Saturday, July 5, 2008

Why growth clusters may be oversold?

I had posted earlier here and here about the disproportionate focus of our industrial policy on growth clusters. While it is undoubtedly true that agglomeration economics - working through density of market linkages, labour market concentration and matching, and network effects from technology and knowledge spillovers - generates positive externalities, the available evidence on the extent of benefits from them do not merit the sort of indiscriminate subsidization that is being advocated and followed.

The latest evidence comes from a study by Philippe Martin, Thierry Mayer, and Florian Mayneris on the French government's policy of "employment areas". They find only marginal improvements arising from any policy of aggressive promotion of agglomeration economies, and feel that many of the gains are already internalized in the firm decisions.

They conclude that "spending public money to foster clusters is only wise if there is evidence that public policy might tap into significant unrealised gains from agglomeration". They write that this involves addressing two questions,

1. How large are the gains from agglomeration? In particular, how much does the productivity of a firm increase when other firms from the same sector decide to locate nearby?
2. Do firms internalise these gains when making their location decisions? In particular, are “natural” clusters too small?

Policy makers in many countries fail to acknowledge the distinction between policies that encourage the setting up of new industries and those that expedites the development of newly established industries. In fact, many of the SEZs in India appear to have been sanctioned to encourage the setting up of new industries. However, SEZs and industrial clusters, and the subsidies that go along with it, by themselves will not trigger the setting up of new industries. It will only help those setting up new industries, optimize their locations and take advantage of agglomeration economies. And in this too, it has been found (from the French evidence and other studies) that firms do internalize a substantial share of the gains from agglomeration economies when making their original locational choice.

The study also cautions about the less discussed issue of the dangers of congestion costs such as the saturation of transport infrastructure, inadequacy of other physical infrastructure, rising land rents, pollution etc. Given the indiscriminate manner in which some of the SEZs have been proposed to be located, and the legacy of governments failing to keep their infrastructure development commitments, there could be serious problems ahead. Already, a number of SEZs are facing problems with absence of adequate power supply and transport infrastructure.

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