The (Almost) Magical Economics of Knowledge Spillover

ECOtality is a company at the forefront of clean transportation and power storage technology, which in 2010 moved its headquarters from Arizona to the Bay Area. It is not the only one. The German company Q-Cells, the Chinese companies Trina Solar, Suntech, and Yingli Green Energy, and the Spanish company FRV have all recently opened shop in the Bay Area. Clean-tech companies are increasingly locating their headquarters and/or their R&D labs in the region. In a recent interview with the CEO of ECOtality, NPR reported that the reason for his move was “to be close to the action.” On some level, this makes intuitive sense. After all, who wants to be away from the action? But on a deeper level, it raises the question of what “being close to the action” really means. Why would all these companies want to be so close to their competitors? What advantages could they possibly derive?

The answer has to do with a simple fact: new ideas are rarely born in a vacuum. Research shows that social interactions among creative workers tend to generate learning opportunities that enhance innovation and productivity. This flow and diffusion of knowledge represents a crucial third advantage for workers and firms that locate within an innovation cluster.

 As we saw earlier, average education is the most important reason that wage levels vary so much across cities. The fact that workers earn more in brain hubs is not an accident but a reflection of the higher labor productivity that comes from working alongside highly skilled colleagues. The wage of the same person can be vastly different depending on whether the people who live around him are well educated or poorly educated. This makes sense in some general way, but it does not tell us why it is true. Understanding exactly how and why knowledge diffuses within a circle of friends, colleagues, or scientists in a city is vital if we want to understand why innovative industries locate in some cities but not in others. Paul Krugman, who conducted trailblazing academic research in this area before becoming a New York Times commentator, once famously wrote: “Knowledge flows are invisible; they leave no paper trail by which they may be measured and tracked, and there is nothing to prevent the theorist from assuming anything about them that she likes.”

Krugman’s skepticism motivated many researchers to intensify their efforts to measure the diffusion of ideas. In 1993 three economists—Adam Jaffe, Manuel Trajtenberg, and Rebecca Henderson—found a usable paper trail: patent citations. When filing for a patent, an inventor is required to list all the previous inventions that her invention builds upon. These links offered the economists an innovative way to track the flow of knowledge among inventors. Their results were surprising: knowledge is subject to a significant degree of “home bias,” in the sense that inventors are significantly more likely to cite other inventors living nearby than inventors living farther away. Because patents are freely available, citations shouldn’t necessarily display geographical favoritism. An inventor in, say, Durham, North Carolina, should have the same awareness of products or ideas generated elsewhere as he does of those generated in Durham. And yet an inventor in Durham is much more likely to cite a previous invention patented by someone else in Durham than one patented in another city.

 The magnitude of the home bias is substantial. Excluding citations that come from the same company, citations are twice as likely to come from the city of their citing patent than from other places. This means that scientists and inventors are more familiar with knowledge produced by those who work near them, presumably because they share ideas and information through informal conversations and interactions. These interactions take place both inside and outside the workplace, including casual settings like local cafés and social events. In Silicon Valley, for example, weekend cricket games are known to be opportunities not just for physical activity but also for networking and exchange of business-related information for the local community of Indian engineers. Increasingly, one of these engineers told the New York Times, “cricket spills over into business.” Geography matters for the spread of knowledge, and knowledge quickly dies with distance. Citations are highest when the citing inventor is located between zero and 25 miles from the cited inventor. Citations are significantly lower when the citing inventor is more than 25 miles from the cited inventor, and the effect completely disappears beyond 100 miles.

Geographical distance seems to impede the flow of ideas even within the boundaries of a firm. This alone should discourage companies from outsourcing any part of the innovation phase to low-cost countries. Take the high-tech company Cadence, with about two thousand employees in San Jose, one thousand workers in India, and another thousand scattered around the world. An Indian software engineer at level T4 makes about a third of what a similarly qualified software engineer in San Jose makes. When I asked Cadence’s executive senior vice president, Nimish Modi, why the company does not move more R&D to India, given the potential savings, he told me that proximity and personal interaction matter to the creativity of its engineers. “We have sophisticated videoconferencing facilities, and we use them all the time to communicate with India. But it is not the same as face-to-face interaction. Nothing replaces a group of engineers sitting together and arguing in front of the whiteboard,” he said.

 As an academic, I am not too surprised by this. Although I communicate daily with distant colleagues by phone and e-mail, my best ideas often occur when I least expect them—over lunch with colleagues or at the water cooler. The reason is simple. Phone and e-mail are great ways to transmit information and keep a research project going once the key creative ideas are in place, but they are not the best way to come up with those ideas. New ideas arise in mysterious and unpredictable ways from free and unstructured interactions. It would be ridiculous to schedule a phone call with a distant colleague to come up with a new idea. My guess is that most researchers share this view. After all, the reason we spend so much time in academia discussing whom to hire and fire is that our colleagues affect our own productivity.

Being around smart people tends to make us smarter, more creative, and ultimately more productive. And the smarter the people, the stronger the effect. Pierre Azoulay, Joshua Graff Zivin, and Jialan Wang quantified this by focusing on what happens to medical researchers when they work with an academic superstar. It is difficult to establish the causal relationship here because of self-selection: superstars tend to work with strong researchers, so the fact that their collaborators are especially prolific may just happen because they are better, not because they are benefiting from knowledge spillovers. To control for this, the three economists had a smart idea. They focused on what happens to the productivity of a superstar’s collaborators when the superstar dies unexpectedly (they identified 112 such deaths). Although nothing changed in the collaborators’ own circumstances following the superstars’ deaths, they experienced “a lasting 5 to 8 percent decline in their quality-adjusted publication rates.”

 It is not just that people publish more when they are close; the quality of their research is better. When a team of Harvard Medical School doctors analyzed all medical research articles published at Harvard and correlated their data with the distance between the authors’ offices, they found that being less than one kilometer away raised the quality of research, as defined by how many other researchers cited the article. The effect was even larger if the authors were in the same building or used the same elevator.

Thus innovative firms have an incentive to locate near other innovative firms. In the same way that having a good colleague next door affects my creativity, having good neighbors—even competitors—improves the creativity of companies and workers. This in turn helps explain why workers in brain hubs earn higher salaries than identical workers in other areas. There is something almost magical in the process of generating new ideas. By clustering near each other, innovators foster each other’s creative spirit and become more successful. These effects have gained importance over time. While many people think that e-mail, cell phones, and the Internet have made physical proximity less important to the creative process, in reality the opposite is true. Location is more important than ever, in part because knowledge spillovers are more important than ever. This is a key reason for the accelerating divergence in the fortunes of the three Americas.

The growing importance of knowledge spillovers does not just affect the cities where businesses and workers are clustering. It is also reshaping the physical layout of the workplace. Offices used to be simple rooms with doors, until the open-space craze revolutionized the design of many white-collar workplaces and introduced the idea of Dilbert-like cubicles. One of the most intriguing new trends is the idea of “cowork.” Born in California, the concept is spreading quickly through the entire country. Cowork spaces typically host dozens (in some cases hundreds) of entrepreneurs, innovators, and artists, who rent desks or offices in the same building and sit next to each other. They are part of a growing number of creative professionals in American innovation hubs who are self-employed and prefer to remain independent of larger companies. In cowork spaces, each of them works on his project, but the setup is appealing because it offers the possibility of sharing ideas, building connections, and fostering creativity. It turns isolated innovators into a real community, a creative ecosystem designed to maximize knowledge spillovers.

 One example is the San Francisco Chronicle Building. It includes, among many other ventures, a high-tech incubator, a school of digital filmmaking, an art gallery, a tool workshop for “inventors, makers, hackers, tinkerers,” and hundreds of engineers, scientists, artists, and social entrepreneurs who have decided that they have a lot to learn from each other. When you enter one of these places, you feel more like you are at a graduate school than in a regular office: people network, exchange tips on how to solve technical problems, and comment on each other’s business plans. The goal is “radical collaboration” among individuals who would otherwise be isolated, working alone in their home offices or garages. In a random day at the Chronicle Building, you might find a fashion designer sketching her future hat collection next to a mechanical engineer operating a laser cutter next to a Berkeley MBA writing a grant for a new Darfur nonprofit organization. The creative energy is palpable. Some cowork places organize lectures or demonstrations of the latest technologies, such as “Startup Demo Night.” Others have happy hours and brown bag lunches with angel investors. It is all about establishing connections and sharing insights. The phenomenon is so new that there are no rigorous studies of how coworking affects creativity and business success. But all the signs point in the right direction. For example, one of the Chronicle Building’s early success stories is Square, a mobile phone credit-card payment processing company started by Twitter cofounder Jack Dorsey, which has grown from five to one hundred employees in just a year.