On Tuesday, Ed Miliband used his keynote speech to the Labour Conference in Liverpool to push for ‘good’ firms to be rewarded by government. While this policy may seem attractive, Henry Overmanusing the example of innovative clusters, argues that this approach overestimates government’s ability to actually improve business competitiveness.

Ed Miliband tells us he wants to reward good families and firms. Where there are details, they raise as many questions as answers. Allocating housing on the basis of criteria other than needs throws up big questions. It’s not clear to me why we want people to do apprenticeships in firms that have government contracts, etc. Stepping back from the details, Ed Milliband says that what they will do is change the regulatory and tax framework to carefully reward good firms. This is fine in principle, but in practice I worry that this sort of thing vastly overestimates the ability of government to intervene in a way that actually achieves its objectives.

One analogy springs to mind – what policy might do to ‘reward innovative firms located in clusters’. For those of you that want the headline message – it turns out to be incredibly difficult to know what we should do (if anything) to reward innovative clusters of firms.

There is an extensive policy literature on clusters that uses the existence of agglomeration economies to justify a whole range of policy interventions. Such an approach could be used to develop policy options for encouraging innovative clusters of firms. Policy makers like this approach because it argues for a strong role for active policy and usually involves the introduction of a range of ‘innovative’ policy measures. A significant number of academics like it too, for similar reasons. In contrast, most mainstream economists, and a number of leading economic geographers, are sceptical, if not hostile, to this approach and thus cautious about the policy conclusions that this literature reaches. As noted by Gilles Duranton, “the [main] problem with the cluster policy literature is one of a lack of well-articulated theory: what is the ‘problem’ that cluster initiatives are trying to fix?” This problem lies at the heart of economists objections to this approach.

A common answer to the question about the role of cluster policy is that it aims to improve local “competitiveness” or productivity. The problem with this answer is that it does not clearly set out the source of any possible inefficiencies (or inequities) and thus cannot explain how to correct for them. Porter’s famous diamond attempts to map out the underlying sources of competitiveness. The resulting model appears to be complex with many different elements all feeding in to one another. But this complexity is actually rather superficial as all of the different elements feedback positively to other elements. A complex policy mix is called for, but fortunately, in Porter’s model, all policy actions on any component of the diamond will help strengthen the cluster.

Of course, in reality this will not be the case because of the presence of negative feedback. For example, in many cases, reducing barriers to entry in a sector which is already reasonably competitive, may hamper the development of new products (because firms offset the cost of innovating against the profits that they make once they innovate; entry drives down these profits and reduces incentives to innovate all else equal). Yet clusters policies often advocate increasing both entry and new product development as mutually reinforcing elements in strengthening a cluster.

The second problem with the diamond model is that, despite its apparent complexity, it pays no attention to some fundamental drivers. For example, what is being assumed about labour mobility? If firms are mobile, but workers are not, how can one be sure that encouraging larger clusters in a particular place is a good idea? Similarly, what is being assumed about the functioning of the land market? It is quite possible that any surplus generated by increasing the size of the cluster just translates in to higher rents for owners of land. Models of urban economics show that the answers to such questions are fundamentally important in understanding the functioning of the spatial economy and in assessing the role, if any, for policy. Yet the diamond model is silent on these issues. This is particularly important in the UK context, where planning for housing and commercial land use is one of the key policy levers available at the sub-national level.

Finally, even if there is positive feedback between the different elements of the diamond model, this does not actually provide a justification for policy intervention. Such a justification needs to be based on carefully identifying reasons why the market ignores these positive feedbacks and produces an inefficient outcome. That is, we need to look for market failures and construct policy to address them accordingly. Unfortunately for the clusters policy approach, simple models that do this, suggest that market failures can lead to clusters being too big as well as too small. In other words, effective clusters policy might actually call for a reduction in the size of clusters.

In the absence of government intervention would we expect cluster sizes to be above or below this optimal size? The answer depends on the mobility of workers and firms. If firms are reasonably mobile (which is likely to be the case) then clusters tend to be too large. This is because when firms enter the cluster they take account of the benefit to them (of being able to pay a higher wage as a result of agglomeration economies), but they ignore the increased costs to all the other firms. This is an example of a coordination failure. One way to solve this coordination problem is to have some large agent come along and help firms recognise the additional costs that they impose on other firms or else restrict the size of clusters. In other words, in this simple world, government should be working to decrease the size of clusters, not increase them.

Of course, this explanation is too simple, because there are externalities on both the benefit and cost side of cluster formation. Firms ignore both types of externalities when making their decisions. Cluster advocates focus on the unexploited benefits to argue that clusters will be smaller than optimal. In reality, there are cost externalities as well as agglomeration externalities which may make the social optimum for the cluster bigger or smaller than the private optimum. However, even if the social optimum is bigger than the private optimum this doesn’t necessarily mean government policy needs to expand the size of the cluster because private decisions may have already led to the cluster being too big relative to the private optimum.

Of course, these conceptual issues might not matter at all if cluster advocates could point to a large number of cases where carefully designed public policies have had significant effect on both the size of clusters and their competitiveness. Unfortunately, a recent meta-survey of more than 750 clusters finds evidence that government policy does not do this. For example, van der Linde finds that “Random events or government influence […] are the least important determinants in competitive clusters, while they play a much more important role in uncompetitive clusters”. Cluster creation policies perform even worse. For the over 750 clusters that van der Linde studied, only one competitive cluster has been established as a result of a specific government policy to attract it. In short, even if we wanted to, simplistic implementation of cluster policies appears to do essentially nothing to create or increase the competitiveness of clusters.

As I said at the very beginning, Ed Milliband’s idea may sound good in theory but it will certainly be very difficult to implement in practice.

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A longer version of this article was originally posted to the LSE SERC blog on 28 September You can also follow the LSE Spatial Economics Research Centre on Twitter at @LSE_SERC.

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