will be bid up or labor will move to that location—further increasing its attractiveness. This is sometimes called the “home market effect,” a term coined by Paul Krugman (Krugman 1991). Firms in areas with good market access will have higher demand for their products, which will push them to increase scale and invest in cost-reducing technologies. As a result of these forces, local policies may be effective in influencing industry location only in areas with good access to domestic and international markets. They are likely to have little impact in areas with poor market access.

34. Firms may also be attracted to areas that already have firms established in their line of business. Why? Because of _localization economies._ By locating near other firms in the same industry, a firm learns about whom to hire, whom to buy from and sell to, what’s new in technology, and what product lines are selling. Finally, firms may choose a location for its economic diversity. Why? Because of _urbanization economies._ Economic diversity means good access to a broad range of producer and consumer goods that typically increases with the size of the agglomeration. The economics literature identifies two main sources of gains from urbanization economies. The first is information sharing and innovation. Large cities are breeding grounds for new ideas and innovations because of the concentration and diversity of knowledge sources—and firms in such cities are more likely to develop new products (Duranton and Puga 2001). The second is access to producer amenities. Firms in large cities tend to have better access to such resources as business services, finance, logistics, banking, advertising, and legal services—all of which can enhance their performance (Abdel-Rehman 1988; Fujita 1988; Rivera Batiz 1988).

35. The source of agglomeration benefits matters for regional industrial policies. If localization economies dominate, it may be possible to induce specific industries to relocate through strategic public expenditure policies. The challenge is to coordinate decisions across many firms in the same industry. But if urbanization economies dominate, so that firms’ performance depends on being in a large, diverse city, using policies to move activities to secondary locations —and to sustain them there—is extremely difficult. Urbanization economies are typically more important for young industries in the innovation phase of their product cycle, while localization economies become more important for more mature industries.

# <u>Functional specialization in Blantyre and Lilongwe</u>

36. In Malawi, manufacturing is concentrated in the country’s two major industrial clusters: Blantyre and Lilongwe. The Malawi Productivity & Investment Climate Survey (ICA, 2004) identifies that 61% of sampled firms are in Blantyre, and 20% in Lilongwe. The ICA data suggest that firms in Blantyre are specialized in relatively high/medium-tech and heavy industries, such as textiles, chemical/chemical products, rubber/plastic products, metal products, and machinery/equipment. Those industries tend to be international market oriented, and export/import linkages are important for firms in these lines of business. In contrast, firms in Lilongwe are producing relatively low-tech and domestic market oriented goods. Food and beverage industries, as well as rubber/plastic products and furniture are the main industries in Lilongwe (Table 10).

37. The difference in Blantyre and Lilongwe’s industrial composition is closely related to their upstream/downstream linkages with external markets. In Blantyre, the proportion of sales for direct exports is 45 percent – in contrast to 9% in Lilongwe. Similarly, 67% of intermediate inputs are imported in Blantyre – compared to 44% in Lilongwe. As producers specialize in activities that internalize location specific constraints, different infrastructure needs emerge in these cities. For firms in Blantyre – the lack of reliable provision of electricity, transportation, and telecommunications are major obstacles for their business operations, as high/medium tech and heavy industries are infrastructure hungry. In particular, unreliable and insufficient electricity supply seems to be the main bottleneck. 56% of ICA

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