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Regional Dimensions of Enterprise Development

Presentation to the Manufacturing Prosperity Conference
Adelaide, 10th July 2000

Introduction

I would like to do two things during this presentation.

The first is to make some brief, general and perhaps already familiar points about the role of enterprise creation in local and regional development.

I will then consider a field that has attracted much policy interest in recent years, namely enterprise clusters and networks. And here I would like to talk about the rationale behind a set of policy recommendations on this theme presented at the first OECD Ministerial Level Conference on SME Development, that took place in Bologna in June 2000. In their essentials, these policy recommendations were adopted by the 47 Ministers and government representatives present at that event.

At a macroeconomic level we can be confident that entrepreneurial activity is one of the keys to economic dynamism and job creation. Not only does entrepreneurship fuel the drive for efficient resource use, it accelerates the process of generating, disseminating and applying innovative ideas, be these technological or organisational. This process of innovation is fundamental to growth.

Indeed, indicative of the dynamic importance of company creation, Canadian data show that new firms in a range of industries tend to be more productive, and pay higher wages, than the firms which they displace. And the overall quantitative importance of new firms in employment creation is often significant. From 1970 to 1985 new firms accounted for 21% of annual job creation in manufacturing in the United States.

How do such macro- considerations relate to regional economic performance ?

There is evidence that fast-growing regions usually have high rates of enterprise start-up. While not all areas with high rates of start-up also grow rapidly, growth is difficult without a healthy level of enterprise creation. Based on US data, work by Reynolds, Storey and Westhead ((1994) "Cross-national Comparisons of the Variation in New Form Formation Rates", Regional Studies, 28.4, pp.442-456) has tentatively concluded that high business birth rates precede increased regional growth. Studies commissioned by Scottish Enterprise have found that UK regions with lower business birth rates generated fewer jobs and experience lower growth. In the U.S. the theoretical underpinning to federal entrepreneurship strategies provided in part by the statistical work of David Birch, who identified business formation as the major factor differentiating growing from declining areas. And econometric work on English counties by Brian Ashcroft and James H. Love ("Employment change and new firm formation in UK counties, 1981-9", in Small Firm Formation and Regional Economic Development, edited by Michael W. Danson, Routledge, 1996) - both at the University of Strathclyde - has shown a strong positive relationship between employment change and new firm formation during the 1980s. This latter study is particularly interesting in that it accounts for the displacement effects that company creation gives rise to.

Rates of enterprise creation differ markedly across regions within OECD countries. Indeed, some regions have annual firm birth rates two to six times higher than others. Significant influences on enterprise creation that can vary from one locality to another include: 
i) demographics, as areas with young populations tend to start more firms and rates of start-up are usually higher in urban than in rural environments; 
ii) unemployment, which for different reasons can both encourage and diminish start-up rates; 
iii) wealth, with wealthier areas expected to have high rates of enterprise creation owing to higher levels of demand and greater availability of capital; 
iv) the educational and occupational profile of the workforce; 
v) the prevalence of small firms, it being argued that employees in small firms will aspire to own other small firms; 
vi) the extent of owner-occupied housing, with property being a frequent source of start-up capital for entrepreneurs; 
vii) infrastructure endowment, which is positively related to investment demand; and 
viii) history, because, amongst other reasons, imitation frequently plays a role in the spread of entrepreneurship.

Many of the policy issues which receive greatest attention in national debates on entrepreneurship concern policy levers largely outside the remit of subnational authorities. This is typically the case with policies affecting the operation of product and labour markets, intellectual property rights, many fiscal issues, administrative burdens and so on. Ways of addressing these broad framework conditions, that critically shape the environment for entrepreneurship, have been outlined in a body of previous work by the OECD (1998 flagship publication, Fostering Entrepreneurship).

But I would like to add here that there is much that local and regional authorities, and locally devolved offices of central bodies, can do to encourage productive entrepreneurship. The range of programmes include initiatives to: bring about attitudinal change towards entrepreneurship; increase the flow of information and advice for starting, financing and managing entrepreneurial ventures; facilitate access to accommodation; improve skills, and promote beneficial collaborative behaviour in enterprise clusters and business networks (such as in mutual credit guarantee schemes and inter-firm networks).

I will concentrate my remaining remarks on the subject of enterprise clusters and networks.

"Clustering" is the tendency of firms in related lines of business to concentrate geographically. Cluster initiatives are now common in developed and developing economies, in wealthy and lagging regions, and in jurisdictions with laissez-faire and dirigiste approaches to economic development. I am aware that a range of clusters schemes exist in various parts of Australia.

Why do clusters occur ?

The economic drivers of cluster formation in particular industries can include:

• proximity to markets. Despite low-cost international transportation, being near to markets can be important in cluster development, especially for products that are not easy to transport or that require continuous interaction with customers.
  
• supplies of specialised labour. The existence of specialised pools of labour, such as occur around many universities;
  
• the presence of input and equipment suppliers. A high frequency of exchanges between co-located capital goods producers and users is likely to underpin the innovative performance of firms in many industrial districts;
  
• the availability of specific natural resources;
  
• economies of scale in production. Such economies may allow only a small number of efficient-scale plants in a given market;
  
• the availability of infrastructure. Some types of infrastructure may also be quite specific, such as with certain transport or tourist facilities, further encouraging agglomeration;
  
• low transaction costs. When firms and their suppliers operate near to each other, and the frequency of interaction is high, the costs of negotiation and contract enforcement may be reduced. This effect may be reinforced by social norms affecting entrepreneurs belonging to overlapping social groups.
  
• superior access to information.

As is well understood, the agglomeration of firms and their suppliers can confer competitive advantage to the enterprises involved. For example, agglomeration can permit the creation of locally concentrated labour markets, specialisation and division of labour between firms (offering greater scale economies for individual firms), attract buyers and sellers, and reduce the unit costs of activities undertaken collectively. The clustering of firms can also reduce the unit costs of technical services provided to members of the cluster. By operating in close proximity firms can also more easily subcontract to competitors those orders that exceed their own capacities, as proximity allows greater knowledge of the capabilities of potential contractors. This may allow firms to retain valued customers. The clustering of firms can likewise facilitate the flow of ideas and information. Such flows occur formally and informally, for example when employees change employer, through contacts with common suppliers, and through social exchanges. Indeed, it is likely that frequent contacts between capital goods users and producers has underpinned productivity growth in firms in many industrial districts. (And the opportunity for financial intermediaries to acquire detailed understanding of firms in a given cluster, on account of frequent exchanges with enterprises of a similar type, may well facilitate efficient lending). And locally overlapping commercial and social institutions can create a social substrate facilitating the reduction of transaction and other business costs.

Sheer physical proximity of numerous producers in related industries can add to competitive pressure, while, as emphasized by Michael Porter, the fact that factor costs are often similar if not identical for the cluster participants, forces innovation along other routes.

A cluster can contain a small or large number of enterprises, as well as small and large-size firms in different ratios. Some clusters, such as many of Italy’s industrial districts, are comprised principally of SMEs. Different clusters involve varied degrees of interaction between the firms involved, ranging from fairly loose networks of association through to multifaceted forms of co-operation and competition.

It is not the case that benefits automatically arise from clustering - there can be congestion effects for example, especially for firms located in clusters belonging to industries other than their own - but gains are sufficiently common for us to take them as read here. Some clusters also decline: Michael Porter notes - in On Competition - how the manufacture of golf equipment in the US shifted from New England, where clubs were based on steel and wood, to California when the use of advanced materials became a possibility.

The degree to which economic activities are clustered is striking. According to one estimate (from the mid 1990s) there are around 380 clusters of firms in the United States operating across a broad spectrum of service and advanced manufacturing industries. Together they employed some 57 per cent of the United States’ workforce and produced 61 per cent of the country’s output. Local industrial districts account for some 30 per cent of total employment in Italy and in 1994 produced 43 per cent of Italy’s exports. Indeed, clusters exist in nearly all economies and are present in many affluent regions such as North-Central Italy, Bavaria in Germany, Cambridge and the M4 region in the United Kingdom, Silicon Valley and Route 128 in the United States, Sophia Antipolis in France, and many others. Indeed, Enright (2000) has noted that clustering can also be seen in some sectors that one might not think of as subject to clustering at all, such as telemarketing and credit card processing.

Intimately linked to the subject of clusters is the theme of business networks. Indeed, many public programmes to encourage inter-firm networks have been inspired by a desire to replicate the success of renowned clusters in such areas as Silicon Valley and Emilia Romagna.

Business networks operate with varied forms and objectives. Some aim at general sharing of information, while others tackle more specific goals. Networks can allow rapid learning - and small companies often favour the peer-based learning that networks permit. Networks can also facilitate the reconfiguration of relationships with suppliers. In some instances networks have led to a new division of labour in a group of firms, allowing individual companies to reap economies of scale and scope. And networks can help exploit the benefits of collective action. In fact, networks have spurred co-operation on issues as diverse as training, technological development, product design, marketing, exporting and distribution. In finance, each year, around one million Italian SMEs receive credits mediated by mutual guarantee schemes, a form of network organisation that is mainly local in scope. And just at the end of June this year, 10,000 SMEs located around Barcelona, about half that city’s total population of small firms, organised through six territorial networks to buy electricity at a rate some 30% below that which they had paid previously (El Pais, 27th June, 2001 page 61).

Furthermore, some government agencies have realised that networks can be a cost effective means for aggregating demand and delivering services to small firms. Thus, in the U.S., networks have become a tool for many federal programs, such as the Manufacturing Extension Partnership (for supply chains and joint R&D); the U.S. Department of Commerce (for marketing cooperatives), and the U.S. Department of Labor (for training alliances).

However, it is important to make a clear conceptual distinction between clusters and networks. In this respect, one can note that:

It is important to make these distinctions because policy towards networks can obviously require resources very different from a range of other policies (say in infrastructure) that might be adopted to foster clusters. And while networks are often easier to form amongst co-located firms, geographic proximity is not a pre-requisite. Policymakers however often mistakenly refer to networks and clusters as if they were one and the same.

Why is there a policy interest in clusters and networks?

It is fully understandable then, for all of the reasons I have cited, why policymakers should be interested in clusters and networks. But just let me recap before moving on to the analysis of the logic of policy.

1. Productivity and innovation

Policymakers are aware that membership of clusters and inter-firm networks can enhance the productivity and rate of innovation of firms. Studies by the Bank of Italy show job creation, and return on investment in Italy’s industrial districts to have all been consistently higher than elsewhere, even in periods of recession. Work by Breschi and Beaudry has shown in the UK and Italy that the location of firms in a cluster populated by innovating enterprises positively affects the probability of innovating.

Disappointment with development approaches based on large firms has also propelled policy on clusters.

2. Addressing problems of enterprise scale

Clusters and networks can allow small firms to combine advantages of small scale with various of the benefits of large scale. Some of the most comprehensive network programmes, such as The Danish Network Programme, begun in the early 1990s, have explicitly aimed to help small firms acquire efficiency, as a group, on a par with larger enterprises, and thus to help SMEs realise the opportunities and meet the challenges associated with globalisation.

3. Affluent area demonstration effects

The examples of affluent regions whose economies are built on localised groups of firms have inspired local, regional and national governments to adopt policies based on enterprise clusters.

4. Enterprise creation

The structure of some clusters can also lead to high rates of enterprise start-up, which is an issue of widespread interest among policymakers. The inter-firm specialisation that clusters can permit allows individual entrepreneurs to start firms that concentrate on only a small phase of production in a given industry. In other words, a low degree of vertical integration in firms belonging to clusters can also lower barriers to entry for entrepreneurs.

What are the characteristics of commonly pursued cluster policies? Such policies often have marked similarities. Many concentrate on small and medium sized enterprises. Others provide generic information on business and economic trends as well as cluster-specific information on parameters such as markets, technologies and competitors. The specific infrastructure and training requirements of a cluster are a common focus. Cluster programmes often use a variety of means to foster business networks, and governments sometimes also provide business services ranging in sophistication from basic research to advice on bookkeeping.

Well-known examples of such service provision include locally-sponsored technical extension centres in Northern Italy, and the Manufacturing Extension Partnership (MEP) in the United States. Finally, initiatives often also seek to assess and upgrade public policies and programmes affecting a cluster.

Differences in cluster development strategies

While there are recurrent features to many cluster programmes, there are also important differences. For example, differences exist in the level of government involved. The public sponsors of cluster strategies have included local, regional, national and even supranational governments. Programmes differ as to whether they focus on developing the existing economic base, or attracting firms into the cluster, or a combination of the two.

Cluster programmes also differ in the process of cluster identification and selection, with some programmes using detailed criteria - such as industry growth rate, multiplier effects, job creation and income potential, match with local resources, relationships with local suppliers, etc.. However, many other programmes use little rigour in the choice of target cluster. In fact, programmes often exhibit marked similarities in the selection of the sectors assisted, often being those in so-called "sunrise" industries such as biotechnology, new materials, information technology and others.

Policy recommendations on clusters and networks

Generic observations:

A policy towards clusters should be based on government supporting existing and emerging clusters rather than trying to create them ab initio. A policy aimed at developing entirely new groups of firms in selected sectors can entail high costs, high risks, serve as a screen for outmoded forms of industrial targeting, and give rise to destructive competition should many regions follow the same policies in pursuit of the same industries. Underlying programmes of cluster development is the idea that firms and industries are part of larger inter-linked systems involving market and non market exchanges. It is difficult therefore for governments to create and manage such complex systems through policy. Accordingly, an indirect role for government is preferable.

There is another economic reason why an enabling role for government is appropriate. Regional and local development agencies sometimes express the view that public spending on cluster development is economically justified because it aims to create positive externalities, that is, it aims to facilitate the agglomeration economies referred to earlier. In fact, such an argument highlights the limits of policy. This is because, while agglomeration economies are clearly significant in many industries, policymakers do not generally have the information with which to judge their magnitude in different industries for agglomerations of different scales. Therefore, policymakers are usually not in a position to assess whether the cost of the support to be given is smaller than the potential benefits. Furthermore, diseconomies of agglomeration - say from congestion or pollution - may occur as clusters increase in size. So, beyond a given scale, a public subsidy of agglomeration may be guaranteed to reduce economic efficiency, although policymakers would not have the data with which to know when this occurs. Such considerations again suggest a non-distortionary and facilitatory role for the public sector, rather than one in which government seeks to plan the creation and development of new agglomerations.

So, essentially, a policy on clusters should provide a framework for dialogue and co-operation between firms, the public sector (particularly at local and regional levels of government) and non-governmental organisations. This dialogue can lead to efficiency-enhancing collaboration amongst firms, such as in joint marketing initiatives, the creation of mutual credit guarantee associations, joint design and sponsorship of training, a more efficient division of labour among enterprises, etc. Such a dialogue can also lead to an improved quality of policy and government action (such as in training, the provision of information, and infrastructure supply). Policymakers can lock-in some of the benefits of existing or embryonic clusters by ensuring suitable institutional conditions. For example, amongst other actions, promoting the establishment of suppliers' associations and learning circles, facilitating contacts among participants in the cluster, facilitating subcontracting arrangements within the cluster, and ensuring effective extension services can all increase the benefits to firms of belonging to a cluster.

Firms should have access to such institutional arrangements whether they belong to a cluster or not. However, it is likely that the benefits of such arrangements will be magnified by cluster membership, and the cost-effectiveness of provision may be greater when supplying to a clustered rather than a dispersed group of firms.

Policy should also obviously be informed by an awareness that programmes need to be tailored to diverse local economic, social and institutional circumstances. Mechanical replication of policy approaches will not produce optimal results.

The choice of policies should reflect the type of cluster in question. For example, a cluster comprised of innovative small-scale firms that engage in collaborative ventures and access international markets will require very different policies from one for a cluster containing many large companies in traditional industries with limited inter-firm collaboration and weak competitive positions.

Policy Recommendations emerging from the Bologna Conference, 
"Enhancing the Competitiveness of SMEs in the Global Economy: Strategies and Policies", June 2000.

On enterprise networks

Implement broad campaigns to introduce the networking concept to businesses. It is important to create informed demand for network services, with networks preferably addressing precise market-driven objectives.

The most successful business networks organise around specific goals. Therefore, public authorities and business associations should seek to raise awareness of the benefits and opportunities of networks in order to increase informed demand for network services.

A degree of financial support, in feasibility work, start-up activities, and the costs of network brokerage, is to be expected.
Aversion to and unfamiliarity with inter-firm co-operation, as well as problems of co-ordination, create barriers to the spontaneous emergence of networks. Public action, at least in a catalytic role, is frequently needed. However, funding should be modest, and should be phased out as participants start to engage more formally and obtain benefits.

Work with realistic time-frames. A commitment of 3-4 years is usually required for a significant business network programme.

Ensure the presence of experienced network brokers. As with many schemes to support enterprise, the quality of management is critical. Persons with direct experience of SME development should be employed as network brokers, providing advice and a neutral corner for firms hesitant at the prospect of co-operation. Network brokers can also help allay concerns over loss of control and appropriation of benefits. Establishing broker teams and facilitating exchanges among them can help maintain effectiveness and motivation.

On enterprise clusters

Facilitate local partnerships involving private actors, NGOs and different levels and sectors of government so as to arrive at agreements on individual responsibilities (for example in co-locating complementary public investments with related concentrations of private investment).

As a good example of partnership, we could note that in the US clusters are becoming a forum for targeting education and training programs. As noted by Rosenfeld (2001) "The recent Regional Skill Alliance grants program of the U.S. Department of Labor funds projects that organize like firms in regions to enable them to better identify common skill sets and standards, to reduce training costs, and to learn from one another. More and more regional institutions of higher education are concentrating their resources on local industry clusters, exemplified by the current proposal to establish cluster hubs at North Carolina’s community colleges."

Another interesting case where partnership is appropriate has to do with the building of collective reputation. In Oregon, the Wood Products Competitiveness Corporation initiated by the legislature established a common "Made in Oregon" brand for their products. Tourism clusters are another case in which collective promotion is important.

Let the private sector lead in cluster-development initiatives, with the public sector playing a catalytic role. Policy makers should generally refrain from seeking to build entirely new sector-specific clusters of firms. There should be an element of market-test before significant public resources are committed to a cluster. Adopting this practice may help avoid situations in which sub-national bodies compete in implementing identical cluster development strategies. Similarly, cluster initiatives should not be used to introduce distortionary industrial policy intended to target "national champions", "sunrise sectors", etc..

Where possible, match initiatives to the most suitable level of government. The ideal level of government will correspond to the physical scope of the cluster while having substantial influence over relevant programmes and expenditures.

Some prioritisation among clusters is generally necessary due to limited resources (selection criteria might include the opportunity for the sponsor to add-value, and the existence of organised nuclei of actors in the cluster). There may also be benefits to working with a portfolio of clusters.

The choice of clusters to work with can only draw to a limited extent on economic theory-based prescription. In many localities the selection of clusters will be self-evident, as there may only be one or two clusters present. But in more economically diverse settings, with a number of clusters, the choice is more complicated. The temptation exists to seek sectoral priorities based on inherent technical or economic characteristics of the industry in question: value addition, the breadth of forward or backward linkages; technological complexity, employment intensity, growth prospects, etc.. This temptation should be avoided.

Even assessing institutional conditions within the cluster, such as the presence of an organised representative body, does not provide a full response to the question, as - while it is easier to work with structured counterparts - policymakers are left with the question of whether to facilitate organisation amongst unorganised actors with developmental potential.

In ideal circumstances, policymakers could allocate resources between clusters if they had a description of the opportunity set of projects in different clusters ranked in terms of benefit/cost ratios. However, while informed policymakers may have access to technical information in a number of sectors suggesting where unexploited good projects exist, they often won’t have this information, especially when working with larger numbers of clusters.

This highlights the importance of an iterative process of dialogue and exchange with the private sector in cluster selection. Private actors will generally have better knowledge of potential opportunities for collaborative projects. While public actors can help by outlining the scope for collaborative action amongst private agents unfamiliar with such experiences. When projects are identified, they might be ranked not in terms of absolute benefits -as this information again will not be available - but in an ordinal manner. Working with any cluster would of course have to be premised on the willingness of private agents to take an active role.

Initially adopt a low risk/early return focus. It is useful to generate small but evident gains through collaborative effort at the outset. As success develops, higher risk and longer term activities can be introduced.

Target market failures.

Policy - in which local and regional authorities are critical - should explicitly target market failures. The fact that clusters can afford competitive advantages for member firms does not in itself constitute a justification for public action. Several forms of market failure are relevant to policy on clusters of SMEs. These include under-supply of public goods, and co-ordination failures.

Michael Porter, in his 1998 book On Competition, provides an example of how various players in an industry may need to upgrade their operations simultaneously if overall productivity gains are to be had: "In the wood products cluster, for example, the efficiency of sawmills depends on a reliable supply of good-quality timber and the ability to maximize the utilisation of timber in either furniture (highest quality), pallets and boxes (lower quality) or wood chips (lowest quality)). Portuguese sawmills suffered from poor timber quality because landowners would not invest in timber management. Hence most timber was processed for use in pallets and boxes, a lower value use that limited the price paid to landowners. Substantial improvement in productivity was possible, but only if several parts of the cluster changed simultaneously. Logging operations, for example, had to modify cutting and sorting procedures while sawmills had to develop the capacity to process in more sophisticated ways. Co-ordination to develop standard wood classifications and measures was an important enabling step. Such linkages can be recognized and captured more easily within clusters than among dispersed participants."

Also important can be failures affecting small and medium sized firms more generally, such as in the supply of industrial real estate and, possibly, the provision of certain technical and financial services. Nevertheless, the fact that markets can fail in some of the above fields does not imply that they will be failing everywhere, and many clusters have thrived in the absence of significant policy support. A proper assessment of how well the relevant markets are functioning should be an integral part of policy formulation.

In addition, by not explicitly identifying market failures a cluster development programme might simply become a source of interest-group support. Indeed, assisting a group of firms to better act in concert can have the unwanted consequence of helping those same firms press for support that is economically unjustified.

Seek to lock-in benefits of existing or embryonic clusters by:

• Facilitating access to accommodation for new and small firms (given the widely reported difficulties faced by small firms, and particularly start-ups, in gaining access to industrial real estate).
  
• Promoting the establishment of suppliers associations and learning circles, and other forms of collaborative undertaking that are made possible by virtue of physical proximity among firms (such as mutual credit guarantee associations).
  
• Allowing specialisation and local adaptation in university-industry linkages including experimentation in incentive structures that can encourage local linkages to industry.

  Many institutional permutations are possible as regards the interaction of local firms, universities and training institutions. For example, university/industry partnership mechanisms can range from grants and fellowships to targeted research contracts, collaborative research and consortia agreements, training, mobility and networking programmes. In terms of functional goals such partnerships often seek to enhance the commercialisation and diffusion of technology, create enterprise spin-offs and support strategic research and technology objectives. A key consideration is that local flexibility should exist in the collaboration that educational and training bodies enter into with adjacent firms, whether in joint development of specialised courses and curricula - national curricula may be too slow to change and be unsuited to the technical specifics of particular enterprise agglomerations - the distribution of financial benefits from collaborative undertakings, or the precise forms of partnership in research and development.

• Ensuring effective technical support and information services. Markets may under-supply some business services and certain types of information, especially to small firms. Policy should address market failures where these are significant and aim to induce private provision as early as possible.

• Ensuring access to specialised infrastructure, communications and transport.

If seeking to attract investments then:

• Have local, regional and national authorities disseminate information about the cluster - and the locational advantages it offers - throughout the business community of a region or country.
  
• Focus investment promotion efforts on linkages within a cluster considered weakest (such as gaps in the chain of local suppliers).
  
• Consider complementing the national collection and organisation of statistics by adopting a frame of reference that would illustrate the geographic concentration of related groups of firms. Data organised according to the Standard Industrial Classification (SIC) omits the extent of inter-linkages among firms in a given locality belonging to different branches of manufacturing (or services).
  
• Evaluate the initiative throughout, not just at the end of the process. Ongoing monitoring and evaluation can serve as a valuable programme management tool, helping assess progress and indicating where changes in implementation are needed. As not all programmes can be successful, initiatives should be ended if they fail to produce results.