Cluster Theory: Why Startups Flock Together

Why do technology firms congregate in Silicon Valley? Why are movie studios in Hollywood and finance firms on Wall Street?

For decades, researchers have debated the Cluster Theory of Entrepreneurship. The central question is: Do clusters form because of entrepreneurship, or do clusters create entrepreneurs?

What is a Business Cluster?

A cluster refers to a geographic concentration of interconnected businesses, suppliers, and associated institutions in a particular field. According to Delgado, Porter, and Stern (2010), these clusters are not just random collections of companies; they are engines of economic efficiency.

The "Spinout" Mechanism

How do clusters actually grow? The primary mechanism is the Employee Spinout.

Spinouts occur when employees leave an existing firm to start a complementary or competing independent venture. Berchicci, King, and Tucci (2011) found that half of all spinouts choose to stay in the same geographic cluster as their parent firm.

They stay because:

• They rely on their existing professional networks.
• They need access to the same specialized talent pool.
• They require the same specialized suppliers.

Policy Implications: The California Effect

The growth of a cluster is heavily influenced by local laws. Cordes et al. (2014) argue that clusters thrive in places where there are fewer barriers to leaving a job.

A famous example is California, which refuses to enforce non-compete agreements. This legal environment allows employees to leave tech giants and start new ventures without fear of litigation, creating a massive "agglomeration" of startups. In contrast, regions with strict non-compete laws often struggle to build dynamic startup ecosystems.

The "Cluster Effect" (Agglomeration)

Why would a shoe store want to open right next to another shoe store? It seems counter-intuitive to be so close to a competitor.

This is known as Agglomeration Economics. When firms cluster, they create more value together than they could alone by:

• Drawing Customers: A street full of shoe stores becomes a "destination" for shoe buyers, increasing foot traffic for everyone.
• Labor Pooling: Specialized workers move to the area, reducing hiring costs.
• Knowledge Spillovers: Ideas flow freely between firms (often over drinks or coffee), accelerating innovation.

1. Agglomeration Theory and Knowledge Spillover Theory

Agglomeration Theory posits that firms cluster to access shared benefits, the most potent being the "knowledge spillovers" central to Knowledge Spillover Theory. While Spillover Theory focuses on the source of the opportunity—often uncommercialized knowledge from universities or incumbents—Agglomeration explains the spatial mechanism required to capture it. Ideas flow most effectively face-to-face; thus, entrepreneurs must physically locate themselves within the cluster to intercept these "spillovers" before they dissipate over distance, turning a geographic choice into a strategic necessity for innovation.

2. Agglomeration Theory and Transaction Cost Theory

From the perspective of Transaction Cost Theory, a business cluster is an efficiency engine. Coase argued firms exist to reduce market friction; Agglomeration Theory extends this by suggesting that location further reduces these costs. By clustering, firms lower the search and transportation costs associated with finding specialized suppliers, labor, and customers. The "thick markets" found in agglomerations essentially minimize the transaction costs of external exchange, allowing smaller, specialized startups to survive without needing the massive internal hierarchies of vertically integrated giants.

3. Agglomeration Theory and Social Capital Theory

Agglomeration Theory relies heavily on the "local buzz" of a region, which is the structural manifestation of Social Capital Theory. The proximity provided by a cluster facilitates the repeated interactions that build trust and dense networks. While Social Capital Theory argues that "who you know" drives success, Agglomeration adds that "where you are" determines who you can know. The physical cluster accelerates the accumulation of social capital, transforming a geographic neighbor into a strategic partner or investor far faster than in isolated regions.

4. Agglomeration Theory and Human Capital Theory

A key driver of Agglomeration Theory is "labor pooling," which directly connects to Human Capital Theory. Becker viewed skills as economic assets; Agglomeration views the concentration of these assets as a magnet for startups. Specialized human capital—like AI engineers or biotech researchers—is not evenly distributed. Entrepreneurs flock to clusters because that is where the human capital stock is deepest, reducing the risk of a skills mismatch. Simultaneously, the cluster increases the return on investment for workers acquiring those specific skills, creating a self-reinforcing cycle of talent attraction.

5. Agglomeration Theory and Institutional Theory

Agglomeration Theory emphasizes the role of "associated institutions" (universities, trade groups) in a cluster's success, echoing Institutional Theory. A cluster is not just a collection of firms but a web of supporting norms and rules. As seen in the "California Effect," regional institutions (like the lack of non-compete enforcement) create the rules of the game that either encourage or stifle the labor mobility and spinouts vital for agglomeration. Thus, the physical cluster is sustained by an invisible institutional framework that legitimizes and facilitates high-velocity entrepreneurial behavior.

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