Strategy for Cluster-based Industrial
Development in Developing Countries
Keijiro Otsuka * and Tetsushi Sonobe *In this short article we formulate an endogenous model of cluster-based industrial development based on case studies in Japan, Taiwan, and China. In this model, the initiation phase
is followed by a quantity expansion phase through imitation and subsequently by a quality
improvement phase through innovation. We argue that such a process of industrial development is supported by the development of market transactions among assemblers, partssuppliers, and merchants, as well as the stimulation of innovation made possible by thebenefits of industrial clusters arising from a large number of enterprises and a variety ofhuman resources being concentrated in a small geographical area. Based on this understanding, we argue that if we provide training programs in management and marketing forenterprise managers in stagnant industrial clusters, which are often found in developing
countries, such clusters may be able to grow sharply; these training programs should stimulate innovation, which should encourage growth for the clusters.

1. Introduction
In order to reduce poverty and to achieve equitable and sustainable
development, we have to develop industries that provide increased employment
opportunities for the poor. Therefore, the development of labor-intensive industries ought to be a central theme of development economics and a central focus
of development policies. Yet, there has been a sheer lack of empirical studies
inquiring into the process of industrial development in developing economies;
this lack has led to the absence of strategic industrial development policies indeveloping countries. Thus, we do not know the answers to even simple andfundamental questions on industrial development, such as what types of entrepreneurs initiate new industries, what institutions support the subsequent development of such industries, and under what conditions new major innovations* A Professor of National Graduate Institute for Policy Studies and a Professorial Fellow at theFoundation for Advanced Studies on International Development.

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Keijiro Otsuka and Tetsushi Sonobe

take place. Without answering these questions, it is difficult to formulate appropriate policies to nurture new industries or to accelerate the development ofexisting industries.
This study presents an attempt to uncover the common processes ofsuccessful industrial development based on the case studies of selected industrial clusters in China, Taiwan, and Japan, as well as other case studies in Vietnam, Bangladesh, Kenya, Ethiopia, and Ghana. We focus on industrial clusters
not only because many of them are found in developing countries, but also
because industrial clusters have clear advantages, particularly in developing
countries where markets are less developed.
The organization of this article is as follows. The next section synthesizes our case studies conducted in Japan, Taiwan, and China. Section III goeson to identify the causes of the success in East Asia. In Section IV, we reexamine the conventional understanding of the advantages of industrial clusters inlight of our case studies. Finally, Section V concludes the paper by drawing
implications for strategy to develop industries.

2. A Synthesis of East Asian Studies
A review of the literature on industrialization in Japan, Taiwan, andChina as well as an examination conducted by Sonobe and Otsuka (2006a,
2006b) of township-level industrial data over time in the three East Asian countries revealed that industrial clusters have made significant contributions toindustrial development in these countries. We visited a large number of manufacturing enterprises in the major industrial clusters to identify the main features of the development process through open-ended interviews with enterprisemanagers, engineers, and public-sector administrators followed by formal questionnaire surveys of a large number of enterprises.
To gain insights into an East Asian model of cluster-based industrial
development, we decided to make a pair-wise comparison of the same or similar industries: (1) the garment clusters in Hiroshima prefecture in Japan and thatin Zhejiang province in China (Yamamura, Sonobe, & Otsuka, 2003; Sonobe,
Hu, & Otsuka, 2002); (2) the motorcycle industry in Japan and that in
Chongqing, China (Yamamura, Sonobe, & Otsuka, 2005; Sonobe, Hu, & Otsu-

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Strategy for Cluster-Based Industrial Development in Developing Countries

ka, 2006); (3) the machine tool industry in Taichung, Taiwan, and the low-voltage electric machinery industry in Wenzhou, China (Sonobe, Kawakami, &Otsuka, 2003; Sonobe, Hu, & Otsuka, 2004); and (4) the printed circuit board
industry in northern Taiwan and that in Jiangsu province in China (Sonobe &Otsuka, 2006b).1
Despite significant differences in political regimes and stages of economic development among the three countries and in production methods andskill requirements across the selected industries, we found extremely similar
processes of industrial development across the eight cases. Thus, these processes may be termed “An East Asian Model of Cluster-Based Industrial Development.” We characterized the development processes into three distinct phases:(1) initiation, (2) quantity expansion, and (3) qualitative improvement (seeTable 1 for a summary of the endogenous model of industrial development).
Table 1. An endogenous model of industrial development
Phase

Prior experienceof managers

Education

Innovation, imitation,and productivity growthInstitutions

Initiation

Merchants /Engineers

Low

Imitate foreign technology
directly or indirectlyInternal production ofparts,components,and final products

Quantity
Expansion

Spin-offs and entry
from various fields

Mixed

Imitate imitated technology;
stagnant productivity;
declining profitability

Market transactions;division of labor;
formation of industrial
cluster

Very HighMulti-faceted innovations;exit of many enterprises;
increasing productivity

Reputation and brandnames; direct sales;
sub-contracts orvertical integration;
emergence of large
enterprises

Second generation
Quality
Improvem- of founders andent
newcomers withnew ideas

If the production method is simple but selling the products is noteasy, as in the case of the garment industry, merchants are likely to be the ones
who establish the new enterprises. They do so often in the suburbs of large
cities or villages not too far away from large cities, taking advantage of their

1

In the studies referred to above, we employed rigorous statistical techniques to test a number of
empirical hypotheses. In this article, we do not discuss the technical aspects of the statisticalanalyses. We focus here on the ideas and logic behind the rigorous statistical analyses.

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Keijiro Otsuka and Tetsushi Sonobe

experience in commercial activities in other industries. If the production
method is complicated, engineers tend to be the new entrepreneurs. Once theysucceed in producing new products, often after long trial and error processes, aswarm of imitators appears, as envisaged by Schumpeter (1912) in his theory of
economic development.
The imitators are often spin-offs, i.e., those who have worked for thefounding enterprises and initiated own enterprises by imitating production
methods and products. Because most enterprises produce the same (or almost
the same) low-quality products using the same low-quality materials and parts,
anonymous market transactions develop; this reduces the entry barriers for new
firms. Indeed, new firms can easily procure all the required materials and partsand sell their products through merchants, and they can recruit workers withdesired skills from inside the cluster while investing in a few pieces of indispensable equipment. Low consumer income means high demand for low-quality products in the domestic markets. This is a clear advantage of initiating new
business in developing countries; the founders of new industries earn huge profits owing to the large demand for their low-quality products. This attracts entryof new enterprises.
The active entry of numerous new enterprises results in geographicalconcentration of enterprises, which attracts traders, parts-suppliers, skilledworkers, and engineers to the industrial cluster. An industrial cluster expands inthis way. Up to this point in the cluster’s development, productivity growth ismodest or could even be negative, as imitation does not improve the production
efficiency even though the quantity of production registers impressive growth.
Typically enterprises at this stage are very small and use labor-intensive production methods.
Active entry increases the supply of products to markets sharply,
thereby reducing output prices and, hence, the profitability of producing lowquality products. This triggers new competition centered on product improvement. At this stage, innovative entrepreneurs begin employing a larger numberof engineers and designers to improve their products. They often start developing long-term subcontracts with specific parts-suppliers to acquire firm-specificand high-quality parts. However, improving product quality alone does not
ensure high profits for innovative enterprises; to differentiate their new high-70Strategy for Cluster-Based Industrial Development in Developing Countries

quality products from the low-quality products produced by the majority ofother enterprises, these entrepreneurs must establish a reputation as high-quality
producers, develop their own marketing channels using their own marketing
agents, and manage their own retail shops in order to sell their products directly
to consumers and users of their products.
If they are successful, they tend to absorb those enterprises that fail toinnovate and let these enterprises to produce products with the same brandnames of the successful enterprises. Many enterprises that cannot catch up with
innovative enterprises have to exit the industry. In our observations, it is at thisstage when the production efficiency of the industry a whole visibly improves.
The size of successful enterprises grows and many of them begin to export.
Another important point is that the industrial cluster sets the stage for innovation towards quality improvement by attracting a pool of human resources useful for improving the product quality and improving the marketing efficiency of
improved products. To use the observation by Schumpeter (1912), innovation is
nothing but a new combination of the existing resources, including engineers,designers, parts-suppliers, and merchants. To realize such innovation potential,
high-quality entrepreneurial ability is found to be indispensable. In other words,
successful entrepreneurs at this stage are highly educated almost without exception, unlike founders of the industry, who are often uneducated but endowedwith skills and ambitions.
Because we failed to collect long-term data of sample enterprises inmany cases, we cannot directly trace the whole process of industrial development from the initiation to the quality improvement phases in all the case studies in East Asia. Nonetheless, all the case studies consistently provide evidencein support of the common endogenous process of industrial development
described above. Therefore, we have developed a rigorous model of theendogenous industrial development process in Sonobe and Otsuka (2006b).

3. Why Is East Asia So Successful?
A critical question is why East Asian economies have developed so
successfully. Like China for the last 28 years, the Japanese economy had grown
at a rate of about 10% per year during the “miraculous growth periods” from71

Keijiro Otsuka and Tetsushi Sonobe

the late 1950s to the early 1970s. The growth rate of the Taiwanese economy
has been no less rapid than in Japan in the past and in contemporary China. Furthermore, the patterns of industrial development among the three countries are
more similar than they are dissimilar. In our view, the successful imitation andassimilation of foreign technologies, the formation of geographically dense
industrial clusters consisting of a large number of small enterprises producing
similar and related products, and the advent of multifaceted innovations leading
to a great leap forward in the industrial structures are three of the important
ingredients of the East Asian model of cluster-based industrial development.
Learning from successful experience of other countries was also likely to be the key to the success, even though it is extremely difficult to quantify
this effect. During our surveys, we repeatedly heard that Taiwanese enterprisemanagers learned a great deal from the Japanese experience. Similarly, Chinese
enterprise managers seem to have learned a number of lessons from both the
Taiwanese and Japanese experiences. While it is difficult to answer the questionof why Japan was successful in the transition from the quantity expansion to thequality improvement phases in much earlier years, it seems clear that the successful development of the Japanese industries became the model of the industrial development in other East Asian countries.
We believe that the successful development of the shoe industry in
Ethiopia was due prominently to the repeated visits of Ethiopian entrepreneurs
to Italy to learn designs, production methods, and marketing skills (Sonobe,
Akoten, & Otsuka, 2006). We were also told by producers of knitwears in therural cluster in northern Vietnam that visiting China is critically important toimprove their technology and management. The development of the huge garment cluster in Dhaka owes its remarkable success to the transfer of technology
and management know-how from Korea.
Foreign technologies were imitated in different manners among thethree countries in the postwar periods. Since the inception of modern economic
development in the late 19th century, Japan had been making every effort tocatch up with the West in industrial technologies by setting up modern government-supported plants modeled after advanced factories in the West, providing
general education and vocational training for workers and engineers, and so on(see, e.g., Otsuka et al., 1988; Hayani & Godo, 2005). Although such processes

72Strategy for Cluster-Based Industrial Development in Developing Countries

were disrupted by World War II, they resumed immediately after the war. The
cases of the garment and motorcycle industries examined by Sonobe and Otsuka (2006b) are two of the early examples of successful industrial development
based on foreign technologies in postwar Japan.
In the case of Taiwan, foreign joint ventures, foreign trading companies, and the Industrial Technology Research Institute (ITRI), a leading national
research and development center founded in 1973, played major roles in introducing new technologies from abroad starting in the 1960s. Spin-offs from thejoint ventures and those who were trained at ITRI often became the founders of
new enterprises in this country. In the case of China, state-owned enterprises(SOEs) were the main sources of human resources, industrial technologies, andmanagerial know-how for the development of collective township and village
enterprises (TVEs) and private enterprises. Thus, SOEs played the role ofmodel plants. According to Otsuka et al. (1998), SOEs were inefficient in management due to regulations but were knowledgeable about modern technologies. Moreover, SOEs had established marketing channels. Thus, the assimilation of technologies and management know-how from SOEs, as well as the useof SOEs’ marketing channels, were the major means for collective TVEs andprivate enterprises to improve the efficiency of production and management.
The three countries differed little in the process of quantity expansion, which led to the formation of industrial clusters consisting of small enterprises. Setting up industrial zones by the government is useful and common.
While marketplaces set up by the local governments played important roles in
the improvement of marketing efficiency in China, the same purpose wasachieved by the densely clustered wholesalers dealing in industrial parts in Taiwan and the active network of merchants in Japan.
The successful implementation of multifaceted innovations by highly
educated entrepreneurs in the three countries, which has led to the quality
improvement phase, seems common. According to our recent studies on industrial clusters in Sub-Saharan Africa (i.e., the shoe industry in Ethiopia by
Sonobe, Akoten and Otsuka (2006), the garment industry in Kenya by Akoten,
Sawada and Otsuka (2006), and the car-repair cum metal processing industrial
complex in Ghana and Kenya), the industrial clusters producing low-quality
products often remain in the quantity expansion stage and fail to innovate,73

Keijiro Otsuka and Tetsushi Sonobe

which, we believe, is a distinguishable feature of industrial clusters in SubSaharan Africa.2 In East Asia, the entrepreneurship of highly educated managers leads to introduction of improved production methods, initiation of theuse of brand names to strengthen their images, development of new marketing
channels, and establishment of long-term subcontract systems.
An interesting question for less industrialized countries is whether thetransition from the quantity expansion to the quality improvement phases canbe facilitated and shortened by participating in global value chains organized by
global-scale retailers or joint ventures with manufacturers in developed countries. These global-scale retailers and manufacturers provide improved production technologies, marketing channels, and new management methods to small
enterprises in developing countries. The answer is affirmative, as far as upgrading product quality is concerned. Yet it is highly questionable whether suchtechnology transfer leads to sustainable cluster-based industrial development.
Because the source of new information is foreign buyers and manufacturers, notneighboring enterprises producing similar products within the cluster, there is
no strong incentive for local enterprises to form industrial clusters. This meansthat the forces within the cluster leading to the transition to the quality improvement phase are absent in industrial development led by global buyers and foreign ventures. Furthermore, the ability to innovate may not be nurtured if local
enterprises depend entirely on the global buyers and foreign ventures. All these
considerations suggest that learning from foreign companies is most effective
when the industry is in the transition from the quantity expansion phase to thequality improvement phase; by that point, the industrial cluster can provide theopportunity to innovate further, and the innovative entrepreneurs have acquired
the experience needed to innovate (Sonobe & Otsuka, 2006b).
Although our study does not provide ample evidence supporting theabove argument that the global value chain is not a panacea, there are several
relevant observations. In the case of the motorcycle industry in China, although
the joint ventures between the SOEs and Japanese enterprises contributed to theearly part of the quantity expansion phase, their growth performance in thequality improvement phase has been mediocre (Sonobe, Hu, & Otsuka, 2006).
2

An exception is the case of the shoe industry in Ethiopia, which has been growing fairly rapidly.

74Strategy for Cluster-Based Industrial Development in Developing Countries

In the case of the printed circuit board industry in China, there is no clear evidence that local enterprises have learned much from foreign ventures: the technology level of the former is far lower than that of the latter, so direct technology transfer or learning is not yet feasible (Sonobe & Otsuka, 2006b). In all othercases we studied, it was the ingenuity and innovation of local entrepreneurs thatbrought on the transition into the quality improvement phase.
Our arguments are clearly supported by the case study of the leather
shoe cluster in Brazil conducted by Bazan and Navas-Alemán (2004), who findthat those shoe makers supplying their products not only to global buyers but
also to the domestic markets and neighboring countries surpassed those who
specialized in export to global buyers in the process of quality upgrading. Basedon this finding and the results of other case studies, Humphrey and Schmitz(2004) conclude that enterprises in developing countries cannot learn muchabout how to achieve qualitative upgrading from global buyers. Likewise, some
empirical studies point out that little benefit of positive externality comes fromforeign ventures. Thus, the opportunities of participating in global value chains
and transacting with foreign ventures can be utilized most effectively if theindustry has reached the last stage of the quantity expansion phase, where someenterprises are ready to innovate.

4. Agglomeration Economies Reconsidered
Since the seminal work of Marshall (1920), three major advantages ofindustrial clusters have been recognized conventionally: (1) information
spillovers, (2) the specialization and division of labor among enterprises, and(3) the development of skilled labor markets. While we do not have major
objections to the importance of these three advantages, our analysis suggests
room for reconsideration.
We agree that information spillovers are common and important in
the cluster. For example, in the garment clusters in both Japan and China, if a
new design introduced by an enterprise turns out to be popular, many otherenterprises copy it within a few days. But information spillovers, which areessentially imitation, are not always that simple. In our observation, less simple
imitation takes place through the spin-offs and recruitment of workers from75

Keijiro Otsuka and Tetsushi Sonobe

other enterprises, which is intensively discussed in our study on the motorcycle
industry in Chongqing. In the case of the printed circuit board enterprises in
Suzhou, a group of spin-off enterprises, whose managers used to work at thesame founding enterprises, employ the same technology to produce the same
products. Thus, information spillovers in the industrial cluster are inseparably
related to the development of skilled labor markets, wherein skilled workers
move from one enterprise to another. According to our respondents, assemblers
develop long-term contracts with parts-suppliers to reduce the risk of the partssuppliers leaking new ideas to other assemblers. If this is the case, the divisionof labor among manufacturing enterprises is also closely related to information
spillovers.
Another important aspect of the industrial cluster is that it reducestransaction costs. Transaction costs have been neglected in the literature on economic geography and spatial economics, where the role of transport costs has
been discussed extensively. Transaction costs arising from moral hazard andhold-up problems are low in the industrial cluster because rumors of suchopportunistic behaviors quickly become public knowledge by word of mouth in
the cluster. We believe that this is the major reason why the division of labor
develops in the industrial cluster. To use the observation of Hayami and Godo(2005), the community mechanism of contract enforcement, which was originally applied in rural communities, works well in the industrial cluster as well.
It is one-sided to emphasize the importance of information spillovers
as an advantage of the industrial cluster if the role of the cluster in promoting
innovation is not equally appreciated. Marshall (1920) argues that information
spillovers become a source of innovation: “if one man starts a new idea, it istaken up by others and combined with suggestions of their own; and thus it
becomes the source of further new ideas.” Based on our empirical findings, we
can add to his argument the hypothesis that the industrial cluster provides a
hotbed of innovation, as it accumulates a variety of human resources useful for
new innovation. We believe the validity of this hypothesis is worth investigating in other case studies.
To sum up, our analysis indicates that the major advantages of clusters are: (1) the development of markets, which facilitates transactions among
manufacturers, merchants and workers, and (2) the promotion of innovations by

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attracting useful human resources.

5. Concluding Remarks
Although effective policies to promote the development of SMEs
have been seriously sought in many developing countries, economic theories
that can guide such policy have been absent. Some economists seem to assume
that the market works so well in the industrial sector that government intervention is unnecessary. Our analysis strongly indicates that the market works fairly
well in industrial clusters because dishonest behaviors potentially arising fromimperfect information are reduced to a significant extent by the informal contract enforcement mechanisms, e.g., gossip through word of mouth. This
explains why people behave honestly in industrial clusters and why industrial
clusters are so prevalent in developing countries. It also suggests that the market tends to fail in allocating resources efficiently in the absence of industrial
clusters. In industrial clusters, marginal and small-scale enterprises (MSEs),
which provide ample employment opportunities for unskilled workers, play a
critical role, particularly in the early phases of industrial development. Thus,
there are good reasons for the government to support the formation of industrial
clusters by setting up model plants to train potential managers and workers,
industrial zones to attract MSEs producing similar and related products, andmarketplaces to facilitate transactions of parts, intermediate products, and final
products among manufacturers and merchants.
It is well-known in the economics literature that the market generally
fails in the transaction of information, particularly if the information is notpatentable or the patent protection is ineffective. This is the case for “imitative
innovation,” which is critically important for the development of industrial
clusters in low-income countries. It is obvious that because of imitation or
information spillovers, investment in innovation falls short of the social optimum. Therefore, it makes sense to support activities leading to innovation inindustrial clusters by means of providing training programs for technological,
managerial, and marketing advancement. Our analysis strongly indicates thatsuch an attempt is likely to be effective when the cluster is in transition fromthe quantity expansion to the quality improvement phases. As our analysis

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implies, technical training alone is not sufficient to stimulate the transition
because what is required is multi-faceted innovations in areas including technology, production organization, and marketing.
A number of industrial clusters have formed in low-income countries
including South Asia and Sub-Saharan Africa. In many cases, however, they failto enter the quality improvement phase and hence remain in the quantity expansion phase. A good example is the garment clusters in Nairobi, where a large
number of small workshops, consisting of three to four workers, produce lowquality products (Akoten, Sawada, & Otsuka, 2006). Another interesting case is
the shoe cluster in Addis Ababa, where a handful of educated managers areattempting multi-faceted imitative innovations by learning from the experience of
Italy (Sonobe, Akoten, & Otsuka, 2006). In all likelihood, these industrial clusters
will be able to take off if appropriate training programs are provided.
Appropriate policies to promote labor-intensive industries are badly
needed to reduce the widespread poverty in low-income countries. We believethat the appropriate policies for such industrial development must support theformation of industrial clusters and their transition from the quantity expansion
phase to the quality improvement phase.

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