Knowledge Spillovers, Mergers and Public
Policy in Economic Clusters
and LYNNE PEPALL
Department of Economics, Tufts University, Medford, MA 02155, USA
Abstract. This paper investigates how market concentration aﬀects research activity in an
economic cluster. The ﬁrms in the cluster play a two-stage game. In the ﬁrst stage the ﬁrms
choose whether or not to engage in costly research that generates technological improvements
that spill over to the other ﬁrms in the cluster. The more ﬁrms engaged in research the richer or
more proﬁtable is the pool of knowledge that spills over. In the second stage after the
knowledge spillovers have occurred, ﬁrms compete in quantities. We solve for the symmetric
mixed strategy equilibrium to the ﬁrst stage of the game, and ﬁnd that too low a degree of
concentration in the cluster will destroy ﬁrms’ incentives to undertake research and so the
cluster risks stagnation. We explore whether a merger can stimulate research activity by
increasing concentration in the cluster. Finally, we consider a public policy response to
stagnation and analyze whether a direct public subsidy to stimulate research is preferable to a
Key words: Agglomeration, clusters, mergers, perfect spillovers.
JEL Classiﬁcations: L10, O38.
Economic clusters are deﬁned as geographic groupings of ﬁrms whose
products are related, either as complements in the case of upstream down-
stream relations, or as substitutes in the case of horizontal competition. Well
known examples of clusters include the ﬁlm industry in Hollywood, Italian
leather manufacture in Northern Italy, Silicon Valley in California, the ﬁ-
nance industry in New York, and the household furniture industry in North
Carolina. These clusters constitute a diverse set of industries employing
diﬀerent technologies and serving diﬀerent kinds of consumers. A natural
question to ask is what advantage the geographic proximity of being part of a
William and Joyce Cummings Family Chair of Entrepreneurship and Business
Economics, Tufts University.
Author for correspondence: Tel:+617-627-5477; Fax:+617-627-3917; E-mail: lynne.
Review of Industrial Organization 25: 155–174, 2004.
Ó 2004 Kluwer Academic Publishers. Printed in the Netherlands.