Heterogeneous Firms and Cluster Productivity: A Neglected Externality Through Survival of the Weakest

We argue that geographical clustering helps the weakest firms to survive. We model this neglected negative externality by adapting the heterogeneous firms model of Melitz (2003) to include firms that invest in R&D and firms that do not. Separating the chance of post-entry market exit into a system risk that is exogenous to all firms and a firm-specific risk that can be reduced by doing R&D, we find that only the most productive firms will invest in R&D. Incorporating knowledge spillovers to proxy for geographical proximity, the benefits from these R&D investments may spill over to other firms. This occurs either directly by reducing the firm-specific risk for non-R&D firm, or indirectly, by making R&D investments cheaper. The effects on innovation are different for these two cases: direct spillovers reduce innovation while indirect spillovers increase it. However, for both cases it holds that the effect on average productivity within the region is clearly negative.