Particular areas or regions within an economy often have groups of firms specializing in the development and production of a particular product located close together – industrial clusters, as they are called.
While it seems logical that firms engaged in producing similar products might want to locate together, the deeper economic reason for doing so is the fact that externalities are created. These externalities are primarily the result of the free flow of ideas that occurs between member firms in the cluster. These externalities are knowledge spillovers that result from research and development activities among the firms. This externality is further reinforced by worker mobility and concentration within the cluster region – when workers change firms or meet casually, ideas and knowledge are more likely to be exchanged and discussed.
The presence of a signficant group of firms having a common focus within a region gives rise to a common skill set among workers that the cluster members find valuable. These common skills create an additional externality that is another source of advantage to the cluster.
It is the total set of externalities working together which allows the cluster members to enjoy cost reductions and a higher rate of product development than they would otherwise.