Journal of Urban Economics 63 (2008) 146162

www.elsevier.com/locate/jue
The two sides of proximity in industrial clusters:
The trade-off between process and product innovation
Jean-Marc Callois

Cemagref, 24 avenue des Landais, BP 50085 63172 Aubire cedex, France

Received 13 April 2006; revised 28 December 2006
Available online 19 January 2007
Abstract
According to the literature on industrial districts, the proximity of small rms operating in a similar sector
can lead to several positive externalities, which enhance collective efciency. We investigate this assumption
by building a microeconomic model in which a set of small rms trades off two opposite effects. First, the
closer they are to each other, the more they can share xed costs or pool risks, and the more they can innovate
on more efcient processes. Second, the closer they are, the less diverse is their cognitive environment, and
the less they innovate on products. We nd that there is a bell-shaped relationship between proximity and
the rms performance. Moreover, equilibrium congurations tend to produce too much proximity from the
consumers and the workers point of view, but too few proximity from the rms point of view.
2007 Elsevier Inc. All rights reserved.
JEL classication: L10; R30; Z13
Keywords: Industrial districts; Clusters; Industrial organization; Process innovation; Product innovation
1. Introduction
The literature on industrial districts or clusters stems from Piore and Sabels [18] seminal
work, as well as the extensive study of the Third Italys production systems by Beccatini [4] and
others. It revisited the early works by Alfred Marshall on external economies between close rms.
As summed up by Fujita et al. [11], Marshall distinguished three types of mechanisms: backward
and forward linkages, the presence of a specialized workforce and knowledge spillovers. Modern
*
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E-mail address: jean-marc.callois@clermont.cemagref.fr.
0094-1190/$ see front matter 2007 Elsevier Inc. All rights reserved.
doi:10.1016/j.jue.2007.01.002
J.-M. Callois / Journal of Urban Economics 63 (2008) 146162 147
literature on industrial districts focuses on non-market interactions, and emphasizes phenomena
such as the informal exchange of services (which smooths variations in activity), common use of
facilities, common negotiation with local governments, common advertising strategies, but also
the innovative behavior facilitated by social interaction.
There is still debate on the existence of specic characteristics of industrial clusters, which
are supposed to stem from non-market relationships between rms. Gordon and McCann [13]
suggest that it is mostly classical market forces that are at play in the so-called clusters. More
radically, Amin [1] argues that the emblematic examples of clusters (Italian districts, London
furniture industry and so on) are simply exceptions observed at a particular point in time. The
aim of this paper is to open a bit more the black box of proximity effects with a microeconomic
framework, in order to see how non-market relationships between rms may inuence efciency.
It is far from obvious that multidimensional (geographical, cultural, social) proximity of in-
dustrial rms should always foster competitiveness. While proximity may induce positive effects,
it also brings about negative ones (Portes and Landolt [19], Durlauf and Fafchamps [9]). The neg-
ative effects of social relationships have often been neglected in the literature on districts, even
in the works that are based on economic mechanisms. The most obvious problem is collusion,
which is generally ruled out in industrial district literature, because cooperation is generally as-
sumed to be limited within the district: full competition rules in outer markets (Brusco [6]).
A subtler effect is the fact that too much proximity tends to limit interaction with external net-
works, leading to redundancies in the ideas circulating inside the cluster. Thus, rms will tend
to lack originality, or to be insufciently acquainted with the recent evolutions of technologies
and markets. Another negative effect is the fact that the security provided by cooperation could
reduce incentives. As a result, there is a trade-off regarding proximity. As both positive and neg-
ative mechanisms are at play, the optimal level of proximity will be determined by the balance
between these forces. Such a trade-off is consistent with the few empirical works that investigate
the non-linear relationship between embeddedness and performance (Uzzi [24,25], Duyster and
Lemmens [10]). These studies nd a positive relationship when embeddedness is low, but there is
a threshold over which performance decreases. It is noteworthy that this characteristic concerns
both innovative activity (as in Duyster and Lemmens [10]) and more traditional industries (for
instance the New York garment industry in Uzzi [25]).
There is a large amount of theoretical literature that studies the positive effect of proximity
due to agglomeration effects, and notably knowledge spillovers. As summed up by Duranton
and Puga [8], proximity magnies the opportunities of learning, and stimulates innovation by
competition on human capital. One of the rst models is due to Ogawa and Fujita [17], using
prot functions with a positive technological externality associated with proximity. More recent
contributions model more explicitly the interactions between rms (Long and Soubeyran [16]).
Moreover, the literature on new economic geography (Fujita and Thisse [12]) has studied a lot
the role of backward and forward linkages in agglomeration phenomena.
A few papers explicitly model industrial districts with microeconomic tools. Soubeyran and
Thisse [22] study the competition between districts where efciency depends on past production
(learning effect). Belleamme et al. [5] use a new economic geography framework to com-
bine proximity effects and classical agglomeration effects. In a similar spirit, Soubeyran and
Weber [23] model two districts where costs decrease with the density of rms, and study the
mix between cooperation and competition that characterizes industrial districts. Basevi and Ot-
taviano [3] study the trade-off between the innovation-stimulating effect of proximity and the
cost-lowering effect of delocation. Keely [14] builds a model where innovation (and thus pro-
ductivity) explicitly stems from the skilled workforces behavior.
148 J.-M. Callois / Journal of Urban Economics 63 (2008) 146162
However, all this literature emphasizes the positive effects of proximity only, typically by
assuming that productivity (costs) increases (decrease) with rm density. But as argued above,
proximity also generates negative effects. In particular, the role of diversity is essential in eco-
nomic efciency, as suggested by the empirical literature on the debate between localization
and urbanization economies (see for instance, Rosenthal and Strange [20]). Sociologist Ronald
Burt [7] studied the relationship between network structure and individual success in a variety
of situations (job-seeking, executive managers, R&D teams and so on). He found that the most
successful individuals were to be found at the interface between dense networks, and never in
the middle of dense networks. In the context of industrial rms, this result nds a natural inter-
pretation by considering how innovation works. Process innovation may be positively inuenced
by proximity, because proximity favors a common understanding of technical problems. This
may be considered as a form of xed costs pooling. However, it is the reverse for product inno-
vation, where new ideas are essential. The more diverse rms are, the more new combinations
(new products) will appear, as suggested by models of knowledge production such as Weitz-
mans [26]. As products tend to becomes more and more differentiated, this negative effect of
proximity may become more and more important for economic performance. Integrating it into
a microeconomic framework should thus give useful insights on the performance of clusters.
In this paper, we model a single cluster to study the trade-off between two opposite mecha-
nisms that are likely to play a signicant role in industrial clusters. First, proximity facilitates
xed cost sharing by lowering negotiation and access costs to common facilities, including
knowledge. The effect on product innovation is interpreted as a form of xed cost pooling,
because solving technical problems requires costs that are not directly related to the level of
production. Second, proximity tends to decrease the diversity inside the district, which is here
interpreted as a lower innovation potential on products. In order to model these two mechanisms,
we use an abstract representation of proximity, encompassing both geographical and socio-
cultural aspects. Firms with identical production functions are located on a circle in a product
space. The proximity parameter is simply the average density of rms in that abstract space.
Each rm produces one good, and all goods are different across rms. Firms perform exter-
nal scale economies by poling xed costs. However, there are negotiation and access costs that
depend on their relative distances. Consequently, the resulting cost is inversely related to rm
density (i.e. proximity) and to the proximity to the center of the district.
On the demand side, the representative consumers utility displays a preference for variety and
for diversity. In classical models of monopolistic competition, all varieties are symmetric, and
variety is measured by two parameters, the number of varieties and a measure of differentiation
(generally the elasticity of substitution). Here, we introduce another ingredient to account for
product diversity (or product innovation potential). The relative position of products is taken
into account in the utility function, and represented by the location of the respective rms in
an abstract product space. Consumers are more willing to buy goods that are produced at the
periphery of the district, or in a part of the district where density is low, as they tend to be more
original. This is because such rms are less embedded in local networks and are more open to the
rest of the world. Conversely where density is high, products are more similar and less attractive
to consumers on average. The effect of proximity is thus qualitatively the reverse of xed cost
sharing.
We then study the trade-off between these two effects of proximity. We rst study location
equilibria, i.e. congurations where no rm has an incentive to change its location in the product
space. We then compare equilibrium density with optimal density (i.e. the density that maximizes
total prot). Under these hypotheses, we nd the bell-shaped relationship between proximity
J.-M. Callois / Journal of Urban Economics 63 (2008) 146162 149
and protability that is mentioned in the empirical literature. We get two other noticeable re-
sults. First, equilibrium density of rms is generally lower than optimal density. Second, there
may be conicting interests between workers and rms. Consequently, the issue of the relation-
ship between proximity and local economic development depends on the class of agents under
consideration.
The rest of the paper is organized as follows. Section 2 presents the formal model and details
the assumptions about the role of proximity on costs and nal demand. Sections 3 and 4 analyze
equilibrium properties and collective efciency respectively. Section 5 discusses these results and
concludes.
2. The model
2.1. Spatial representation of rms
We suppose that there are n + 1 rms in the economy. n rms form the industrial district
(n is taken exogenous for now but will be made endogenous later). Every rm produces a single
good, that is different to the goods of all the other rms. The zero rm produces a composite
good that aggregates all the other products of the economy. Thus, this zero rm sums up all
the other sectors in the economy, and is used as a reference for the products of the district.
It plays somehow the role of the classical sector in economic geography models (Fujita and
Thisse [12]), although it enters the utility function quite differently, due to the peculiarities of the
model.
Firms are located in a product space, which in practice is linked to the many notions of
distance, encompassing geographical, social and cognitive aspects. The crucial assumption of
this model is that the closer two rms are, the more they communicate, trust each other, and share
similar ideas. Consequently, close rms will more easily engage in collective action and common
projects. As their problems tend to be similar, they are likely to improve the efciency of their
production processes. Conversely, as they produce similar products, they will fail to generate
innovative knowledge recombinations and to create new products. The notion of space in this
model thus encompasses a behavioral aspect of agents, as two close rms will tend to exchange
more on similar products, leading to a higher process innovation potential (and to lower costs).
The spatial distribution of rms is the following (see Fig. 1). The n rms of the district are
situated on a circle of radius d, within an arc of length l < d (i.e. all rms are on the same
half-circle) Without loss of generality, the origin of curvilinear abscissas is set at the center of
Fig. 1. The industrial district and the zero rm.
150 J.-M. Callois / Journal of Urban Economics 63 (2008) 146162
this arc (i.e. the rm in x =0 is exactly in the middle of the district, whose boundaries are l/2
and l/2).
The zero rm is located at the center of the circle. Consequently, all rms of the district
are at the same distance d from the zero rm. Parameter d measures the degree of originality of
the goods produced in the district, with regard to all the other goods produced in the economy.
Firm i in the district is located at curvilinear abscissa x
i
[l/2; l/2]. This representation is
analogous to Salops model [21]. However, besides the fact that location represents products and
not individual skills, there is an important difference with the Salop model: only a fraction of the
circle (of the product space) will be active, because rms need proximity to pool xed costs.
2.2. Demand
Consumers seek to maximize the diversity of the goods they purchase. In this framework,
diversity is measured by the spatial distance between rms. Take for instance the case of three
rms (n = 3) located at abscissas l/2, 0, and l/2 respectively. The products of the central
rm will be the least attractive to the consumers, because they will be less original, sharing
characteristics of the two other rms. It is well known in marketing studies that consumers are
looking for goods with salient characteristics. A trivial example would be holiday destinations.
The two extreme locations could be a ski resort and a sea resort. A central location in a plain
would share some characteristics of the two latter (say hills for mountain-biking and lakes for
bathing) but would be on the whole less attractive.
To get back to the topic of industrial districts, this amounts to considering that the central rm
will be too much embedded in local networks, and will not be at the leading edge of progress
in any domain. Taking the classical example in district literature of the shoe industry, the rms
in the district will have an interest in specializing in particular shoes (e.g. sport shoes or shoes
with a special style), not regular shoes. The fact that agents in the middle of dense networks have
a disadvantage in acquiring fresh information is consistent with the empirical ndings of Ronald
Burt [7] mentioned in the introduction.
Thus, all goods are not symmetric from the consumers point of view, as in the localized
approach of product differentiation (Anderson et al. [2, Chapter 6]). However, in that classical
approach, consumers are localized on the circle, and tend to consume more the goods that are
the closest to them because of transportation costs. In our approach, consumers are not on the
product circle (they are not spatially located). Their preferences only depend on the respective
spatial positions of rms.
The usual formulations of demand are not adapted to model the main intuition of this paper.
The preference for variety that is associated with the usual CES form is not sufcient, because it
does not take into account the relative position of goods in the product space. However, a weighed
CES utility function such as the following does possess the qualitative properties that are needed
to formalize the intuition of the model:
U(q
i
) =
_
n

i=0
_
q
11/
i
_
_
n

j=0
d(i, j)
_
1/
__
/(1)
(1)
where q
i
is the quantity consumed of the ith product and > 1 the elasticity of substitution.
In this equation, the consumption of each good is weighted by a simple function of the position
of the corresponding rm inside the district.

n
j=0
d(i, j) is higher for peripheral rms, which
are thus more attractive for consumers.
J.-M. Callois / Journal of Urban Economics 63 (2008) 146162 151
Denote Y the total consumers income (which is exogenous in the model), and p
i
the prices.
We obtain the following demand function:
q
i
=
p

n
j=0
d(i, j)

n
j,k=0
p
1
k
d(j, k)
Y. (2)
To the preference to variety that is associated to the CES form, we have added here a preference of
diversity: consumers prefer eccentric (distant in the product space) goods. Note that in the case
when all prices are equal, Eq. (1) can be derived as the limit distribution of a simple Markovian
process, in which the probability of purchasing a good is proportional to the distance to the last
good purchased.
Putting (2) into (1) yields indirect utility:
V =
_

i,j
p
1
i
d(i, j)
_
1/(1)
Y. (3)
Recall that the n rms of the district are situated on a circle of radius d, and that the zero rm
is at the center of that circle. Parameter d thus represents the global originality of the products of
the industrial district with regard to the other goods available to the consumers. Taking the zero
good as the numraire (p
0
1), we get:
q
i
=
p

i
_
d +

n
j=1
|x
i
x
j
|
_
_
nd +d

n
k=1
p
1
k
+

n
j,k=1
p
1
k
|x
j
x
k
|
_Y
for i > 0, and
q
0
=
nd
_
nd +d

n
k=1
p
1
k
+

n
j,k=1
p
1
k
|x
j
x
k
|
_ Y.
In order to get analytically tractable expressions, we assume from now on that the rms of the
industrial districts form a continuum. That is, instead of assuming n separate rms, the district
consists of a continuum of rms of total mass n. Denote the density function of rms on the
circle. The demand function for a rm located in x becomes:
q(x) =
p(x)

(d +
_
|x y|(y) dy)
(nd +d
_
p(y)
1
(y) dy +
__
p(y)
1
|y z|(y)(z) dy dz)
Y (4)
where the integral sign stands for integration along the circle.
2.3. Production
Following Krugman [15], we assume that each rm bears constant marginal and xed costs.
A rm in x incurs a xed cost f (x) and a variable cost c (the latter is exogenous and identical
across rms). The cost function is thus simply f (x) + cq, where q is the quantity produced.
When rms are isolated in space, their xed cost is F. However, rms can pool their xed costs,
creating a local public good, which is localized at a xed point in space. By so doing, they
have to bear two additional costs:
Access costs to the public good. These include both physical access costs but also various
transaction and use costs that are due to the fact that the public good will be more suited
to some rms that to the others. These costs are supposed to be proportional to the xed
152 J.-M. Callois / Journal of Urban Economics 63 (2008) 146162
cost F and to the square of the distance between the location of the rm and the location of
the public good. The latter is obtained by minimizing the sum of access costs for all rms.
Consequently, the public good is located at the barycenter x of the rms of the district.
Assuming that access costs are a convex function of distance is usual is spatial economics
(Anderson et al. [2]). It is also coherent with the literature on knowledge spillovers (Long
and Soubeyran [16]), and of course magnies the positive effects of proximity.
Negotiation costs, which are similar for all rms, and increase with the number and the
dispersion of rms. These costs stand for all transaction costs common to all rms, due to
discussing the nature of the public goods, conditions of use, all the time spent in meeting
and arguing and so on. The term negotiation cost is thus a bit misleading as they include
monitoring costs as well, but will be used for convenience. These costs obviously increase
with geographic, cognitive (understanding) and social (e.g. peer monitoring) proximity. They
are supposed to be proportional to the xed cost F and to the variance of the rms location
times the number of rms.
1
Consequently, the advantage of sharing xed costs depends on the spatial distribution of rms.
Formally, the effective xed cost f (x) of a rm in x is the following:
f (x) =
_
1
n
+t x
2
+s
_
y
2
(y) dy
_
F. (5)
The three terms in brackets are xed costs, access costs (parameter t ) and negotiation costs
(parameter s) respectively. This expression shows that the closer the rms (the higher the density
of rms ), the smaller their xed costs. Moreover, the most central rms have lower costs. Thus,
the further a rm from the others, the less it has incentives to share its costs.
Note that under simple assumptions, another type of collective action, risk-pooling, is for-
mally equivalent to the xed-cost pooling mechanism described here. Assume that the entrepre-
neurs utility displays a constant absolute risk aversion a, and that prot is stochastic, with
variance . Then, expected utility is: E(U) = E() (a/2)
2
. When risk is pooled between
n agents, variance is divided by n. The term (a/2)
2

can thus be considered as a xed cost.

Consequently, this simple model of collective action encompasses a lot of phenomena described
in the qualitative literature on districts.
Last, rms in the district compete under monopolistic competition as usual. The CES form
ensures a xed mark-up rate, and a xed price across rms. Using (4) and observing that demand
is isoelastic, price takes the usual form:
p =c/( 1). (6)
We now have all the ingredients for determining the location equilibria of the model.
3. Location equilibrium
In this section, we study the equilibrium properties of the model. The only decision variable
of a rm of the district is its location on the circle, so a conguration is entirely dened by
the density function of rms. A Nash equilibrium is a density function such that no rm has
1
Another way to state this assumption is to suppose that negotiation costs are proportional to the sum of the squares of
the distance between each rm and the others. This can be seen by the following identities: n. var(x
i
) =

n
i=1
(x
i
x)
2
=
1
2n

n
i,j=1
(x
i
x
j
)
2
.
J.-M. Callois / Journal of Urban Economics 63 (2008) 146162 153
an incentive to move to another location. Howcan a rmchoose its location in reality? Remember
we are dealing with a product space, essentially representing an abstract social and cultural space,
and that all rms in the district are supposed to be at the same distance from the composite
rm producing all other commodities produced in the economy. Moving toward the center of
the district could mean spending more time with rms of the district (especially central ones).
This will give access to more appropriate technologies, ease common problem solving, lower
transaction costs with other rms of the district and simplify the use and monitoring of the public
good of the district. Conversely, moving away from the center of the district could mean more
opening to new ideas from outside the district, and more reactivity to the evolution of markets.
By moving away, a rm gains in originality, but it will be more costly for it to access the public
good, which could for instance be less suited to its needs.
3.1. Short-run analysis (xed number of rms)
In this section, we consider the case when the number of rm n is exogenous. For a given
density function to be a Nash location equilibrium, three conditions must be met. First, it must
be protable for rms to pool xed costs (else there is no district). Second, prot should be the
same for all rms inside the district. Third, no rm should have an incentive to locate outside the
boundary of district. Let us examine these three conditions in turn. To begin with, we rst give
a rst very useful result:
Lemma 1. Any Nash equilibrium is a uniform density function on a segment: there exists > 0
such that the density functions (x) equals on [n/2; n/2] and zero elsewhere.
Proof. Using (4), (5) and (6), the prot of a rm located in x for a given density function (y)
reads:
(x) =
d +
_
|x y|(y) dy
(nd(p

+p) +p
__
|y z|(y)(z) dy dz)
(p c)Y

_
1
n
+t x
2
+s
_
y
2
(y) dy
_
F.
Denote A = (p c)Y/(nd(p

+p) +p
__
|y z|(y)(z) dy dz) to simplify formulae.
A depends on the density function but not on x.
For to be a Nash equilibrium, we must have: /x =A

x
[
_
|x y|(y) dy] 2t Fx =0
on the support of (i.e. on the domain where is not equal to zero).
Further, note that:

x
_
+
_

|x y|(y) dy
_
=

x
_
x
_

(x y)(y) dy
_
+

x
_
+
_
x
(y x)(y) dy
_
=
x
_

(y) dy
+
_
x
(y) dy.
Hence: /x =A[
_
x

(y) dy
_
+
x
(y) dy] 2t Fx.
154 J.-M. Callois / Journal of Urban Economics 63 (2008) 146162
By deriving a second time, one nds that
2
/x
2
=2[A(x) Ft ] =0, where A is indepen-
dent of x. Accordingly, any density function such that prot is identical for all rms is constant
on its support. 2
This lemma simplies considerably the study of the model. It implies that the equilibria are
dened by a single parameter, rm density , from which we deduce the size of the district l =
n/. The density parameter will be naturally taken as the proximity parameter of the district.
The intuition behind this result is that at equilibrium (constant prot), there is a substitution effect
along the district between the advantages of embeddedness (lower xed costs) and of openness
(more original products). Central rms have lower costs, but less attractive products. It is the
reverse for peripheral rms.
In the remainder of the paper, we restrict to this type of density functions only. Now we can
derive an expression for the prot. First, the demand addressed to a rm located in x is given by:
q(x) =
d +(x
2
+(n/2)
2
)
nd(p

+p) +pn
3
/3
Y. (7)
As expected, the higher the density or the proximity to the center |x|, the lower the sales.
Note that indirect utility is given by:
V =
_
nd
_
1 +p
1
_
+n
3
p
1
/3
_
1/(1)
Y. (8)
Obviously, indirect utility increases with n (number of rms/varieties), d (distance of the
district to other goods of the economy), and decreases with (proximity of rms within the
district).
Turning to the expression of xed costs:
f (x) =
_
1
n
+t x
2
+s
n
3
12
2
_
F. (9)
In accordance with intuition, the higher the density, the lower the costs.
Finally, the prot of a rm located in x is:
(x) =
d +(x
2
+(n/2)
2
)
nd(p

+p) +pn
3
/3
(p c)Y
_
1
n
+s
n
3
12
+t x
2
_
F. (10)
Equation (10) is the basic equation that allows the analytic study of the model. It displays the
fundamental trade-off between the positive (demand side) and negative (xed-cost side) effects
of proximity.
Now we study the rst condition for an equilibrium to exist in the district, which is that
rms nd it protable to pool xed costs. Using (9) one can see that this is true as long as
f (n/2) < F. This leads to the following result:
Lemma 2. The district exists (i.e. rms pool xed-costs) as long as:
>
0

_
n
3
4(n 1)
(t +sn/3) i.e. l < l
0

_
4(n 1)
n(t +sn/3)
. (11)
Note that if s = 0,
0
is of order n when n tends to innity. If s > 0,
0
is of order n
3/2
.
That is, when there are negotiation costs, the spatial limit of viability of the district (l
0
=n/
0
)
decreases to zero. When there are no negotiation costs, it is roughly constant. Negotiation costs
J.-M. Callois / Journal of Urban Economics 63 (2008) 146162 155
are expected to be large in sectors where there is a lot of tacit knowledge or where information
disclosure implies a lot of trust because it may have huge strategic consequences (e.g. nance
and high-tech activities). Equation (11) implies that in such sectors, it is very unlikely to observe
a large cluster, i.e. clusters will be very specialized. In the following, we assume that condition
(11) is true.
We now study the second condition to have a location equilibrium, which is that the prot is
the same for all rms in the district. Using (10), one can see that there is a single value of for
which prot is the same for all rms in the district. This is the value
eq
that solves the equation
(pc)
nd(p

+p)+pn
3
/3
Y =t F, i.e.

eq
=
Ft nd(p

+p) +
_
(Ft nd(p

+p))
2
+4Ftpn
3
Y(p c)/3
2Y(p c)
. (12)
Note that, from (10), we see that when
(pc)
nd(p

+p)+pn
3
/3
Y > t F peripheral rms make the
highest prot. In the opposite case, it is the central rms that are more protable. This property
implies the stability of
eq
. When >
eq
, central rms tend to move to the periphery, thus
tending to reduce (and vice versa).
Note that Eq. (12) simplies when n is large:
eq

_
Ftp
3Y(pc)
.n
3/2
. This means that asymp-
totically,
eq
is of order n
3/2
. Last, substituting (12) into (10) yields:

eq
=
_
dt

eq
+
t n
2
4
eq 2

1
n
s
n
3
12
eq 2
_
F. (13)
We still need to check that no rm has an incentive to locate outside the segment
[n/2, n/2]. Suppose a rm (whose impact is assumed to be negligible on the others) lo-
cates in x n/2. We would then have:
(x) =
_
dt

eq
+
xnt

eq

_
1
n
+t x
2
+s
n
3
12
2
__
F. (14)
The function in (14) has its maximum in x = n/2, where (x) =
eq
. Consequently, it is
never protable to quit the district.
All this reasoning is valuable only if prot is nonnegative. Again, it is not possible to de-
rive analytical conditions, but asymptotic results can be obtained, and their robustness has been
checked by numerical simulations. We obtain the following proposition:
Proposition 1 (Existence of a Location Equilibrium). When there are no negotiation costs, and
when Y/F > 4/3 and Y/F > (p
1
+ 1), there exists a unique location equilibrium with
positive prot whatever the number of rms.
When Y/F < 4/3, there is no location equilibriumwhen the number of rms is large enough.
When Y/F < (p
1
+1), there is no location equilibrium when the number of rms is small
enough.
When there are negotiation costs, there is no location equilibrium when the number of rms
is large enough.
In all cases, equilibrium density when it exists is independent of negotiation costs.
Proof. See Appendix A. 2
156 J.-M. Callois / Journal of Urban Economics 63 (2008) 146162
Market potential relative to the degree of increasing returns (Y/F) is the crucial parameter. It
must be high enough relative to the elasticity of demand. Note that (p
1
+1) is an increasing
function of marginal cost c and (except for very low values of c) of demand elasticity . Equi-
librium density is independent of negotiation costs because negotiation costs are common to all
rms whatever their location. The deviation of one (atomistic) rm will not alter its negotiation
cost, which will thus have no inuence on the determination of the equilibrium. Conversely, as
we shall see below, negotiation costs have a prominent inuence on optimum properties.
It is unusual that there may be no equilibrium with positive prot when the number of rms is
low. Generally, it is when the number of rms is too high that prot vanishes. This result is due
to the possibility that when there are few rms, pooling may not be sufcient to overcome high
(individual) xed costs.
3.2. Free entry case
When the district is protable, it is likely that new rms will try to enter it, until prot
reaches zero. According to Proposition 1, it is only when there are negotiation costs, or when
Y/F < 4/3 but Y/F > (p
1
+1) that there may be a maximum number of rms. The most
interesting case arises when there are negotiation costs and when Y/F > 4/3. Then, if nego-
tiation costs are low enough, the following approximation holds for the number of rms at free
entry equilibrium:
n
eq

t
s
_
3 4
F
Y
_
. (15)
As expected, the number of rms rises with Y/F, decreases with elasticity of demand , and
with negotiation costs s. The only unexpected feature is that it increases with access costs t . In
fact, when access costs are large, the behavior of rms at equilibrium is closer to the optimal
behavior, because it is more costly to free-ride and locate far from the center to capture benets
from originality. Thus, the district can sustain a larger number of rms at equilibrium.
The next section studies the collective optimum for rms and compares it to the equilibrium
outcome.
4. Collective optimum
In this section, we suppose that rm density is not the result of an economic process. For
instance, may result from the sociological proximity of the rms of the district, which itself
could be a consequence of the particular sociological history of the region under study. So in this
section, and n are considered as exogenous. This section gives the main result of the paper
(Proposition 4), namely that there is a bell-shaped relationship between proximity of rms and
efciency. To do so, we rst derive conditions of protability, and study how total production
relates to proximity. Last, we discuss the relationship between equilibrium and optimum, and the
main parameters inuencing it.
4.1. General results
We rst study the condition for the district to exist. In addition to condition (11), prot must
be nonnegative for all rms. Using Eq. (10), one can see that the following proposition holds:
J.-M. Callois / Journal of Urban Economics 63 (2008) 146162 157
Proposition 2 (Sufcient Conditions of Viability of the Industrial District). Firms share their
xed costs as long as condition (11) holds. Moreover:
If Y/nF > (p
1
+1) > 4/3, then for all , all rms make positive prots.
If Y/F > (p
1
+1), then there exists > 0 such that all rms make positive prots.
Proof. See Appendix B. 2
These conditions can be viewed again as thresholds on the ratio (Y/F), which represents mar-
ket potential (Y) relative to the extent of increasing returns (F). Note that the second condition
Y/F > (p
1
+ 1) is the same as in Proposition 1. As expected, the higher the number of
rms n, the marginal cost c, and the elasticity of substitution , the more difcult it is for rms
to make prots. Moreover, a higher value of proximity is more likely to ensure positive prots,
even if it may not be an optimal situation for rms, as Proposition 4 will show.
We now examine total quantities and prots. According to Eq. (9), total quantity produced in
the district is:
Q=
3d +n
2
3d(p

+p) +pn
2
Y. (16)
Equation (16) shows that as (or n) varies, the maximum quantity produced in the district is
Y/p, and the minimum quantity is Y/(p

+p). It is straightforward to check that Q decreases

with and increases with n (but less than proportionally). In other words, production decreases
when proximity increases. The intuition behind that result is that rising proximity decreases the
range of diversity of the goods in the district, thus making them less attractive to the consumers.
Proposition 3 (Effect of Proximity on Production/Employment). Total production (employment)
decreases when the proximity parameter rises.
Now if we assume that production is positively related to labor demand, this means that em-
ployment decreases when proximity increases. From an employment point of view, it is thus
optimal to have the lowest possible proximity (that is, =
0
). Moreover, as
0
decreases with n,
an increase of the number of rms will unambiguously raise employment. There is thus a po-
tential conict of interest between rms and labor, for as we are going to see, a high level of
proximity is generally favorable to the rms prot.
4.2. Optimal density
Let us now examine total prot. Integrating Eq. (10) across rms yields:
=
3d +n
2
3d(p

+p) +pn
2
(p c)Y
_
1 +(t +ns)
n
3
12
2
_
F. (17)
Note that (17) implies that the maximum possible value of total prot as varies is
(p c)Y/p F. The rst derivative of total prot with respect to is given by:

=
3dn
2
p

(p c)
[3d(p

+p) +pn
2
]
2
Y +
(t +ns)n
3
6
3
F. (18)
Equation (18) displays the trade-off between positive and negative effects of proximity
from the rms point of view. Indeed, there is a bell-shaped relationship between global prot
158 J.-M. Callois / Journal of Urban Economics 63 (2008) 146162
and proximity: prot rst rises with proximity, then decreases to the limit value (p c)Y/
(p

+p) F. Consequently, there exists a value

> 0 such that total prot is maximal. When

/(
0
) < 0, we have

=
0
. Else,

is the unique solution of the equation / =0.

It is not possible to derive an analytical expression for

. However, asymptotic properties can

be obtained when n tends to innity (see Appendix C). The main result is that when s =0,

is
of order n
5/3
and when s > 0, it is of order n
2
. In both cases, the optimal length of the district
l

=n/

tends to zero as n tends to innity.

The asymptotic results for large n must be completed by numerical simulations, in order
to study the qualitative effects of the exogenous parameters.
2
These simulations show that the
asymptotic results are robust when n is small. The optimal density rises with negotiation and
access costs. It decreases with relative market potential Y/F and originality of the district d.
The following proposition sums up the foregoing results:
Proposition 4 (Effect of Proximity on Total Prot of Firms in the District). The effect of the
proximity parameter on total prot displays a bell-shaped relationship. The optimal value

rises with costs associated with pooling xed costs. It decreases with relative market potential
Y/F and originality of the district d.
Note that this bell-shaped relationship is consistent with the empirical evidence mentioned in
introduction.
4.3. Relationship between equilibrium density and collective optimum
We now examine the relationship between

and
eq
. Equations (12) and (18), which give
these values, have very different forms, and one can be larger or smaller than the other depending
on the parameters. However, we know that
eq
is of order 3/2 as n tends to innity, while

is of order 5/3 or 2. Accordingly, when n is large, we must have

eq
. Moreover, as

depends positively on negotiation costs s, but not

eq
, we generally have

>
eq
when there
are negotiation costs.
Proposition 5 (Equilibrium and Optimal Degree of Proximity). When the number of rms is
large enough, the degree of proximity of rms at equilibrium is generally too small with regard
to collective optimum (

>
eq
), especially when there are negotiation costs.
The economic interpretation of this proposition is the following. Proximity allows signicant
economies of xed costs when the number of rms is large, because then negotiation costs are
very large. Conversely, from an individual point of view, rms tend to favor too much the origi-
nality of their product. By doing so they locate too far from the center of the district, thus creating
negative externalities to the other rms (because the management cost of the public good depends
of the location of all rms).
5. Discussion
The model developed in this article may look very abstract with regard to the reality of in-
dustrial districts. In particular, the originality effect was modeled only on the consumer side,
2
These simulations are available at request at the author.
J.-M. Callois / Journal of Urban Economics 63 (2008) 146162 159
without modeling innovation phenomena explicitly. However, the formulation used for consumer
behavior captures the desired qualitative properties that characterize the ideas of originality and
product innovation.
As argued in the introduction, when proximity between economic agents is high, it is unlikely
to play a positive role on innovation. The image of people in the same room having a brain-
storming session is only valuable if these people have diversied backgrounds. That is, they
should not be too similar for innovations to emerge. Empirical arguments (notably the numer-
ous studies collected by Burt [7] on the role of weak ties on performance) suggest that a high
proximity is detrimental to individual performance in various domains (job seeking, managers
careers, efciency of R&D teams and so on).
The fact that the originality of products in an industrial district is a crucial element of its
performance is also emphasized in the district literature. According to Becattini [4], the variety
of products in the district is an essential ingredient of the success of these districts, as is human
interaction inside districts. However, other important mechanisms may be at play, than the two
studied in this article. Free riding in the use of the public good is one of them. Here, this aspect
is supposed to be included in negotiation costs (which includes both ex ante and ex post costs).
Taking these points for granted, this model provides a simple way of nding the bell-shaped
relationship between embeddedness and protability found by Uzzi [25] among others. More-
over, it gives three noteworthy results. First, there are conicting interests between consumers
and workers on the one hand, and rms on the other hand. The former would like proximity to
be as low as possible, whereas the latter have in general an optimal level of proximity that is
much higher. Implementing a policy to favor the rms proximity could further reduce both di-
versity and production, which would be benecial for rms but not for the other economic agents
(consumers and workers). A more efcient policy, which would increase both production and di-
versity, would be to decrease negotiation costs (but not access costs), thus rising the number of
rms.
The conict of interest between rms and labor shows that the discourse on industrial districts
should not only take into account the rms point of view. In fact, Brusco [6] already noted that
social conditions of workers are often bad in industrial districts. However, given that this is a
partial equilibrium model, these results should not be generalized without caution. Districts may
bring about other advantages for workers (such as reducing uncertainty thanks to labor pooling).
Second, the equilibrium level of proximity is in general too low with regard to the collective
optimum of rms. This feature is all the more signicant that negotiation costs are large. Given
the existence of externalities, the fact that equilibrium and optimal situations do not coincide is
not surprising. A policy favoring proximity of rms may thus prove useful in order to improve
efciency, especially in sectors where research and development are important. The fact that
there may be divergence of interest between classes of economic agents makes the decision of
the policymaker difcult. However, in the context of international competition between regions,
the rms protability may be an essential feature of the long-term viability of the district.
The fact that equilibrium density is independent of negotiation costs is an interesting property.
It implies that the structure of the relationships between rms in a cluster should be quite similar
across sectors. This property is supported by the work of Burt [7] at individual levels, as Burt
nds very similar structures in a wide range of contexts. But it remains to be tested for rms, and
calls for thorough empirical work.
Third, market potential relative to xed costs and elasticity of demand are the essential para-
meters that determine the viability of the industrial district. Neither the global originality of the
district, nor the number of rms play an important role. This is an encouraging message for the
160 J.-M. Callois / Journal of Urban Economics 63 (2008) 146162
attempts to develop new industrial complexes in restructuring areas. It means that once a type of
production is known to be protable, the efforts should be focused on nding the right proximity
structure and lowering negotiation costs (to increase the number of rms).
This model constitutes a rst step towards introducing the idea of proximity into a microeco-
nomic framework. However, these results were obtained by using very restrictive hypotheses. It
would be useful to assess their generality by using other functional forms. At any rate, these re-
sults show that the contention that proximity is good for economic development as long as there
is no collusion should be regarded with caution. It depends on both the type of agent under
consideration and the magnitude of the different costs supported by the rms.
Appendix A. Condition of existence of an equilibrium with nonnegative prot
We study the asymptotic properties of prot when n tends to innity, and then when n tends
to zero. Recall that:

eq
=
Ft nd(p

+p) +
_
(Ft nd(p

+p))
2
+4Ftpn
3
Y(p c)/3
2Y(p c)
and

eq
=
_
dt

eq
+
t n
2
4
eq 2

1
n
s
n
3
12
eq 2
_
F.
First, when n tends to innity, we saw that:
eq

_
Ftp
3Y(pc)
.n
3/2
.
Consequently, if s =0, we have

eq

_
3Y(p c)
4Fp
1
_
F
n
=
_
3Y
4F
1
_
F
n
.
Thus, prot is positive if Y/F > 4/3.
If s > 0, then
eq
sY/(4t ) < 0
Second, when n tends to zero, we have:

eq

Ft d(p

+p)
Y(p c)
.n.
Thus:

eq

_
Y(p c)
F(p

+p)
1
_
F
n
=
_
Y
F(1 +p
1
)
1
_
F
n
(because p =c/( 1)).
In conclusion, prot is positive if Y/F > (p
1
+1).
Numerical simulations are necessary to study the behavior of prot for intermediate values of
n. However, in the case s =0, the asymptotic properties are sufcient to know the sign of prot:
When Y/F > 4/3 and Y/F > (p
1
+1), prot is always positive.
When Y/F < 4/3 and Y/F < (p
1
+1), prot is always negative.
When Y/F < 4/3 but Y/F > (p
1
+ 1), prot is positive for low values of n, then
negative.
When Y/F > 4/3 and Y/F < (p
1
+ 1), prot is negative for low values of n, then
positive.
J.-M. Callois / Journal of Urban Economics 63 (2008) 146162 161
When s > 0, prot is always negative when n is large enough. When Y/F > (p
1
+1), it
is positive for low values of n. When Y/F > (p
1
+1), it is negative for low values of n, but
depending on the parameters there may be intermediate values of n for which it is positive.
Appendix B. Proof of Proposition 2
We have:
(x) =
d +(x
2
+(n/2)
2
)
nd(p

+p) +pn
3
/3
(p c)Y
_
1
n
+s
n
3
12
2
+t x
2
_
F.
Because condition (11) holds and as x
2
0,
(x) >
d +n
2
/4
nd(p

+p) +pn
3
/3
(p c)Y F.
Consequently, if Y/nF > (1 +p
1
) =(p +p

)/(p c), then:

(x) > F
_
d +n
2
/4
d(p

+p) +pn
2
/3
_
p +p

_
1
_
.
Thus, we are ensured that (x) > 0 provided that (p +p

)/4 p/3, or written differently,

that (1 +p
1
) 4/3. This is the rst part of Proposition 2.
For the second part of Proposition 2, observe that when tend to innity,
(x)
d +x
2
nd(p

+p)
(p c)Y
F
n
.
x
2
itself tends to zero because |x| n/. Consequently, (x)tends to
(pc)Y
n(p

+p)

F
n
, which im-
plies that whenever Y/F > (1 +p
1
) =(p +p

)/(p c), prot is positive for a sufciently

large value of .
Appendix C. Properties of

as n tends to innity
The collectively optimal density

is given by the root of the equation:

3dn
2
p

(p c)
[3d(p

+p) +pn
2
]
2
Y =
(t +ns)n
3
6
3
F,
in other words:
18dp

(p c)Y
(t +ns)nF

3
9d
2
(p

+p)
2

2
6d(p

+p)pn
2
p
2
n
4
=0
which gives the largest value of global prot . This is a polynomial of degree three in , thus
all roots can be expressed with powers and radicals. Consequently, as n tends to innity, all roots
have an equivalent of the form An
k
.
Substituting by An
k
in the above equation, and selecting the terms of highest degree in n,
one can see that:
When s = 0, we have necessarily k = 5/3, A =
3
_
p
2
t F
18dp

(pc)Y
, and maximal global prot
tends to (p c)Y/p F as n tends to innity.
When s > 0, we necessarily have k =2. Constant A does not have any analytic expression,
and prot tends to
3Ad+1
3Ad(p

+p)+p
(p c)Y (1 +
s
12A
2
)F as n tends to innity.
162 J.-M. Callois / Journal of Urban Economics 63 (2008) 146162
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