Employees' break-offs and location selection: The birth of industrial clusters

Empirical observation suggests that several industrial clusters originate from employees who break off and locate their new firms close to former employers. The reasons for such a choice are complex and include a variety of costs considerations. We present a two-player three-stage simultaneous game with interdependent decisions concerning break-offs, deterrent compensations, location, and profit-maximizing production outputs. The structure of the game explains under what conditions a break-off is desirable, what locations choice makes it optimal, and why the break-off process may lead to the birth of a cluster. We demonstrate how marginal production/congestion cost, degree of product differentiation, R&D investment in a region, and market size, all influence the likelihood of a firms break-off and its subsequent location decision. Our results provide a rationale for why, in industries in which technology plays a significant role, an increase in R&D investment in the region may encourage the break-off firm to locate away from the incumbent. We also show that subsidies aimed at increasing manufacturing activities and diffusing commercializable innovations can be ineffective in promoting clustering and unnecessary in larger markets, and their exact size is crucial in determining their effectiveness.