Comparative Advantage of a Region May 11, 2011

2 Comparative Advantage of a Region I.Alfred Marshall’s industrial cluster II.Michael Porter’s diamond model III.Paul Krugman’s economic geography IV.Examples: Silicon Valley, Hsinchu

3 Industrial cluster  Alfred Marshall explains the geographical concentration of industry (industrial cluster, industrial district) by external scale economies, which are underlined by three forces: specialized suppliers, labor pooling, and knowledge spillovers.  Specialized suppliers: Specialized suppliers provide machinery, equipment, intermediate goods so as to increase productivity of all firms in the region. Specialized suppliers arise only if the industry and the number of firms are large.

4 Industrial cluster  Labor pooling: Concentration of industry leads to concentration of skilled workers, increasing the flexibility of labor market and reducing the cost of labor turnover. Labor pooling also intensified the inter- firm competition within the region, making entry and exit easy, which in turn, supporting the long-term dynamics of the region.  Knowledge spillovers: Proximity of firms facilitates knowledge spillovers, which improve the efficiency of R&D and accelerates innovations. In addition, proximity also facilitates information dissemination, which enhances the market efficiency and reduces the cost of enforcing market-institutions (e.g., commercial norms).

5 Industrial cluster  Marshall explains the positive feedback process (agglomeration) of an industrial cluster, but not the origin of the cluster. The origin may be traced back to natural resources, geography (transportation), human resources, or some historical incidents. It is most difficult to find the recipe that starts a cluster.

6 Diamond model  Michael Porter’s explains the competitive advantage of a region (nation) by four factors: (1) firm strategy, structure, and rivalry, (2) demand conditions, (3) related and supporting industry, (4) factor conditions.  Structure and rivalry: A pro-competition market structure with good rivalry is conducive to a competitive advantage.

7 Diamond model  Demand conditions: This is amounts to a home- market effect. Home market demand conditions define product differentiation and builds a special strength for the local industry. For example, German values precision, French values glamour, American respects forces and power, Japanese living conditions give rise to a market for miniatures.

8 Diamond model  Supporting industry: The strength of the supporting industry and the working of industry network are key to a region’s competitiveness. A country can not have a good auto industry without a good metal industry. A country can not have a good electronics industry without a good chemical and a mould industry. The proximity of supporting industry reduces coordination costs and facilitates information exchange.

9 Diamond model  Factor conditions: Both natural resources and specialized factors can be a source of competitive advantage, but the latter is more important. Specialized factors include skilled labor, capital, and infrastructure. They are not endowed but created and invested. Switzerland dominates the world’s watch industry with its technicians. Scientists, engineers, traders, financiers can all be sources of competitive advantage.

10 Diamond model  Porter’s model points out the roles of market structure, demand conditions, and cultivated resources.  The role of market structure in trade can be illustrated by the difference in Taiwan and Korea’s competitive advantage in semiconductor, consumer electronics, and auto industries. It can also be illustrated by the difference between US and Japan, or between Germany and Italy.

11 Diamond model  Demand conditions matter only if domestic sales precede exports, which is more true for developed countries. The premise is also true for service trade. Domestic demand shapes the direction of differentiation.  The role of human resources are also highlighted by macroeconomics in the 1990s as the central force of endogenous growth.

12 Paul Krugman  Krugman brought a new perspectives to economic geography (new economic geography) by introducing the concepts of product differentiation and scale economies.  Krugman’s model highlights the “size” effect, which differs from the traditional trade models.  A large country dominates a small country by offering more varieties of products at lower prices under autarky.  When trade opens and transportation cost is non-zero, which is key to his model, a large country enjoys a wage premium over a small country due to the advantage of proximity to a large home market—home market effect.

13 Paul Krugman  However, in a two-factor (worker and peasants) two- sector (manufacture and agriculture) model, a large worker group competes for agriculture products, resulting in a higher agriculture price or a lower real wage rate—competition effect.  The home market effect leads to a convergence of manufacturing production while the competition effect leads to a divergence. The degree of concentration depends on transportation cost.

14 Examples  Anne Saxenian’s study of Silicon valley vs. Route 128 (Boston) found that the structure of regional economies matters.  Studies of high-tech clusters identified three factors to be important to the emergence of such clusters: entrepreneurship, skilled workers, linkage to a growing market.  Hsinchu was considered one of the few successful high- tech clusters in developing countries.  All three factors mentioned above can be identified; but scale economies (industry size) and innovation appear to be important as well.

15 Examples  Shahid Yusuf identified several common features of clusters:  Products: Cluster is a congregation of firms in the same industry, however broadly defined. Horizontal and vertical linkages are evident.  Geography: A cluster is almost sure to be located near a urban setting.  Good environment to do business: An environment which is friendly to start-ups and growth of business firms.

16 Examples  Incentives: Policy incentives provided by central and local governments.  Labor market: Access to a deep pool of skilled and technical workers.  Innovation: The innovation capability comers from (1) industry size (2) knowledge base (3) linkage to a growing and changing market. A cluster lacking the innovation capability will not last, i.e. a competitive advantage does not sustain without changes.