Agglomeration and Adverse Selection: Evidence from multi-plant firms

Do high or low productivity firms self-select into locations characterized by high industry establishment density? On the one hand, productive firms may benefit more from the presence of specialized suppliers in agglomerated areas and they are also more likely to survive heightened product market competition. On the other hand, productive firms face greater risks of knowledge dissipation to collocated rival firms and contribute more than they receive in terms of knowledge spillovers. We examine unique data on the location of new plant establishments by multi-plant manufacturing firms in Japan, relating location decisions to firms’ prior productivity in existing plants. Estimating conditional logit models of location choice for close to 3,666 plant location decisions (2002-2008) covering more than 1,000 towns, wards, and cities, we find that the adverse selection effects of industry agglomeration dominate. These effects are substantially stronger if there is no association between establishment density and local competition: if incumbent plants are exporting or if the investing firm or new plant entry focuses on export markets. We conclude that sorting processes do occur, but that these can only be uncovered in a more fine-grained analysis that takes into account ex ante measures of firm heterogeneity and the nature of product markets.