneur is a person seasoned by hard experience. In the UK, by contrast, it seemed to be damning. A failed entrepreneur found it more difficult in the UK than it would be for him or her in the United States to raise funds, put together a team, and get the first few sales. In short, despite the learning experience, it was difficult for a failed UK entrepreneur to get another new business off the ground.

Why Not “Go all the Way”?

Given all the advantages that clusters bring, one can ask, why don’t firms in a cluster end up acquiring each other to form larger enterprises, if closeness is so advantageous? Transaction cost economics53 suggests that being part of a single organization can have many benefits, as incentives are more aligned, the need for formal contracting is eliminated, and decision-making can be faster. The answer, most likely, is that membership in a cluster provides what engineers and economists call “real options”—cluster membership gives member companies the right (or opportunity) but not the obligation to do business with any other cluster member.

In many ways, a cluster may be an optimal balance between the complexity, bureaucracy, lock-in with internal suppliers, unionization, and slow decision making that hamper innovation in large enterprises, and the lack of scale and reach that holds back smaller firms. In a dynamic environment, when innovation and fast market response are keys to competitive advantage, the tacit communication and trust building between smaller firms (and between their employees, who share culture and extensive personal contact) allows for joint learning and adoption of best practices. Yet the separate and independent decision making of the firms in the cluster may decrease “groupthink,” allowing the cluster to adopt new technologies and process innovations, thus renewing itself and remaining competitive. Consequently, a cluster may be an advantageous organizational structure, balancing flexibility and fast decision making on the one hand with reach and resource availability on the other. In Porter’s words, “A cluster allows each member to benefit as if it had greater scale or as if it had joined with others formally—without requiring it to sacrifice its flexibility.”54


The Ongoing Quest for Economic Elixirs

In large part because of the influence of Porter’s work (as well as others), many governments have chosen the cluster development path to foster economic development. The reason may have a lot to do with the phenomenal success of the well-known clusters of Silicon Valley, Hollywood, and Wall Street. As some economists have argued, it also gives policymakers a strategy and rationale for economic interventions and the implementation of industrial policy. In addition, the cluster model is intoxicating in that many governments believed that they only have to start the “flywheel” and the positive feedback loop of early companies getting economic advantages that draw in more and more companies will grow the cluster “automatically.” This seems like a panacea—just put in some of the initial ingredients and the cluster will grow on its own.

Many economists, however, have pointed out several negative effects of clusters and risks associated with pursuing cluster-based development strategies. They argue that some of the very ingredients that make clusters successful can be their Achilles’ heels.

Downside of Clusters

Unlike diamonds, clusters are not forever. Most clusters have life cycles, starting with a nascent period generated by innovation or internal investments; growth, when imitators and competitors move in and entrepreneurs spin off new companies; maturity, when competition is based on costs and more outsiders move in; and decay, when products or services become replaceable by lower cost and/or better substitutes elsewhere.55

For example, in the 1940s, St. Louis, Missouri, was dominated by the shoe industry. As the saying went then, “St. Louis was first in shoes, first in booze, and last in the American League [in Major League Baseball].” Yet, a few decades later, the shoe industry was basically gone. Similar fate was experienced by the British cotton industry in Lancashire;56 the copper smelting industry in Swansa, Wales;57 and the tire industry in Akron, Ohio. In a detailed analysis, Donald Sull chronicled how the tire industry, which was among the most innovative in the United States between 1900 and 1935, faltered between 1970 and 1980 in the face of the radial tire technology introduced by the French company, Michelin. In the span of eighteen months, three of the four Akron tire manufacturers ceased to exist as independent corporations.58

One of the explanations for cluster decline and failure is that their very advantage—the flow of information and knowledge—can create a kind of groupthink that hampers the ability of cluster firms to respond to external changes. Such a phenomenon is likely to take place in mature clusters, which have settled on a dominant design and “best” set of processes. The benefits of all forms of knowledge exchange decline as the cluster matures, while the risks of inertia rise. Existing processes and common wisdom are taken for granted, regardless of changes in the competitive environment.59 Furthermore, bureaucratic processes set in and the resistance to change grows.60 In his 2012 book about the near-death and resurrection of the Ford Motor Company, Bruce Hoffman describes this phenomenon at length within Ford and at the two other Detroit auto giants, leading to government bailouts of GM and Chrysler, the bankruptcy of GM and the takeover of Chrysler by Fiat.61

Risks of Cluster-Based Development Strategy
As national and local governments pursue cluster strategies, they should be aware of several risks associated with such a course of action. First, such economic development strategy calls for “picking winners.” In other words, the government has to decide which industry it intends to support for cluster development. Governments, however, may not be adept at this and may not be able to bring together all the ingredients of successful clusters. Thus, projects like Tsukuba, Japan’s “Science City,” and Egypt’s “Silicon Pyramid” have not developed into the engines of economic growth that their backers hoped.

A 2011 story in the Wall Street Journal chronicled the failed effort to start a chip-making industry in Orlando, Florida. A public-private coalition spent more than a billion dollars to build advanced microchip labs. They also offered further grants and tax breaks to other semiconductor companies, and funded job-training programs at local universities. The industry, however, shifted to Asia and the advanced labs were physically demolished in 2010. The article outlines several other failures of cluster building efforts.62

Making matters worse, the essence of cluster strategy is to promote only certain industries, thus “putting many eggs in a single basket.” In other words, such a strategy may accentuate the risk of a regional recession when the cluster fails, as happened in Akron when the tire industry there failed. In fact, the main impetus for the development of the logistics cluster in Zaragoza, Spain (see the third section of chapter 1) was the drive to diversify the local economy, which was strongly dependent on the local automotive cluster around the local GM Opel plant.

In many cases, cluster strategies are aimed at supporting existing local industries. The main analytical tool used to identify such industries is the so-called “Location Quotient” (LQ), which is the ratio of the percent of people employed locally in a given industry to the percentage of employment in that industry nationally. A ratio greater than 1 indicates the prevalence of a particular industry in a location, possible existing export activities, and that this high-ratio industry qualifies as a target for public investment. More advanced approaches augment the LQ by adding other factors. For example, the method developed by the Regional Economic Development Research Laboratory at Clemson University63 identifies local industrial clusters by adding other screens to the LQ, including the number of establishments of a particular industry in the region and an identification of the industry’s value chains’ tie to companies in the cluster under study.

The basic criticism of such approaches is that despite recent advances, they can identify only past and present strengths and therefore may lead to investments in past industries—“chasing smokestacks.” And since, as every investment advisor tells her clients: “past performance is no guarantee of future results,” the effects on investments in current industrial strengths are not clear. It is unlikely that emerging or nascent industries will be identified as investment candidates by any method looking at past and present numerical data. Such shortcomings may also take place, in part, because existing industries in a region have the money and political connections to press for public investments benefiting them.

Logistics Clusters
This book focuses on a specific type of cluster—logistics clusters. These clusters include firms providing logistics services, such as third party logistics service providers (3PLs), transportation carriers, warehousing companies and forwarders; the logistics operations of industrial firms, such as the distribution operations of retailers, manufacturers (for both new products and after-market parts) and distributors; and the operations of companies for whom logistics is a large part of their costs.

As outlined in the following chapters, successful logistics clusters require certain geographical attributes, such as a central location and significant government investments in physical infrastructure. These are in addition to an appropriate labor pool, information and communications technology infrastructure, availability of a strong financial services industry, and a competitive regulatory regime.

Many locales are looking to develop logistics clusters for four main reasons:

First, in developed economies, the logistics industry can replace lost manufacturing jobs, as happened in southern California in the last part of the twentieth century and the first decade of the twenty-first.

Second, the logistics industry is less susceptible to “off-shoring” because of the technology and economics of transportation and distribution. The first and second factors mean that logistics clusters can ease unemployment pressures, especially for low-end jobs, while also adopting, relying on, and developing leading-edge information and communication technologies.

Third, a logistics cluster can serve as “infrastructure” to other industries that require specific logistics capabilities. This phenomenon seems to be the case in China, where a significant number of large logistics clusters have been developing at the beginning of the twenty-first century and new ones are under development in support of the manufacturing base and the burgeoning internal markets of China.

Finally, the logistics industry does not depend on a single industrial vertical; logistics clusters serve multiple industries and thus are less vulnerable to the vagaries of any particular industry.

These themes are revisited, in more detail, in later parts of this book.

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Copyright © 2012 Massachusetts Institute of Technology. (All rights reserved.)
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