Heterogeneous firms and cluster externalities: how asymmetric effects at the firm level affect cluster productivity

When firms are heterogeneous, externalities within clusters can affect firms asymmetrically. These asymmetries at the firm level lead to a productivity effect at the cluster level that has been overlooked thus far. We develop a heterogeneous firm model where firms with different productivity levels decide how much to invest in market survival. With this model, we find a differentiation between high-productivity firms investing in market survival and low-productivity firms not investing in market survival. Cluster externalities alter the optimal market survival investment of firms, which in turn affects both cluster composition and cluster-level outcomes. By focusing on cluster productivity and assuming that cluster externalities take the form of knowledge spillovers, we find that the effect on the cluster depends on the particular type of knowledge spillovers. Using modelling outcomes and an extensive numerical simulation, we show that knowledge spillovers that reduce the cost of investment benefit investing, high-productivity firms and increase cluster productivity. By contrast, knowledge spillovers that imply that non-investing, low-productivity firms can free ride on the efforts of investing firms tend to reduce cluster productivity. We discuss ramifications for research on clusters and cluster policy, highlighting the importance of industry and knowledge spillover characteristics.