Does Industry Agglomeration Attract Productive Firms? The Role of Product Markets in Adverse Selection

ABSTRACT The literature has produced mixed findings on the relationship between industry agglomeration and firm‐level productivity where it concerns the self‐selection of productive firms into locations characterized by different levels of industry agglomeration. We argue that the nature of this self‐selection crucially depends on whether incumbent and entrant firms compete on the same market. Adverse selection of less productive firms into a location only dominates if knowledge spillovers in agglomerated locations are harmful to productive entrants: when the entrant and local incumbents target the same (domestic) product market and the entrant risks losing market share and profits. We find evidence for this notion in analysis of location decisions for new plants at the fine‐grained geographical level in Japan by firms with known productivity records in the industry (multi‐plant firms). We conclude that sorting processes do occur, but that the nature of these processes can only be uncovered in analysis that considers competition on product markets and accurate measures of firm heterogeneity in productivity.