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Silicon City
Silicon Valley has been the shining light of the Internet revolution of the 1990's with its tens of billions of dollars in venture capital awarded each year, soaring home prices, and young millionaires. Scores of other cities have sought to replicate the success of the Valley by building industrial centers and legitimating them with a slogan like Phoenix's "Silicon Desert," Los Angeles' "Digital Coast," New York's "Silicon Alley," England's "Silicon Fen," and Israel's "Silicon Wadi." This paper will explore the economic justification for and dynamics of agglomeration in high tech industries to explain the economic basis of the high tech industrial park and to argue against futurists who see in the Internet and telecommunications technology a substitute for face-to-face meetings and cities.
Before arguing for the geographic concentration of the high tech industry, we must determine whether or not agglomeration is a real phenomenon and not something that can be replicated randomly. After throwing only six darts at a map of the United States, there is a better than 50/50 chance that two darts will be in the same state (Ellison and Glaeser 2). Nevertheless, Ellison and Glaeser through the construction of an index of geographic concentration and data on the employment distribution for the 459 manufacturing industries defined by SIC codes (12, 14), found that in 446 of the 459 industries the level of concentration exceeds that which would be expected to occur randomly. In fact, the difference between actual concentration and predicted random concentration is more than twice the actual concentration's standard deviation in 369 of the 446 industries (17). Clearly, Silicon Valley type agglomerations are more the rule than the exception. The analysis suggests strongly that localized industry is ubiquitous.
In 1920, Marshall suggested three theories for industry agglomeration. Marshall's first explanation suggested the presence of suppliers and customers as causing high levels of industry-specific geographic concentration. Arguing that transportation costs force firms to trade off between distance to inputs and distance to customers, Marshall viewed transportation costs as a major factor in the decision to select a location. Dumais, Ellison, and Glaeser in an NBER Working Paper entitled "Geographic Concentration as a Dynamic Process" claim that "the effects of the presence of input suppliers and customers are fairly modest" with a one standard deviation increase in the presence of input suppliers leading to only a 0.03 increase in the number of new firms (28). While perhaps important at the time Marshall wrote, the advent of the train, interstate highway, and airplane have made transportation costs much less important.
Marshall's second explanation for agglomeration, that labor market pooling provides benefits to both employers and employees, fits modern data much better. Dumais, Ellison, and Glaeser conclude that "plants do seem to locate near other industries when they share the same type of labor" (30). Employees benefit from labor market pooling by facing less risk of unemployment in areas of high agglomeration as many potential employers exist; employers benefit as workers are willing to accept lower wages in return for lessened risk of unemployment. Dumais, Ellision, and Glaeser have found that a one standard deviation increase in the level of labor mix causes a .18 increase in the number of new firm startups. The most difficult to measure, yet most economically interesting, of Marshall's three explanations for agglomeration is that agglomeration allows for information spillovers to take place as firms learn from other firms through employees educating each other and through innovators copying each other. Dumais, Ellison, and Glaeser suggest that a one standard deviation increase in technological spillovers induces at least a .08 increase in new firm startups (28). Silicon Valley, which is highly touted for its open labor market and networks of contacts that help further innovation in a complex business environment (Saxenian 2-13), might be expected to benefit greatly from agglomeration.
However, some authors have suggested that the high-tech, telecommunications-reliant nature of industry in Silicon Valley will eventually lead to the obsolescence of cities as electronic meetings in cyberspace are substituted for face-to-face interactions. According to this view, cities, whose primary purpose is to reduce interaction costs, will be overcome as the technology improves, and city dwellers migrate to less expensive real estate. Not necessarily specious, the argument relies on the fact that video teleconferencing, telephones, email, and fax machines are substitutes for face-to-face interactions.
In contrast with this view, Gaspar and Glaeser suggest that telecommunications devices and face-to-face interactions are not substitutes but complements. One result of improved telecommunication is that people can generate more contacts as email and phone conversations may be used to setup face-to-face interactions (Gaspar and Glaeser 3). To the extent that cities are centers of telecommunications technology, "improvements in information technology will help cities even more" (4). In addition, since improved technology typically results in increased division of labor, this effect alone necessitates more interaction. Since these interactions will be used to communicate relatively complex thoughts about technology, face-to-face visits may be necessary.
Moreover, the introduction of the telephone was a much larger and groundbreaking invention than email or fax as it allowed easy contact over long distances for the first time. However, "we find that the introduction of the telephone, a revolutionary innovation in telecommunications, seems to have had a small influence on the path of urbanization in the US" (Gaspar and Glaeser 7, 36). In fact, telephone usage and urbanization seem to increase together in cross-country data. Telephones do not replace face-to-face interactions but seem to complement them as 40 percent of phone calls are made to locations within a two-mile radius of the caller while 75 percent are made to locations within a six-mile radius (7-8). Telecommunications may also facilitate travel for face-to-face interactions. Telephones, email, and faxes are used more and more by business travelers to make their absence from their offices less costly and to make it easier for them to visit many different people. Perhaps as a result, business travel since the mid 1980's has increased 50 percent (41).
The fact that Silicon Valley, the most famous and replicated agglomeration of industry, occurs in the most technological field further disproves the obsolescence of cities hypothesis; the Valley's genesis requires further explanation. Borrowing from the literature explaining agglomeration in the art world, we can see Silicon Valley as useful to the coordination of many creative and ordinary inputs while simultaneously facilitating entrepreneur development and the filtering responsibility of venture capitalists who act as gatekeepers, allowing for the creation of viable ideas and rejecting unpromising ones (Caves 26). In addition to providing the capital, venture organizations typically receive scores of business plans for each one it decides to fund. They also complete lengthy analyses of markets and business ideas as well as an extensive background check on the entrepreneur that could lead the organization to contact as many as 100 references. The venture firm also provides monitoring and oversight by taking a role on the board and staging its investments (Gompers and Lerner 232).
An entrepreneur in need of funding will seek out a venture capitalist after proving his idea on a limited basis. Most Silicon Valley entrepreneurs are in constant need of funding as few companies are profitable. Most continue to ask venture capitalists for additional investment, eventually going public deep in the red. A representative example is Snowball.com (SNOW) which did an IPO in April despite 1999 revenues of $6.6 million and costs of $37.5 million (Snowball.com Prospectus). Because venture capitalists act as the gatekeepers who play the important economic role of only funding the best ideas and because they require close oversight of the funded company, venture capitalists prefer to invest in companies in their own geographic vicinity. In fact, 75 percent of venture capital in California is invested in California companies (Bygrave and Timmons, 240). We might thus expect to see agglomeration wherever there are the most venture capital funds available since success of an entrepreneurial venture depends critically on access to funds and since venture capitalists celeris paribus would prefer to invest in nearby companies. This is of course exactly what we observe with California leading the United States in entrepreneurial activity and venture capital, followed by Massachusetts. This creates the possibility for what Myrdal termed "circular causation." In a virtuous circle, entrepreneurs will concentrate around venture capitalists who will concentrate around entrepreneurs, etc (Krugman 486). The result is agglomeration in Silicon Valley and Route 128.
This story may seem unappealing since venture capitalists, by all gathering in one area, might be forced to vigorously compete for entrepreneurs who must also vigorously compete for venture capitalists. However, there are at least two factors militating against this outcome. First of all, entrepreneurs often do not have much money pre-investment and must seek out scores of venture capitalists before arriving at a successful match. If the VCs were scattered randomly around the country, the cost of the search could be prohibitive. Along these same lines, most venture capitalists syndicate their investments, and this syndication requires face-to-face meetings among the investors for quick transmittal of nuanced, complex information (Gompers and Lerner 269-278). In addition, entrepreneurial ideas are differentiated offsetting the disadvantage of proximity (Caves 30). While money is limited and all ideas compete for the same amount of funds, entrepreneurial plans are not perfect substitutes.
While VC money is the foundation of Silicon Valley, VC firms did not arise exogenously on Sand Hill Road but over time as the result of favorable business conditions. The Second World War played an important role in the development of Silicon Valley as the government supported research and weapons manufacturing. Stanford's brilliant students and its strong ties to industry also played a large role in the development of the Valley. As Frederick Terman, electrical engineering professor at Stanford and angel investor in his students' William Hewlett and David Packard's idea noted:
"The West has long dreamed of an indigenous industry of sufficient magnitude to balance its agricultural resources. The war advanced these hopes and brought to the West the beginnings of a great new era of industrialization. A strong and independent industry must, however, develop its own intellectual resources of science and technology. For industrial activity that depends on imported brains and second-hand ideas cannot hope to be more than a vassal that pays tribute to its overlords and is permanently condemned to an inferior competitive position." (Saxenian 22)
With the success of Hewlett-Packard, Terman's initiative to create a research institute to pursue business for practical purposes, and his development of the Stanford Industrial park which in 1961 employed 11,000 people, Silicon Valley became a center for electronics research. In 1954, William Shockley established a transistor business in Palo Alto, and two years later, its eight leading engineers ("the traitorous eight") left to create a competing business named Fairchild, which by 1963 had annual sales of $130 million. The "traitorous eight" went on to continue promoting entrepreneurship. Robert Noyce, Gordon Moore, Andy Grove (founder of Intel), and Eugene Kleiner (of Kleiner Perkins) all made large contributions to the Valley. Between 1959 and 1976, only five of the United States' forty-five semiconductor firms were located outside of Silicon Valley. By the early 1970's, the military, which accounted for more than half of semiconductor shipments during the 1960s, constituted less than 10 percent of semiconductor shipments, and venture capital replaced the military as the leading source of financing (Saxenian 26).
Bygrave and Timmons suggest the importance of societal values in shaping Silicon Valley's success as "an entrepreneurial society has investors, bankers, lawyers, workers, suppliers, and customers that know the importance of entrepreneurs" (253). Founded by pioneers distrustful of "Eastern," "established" attitudes, the early entrepreneurs experimented with organizational forms. With the "Fairchild family" genealogy of entrepreneurs hanging on the wall of many Silicon Valley businesses, the early entrepreneurs are heroes and role models to the modern generation of entrepreneurs. Moreover, the Valley has a favorable attitude toward failure, which is necessary, if people are to start uncertain ventures. As George Gilder notes: "The tolerance of failure is absolutely critical to the success of Silicon Valley. If you don't tolerate failure, you can't permit success. The successful people have a lot more failures than the failures do" (Saxenian 112). Such tolerance is necessary for people to rejoin the workforce with experience, regardless of whether the experience was a success or a failure. The importance of societal values in shaping entrepreneurial tendencies is further suggested by the fact that Israel is second to the United States in venture capital invested (Gompers and Lerner 238). Given that Israelis, like Americans, "prize education, revere entrepreneurs, cater to the American market, and developed technological prowess through major government spending on defense" while at the same time possessing the capacity to deal with risks given their establishment of a country in a hostile land, we should not be surprised at Israel's superiority in establishing high-tech companies, even in comparison to larger countries like Germany, Canada, France, etc.
In addition to the favorable values of its inhabitants, Silicon Valley is uniquely poised to benefit from the aforementioned Marshallian knowledge spillovers. With a workforce fixated on the dream of the entrepreneur and a business culture created by groundbreaking entrepreneurial pioneers, Silicon Valley developed into an ideal place for the transmittal of knowledge spillovers. As more firms enter and participate in the culture, the network effects increase, as all firms are better off after realizing the positive externality of additional entrants. Average annual employee turnover exceeds 59 percent in the Valley, which enjoys a level of workplace mobility deemed "pathological" by some (Saxenian 34). One commentator noted: "People change jobs out here without changing car pools" (36). As a result of the high mobility, firms benefit from the diversity of management styles as new employees with varied backgrounds bring to the new firm a different perspective on business. This job-changing also blurs the line between firm and competitor as a network of engineers and entrepreneurs exists that can transcend competition. The interfirm networks convinced many firms to expand their presence in Silicon Valley to take advantage of the speed of idea dissemination in a business dominated by rapid obsolescence and constant innovation.
In contrast with the success of Silicon Valley as the agglomerative center of the high tech world, Route 128 in Massachusetts runs a distant second to CA despite many similar conditions, including access to MIT, the importance of government contracts in the 1950s and 1960s, a history of high tech employment, and a large number of venture capitalists. As the charts below make clear, Route 128 lost parity with Silicon Valley. However, this performance gap cannot be attributed to regional differences in real estate costs, wages, or tax levels (Saxenian 108). Saxenian and many authors instead condemn Route 128's rigid hierarchical system, isolated corporate culture, and traditional way of business for hampering its ability to evolve quickly as a technological Mecca. More a collection of independent firms than a network of startups, Route 128 companies have much lower employee turnover than the Valley, a workforce willing to work up corporate hierarchies, and less opportunity for information sharing. Although Route 128 was once the center of semiconductor production (Saxenian 78) and although as late as 1965 Route 128 led Silicon Valley in high tech employment, Route 128's employment is less than one-third Silicon Valley's employment. Route 128's Puritanically self-reliant firms imitated the organization and corporate structure of major corporations like IBM, GE, and GM, and investors continued to demand gray-hairs of entrepreneurial management teams (Saxenian 60, 71-72). This behavior ultimately doomed Route 128 to the sidelines, as modern, complex innovations in an industry dominated by TTM concerns and obsolescence require more interaction and less managerial structure. In 1997 alone, Silicon Valley received more venture funding than Southern California, Texas, and New York combined (Miller). (See illustrative charts below.)
Sales per employee of Silicon Valley firms and their Route 128 counterparts, 1990 ($ thousands)
| Silicon Valley | Route 128 | | Apple | 382.6 | Prime | 128.0 | | Sun | 214.6 | Wang | 123.0 | | Silicon Graphics | 200.0 | Data General | 114.0 | | HP | 143.8 | DEC | 104.4 |
Source: Saxenian
Source: Saxenian
Clearly, history played a crucial role in the formation of Silicon Valley. Had MIT fostered greater entrepreneurship and had Shockley and Terman lived in Boston, it might be the center of the high-tech world. Krugman notes the importance of history in determining agglomerations like Silicon Valley writing: "had the distribution of population [or entrepreneurs] at that critical moment been only slightly different, the roles of the regions might be reversed" (487). In addition, there is a possibility for "self-fulfilling" prophecy in agglomeration centers. In determining whether to migrate to another region, people must look at both current earnings and expected future earnings. In the presence of an externality, each additional person moving into an agglomeration region increases the future earnings of everyone else. Thus, if everyone believes a region will become an agglomeration region, the expectation can affect causation (Krugman 654).
Krugman in a highly stylized model determined that three factors affect whether history or expectations affect outcomes: the interest rate, a measure of the strength of external economies, and a measure of the speed of adjustment. For large values of the interest rate, the future is heavily discounted thereby increasing the role of history. Similarly for small values of the measure of externality, history will matter more than expectations since there will not be enough interdependence among decisions to support a self-fulfilling prophecy. Lastly, if the economy adjusts slowly in the face of potential agglomeration regions, history will be decisive since current earnings levels will dominate the decision-making framework of potential migrants to the new agglomeration region (Krugman 664). We thus see that both historical accident and future expectations can affect the dynamics of agglomeration, and both likely played an important role in the success of Silicon Valley.
While history may have set the stage for a favorable entrepreneurial culture, the magnitude of the region's success likely was affected by people's expectation that the ascendancy of Silicon Valley would continue into the future. As entrepreneurs flocked to the region and hundreds of established companies setup regional Silicon Valley offices, the Valley exploded with growth. The fact that over 40 cities, according to the web site http://www.tbtf.com/siliconia.html, now claim a technological moniker suggests that these cities understand the importance of creating an expectation of future high-tech growth. They seek to draw entrepreneurs and investors to their area with the promise of being the first ones to help establish a new agglomeration.
While history and expectations played a large role in establishing Silicon Valley over Route 128 as the leader of American high-tech industry, we must further understand the dynamics of agglomeration to discern how to repeat Silicon Valley's success in other regions and to analyze the question of whether or not Silicon Valley can lose its status as the foremost agglomeration of high tech industry in the world. Thus, while Silicon Valley is the unquestioned leader of all high-tech agglomerations with its growth rate of 4000 companies / year and its absolute dominance in venture capital funding, the question remains of whether or not it will remain so.
 
Given the extremely high and ever-increasing cost of business in Silicon Valley suggested by the below charts, we must wonder when and if the
 
high rents and cost of living will chase entrepreneurs out of the Valley as happens in other centers of agglomeration in other industries.
The dynamism of agglomeration centers is well known in the artistic world as artists in need of loft space to exhibit their wares to customers and agents face very high rents in mature artist ghettos. Caves summarizes the migration patterns of agglomeration in the art world:
"This process has repeated itself in New York several times. Starting around 1982, the East Village went through the cycle in less than a decade. The area was seriously run down and its previous low-income community disrupted by crime, which opened up low-rent space to artists. Lightly capitalized contemporary art galleries quickly followed. With the joys of le premier cri freshly recalled from SoHo, the arts and culture media immediately arrived at the scene. Shoppers and tourists followed, gentrification was set in motion, and the neighborhood business and cheap clubs that supported the artists' communication and interchange were squeezed out. At the end of the decade an art-market recession eliminated many of the galleries, the more successful ones moved out, and the artists sought their next vibrant slum, a largely empty district of factory buildings in Brooklyn known as DUMBO. The process has been repeated in other cities—note Venice in the Los Angeles area and SoMa in San Francisco." (Caves 31, 32)
Since entrepreneurs are similar to artists in the sense that they lack pecuniary resources yet must locate near each other and venture capitalists, we might expect constant flux in the centers of entrepreneurial energy. The 40 different regions with high tech monikers provide evidence of exactly this phenomenon.
James Rauch formalizes the geographic dynamism of the industrial park and the explanations for shifts of agglomerated industries from high-cost to low-cost locations. Given that history clearly plays an important role in determining the success of agglomeration centers, Rauch attempts to answer the questions of whether or not history will choose an efficient outcome, and if it does not, what ensures that the industrial park will eventually migrate to a different location? Rauch finds that history, as a sequence of largely random events, does not necessarily favor the most efficient outcomes. However, he has identified a mechanism that allows for the relocation of centers of agglomeration from established sites to new, low wage sites (848).
Old centers of agglomeration have an advantage over new centers in that they have achieved success due to the positive externality and knowledge spillovers of having many firms located in one region. Thus, the first company to move to a new region faces an enormous cost, thereby potentially forcing the companies to remain in an inefficient high-rent area (849). The industrial park, the archetype of which is Orange County's Irvine Spectrum, which employs 25,000 workers and is home to 25 Fortune 500 companies and 21 regional headquarters of Pacific Rim companies, is the economic solution to this potential efficiency problem. Because the first few firms to move to the new industrial park face the uncertainty of whether all companies will move and thus the potential loss of the positive externality, the organizers of the new industrial park offer special rates to "seed tenants" who act as "loss leaders." These seed tenants receive space at below cost and are chosen by the industrial park to "set the reputation and character" of the eventual industrial park (856). In fact, a survey by Lee and Wong found that developers sell land that cost 22.6 cents / sq. ft. at 18.6 cents / sq. ft. to the first few tenants. Once the new industrial park begins to reach critical mass and achieves the externality benefits of the old industrial park, the developer increases prices and profits off the externality. As Rauch concludes: "later tenants are paying for the privilege of benefiting from economies of agglomeration as firms accumulate within the park, allowing the developers to recoup the costs they occurred in subsidizing early tenants."
Agglomeration in the high-tech industry is rooted in the labor market pooling and knowledge spillovers, which provide positive externalities to all members of the agglomeration. However, what made Silicon Valley the premier center for entrepreneurial energy is history and expectations. A pioneering, rebellious group of entrepreneurs moved to California with no desire to found a hierarchical corporation isolated from its surroundings. As a result of the favorable relationship between Stanford and surrounding business and the societal faith in the entrepreneur, Silicon Valley realized tremendous success. The historical accident of agglomeration has occurred elsewhere. Seattle has an extremely large high-tech population because Bill Gates and Paul Allen decided to bring their 13 employees to their hometown and grew the company to 46,000 people with a payroll of over $3 billion. Microsoft attracted thousands of programmers and its incredible wealth generation created thousands of Microsoft millionaires willing to found other businesses. Microsoft drew the talent and created the wealth necessary to support Seattle's 3,000 high-tech companies (Allbritton). The vision of one man created a high-tech city.
However, cities need not rely on chance for their technological hubs. California's Orange County industrial park is a fantastic success and a hub for biotechnology since its inception. Governments and businesses that have the resources can finance agglomerations as entrepreneurs will always be lured by venture capital, infrastructure, and cheap real estate. Nevertheless, maintaining a region's position as the premier high-tech agglomeration will be extremely difficult as labor shortages and outrageous real estate prices deter entrepreneurs from establishing offices in Silicon Valley, especially given the efforts of many other cities to convince investors and entrepreneurs to create a rival to the Valley.
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