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Strategic Management Journal
Strat. Mgmt. J.
,
26
: 595–615 (2005)Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.464
TYPES OF FIRMS GENERATING NETWORK EXTER-NALITIES AND MNCs’ CO-LOCATION DECISIONS
SEA-JIN CHANG
1
* and SEKEUN PARK
2
1
School of Business Administration, Korea University, Seoul, Korea
2
The Export–Import Bank of Korea, Seoul, Korea
This study identifies and examines sources of network externalities that influence MNCs toagglomerate their foreign operations in specific regions. Using data for Korean firms that invested in China, this study found that network externalities were sensitive to the types of firmsconstituting a regional network. It also found stronger network externalities within firms thanacross firms, from firms of the same nationality than from those of different nationalities, and  from firms in the same industry than from those of different industries. As we defined the types of  firms more precisely, distinctive curvilinear relationships between network externalities and thelikelihood of co-location emerged.
Copyright
2005 John Wiley & Sons, Ltd.
Why do multinational corporations decide to locatein one area rather than another? To date, researchon this question has examined firms’ motiva-tions for these decisions, the modes they usewhen entering an area, and the sequences of their entry decisions in that area. This work has been guided by the theme of foreign directinvestment (Hymer, 1960; Dunning, 1988; Hen-nart and Park, 1994; Chang, 1995; Kogut andChang, 1996). It has also considered such deci-sions at the national level, rather than assessingwhy a firm might enter one region within a nationrather than another. We argue that internationalbusiness scholars should explore regional locationdecisions much more extensively, as these deci-sions shed light on MNCs’ foreign entry strategies.When MNCs announce they are investing in acountry, they often specify a location they havedecided upon prior to the announcement. Most
Keywords: network externalities; agglomeration;co-location; foreign direct investment
∗
Correspondence to: Sea-Jin Chang, School of Business Admin-istration, Korea University, Seoul, Korea 136-701.E-mail: schang@korea.ac.kr
countries consist of many regions, which differgreatly from each other in terms of prevailingwages, populations, technology bases, and infra-structures. Since MNCs presumably choose loca-tions that seem to fit best with their strategic goals,the location decision
within
a country (e.g., Shang-hai or Beijing) may be more important than thedecision at the country level is (e.g., opening afactory in China). Furthermore, one firm’s locationdecisions could be influenced by the presence of other firms in a region. Foreign and local incum-bents within a region can pose great threats andchallenges to new entrants. At the same time, theycan be great sources for complementary resourcesand learning. In a country such as China, whichcomprises vastly heterogeneous regions, it is cru-cial to examine location decisions at the regionallevel in order to understand MNCs’ entry strate-gies.Recently, several studies have focused on loca-tion decisions within a country. Head, Ries, andSwenson (1995), Shaver and Flyer (2000), andChung and Song (2004) studied how Japanesefirms chose manufacturing locations in the United
Copyright
2005 John Wiley & Sons, Ltd.
Received 4 June 2003Final revision received 15 December 2004
 
596
S.-J. Chang and S. Park 
States. They found that Japanese firms locatedtheir manufacturing facilities in states where manyother Japanese firms had been located, althoughthis tendency depended upon these firms’ rela-tive resource strengths and their prior investments.These researchers suggested that positive network externalities might explain this pattern of agglom-eration. A network externality occurs when thebenefit or surplus that an economic agent derivesfrom a good depends in part on changes in thenumber of other agents consuming the same kindof good (Katz and Shapiro, 1985; Arthur, 1990;Liebowitz and Margolis, 1995). It thus denotes sit-uations when a product or service becomes morevaluable as more people or firms use it. For exam-ple, when General Motors entered China in 1997via a joint venture with Shanghai AutomotiveIndustry Corporation (SAIC), it was able to capi-talize on the infrastructure of qualified managers,laborers, and suppliers that Volkswagen, SAIC’sother joint venture partner, had developed since1984. MNCs can also learn from earlier entrants’experiences and avoid making similar mistakes.This recent work has, however, been limited inthree important ways. First, in focusing exclusivelyon economic reasons for agglomeration, it has notconsidered the possibility that agglomeration mightoccur even without obvious economic reasons.Firms might, for instance, imitate other firms inorder to gain legitimacy or reduce uncertainty(DiMaggio and Powell, 1983; Levitt and March,1988). Foreign investments, especially in countrieswhere the culture and language are distinct fromthat of an MNC’s home country, carry risks thatare captured by the term ‘liabilities of foreignness.’Such risks are greater in transitional economies,such as China. It is possible that foreign firmsinvesting in China flocked to Shanghai or Beijingonly because many other foreign firms had doneso already.Second, most of this work has focused onlyon positive forms of network externalities. Whenagglomeration occurs, competition in factor andproduct markets increases costs. For instance, inShanghai, foreign firms now have to pay topsalaries to attract local managers, and housing forexpatriates is extremely expensive. Local firmslocated near an MNC may be able to access tech-nology or know-how by hiring local managers andengineers away. Organizational ecologists havelong argued that increases in population densitydiminish new entrants’ survival rates (Hannan andCarroll, 1992). Thus, MNCs should evaluate thecosts of both negative and positive externalities.Third, these studies have ignored variationsamong the types of firms that make up a regionalnetwork. Although some studies considered theheterogeneity of investing firms (Shaver and Flyer,2000; Chung and Song, 2004), most have exam-ined only a subset of all the firms in a region (e.g.,Japanese investors and local firms in the UnitedStates) and often considered only one industry(e.g., electronics). We argue that the degree of externalities is contingent upon the compositionof regional networks. For instance, Korean firmsinvesting in China may derive stronger network externalities from other Korean firms than theycan from non-Korean firms, and from firms in thesame industries than they can from firms in otherindustries.This paper considers two empirical questions.First, it uses data for Korean firms that investedin China to examine whether positive or nega-tive network externalities are larger. Although wecannot distinguish empirically between network externalities derived from real economic gains andthose derived from legitimacy, we examine variousarguments for network externalities and develop ahypothesis that argues for a curvilinear relation-ship. We expect that the likelihood of experiencingnegative network externalities is more substantialwhen firms’ agglomerative behaviors are moti-vated by a desire to gain legitimacy rather thanby real economic gains. Second, this study exam-ines how network externalities vary according tothe types of firms within a regional network. Inother words, this study examines to what degreenetwork externalities are firm specific, nation spe-cific, or industry specific. This study also exploreswhat choices by firms might maximize the net ben-efits of network externalities.
NETWORK EXTERNALITIESAND LOCATION DECISIONS
Network externalities
Economists have long emphasized the impor-tance of network externalities (Marshall, 1920).Porter (1998) summarizes the potential benefitsof agglomeration: (1) it improves accessibility tospecialized factors and workers; (2) it improvesaccess to information about market and tech-nology trends; (3) it promotes complementarities
Copyright
2005 John Wiley & Sons, Ltd.
Strat. Mgmt. J.
,
26
: 595–615 (2005)
 
Types of Firms Generating Network Externalities
597
among firms and promotes cooperation amongfirms; (4) it improves access to infrastructure andpublic goods; and (5) it increases competitive pres-sure among firms. Henderson (1986) empiricallydemonstrated that agglomeration increases fac-tor productivity. Saxenian (1994) documented howmicroelectronics firms clustered in Silicon Val-ley. Krugman (1991) developed a formal model inwhich agglomeration results from manufacturingfirms’ desire to locate in a place of larger demandin order to exploit scale economies and minimizetransportation costs, while the location of demanddepends on the location of manufacturers.Several studies of MNCs’ regional agglomera-tion patterns were based upon this economic ratio-nale.
1
Smith and Florida (1994) and Head
et al
.(1995) observed that Japanese firms co-locatedwith other Japanese firms. They pointed to tech-nological spillovers, specialized labor, and otherinputs as the main reasons for agglomeration.Chung and Song (2004) found that Japanese elec-tronics firms in the United States tended to co-locate with other Japanese firms when they hadless prior experience. At the country level, Song(2002) showed how Japanese firms’ prior invest-ment in technological and sourcing capabilities ledto subsequent investment in the same countries.Chung and Alcacer (2002) also found that firmsin research-intensive industries are more likely tolocate in regions with high R&D intensities.Although economists generally attribute regionalagglomeration to real economic gains, organiza-tional theorists have argued that agglomerationmight occur for non-economic reasons. Agglom-eration might occur, for instance, when firmswish to improve their legitimacy in order toaccess resources they need for survival and growth(DiMaggio and Powell, 1983; Suchman, 1995). Afirm might locate in a popular place simply becauseso many other firms have located there already,thus legitimizing the location. This mimetic behav-ior has been observed in various contexts: adop-tion of the M-form organization structure (Flig-stein, 1985) and the poison pill (Davis, 1991),and acquisition decisions (Haunschild, 1993). Fur-ther, the risk and uncertainty of venturing into aforeign country could increase firms’ imitation of 
1
Early work in economic geography studied the impact of income, tax incentives, wage, and unionization on attractingmore foreign direct investment (Coughlin, Terza, and Arromdee,1991; Wheeler and Mody, 1992; Friedman, Gerlowski, andSilberman, 1992).
other firms (Levitt and March, 1988). Empiricalwork has indicated that legitimacy and uncertaintyinfluence MNCs’ expansions into foreign coun-tries. Guillen (2002) found that emerging multi-nationals that were in the early stages of inter-nationalization imitated other firms. Henisz andDelios (2001) demonstrated that Japanese firmsthat lacked international experience relied moreheavily on the past international expansion deci-sions of other firms in their reference group ascues for their own entry decisions. Knickerbocker(1973) also pointed out that MNCs in oligopolis-tic industries tend to imitate each other when theyexpand into foreign markets.In addition, some research has found that agglo-meration can lead to negative externalities. Forexample, firms can benefit from the spillover of other firms’ knowledge and technologies, but theirown knowledge and technologies can spill over toother firms. Appold (1995) found that agglomer-ation was negatively associated with performancein the U.S. metalworking sector. Shaver and Flyer(2000) argue that benefits and costs firms derivedfrom co-location could differ according to theirown core competences. They contend that firmswith relatively more resources avoid agglomer-ation because, for them, the potential costs of spillovers are greater than the potential benefits.Agglomeration can also lead to intensified com-petition in both product and factor markets amongadjacently located firms. Baum and Mezias (1992)demonstrated that hotels located in Manhattan thatwere similar in terms of location, price, and sizeposed greater threats to each other and reducedeach other’s chances of survival as the area becamemore crowded. Agglomeration also drives up thecosts of locally sourced inputs, such as wagesof local managers and engineers and housingexpenses for expatriates.Agglomeration can also reduce innovation viagroupthink (Porter, 1998), thereby creating nega-tive externalities. It can make firms in a regionalcluster look only inward and reject ideas fromother areas. Detroit’s attachment to gas-guzzlingautomobiles in the 1970s amidst oil shortages is aprime example of such rigidity.We expect that multinational corporations willconsider both positive and negative network exter-nalities. Population ecologists have long arguedthat population density influences startups’ perfor-mance. They have found that an increase in popu-lation density is initially positively correlated with
Copyright
2005 John Wiley & Sons, Ltd.
Strat. Mgmt. J.
,
26
: 595–615 (2005)
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