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____________________________________________

EXPLORATION OF INNOVATION AND


THE ROLE OF CLUSTERS IN ECONOMIC
GROWTH AND DEVELOPMENT
____________________________________________


SCHULICH SCHOOL OF BUSINESS
PROFESSOR ASHFAKUDDIN RUBEL


BY ASHARIB SYED & RADU STOIAN
APRIL 2014


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TABLE OF CONTENTS
Section I: Foundation of Economic Discussion ............................................................................................ 3
Introduction, Overview of Scope and Opportunity ................................................................................... 3
Literature Review ...................................................................................................................................... 3
Data and Analytical Methodology ............................................................................................................ 4
Section II: Theoretical and Practical Exploration of Innovation and Cluster Formation .............................. 5
Significance of clusters and Innovation .................................................................................................... 5
Analysis of Innovation and Cluster Formation ......................................................................................... 6
Relevant Economic Theories ................................................................................................................. 6
Why the Concern about Clusters ........................................................................................................... 7
Components of Cluster Development .................................................................................................... 8
Evaluating and prioritizing Cluster components ................................................................................. 11
Stages of Development and the Role of Innovation ............................................................................ 12
A study of Dichotomy: Clusters in Variable Economic Environments .................................................. 13
Section III: Comparative Analysis of China and USA ............................................................................... 18
Discussion on United States .................................................................................................................... 18
Discussion on China ............................................................................................................................... 20
Comparison ............................................................................................................................................. 22
Analysis and Summary ........................................................................................................................... 29
Section IV: Implications for Domestic Economic Policy and International Relations ............................... 31
Lessons for International Relations......................................................................................................... 33
The Evolutionary Contributions of Cluster Creation in an Economy ..................................................... 33
Section V: Conclusion ................................................................................................................................ 34
Section VI: Appendices .............................................................................................................................. 35
Section VII: Works Cited and Resources USED ........................................................................................ 39

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SECTION I: FOUNDATION OF ECONOMIC DISCUSSION
INTRODUCTION, OVERVIEW OF SCOPE AND OPPORTUNITY
Clusters are economic phenomena of tremendous importance to contemporary nations. They are
engines of innovation, productivity, competition; and clusters such as Silicon Valley have rightly
earned the awe of the world for their impact on the world.
Given the economic significance of clusters there has been much research done to explore,
quantify, and categorize this phenomenon. Though there have been great insights reached in the
discipline of cluster theory, in certain respects it is lacking. Much of the studies done in this field
are Western-centric ideas of cluster theories. The areas that are especially skewed are those
which dictate private vs. public action related to creating and supporting clusters.
This paper then aims to deliver a more complete, wider ranging, and accurate view of cluster
theory. To accomplish this, this paper will first deliver a far reaching review of pertinent
theoretical and empirical cluster characteristics that are relevant for this report. Following this,
the paper will compare and contrast between a developed and an emerging economy in terms of
the nature, and public/private efforts of industry clusters. It is the hope of this paper that the
aforementioned section will enlighten readers a holistic picture of economic study, rather than
the commonly misconstrued (i.e. Western-centric) ideas of cluster theory. The latter most
sections of this report will then outline some policy decisions pertinent to both developed and
developing nations.

LITERATURE REVIEW
There is a wide variety of literature pertaining to cluster theory. This literature is abundant, in
depth, and generally completed by respectable sources. Among the pioneers in researching and
quantifying the relationship between locational clusters and their roles in innovation, economic
growth and their multiplicative consequences; are Michael Porter and his colleagues from
Harvard Business School Mercedes Delgado and Scott Stern.
The predominant majority of landmark papers regarding this topic such as Clusters,
Convergence, and Economic Performance by Porter, Delgado and Stern provide an academic
study on the topic of clusters. Specifically, these papers provide much insight as to the
contribution of clusters with regards to the innovative ability of a nation. They also note policy
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objectives and actions by governments, and also document private action with regards to cluster
formation and development.
Existing works are lacking in some respects however. Currently, existing works are limited in
their scope as they are conventionalized: a) from the vantage point of USA, a developed nation;
and b) lack sensitivity to differences around the world in cluster development based on: varying
government roles, economic growth stage of the nation, and its existing patterns of competitive
advantage as a determinant of future cluster potential.
That being said, this paper is an opportunity to present an analytical exploration of economic
growth in clusters and innovation; with contrasting insights by using both a developed nation
(USA) and a developing nation (China) as an evaluation of not only a) the variable geographies
of innovation and cluster development, but also b) the diversity in government roles in a free
market system contrasted against a state capitalism model (USA and China). The directed
goal of this paper is to:
Compare and contrast between a developed and an emerging economy; the nature and
relationship of innovation in industry clusters and their contribution to economic growth and
development

DATA AND ANALYTICAL METHODOLOGY
There were essentially two types of data that were relied upon for the creation of this report;
scholarly reports or articles, and raw data.
The reports and articles used were mainly works by esteemed cluster theorists (i.e. Michael
Porter), business professionals, and notable institutions such as the World Bank. The other set of
data we used was raw empirical data extracted from the Global Competitiveness Report,
completed annually by the World Economic Forum. A full list of sources used is available at the
end of this report.
The reports had valuable data pertinent to our topic such as nation-specific data, and general
figures on cluster theory applicable to any nation. These essentially provided a very insightful
and thorough qualitative lesson on cluster theory. As previously stated, the sources used
included esteemed academic institutions and leading economic scholars; which was certainly
another reason why the decision was made to use these particular references.
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In our initiative to add valuable new insights in the world of cluster theory, this report ventured
to analyze raw data to provide innovative quantitative analysisdoing so in a way that has not
been done before. The raw data was also published by a very reliable source, and there is no
doubt that the data is accurate. There is a caveat however. The data used is annual data over an
interval of 8 years (2006 2013), and as such it is too small a sample for any sort of firm
statistical model to be generated. It should be noted that though regression techniques will be
performed on the data, that outcome should be taken as a general trend line and, as previously
stated, not a firm statistical model.
Another point to be made is that there is no alternative data that can be used for the sort of
analysis that this report will undertake, indicating that this is a true intellectual opportunity.
Furthermore, Michael Porter himself has made much use of the same data sources as a basis for
his study of clusters. Over the years as the World Economic Forum continues their surveys of
national competitiveness, we hope to continuously add further points into our study.

SECTION II: THEORETICAL AND PRACTICAL EXPLORATION OF
INNOVATION AND CLUSTER FORMATION
SIGNIFICANCE OF CLUSTERS AND INNOVATION

The dawn of human civilization was defined by a gradual yet momentous transition into
specialization of roles and responsibilities. Across human history, civilizations, empires and
nation-states brought value because they provided a network for unifying interdependent
relationshipsamong people with different roles and responsibilities living within a
geographically unified area, for the benefit of members within its borders. With this lens, human
history is a study of interdependent relationships.
Likewise, contemporary society is a mosaic of interdependent relationships defined by the
dominant forces within these complex networks of dependence. Just as technical specializations
carved way for human civilization as a fruit of interdependent relationships; today, our
globalized society is defined by networks of clusters that define not only the flow of trade and
finance, but the creation and dispersion of ideas and innovation.
For economists, the role that these networks have on domestic employment, stable economic
growth and long term national developmentare among the primary goals of economic study.
As economist Paul Krugman and geographer Paul Knox explain in their discussions on the topic
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of spatial disparity
i
, as the economic contrast between cores and peripheries deepen in
response to these network effects, human populations move and evolve in response, defining the
very creation of cities and new urban cores.
As such, exploration of these interdependent networks and their role in creating social utility and
positive externalities; is not just a question for economists, but a shared concern among
politicians, businesses and citizens alike. For a sovereign nation the development of clusters and
nurturing innovation is a means of increasing international competitiveness, it means the growth
of human capital that will span generations, it means greater average living standards with higher
national productivity, and it means the creation and dispersion of new technology that increases
social utility for better consumer choices. [Appendices A and B overview graphical data in
support of the role that clusters play within their national economies, as summarized here.]
Just as a living organism, the system that forms within and around clusters not only evolves over
time, but often has regional and national multiplier effects based on its network of
interdependent relationships. While this study focuses on the economic theory and application of
clusters, it is nonetheless critical to appreciate the significance of this topic from a broader
horizon. Therefore, we will continue our discussions at the end of this report with industrial and
foreign policy recommendations to promote clusters and innovation.

ANALYSIS OF INNOVATION AND CLUSTER FORMATION
RELEVANT ECONOMIC THEORIES

Malthusian theory prophesized dystopian outcomes as the worlds limited resources are shared
among increasing humans populations. What was overlooked in this analysis was the touchstone
role that innovation and technological progress would have in ensuring long term growth.
Despite a world of increasing populations and decreasing natural resources, innovation and
advances in technology have had a fundamental role in intergenerational economic growth.
Similarly, the Solow Model presents a neoclassical concept of balanced growth where in the
long term; nations would achieve a steady state of growth. In the Endogenous Growth Model that
builds on these foundations; the role of innovation, knowledge creation and technology are now
critical towards achieving increased effectiveness of factors of production, increased labor
productivity, and real economic growth in the long term
ii
.
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Therefore an understanding of how these endogenized elements [innovation and technological
progress] develop, the networks of support they require, and the nature of their geographic
agglomeration, is critical for economists pursuit of long term national growth.

WHY THE CONCERN ABOUT CLUSTERS

Clusters are networks of interdependent companies, suppliers and institutions that compete and
cooperate with each other in a geographically concentrated area, benefitting from common
infrastructure, deep linkages and relationships that create value for members within the cluster,
and those living within its reach. Fundamentally, the study of clusters is a reflection on the
importance of networks and interdependent relationships.
While the creation of innovation and technological progress is of national importance, the actual
process of its creation is best described as a team sport, where each component of a cluster is
both an input factor contributing to innovation; and also a receiving node that benefits from the
innovation in a feedback loop with multiplier effectswhere the role of all parties within the
cluster aggregates benefit to everyone within the cluster.
But what are the direct and indirect components of cluster development, and how is the network
conducive to spurring innovation and technological progress? This is explored in the following
section. The charts below illustrate using data from the Global Competitiveness Report for both
China and USA, a general trend that as the state of cluster development increases, innovation
metrics also improve.
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COMPONENTS OF CLUSTER DEVELOPMENT

Within a geographically concentrated area, the following Diamond Framework
iii
presents a
foundation of four categories essential towards the progress of innovation and cluster creation:
1. Factor/Input Conditions
2. Related and Supporting Industries
3. Demand Conditions
4. Context for Rivalry and Competition

FACTOR CONDITIONS
This category caters to basic necessary inputs for the existence and growth of clusters. The
nature of human capital is a vital component of factor conditions, where the supply of technical
talent needed by companies of a cluster is dependent on the level of human capital available.
Similarly, the existence of prominent educational institutes such as universities and research
centers, provide fertile grounds of realizing the commercial potential of new academic concepts.
Just as labor talent and advanced academic insight is essential, likewise businesses often require
initial financing for future growth. Capital providers such as angel investors, venture capitalists,
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private equity firms and corporate banks provide risk capital that is often a necessary catalyst for
continued growth.

RELATED AND SUPPORTING INDUSTRIES
These are complementary parties necessary for the successful development of a cluster. From the
perspective of a products value chain, related and supporting industries include everything that
is needed for a concept to transition into the final stage of public consumption. Whether this is
innovative hardware designers that complement and work with software developers, or simply
competitively priced suppliers of raw parts needed for a final product. Overall, networks of
supporting industries, their cooperation and their reliability to deliver needed results are critical
for overall cluster development.

DEMAND CONDITIONS
While factor inputs and supporting industries play a significant role within the creation and
evolution of clusters, its the willingness and demand of end consumers that define the success of
any product. This could include the excitement and propensity of customers to accept change and
adopt novel products or ideas. An ideal environment would be where consumers are devout
followers eager to purchase new technological trends, with significant segments of the
population being early adopters that provide not only market validation for new innovations,
processes or ideasbut provide the early revenue needed to later expand in new geographies.
The extent of local demand at the disposal of companies within clusters is essential to both
individual firms, and the overall cluster. The nature of local demand is a touchstone in explaining
how local and regional successes often become national and finally international success stories,
through the execution of scalable and replicable concepts.

CONTEXT FOR RIVALRY AND COMPETITION
Just as microeconomic theory suggests, supernormal profits accrued by an innovative firm
attracts new entrants allured by the promise of financial gain. If firms manage to compete where
barriers to entry are low, any innovation and competitive advantage will likely be only temporary
security. This leads to a virtuous cycle of competition and innovative response, as firms pursue a
strategy of constant innovation, improvement, efficiency and competitiveness to survive. The
presence of growth-oriented rivalry leads to positive consequences for everyone in the cluster
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network, from competing firms, their shareholders and financiers, and finally the end consumer
that benefits from enhanced choices.
COMMON ENVIORNMENTAL CONDITIONS
Supplementary to the four categories examined above, are environmental considerations
important to cluster formation and innovation. This includes common infrastructure, linkages
and governmental policies impacting members of a cluster. Common infrastructure is a broad
category that ranges from basic infrastructure of transportation and commuting networks, to
more complex infrastructure such as high capacity underground fiber optic grids.
Linkages within a cluster represent the extent and depth of interconnectedness of a cluster.
Educational institutes, research centers, consortiums and forums of discussion are avenues that
facilitate greater communication, understanding and awareness between members in a cluster.
These linkages play an essential role in ensuring that innovative progress within a cluster,
achieves rapid dispersion and commercialization to the benefit of national interests. Otherwise,
competing nations can be quick at adopting and commercially exploiting these developments for
their own advantage, if the host nation fails to capitalize them first.
One historic landmark example is the development of the VCR in America by Ampex in 1970,
which failed to spur large scale domestic manufacturing in USA
iv
. By mid-1980s, no VCRs were
built within American and Japanese manufacturing success in producing the VCR spurred an
entire consumer electronics revolution, bringing with it decades of trade surplus in Japan and
trade deficits in USA.
Likewise, the role of government in encouraging and often catalyzing clusters cannot be
discounted. There are two possible diverging approaches, one is top-down central involvement
where the government plays both direct and indirect roles to ensure successful clusters; the
second perspective is a laissez-faire inspired, bottom-up approach where the government is
merely a facilitator or initial catalyst for market forces. Governmental policy and international
relations are explored in Section IV of this report.




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EVALUATING AND PRIORITIZING CLUSTER COMPONENTS
While a categorical analysis of cluster components can suggest a diverse range of inputs into
cluster creation and the growth of innovation, some factors are more significant determinants
than others.
In a study by the Harvard Institute for Strategy and Competitiveness, Van Der Linde and
Michael Porter studied 833 clusters, concluding that the most significant determinant in the
creation of clusters was factor conditions of the area, followed by demand conditions and
supporting industries
v
. The following graph illustrates these results:


However, even while comparing already developed clusters, there is an opportunity for us to
evaluate differences between competitive clusters and their less competitive counterparts. The
following diagram provides an overview of this contrast:


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While factor conditions are the largest component in both competitive and uncompetitive
clusters, competitive clusters use all 4 components of the diamond model, where rivalry
between firms is of material importance. There is a decreased dependence on factor conditions in
competitive clusters, along with increased participation from supporting industries and local
competition.
It can be criticized that uncompetitive clusters in their path of becoming more competitive,
would grow in profits and eventually attract more competition and rivalrywhich would then be
an invitation for supplementary industries to enter and provide services to an eager base of
clients. As firms benefit from the arrival of related industries, they compete in producing
innovative products that are consumed by a base of eager customers. Naturally, this discussion
leads one to consider the evolution or timeline by which clusters agglomerate within a
geography.


STAGES OF DEVELOPMENT AND THE ROLE OF INNOVATION
The World Bank represents cluster development as a four-staged process:
I. Mobilization Preparing stakeholders and environmental conditions
for cluster growth
II. Diagnosis Evaluating current circumstances and empowering areas
of weakness
III. Collaborative Strategy Catalyzing relationships with public and
private members towards a unified strategy of interaction and growth
IV. Implementation Structuring defined action plan with an
implementation timeline

While this method of segmenting stages of cluster development has academic merit, we would
argue that the process is more a homogenous collection of internal and external relationships;
rather than separate chronologically presented stages. Nonetheless, examining gradual stages
of development gives insight into the interaction of cluster components, which becomes
especially critical in our final discussions on economic policy.



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A STUDY OF DICHOTOMY: CLUSTERS IN VARIABLE ECONOMIC
ENVIRONMENTS
While the overall exploration of economic theory behind clusters is academically available, we
believe theres considerable opportunity to investigate differences of cluster formation in
variable economic conditions.
Because existing patterns of international trade, national stock of factors of production, the
dominant economic model [free-market economy, or centrally planned] and the roles of
governments differ between nationsgeneral discussions of cluster development must be
strategically evaluated before application to individual economies. While differences are
expected, there may also be categorical similarities between developed and developing
economies. The following diagram begins some of this discussion below:



The role that factor conditions play for clusters in developing economies is almost twice the
significance they have within developed nations. The weight diverted from factor conditions is
contributed towards the category of corporate rivalry and supporting industrieseach
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comprising more than double their significance in a developed economy against a developing
one.
While factor conditions are a primary concern in both economiesthe diagram below indicates
that successful clusters rely less on factor conditions and benefit from the broader horizon of
competitive environments and supporting industries:


Appreciating the nature of these differences will be principal as we later compare and contrast
the nature of clusters in China and USA. Furthermore, they are vital in our concluding
discussions on industrial policy and international relations. Some fundamental differences
between developing and developed economies are analyzed below:

I. THE GOVERNMENT

The stability and reliability of domestic governments, define the extent of central
involvement in increasing public welfare through cluster creation. Public trust of
government officials, lack of corruption and a highly functional legal system that
protects both physical and intellectual propertyare vital considerations in the role of
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central governments. More simply, the sophistication of government involvement and
their desire to intervene in issues of social welfare will again by a limiting factor.

II. THE PREVAILING ECONOMIC MODEL

Whether a countrys predominant economic model is socialism, state capitalism or
free-market capitalismthis will define if a natural bottom-up approach to cluster
creation occurs, or a more centrally involved top-down system of cluster
development (or a combination of both). This is integral not only for the role that
governments play, but also in the expectations and perception of businesses and
entrepreneurs. While in a centrally planned economy businesses may anticipate
government assistance and plan their own initiatives and risks correspondingly, in a
market economy entrepreneurs may have greater burden of economic mobilization,
coordination and execution.
III. PUBLIC VERSUS PRIVATE

The central product, idea or trend within a cluster will be a chief determinant of its
public and private benefits. In developed markets, entrepreneurs create business to
maximize private utility, increasing profits and shareholder value for their investors.
As a consequence, consumers are courted with competitive pricing and abundance of
choices. While average economic wellbeing may improve as measured by growth in
GDP per Capitathe distribution of economic wellbeing will be unequal over time;
reflecting that the nature, objectives and control of these clusters was oriented for
private gain.

In other circumstances, clusters may develop expressly with public intent for
increasing social welfare. One potential example in a developing economy is a cluster
thats developing innovative processes to increase overall labor productivity in a
labor intensive societyenabling greater social utility through increased leisure time.
IV. AVAILABILITY OF FINANCING

In a developed economy where financial markets have matured and capital providers
are eager to invest in lucrative ventures, starting a business that requires initial risk
capital is fairly attainable. In contrast, a developing economy where even basic
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banking is in its infancy let alone the market for risk capital, access to adequate
funding can be a debilitating environmental condition.

Similarly, the extent of property rights and concepts of collateral are far more
developed in advanced economies relative to emerging ones.
V. NATURAL STOCK OF RESOURCES

The existing natural stock of a nation (whether its abundance or scarcity) will define
how resources are allocated and the opportunity costs in pursuing novel, yet uncertain
initiatives. The absence of rich national factors of production in places like Japan can
be seen as a fascinating opportunity to motivate domestic specialization, cluster
development and innovation to compensate for scarcity in other areas. However,
places rich in resources often experience what Jeffery Sachs and Warner refer to as a
curse of natural resources, which includes becoming a net importer of innovation
and technology, dependent on the abundant monetized value of their resources
vi
.

The following graph was used by Jeffery Sachs and Andrew Warner to depict this
relationship across a variety of nations:
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VI. EXISTING TRADE PATTERNS AND RELATIONSHIPS

In continuity from our discussion of domestic natural stock; trade patterns of the host
nation are definitive in how clusters develop, and in which industries they are
concentrated around. Patterns of trade deepened by decades of habit, lay the ground
works for industries, networks and infrastructure used in support of domestic trade
patterns. This foundation is likely to be fertile grounds where cluster creation can
begin.

VII. DESIRED ROLES IN INTERNATIONAL RELATIONS
While clusters may develop to improve existing trade patterns, others may develop
not as a reflection of the current national positionbut where the country wants to be
in the future, and its desired role on the international stage. For example, a region that
has historically been dependent on its natural reserves, may desire greater security
from diminishing reserves and invest its trade surplus towards more advanced
production and innovation. While the Middle East has only recently realized the
urgent importance of diversifying its economy beyond the oil industry; industrial
cluster development in Scandinavian countries were influenced by national interests
to diversify into high-tech export oriented areas.

Having analyzed numerous factors affecting developed and developing economies in
their respective journey of cluster development and innovation; the following section
explores particular contrast in two select model nationsUSA and China.

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SECTION III: COMPARATIVE ANALYSIS OF CHINA AND USA

As was previously explained, clusters are a vehicle by which nations create value for
supply-side economics, in efforts to elevate natural output levels. Though all of these factors are
important, this report mainly focus on innovation; and specifically, the differences in approaches
to cluster development (and therefore innovation development) between clusters in
socioeconomically differing nations.
As was alluded to in earlier sections, most of the studies on clusters are Western-centric;
and even in this sphere most of the data is US-centric. Not only is the data biased towards the
United States, but most studies are themselves generated by individuals that may have a
philosophical bias with regards to their views on clusters. One such individual is Michael Porter.
Though he is one of the pioneers of cluster theory and has contributed exceptionally important
insights in this area, one can clearly see from his works that he is a strong adherent of the free
market (laissez faire) mentality. Though this has proven an appropriate mind-set for cluster
analysis in the United States, this may not prove an effective vantage point from where to
evaluate clusters in nations whose economies have a wider degree of government intervention; or
whose input markets (i.e. labor, financial) are not as developed as those of the United States.
To achieve a more core understanding of clusters, it is beneficial to examine multiple
nations of varying socioeconomic conditions to gain a wider ranging sense of cluster theory. For
the purposes of this report, cluster and competitiveness data (from the World Competitiveness
Report) for both the US and China will be examined. It is the hope of this work that readers will
be able to draw on the differences between how clusters form, operate, and benefit these two host
countries differently. The role of governments with regards to cluster development will be the
main focal point of this section. The differences between cluster development and impact in
these two nations may also serve as a base example between clusters in the developed and
developing world.

DISCUSSION ON UNITED STATES
This section introduces cluster details pertinent to the United States, such as how clusters grow
and develop expressly within America. Additional areas covered will include the degree (and
type) of government involvement in clusters as well as some key features of US clusters.
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One of the key points that American cluster theorists such as Michael Porter teach; is that cluster
development is a bottom-up approach. The bottom-up approach is essentially a cluster that was,
over a long period of time, created by market forces
vii
. The beginning market forces in this case,
are phenomena such as a specialized strength in business or economic factors created through
some historical circumstance. An example of this could be the natural formation of clusters
around areas where a skilled labor force is present; e.g. the formation of a technology-based
cluster near a post-secondary educational institution which is specialized in technology and
quantitative subjects. The students at this institution would be great assets to technology based
firms so many companies would locate close to the educational institution to take advantage of
the talent which is there. Eventually, specialized suppliers and other supporting industries (and
institutions) would locate to this area to take advantage of the influx of firms. This is essentially
how clusters form.
Other examples of the first step of the bottom-up approach include: firms locating to a region
because many suppliers are present in the area, there is a sophisticated local demand in an area
and fast follower firms locating near an innovative firm. All these market driven cluster creation
examples follow the same basic mechanism, and bottom-up cluster creation can then be
condensed to this definition: bottom-up cluster development is when a cluster forms by way of a
chain reaction of market forces which is spurred by the entrepreneurial climate of a given region.
This form of cluster creation is the prevailing way by which clusters develop in the United
States. It is also the method most studied by theorists and most supported by politicians in this
nation.
The development of clusters in the United States is a bit more predictable. The rate at which a
cluster develops is highly impacted by the strength of the feedback loop within the Diamond
Model
viii
. Three of the most important of these factors that influence cluster growth are: the
intensity of local competition, the overall business environment for new business formation, and
the efficacy of networking and research institutions (both public and private). As with cluster
formation, the state of cluster advancement in the United States is also a bottom-up
phenomenawith market forces as prime drivers. There is only relatively miniscule direct
government intervention.
Though direct government intervention is not common in cluster development in the United
States, there are various indirect approaches that Federal, State, and local governments (and other
public institutions) take to ensure the success of clusters. A key example of this is university-
business interaction programs, such as the UCSD CONNECT program established at the
University of California in 1985
ix
. This program was established by this University to provide a
better network between local businesses and the university (e.g. its students, research facilities).
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By way of adding this network, the feedback loops in the diamond were augmented. Policy
makers in the United States also set up research institutes, invest in infrastructure, invest in
research and development, invest in education, and create appropriate regional (and state,
national) regulations to indirectly spur the creation and growth of clusters. Regulations especially
pertinent to clusters involve the protection of intellectual property rights. Government
involvement in clusters can then be seen as indirect policy actions aimed to strengthen the
feedback loops within clusters and contribute to their growth and success.
Though cluster scholars concede that all levels of governments in the United States have
beneficial and necessary roles to play with regards to clusters, the fact remains that Porter and
other scholars are strong advocates of the bottom-up approach for both cluster creation and
development. This approach has widely influenced both the private sector and policy makers in
the United States. Porter specifically writes The private sector must take a leading role in
regional economic development, not leave it to the government. Private-sector leadership is often
critical for success (75)
x
. He attributes this to the increased ability of companies (relative to
government) in understanding private sector needs and constraints.
Another key feature about US clusters is that they are generally formed around high tech
products and services. Examples include: Atlanta for Financial Services, San Diego for
pharmaceuticals, biotechnology and communications, Wichita for aerospace and defense,
Pittsburgh pharmaceutical, biotechnology and production technology, and Silicon Valley for
computing.

DISCUSSION ON CHINA

China has grown rapidly during the past few decades. Though there are a multitude of factors
that influenced the economic growth of this nation, clusters were surely a significant part of this.
Though they lead to the same general result wherever they are, clusters have different features in
developed vs. developing countries, as shall be seen by the various differences between the
United States and China.
One of the main differences between China and the United States is the way by which clusters
are created. Though a large amount of clusters do occur in China by the same bottom-up
methods described earlier, they also occur via the top-down approach. The top-down approach is
essentially the creation of a cluster as a result of sizable government intervention. The top-down
approach to cluster creation includes a multitude of different methodologies. For China, there
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creation and nurturing of Special Economic Zones (SEZs) are critical as we will explore. SEZs
are essentially regions that the government has given special economic leeway to, and as
previously stated, they are a source of top-down cluster creation.
Special economic zone is a generic term that covers recent variants of the traditional
commercial zones. The basic concept of a special economic zone includes several specific
characteristics: (a) it is a geographically delimited area, usually physically secured; (b) it has a
single management or administration; (c) it offers benefits based on physical location within the
zone; and (d) it has a separate customs area (duty-free benefits) and streamlined procedures
(World Bank 2009). In addition, an SEZ normally operates under more liberal economic laws
than those typically prevailing in the country
xi
.
Preferential policies in SEZs include: inexpensive land, tax breaks, rapid customs clearance, the
ability to repatriate profits and capital investments, duty-free imports of raw materials and
intermediate goods destined for incorporation into exported products, export tax exemption, and
a limited license to sell into the domestic market, among others.
These SEZs, through their lenient regulations and restrictions, essentially accelerate the process
of cluster creation. Instead of cluster creation involving a chain of private forces [as described
earlier]; it becomes more of a circus of firms rushing into a specific economic zone to reap the
benefits of that specific economic zone (each zone is designed to attract specific industries with
specific goals). SEZs therefore artificially create clusters.
Not only is the creation of clusters in SEZs much more of a public effort, but once a cluster is
formed in an SEZ, the government of China is much more involved in supporting and directing
these agglomerations; both directly and indirectly.
Clusters in SEZs are generally technology-based, capital intensive, and have a lot of government
support. Examples of these are the information and communication technology clusters in
Beijing and Shenzhen, the electronics and biotech clusters in Shanghai, the software cluster in
Dalian, and the electronics cluster in Wuhan. The creation and development of these clusters is
positively correlated with the success of their respective SEZs; and that being said, their
continued success also hinges on the success of the SEZ
xii
.
In general, there have been many more patents per capita registered with the PCT in American
clusters than in Chinese clusters. With regards to non-SEZ clusters the difference is staggering,
but in SEZ clusters the number of patents per capita is approaching those in American clusters.
This suggests that, under normal market circumstances, Chinese clusters do not have a knack for
innovation.
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Clusters in non-SEZ regions have vastly different characteristics to their counterparts in SEZs.
They are generally in low-technology technology industries, they are labor intensive, and they
have a much lower degree of government direction. Additionally, there is much less government
support for these clusters.

COMPARISON

Overall, cluster creation and development in the United States is primarily a bottom-up approach
which contains a wide variety of indirect support from the government.
In China, cluster creation and development happens in many instances, just as it does in the
United States (i.e. bottom up), where the government provides comprehensive indirect
assistance. SEZs highlight the main difference between clusters in the two nations; i.e. that
cluster creation and development also occurs via the top-down approach, and that the
government of China has a much larger direct role in the process. A hypothesis as to why the
Chinese government has taken upon itself the responsibility to aid clusters will be examined in
the following section.
Another point that must be considered is the difference in the sustainability between clusters in
the two countries. Given that clusters in the United States develop via the bottom-up approach,
they can be assumed to be fairly self-sufficient. Chinese clusters that form in SEZs are at least
somewhat dependent on the success and dynamics of their respective SEZs, and also on the
support of the Chinese government. It is then possible that these top-down creations might be
relatively less self-sufficient and sustainable.

ANALYSIS
This section analyzes clusters in the United States and China from a more quantitative
standpoint. The data used is from the Global Competitive Index, published annually by the
World Economic Forum since 2004
xiii
. All data are in the form of indexes (from 1 to 7)
developed by this organisation. It is important to stress that because there is so little data with
which this report has to work with (i.e. 8 year interval), that the regressions that will be shown
should be interpreted as general trends and valuable insight to our discussions. The point of this
section is to analyze these general trends in order to apply some measure of quantitative
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reasoning for why the differences between cluster-creating forces differ in the two
aforementioned nations.
As we can see from the following two trend lines, there is a positive trend between the state of
cluster development and innovation in both America and China. Each point represents a state of
cluster development index and an innovation index for a given year. There appears to be an
upward trend in both nations, but the trend line is much steeper in China than for the United
States.
The fact that the state of US cluster development has been higher than in China over the last 8
years, and that the US has a flatter trend, could perhaps indicate diminishing returns in
innovation with regards to cluster development. Perhaps the reason why the Chinese government
invests more into cluster development is because they receive a higher return in terms of
innovation created.

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The graphs below show a trend between the state of cluster development and production process
sophistication in both countries. Each point represents a state of cluster development index and
a production process sophistication index for a given year. Production process sophistication
is essentially productivity enabling elements that contribute to a more effective workforce. The
graphs show that there is a slight positive trend in the United States, where the same trend is
much steeper in China. The introduction of these graphs brings another point into consideration.
A fair proportion of the innovation being generated in America is innovation in consumer goods
that do not necessarily improve productivity (and therefore do not improve wages of workers). In
China however, a very large proportion of the innovation gained from SEZs and clusters comes
in the form of increased workforce productivity
xiv
. This is especially true when one considers
that the growth of clusters in China has brought in FDI, which has increased output. This could
be another reason why the Chinese government is investing much more highly in cluster
development than the United States.
By investing in clusters, they are essentially investing to increase the productivity and the wages
of their labor force; thereby increasing the size and prosperity of their middle class. It is
important to remember that the Chinese government, being a non-democratic regimeneeds to
take a multitude of measures to limit dissent among the populace. Supporting phenomena such as
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clusters that increase wages and economic growth (which keeps the population happy) could be a
way by which the Chinese Communist Party is able to remain a resilient authoritarian regime.




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These graphs show that increased cluster creation is increasing technological readiness of
Chinese firms. Each point represents a state of cluster development index and a technological
readiness index for a given year. The graph pertinent to China shows that as cluster
development increases, Chinese firms are becoming especially better at absorbing technology.
As with the previous examples, the relatively high return on investment by fellow Chinese firms
with regards to this metric might be why the Chinese government is taking a strong role with
regards to developing clusters.
There is almost no trend line between these variables in America, which may again indicate little
or diminishing marginal returns. As with the previous examples, it is again apparent that the US
government might be contributing less to cluster development relative to China because of its
relatively lower return on public investment.


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This next graph is a time-series plot of the index of private spending on research and
development (R&D). R&D, a crucial component that leads to innovation and successful
clusters, is heavily invested in by companies in the United States, but less so by companies in
China.
This might again illustrate why the government of China is more active in promoting clusters
than its counterpart in America. The United States has had a relatively long history of private
companies learning that heavy investment in R&D is key to long-run competitiveness and
survival. As the graph shows, this is not true in China.
Not only does the US government receive a relatively lower return on investment if it diverts
resources to support clusters, but it also has less reasons to do so. This is because US firms are
themselves engaging in practices that support innovation and cluster development. With far
lower private sector spending on research and development, this is not the case for China. Lack
of private investment in factors (i.e. R&D) that are key for cluster development could be a reason
for why the Chinese government has taken such a direct role.

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Below is a time-series plot of various diamond forces in both the US and China. This graph
highlights that China has weaker diamond forces than in the United States. As with the graph
relating private R&D spending in the two nations, this might be a key to understanding why the
Chinese government plays a wider role in its clusters than does America.
China wants to be more innovative as a nation, but it has relatively weak diamond features (i.e.
competitiveness, development of financial market). The relatively weak state of the diamond
forces essentially mean that in China the tendency for cluster creation will be lower and the
development of clusters will be lacking. In addition, this nations naturally occurring clusters
have a tendency to form around low-skill labor intensive industries that do poorly with regards to
patent creation and innovation. The above points essentially mean that if China wants to be
innovative it cannot rely solely on the private-driven bottom-up approach to cluster creation and
development.
China has therefore created (and is intervening in) SEZs to form high skill, capital intensive, and
technology intensive clusters that spur innovation. This point, coupled with the fact that the
Chinese government receives a high return on its investment for intervening in clusters, could
very well be reasons why the government is so actively involved in supporting clusters.
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On the reverse, The United States has very developed diamond forces and naturally occurring,
technologically innovative clusters. This means that clusters are easily formed and developed by
private forces, and the ones that do develop are in innovation rich fields that truly benefit the
nation. Coupled with the diminishing returns discussed earlier, the United States government has
a strong incentive to let the private sector take the leading role with regards to clusters.



ANALYSIS AND SUMMARY

In the United States, cluster creation results as a result of the bottom-up approach; i.e. when a
cluster forms by way of a chain reaction of market forces spurred by the entrepreneurial climate
of a given region. Cluster development then occurs primarily via a periodic strengthening of the
feedback loop (i.e. the diamond forces) within the cluster. Development is however also aided
indirectly by the US government. This methodology of clusters is supported both by US policy
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makers and cluster theory authorities such as Michael Porter. Lastly, clusters in the US have a
strong tendency to form around high tech products and services, and they generate much
innovation in terms of patents per capita.
In China, cluster creation and development results from both the bottom-up approach as well as
the top-down approach. This paper primarily studies the effect of Chinese SEZs and their role in
top-down cluster creation. SEZs are zones which have a wide range of economic benefits for
companies compared with other regions in China. Through designing Specialized Economic
Zones, the Chinese government is essentially artificially creating clusters in these regions.
Clusters that develop outside SEZs are in low-technology and labor intensive industries. They
also have a much lower degree of government direction/support, and are lacking in innovation.
Firms in SEZ clusters are generally technology-based, capital intensive, have substantial
government support, and contribute much in the way of innovation.
Through analysis of trend-lines and time-series plots generated using data from the Global
Competiveness Report, published by the World Economic Forum; numerous conclusions have
been generated as to why government involvement in cluster development differs between the
two nations.
As was observed with the trend-lines, it appears that Chinese government has relatively more to
gain than does its counterpart in the United States if it invests resources into cluster development.
The situation arises because Americas clusters are already well developed and it suffers from
diminishing returns. This government invests less than the Chinese government because its
return on investment is lower.
Another explanation for the difference in government action is that Americas diamond forces
are well developed. Cluster formation and development in this nation are therefore successful
without the direct intervention of the public sector. Additionally, clusters that emerge in the USA
(i.e. high technology/capital) generate a multitude of innovation (i.e. patents), and are therefore
favourable. Favourable clusters develop on their own in America, and there is therefore no
reason for the government to directly intervene.
The above situation does not mimic the case in China. Chinas diamond forces are weaker,
which implies that cluster creation and development will be lacking compared to America.
Furthermore, naturally occurring clusters in China are not in favourable sectors. To achieve
innovation through clusters, the Chinese governments only option then becomes to initiate their
creation through the top-down approach.

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SECTION IV: IMPLICATIONS FOR DOMESTIC ECONOMIC POLICY AND
INTERNATIONAL RELATIONS
Having analyzed the significance of cluster creation and innovation under both a developed
economy and a developing one, we must now consider potential opportunities for governmental
policy and industrial strategysupporting both existing clusters and the development of new
ones. As cluster development and the growth of innovation have vast consequences of national
interest; we will conclude this section with an analysis of a nations role in international relations
across time.
The following are opportunities of direct and indirect intervention defined categorically:
I. FACTOR CONDITIONS

Human Capital: Increase the accessibility of postsecondary education through
subsidies for lower quartile populations, or provide scholarships and interest-
free loans. Governmental impact can also be integral in advancing knowledge
capital by increasing the availability of research grants, R&D subsidies and
financial rewards for innovation creation.

In financial markets, a relaxation of legislative requirements and financial
limits for providers of risk capital, including providing tax concessions to
incentivize riskier early investmentcan increase the willingness of investors
to risk their capital if they have federal cooperation and are rewarded for the
risks they assume.

II. DEMAND CONDITIONS

While consumer trends and preferences is arguably an exogenous variable
beyond direct governmental influence, the availability and penetration of
knowledge can certainly be a determinant of demand.

As such, any initiatives or institutions such as entrepreneurial incubators,
venture advisory firms or consultancies that expedite the process for domestic
products to achieve critical mass adoption by efficient dispersion; will help
create a pool of eager domestic demand. Moreover, the promotion of
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nationally created innovation and technology as fulfillment of patriotic spirits,
indirectly benefits the growth of innovative brands that are important to
national interest. The iconic role of Research in Motion for Canadas
Technology Sector is an example of a national brand holding significant
domestic interests.
III. RIVALRY AND COMPETITION

Firstly, the existence of robust property rights are vital for healthy competitive
progress. When firms know their intellectual and financial investments are legally
secure, they would be much more likely to exchange mutually beneficial dialogue
in collaboration with competitors.

Whether its by the initiative of governmental parties, academic institutions or
external research bodies; any platform that invites competing members of a
cluster to discuss progress and explore mutual opportunitieswill only lead to
increased linkages that create shared value and mutual progress.

While existing national brands may become local economic heroes, its vital that
favoritism for both state-run and private enterprises should not deter a nations
willingness to allow new entrants to prosper. Policies that reduce barriers of entry
allows not only more consumer choice, but ensures that players within the cluster
remain financially efficient, and fiercely driven to innovate.
IV. RELATED AND SUPPORTING INDUSTRIES

The absence of laborious legal requirements, bureaucratic red-tape and lengthy
governmental paperwork is important to create an environment where related and
supporting industries feel compelled to enter. While this is critical for all the
aforementioned categories, this is especially true in attracting a broader network
of supporting and related industries.

Comparably, financial incentives through subsidies and tax breaks can be an
excellent monetary motivation for firms within clusters. Although corporations
may not receive as much direct governmental sponsorship in USA, given the
nations progressive taxation systemthe large existence of subsidies and tax
allowances are critical to the growth of both small and large enterprises.
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LESSONS FOR INTERNATIONAL RELATIONS

In an increasingly interconnected world of free trade, the only remedy to international
competition is a nationally competitive response. As defensive protectionism becomes politically
intolerable, and the financial burdens of national governments limit any possible direct
involvementcatalyzing cluster formation is a high-return investment that maximizes impact
because of its network multiplier effects. As summarized in Appendix C, the ultimate economic
incentive behind clusters is not just a temporary increase of productivity or technological
progressbut a continuous increase in social welfare due to the infinite feedback loop between
inputs and outputs in the development of clusters and innovation.
THE EVOLUTIONARY CONTRIBUTIONS OF CLUSTER CREATION IN AN ECONOMY

Almost a third of clusters play a nationally significant role within their host economy [Appendix:
B]. As the success of nationally significant clusters reach international proportions, it brings
considerable inflows of foreign direct investment, trade revenues and increasing international
recognition.
For a nation like China that has experienced decades of trade surpluses largely due to its
manufacturing networks, these trade surpluses bring a world of economic and political
opportunities. As anticipated in our discussion of the infinite loop between cluster inputs and
outputs; the Chinese government is reinvesting considerable amounts into infrastructure
development and the construction of advanced urban cities.
Overall, as this virtuous cycle continues, it increases both social welfare and the countrys
international presence. We believe that the development of clusters and its role in the creation of
technology and innovation, is integral in the transition of a developing economy towards a
developed one. Consequently, the role of government also changes from direct top-down
involvement, towards a peripheral role.
This was seen in Taiwan where the government took initial efforts of mobilization and
catalyzing collaboration in a research consortium. Afterwards as network effects widened and
the dynamic roles of individual parties began to shape the overall environmentthe government
was able to play a peripheral role as a facilitator [which is conveniently also less financially
demanding].

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SECTION V: CONCLUSION
In Section I we analyzed the critical role that cluster development has for a nations economic
growth and development. We observed that while there was considerable academic research in
the area of cluster development, the concentration of these efforts were biased with a US
vantage. As such, there was a fascinating opportunity to add value by analyzing comparative
traits of cluster developments across variable economic geographies.
Using data from the Global Competitiveness Report as a foundation, we undertook an initiative
to observe potential trends between US and Chinese landscapes. In Section II we explored the
role that networks and interdependent relationships have in defining the economic, political and
social conditions of a nation. We analyzed Malthusian economic theories and later contrasted
The Solow Model with the Endogenous Growth Modelappreciating that innovation and
continual technological progress are the only vehicles to drive long term growth. Consequently,
we evaluated the role of clusters in the creation and dispersion of innovation. Adeptly
summarized as a set of input and output relationships with an infinite feedback loop, we explored
components of clusters in greater detail; prioritizing the contribution of factor conditions,
demand conditions and supporting industries as leading cluster components.
Thereafter, we explored variability between competitive and uncompetitive clusters; appreciating
that successful clusters incorporate all inputs from the diamond model, whereas unsuccessful
clusters rely heavily on factor conditions with little support from relevant industries.
Subsequently, the report evaluated systematic areas of contrast that impact cluster development
among developed and emerging economiesincluding the role of governments, economic
models, private and public interests, existing trade patterns, national availability of factors of
production and a countrys international relations objectives. Thereafter in Section III, we
applied the economic discourse of clusters and innovation into case studies of American and
Chinese cluster development. While detailed summary of conclusions are found in page 22 of the
respective sectionour findings proposed the tendency for developing economies to
strategically engage in top-down initiatives such as SEZs to cultivate national innovation and
clusters. However in developed economies, governments often engage in indirect (and often
direct) strategies to further national interests in clusters and innovation.
In our final criticism, we examined that the broader evolution of nations from developing to
developed economies; is corresponding to the intensification of national networks of
cooperation, and the reinvestment of trade surplus and cluster profit to accumulate more inputs
for a cycle of continuous growth. Overall, clusters are integral networks for spurring innovation,
creating lasting growth and development for the welfare of both nations and the global economy.
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SECTION VI: APPENDICES
APPENDIX A: ROLE OF CLUSTERS IN A SOCIETY
(Harvard Institute of Strategy and Competitiveness, Van Der Linde and Porter)


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APPENDIX B: SIGNIFICANCE OF CLUSTERS DOMESTICALLY
(Harvard Institute of Strategy and Competitiveness, Van Der Linde and Porter)



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APPENDIX C: CLUSTER CREATION EXPRESSED AS A FUNCTION OF INPUTS AND OUTPUTS
[Infinite Loop concept in cluster creation and innovation developed by Syed and Stoian]











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SECTION VII: WORKS CITED AND RESOURCES USED

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