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 CHANG1 * and SEKEUN PARK2
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 to
agglomerate 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 firms
constituting a regional network. It also found stronger network externalities within firms than
across 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 the
likelihood of co-location emerged. Copyright  2005 John Wiley & Sons, Ltd.

Why do multinational corporations decide to locate
in one area rather than another? To date, research
on this question has examined firms’ motiva-
tions for these decisions, the modes they use
when entering an area, and the sequences of
their entry decisions in that area. This work
has been guided by the theme of foreign direct
investment (Hymer, 1960; Dunning, 1988; Hen-
nart and Park, 1994; Chang, 1995; Kogut and
Chang, 1996). It has also considered such deci-
sions at the national level, rather than assessing
why a firm might enter one region within a nation
rather than another. We argue that international
business scholars should explore regional location
decisions much more extensively, as these deci-
sions shed light on MNCs’ foreign entry strategies.
When MNCs announce they are investing in a
country, they often specify a location they have
decided 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 differ
greatly from each other in terms of prevailing
wages, 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 the
decision at the country level is (e.g., opening a
factory in China). Furthermore, one firm’s location
decisions could be influenced by the presence of
other firms in a region. Foreign and local incum-
bents within a region can pose great threats and
challenges to new entrants. At the same time, they
can be great sources for complementary resources
and learning. In a country such as China, which
comprises vastly heterogeneous regions, it is cru-
cial to examine location decisions at the regional
level in order to understand MNCs’ entry strate-
gies.
Recently, several studies have focused on loca-
tion decisions within a country. Head, Ries, and
Swenson (1995), Shaver and Flyer (2000), and
Chung and Song (2004) studied how Japanese
firms chose manufacturing locations in the United

Copyright  2005 John Wiley & Sons, Ltd. Received 4 June 2003
Final revision received 15 December 2004
596 S.-J. Chang and S. Park
States. They found that Japanese firms located
their manufacturing facilities in states where many
other Japanese firms had been located, although
this 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 the
benefit or surplus that an economic agent derives
from a good depends in part on changes in the
number of other agents consuming the same kind
of good (Katz and Shapiro, 1985; Arthur, 1990;
Liebowitz and Margolis, 1995). It thus denotes sit-
uations when a product or service becomes more
valuable as more people or firms use it. For exam-
ple, when General Motors entered China in 1997
via a joint venture with Shanghai Automotive
Industry Corporation (SAIC), it was able to capi-
talize on the infrastructure of qualified managers,
laborers, and suppliers that Volkswagen, SAIC’s
other joint venture partner, had developed since
1984. MNCs can also learn from earlier entrants’
experiences and avoid making similar mistakes.
This recent work has, however, been limited in
three important ways. First, in focusing exclusively
on economic reasons for agglomeration, it has not
considered the possibility that agglomeration might
occur even without obvious economic reasons.
Firms might, for instance, imitate other firms in
order to gain legitimacy or reduce uncertainty
(DiMaggio and Powell, 1983; Levitt and March,
1988). Foreign investments, especially in countries
where the culture and language are distinct from
that of an MNC’s home country, carry risks that
are captured by the term ‘liabilities of foreignness.’
Such risks are greater in transitional economies,
such as China. It is possible that foreign firms
investing in China flocked to Shanghai or Beijing
only because many other foreign firms had done
so already.
Second, most of this work has focused only
on positive forms of network externalities. When
agglomeration occurs, competition in factor and
product markets increases costs. For instance, in
Shanghai, foreign firms now have to pay top
salaries to attract local managers, and housing for
expatriates is extremely expensive. Local firms
located near an MNC may be able to access tech-
nology or know-how by hiring local managers and
engineers away. Organizational ecologists have
long argued that increases in population density
diminish new entrants’ survival rates (Hannan and
Copyright  2005 John Wiley & Sons, Ltd.
Carroll, 1992). Thus, MNCs should evaluate the
costs of both negative and positive externalities.
Third, these studies have ignored variations
among the types of firms that make up a regional
network. Although some studies considered the
heterogeneity 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 United
States) and often considered only one industry
(e.g., electronics). We argue that the degree of
externalities is contingent upon the composition
of regional networks. For instance, Korean firms
investing in China may derive stronger network
externalities from other Korean firms than they
can from non-Korean firms, and from firms in the
same industries than they can from firms in other
industries.
This paper considers two empirical questions.
First, it uses data for Korean firms that invested
in China to examine whether positive or nega-
tive network externalities are larger. Although we
cannot distinguish empirically between network
externalities derived from real economic gains and
those derived from legitimacy, we examine various
arguments for network externalities and develop a
hypothesis that argues for a curvilinear relation-
ship. We expect that the likelihood of experiencing
negative network externalities is more substantial
when firms’ agglomerative behaviors are moti-
vated by a desire to gain legitimacy rather than
by real economic gains. Second, this study exam-
ines how network externalities vary according to
the types of firms within a regional network. In
other words, this study examines to what degree
network externalities are firm specific, nation spe-
cific, or industry specific. This study also explores
what choices by firms might maximize the net ben-
efits of network externalities.
NETWORK EXTERNALITIES
AND LOCATION DECISIONS
Network externalities
Economists have long emphasized the impor-
tance of network externalities (Marshall, 1920).
Porter (1998) summarizes the potential benefits
of agglomeration: (1) it improves accessibility to
specialized factors and workers; (2) it improves
access to information about market and tech-
nology trends; (3) it promotes complementarities
Strat. Mgmt. J., 26: 595–615 (2005)
 Types of Firms Generating Network Externalities
among firms and promotes cooperation among
firms; (4) it improves access to infrastructure and
public goods; and (5) it increases competitive pres-
sure among firms. Henderson (1986) empirically
demonstrated that agglomeration increases fac-
tor productivity. Saxenian (1994) documented how
microelectronics firms clustered in Silicon Val-
ley. Krugman (1991) developed a formal model in
which agglomeration results from manufacturing
firms’ desire to locate in a place of larger demand
in order to exploit scale economies and minimize
transportation costs, while the location of demand
depends 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-located
with other Japanese firms. They pointed to tech-
nological spillovers, specialized labor, and other
inputs 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 had
less prior experience. At the country level, Song
(2002) showed how Japanese firms’ prior invest-
ment in technological and sourcing capabilities led
to subsequent investment in the same countries.
Chung and Alcacer (2002) also found that firms
in research-intensive industries are more likely to
locate in regions with high R&D intensities.
Although economists generally attribute regional
agglomeration to real economic gains, organiza-
tional theorists have argued that agglomeration
might occur for non-economic reasons. Agglom-
eration might occur, for instance, when firms
wish to improve their legitimacy in order to
access resources they need for survival and growth
(DiMaggio and Powell, 1983; Suchman, 1995). A
firm might locate in a popular place simply because
so 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 a
foreign country could increase firms’ imitation of
1
Early work in economic geography studied the impact of
income, tax incentives, wage, and unionization on attracting
more foreign direct investment (Coughlin, Terza, and Arromdee,
1991; Wheeler and Mody, 1992; Friedman, Gerlowski, and
Silberman, 1992).
Copyright  2005 John Wiley & Sons, Ltd.
597
other firms (Levitt and March, 1988). Empirical
work has indicated that legitimacy and uncertainty
influence 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 and
Delios (2001) demonstrated that Japanese firms
that lacked international experience relied more
heavily on the past international expansion deci-
sions of other firms in their reference group as
cues for their own entry decisions. Knickerbocker
(1973) also pointed out that MNCs in oligopolis-
tic industries tend to imitate each other when they
expand into foreign markets.
In addition, some research has found that agglo-
meration can lead to negative externalities. For
example, firms can benefit from the spillover of
other firms’ knowledge and technologies, but their
own knowledge and technologies can spill over to
other firms. Appold (1995) found that agglomer-
ation was negatively associated with performance
in the U.S. metalworking sector. Shaver and Flyer
(2000) argue that benefits and costs firms derived
from co-location could differ according to their
own core competences. They contend that firms
with 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 among
adjacently located firms. Baum and Mezias (1992)
demonstrated that hotels located in Manhattan that
were similar in terms of location, price, and size
posed greater threats to each other and reduced
each other’s chances of survival as the area became
more crowded. Agglomeration also drives up the
costs of locally sourced inputs, such as wages
of local managers and engineers and housing
expenses for expatriates.
Agglomeration can also reduce innovation via
groupthink (Porter, 1998), thereby creating nega-
tive externalities. It can make firms in a regional
cluster look only inward and reject ideas from
other areas. Detroit’s attachment to gas-guzzling
automobiles in the 1970s amidst oil shortages is a
prime example of such rigidity.
We expect that multinational corporations will
consider both positive and negative network exter-
nalities. Population ecologists have long argued
that population density influences startups’ perfor-
mance. They have found that an increase in popu-
lation density is initially positively correlated with
Strat. Mgmt. J., 26: 595–615 (2005)
598 S.-J. Chang and S. Park
the founding rate of startups because it provides
legitimacy and acceptance. After a certain level,
however, population density is negatively associ-
ated with the founding rate due to increased com-
petition in that particular niche (Hannan and Car-
roll, 1992). By a similar logic, we expect that firms
will agglomerate up to a point, but that increases
in negative network externalities outweigh any
increase in positive ones after that level is reached.
We expect that marginal benefits from agglomer-
ation will decline since knowledge or experience
spillovers and legitimacy gained from an additional
firm in a region would become redundant and neg-
ligible. On the other hand, marginal costs from
agglomeration will increase since the competition
in both product and factor markets will become
more severe and potential hazards from groupthink
would become larger. Above that level, marginal
costs exceed marginal benefits and the likelihood
of co-location will decline (see Figure 1).
The likelihood that marginal costs exceed margi-
nal benefits is greater when firms decide to co-
locate in order to gain legitimacy rather than for
economic reasons. When there are no real eco-
nomic gains, the marginal benefits of legitimacy
drop quickly and will be completely offset by the
marginal costs of both intensified competition and
the hazard of groupthink. Since Korean firms were
at an early stage of internationalization and China
posed great uncertainty as a transitional economy
during the period we studied, their agglomera-
tion was substantially motivated by the desire to
gain legitimacy and avoid uncertainty. Given this
assumption, we also believe it is more likely that
Net of positive & negative
network externalities
Positive externalities
Negative externalities
MC
MB
Density
Figure 1. Rationale for a curvilinear relationship
Copyright  2005 John Wiley & Sons, Ltd.
network externalities were curvilinear as a function
of the number of firms.
There is, however, a possibility that marginal
costs from agglomeration might not increase when
an additional firm locates in a region. Porter
(1998) and Porter and Stern (2001) argue that
intensified competition in a regional cluster can
promote innovation, which may lower the marginal
cost curve in the long run. Some regional clusters,
such as Silicon Valley, have been extremely inno-
vative and cost efficient despite intense competi-
tion and high levels of agglomeration may neutral-
ize any cost increasing pressures. Similarly, some
firms can manage better the hazard of groupthink.
In our study, we test for this relationship by
inserting both a monotonic and a quadratic term for
the intertemporal population of firms constituting a
regional network. An alternative hypothesis is that
network externalities are monotonically positive or
negative.
Hypothesis 1: The likelihood that a firm chooses
a location increases as the number of firms
already present in the same region increases to
a certain point, and declines after that point.
Types of firms generating network externalities
Most of the agglomeration benefits identified by
Porter (1998) originate from flows of experience-
based knowledge among firms. By hiring spe-
cialized workers and purchasing other inputs, a
firm can tap the knowledge embedded in such
resources. Firms can also share knowledge by
detecting market and technological trends and pro-
moting cooperation. The international business lit-
erature has stressed that it is important for firms
to transfer and seek knowledge or experience
when they invest in foreign countries and decide
what entry mode to use. Johanson and Vahlne
(1977), Kogut (1983), Barkema and Vermeulen
(1998), Chang (1995), Kogut and Chang (1996),
and Chang and Rosenzweig (2001) demonstrated
how the knowledge or experience firms gained
from their prior entries affected their subsequent
entries and their choices of entry mode. Shaver,
Mitchell, and Yeung (1997) argue that subsequent
foreign entrants observe and learn from the success
or failure of earlier entrants.
Such benefits are, however, neither automatic
nor guaranteed. Kogut and Zander (1992) and Zan-
der and Kogut (1995) showed that knowledge that
Strat. Mgmt. J., 26: 595–615 (2005)
 Types of Firms Generating Network Externalities
is less codifiable and teachable and more com-
plex is more difficult to transfer even within a
firm. They also demonstrated that, due to this dif-
ficulty, firms often hire workers away from the
target firm to facilitate knowledge diffusion. Szu-
lanski (1996) similarly observes that causal ambi-
guity and the absorptive capacity of the recipient,
among other factors, lead to ‘stickiness’ and inhibit
the transfer of knowledge to other parts of an
organization. Hansen (1999) also shows that weak
inter-unit ties among various product development
teams in a firm help a project team search for use-
ful knowledge in other subunits, but strong ties
enable the transfer of complex knowledge. Accord-
ing to these studies, knowledge transfer and shar-
ing can be difficult even within a firm or among
affiliates within the same business group. This
study thus treats a firm’s own prior experience,
which has been conventionally taken for granted,
as a source of network externalities for itself.
Agglomeration may facilitate flows of knowl-
edge among firms or within a firm, as it increases
a firm’s ability to communicate with or hire people
working for other firms or other divisions. The pos-
sibility of these flows might also be contingent on
other factors, such as the identities of the firms tar-
geted as sources of knowledge. We expect that it is
easier to transfer knowledge among firms of simi-
lar background since there is less causal ambiguity
and higher levels of absorptive capacity among
such firms. Chung and Kalnins (2001) found that
hotels that were similar in size and were affili-
ated with a chain derived greater agglomeration
benefits.
The extent to which firms co-locate to gain legit-
imacy also depends upon the types of firms that
it can imitate (Haunschild and Miner, 1997). For
example, trait-based imitation occurs when a firm
imitates the behavior of high-status organizations
(Fombrun and Shanley, 1990; Haveman, 1993).
Guillen (2002) argues that firms expanding into
foreign markets tend to imitate other firms whose
experience, history, or location is relevant to their
own situation. As a consequence, emerging multi-
nationals tend to imitate other firms with which
they are familiar because they are in the same
industry or part of the same business group.
In this study, we test whether network external-
ities are firm specific, nation specific, and industry
specific. First, we expect that knowledge sharing
and transfer are easiest and imitation is most preva-
lent when they occur inside a firm. A firm may
Copyright  2005 John Wiley & Sons, Ltd.
599
invest more than once in a foreign country. It may
locate its investments in the same region to bene-
fit from the experience it has gained. Since many
firms are diversified and are organized into prod-
uct divisions, co-locating investments for multiple
divisions helps firms share plants, equipment, and
workers. Expatriate managers can add more busi-
nesses at the same location without hiring more
managers. Business groups in many countries,
where many legally independent firms are under
the same ownership and administrative control,
facilitate resource sharing among member firms
(Granovetter, 1995). For instance, Samsung Group
uses regional organizations to facilitate knowledge
sharing by its affiliates. Samsung China coordi-
nates various activities by the subsidiaries of its
affiliate firms in China. In turn, these affiliates fre-
quently emulate other affiliates when they expand
into a new region. For instance, when Samsung
Electronics is located in Tianjin, other affiliates
of the Samsung Group such as Samsung Corpo-
ration and Samsung SDI are more likely to locate
in Tianjin than they are in other regions since they
can learn from Samsung Electronics’ experience in
the same location and since Samsung Electronics’
presence legitimizes their own location choices.
For his sample of Korean firms that invested in
China, Guillen (2002) found strong evidence that
a firm’s rate of entry increased as its affiliates
set up their own plants. Martin, Swaminathan,
and Mitchell (1998) showed that Japanese automo-
bile suppliers followed their buyers, competitors,
and suppliers into the United States. Bastos and
Greve (2003) also found that industry affiliation
and board interlocking ties were strong predic-
tors for Japanese firms’ mimetic entry behaviors
in Europe. We thus expect that marginal benefits
from an additional firm in a region will be greater
if the new firm is in the same boundary than they
are if the new firm is unrelated.
On the other hand, the marginal cost increase
associated with agglomeration will be smaller
when the same firm or affiliated firms are co-
locating investments than it is when unaffiliated
firms co-locate, since a firm or a business group
should be more able to coordinate its location deci-
sions to avoid any competition among its own
foreign operations. A firm or a group’s delib-
erate effort to avoid any pitfalls of groupthink
can also lower the marginal costs of agglomer-
ation. For instance, the LG Group deliberately
spread the operations of its individual affiliates
Strat. Mgmt. J., 26: 595–615 (2005)
600 S.-J. Chang and S. Park
over many regions, including several remote areas,
while avoiding too much concentration in a few
popular coastal areas. By doing so, it achieved
balanced growth in the Chinese markets and max-
imized knowledge sharing at the group level. We
therefore expect:
Hypothesis 2: Network externalities are stronger
within firms and among firms associated with the
same business groups than they are for unaffili-
ated firms.
We also expect that a firm’s country of origin
significantly affects the degree of network exter-
nalities it can derive from other firms. Since each
country has its own culture, national origin may
affect the types of experiential knowledge a firm
creates (Hofstede, 1980). As a consequence, some
knowledge or experience may be nation specific,
and firms may be able to learn more from the expe-
rience of firms from the same nation than they
can from firms that are from different nations. For
instance, a Japanese firm that transfers labor rela-
tionship practices commonly used in Japan may be
uniquely qualified to learn from the past experience
of other Japanese firms that implemented similar
practices in the same foreign location. A Korean
firm may be relatively more able to recruit a local
manager who can speak Korean from a subsidiary
of another Korean firm. Also, when there is a large
community of firms from the same country, these
firms often create country-specific infrastructures
such as a Swedish school for Swedish expatriates’
children.
A firm may also pay more attention to the
actions of other firms from the same nation than
it does to those of different nations, revealing
another type of trait-based imitation. Such imita-
tive behavior among firms from the same nation
might be even stronger for firms from countries
that have strong ethnocentric orientations, such as
Korea and Japan. Various researchers have shown
that Korean and Japanese firms frequently emu-
late each other (Guillen, 2002; Head et al., 1995;
Henisz and Delios, 2001; Chung and Song, 2004;
Alcacer, 2004). We thus expect the marginal ben-
efits from agglomeration to be higher when firms
of the same nationality co-locate investments than
they are when firms of different nationalities co-
locate.
It is also possible that an agglomeration of firms
from the same nation might increase marginal
Copyright  2005 John Wiley & Sons, Ltd.
costs, such as the costs of nation-specific inputs
and the hazards of groupthink, than would an
agglomeration of firms from several nations. We
expect, however, that the proportion of nation-
specific inputs to overall costs is low relative to the
potential benefits from spillovers of nation-specific
experience or knowledge, especially for firms in
which ethnocentrism is strong. Since Korean firms
are as ethnocentric as Japanese firms are, we
hypothesize:2
Hypothesis 3: Network externalities are stronger
for firms from the same nation than they are for
firms from different nations.
In addition, some network externalities may be
industry specific. Although components of infras-
tructure, such as roads, transportation, and housing
for expatriates, are shared by all firms, it may be
easier to share other resources, like specialized
suppliers and workers, within an industry bound-
ary. Shanghai General Motors probably benefited
more from Shanghai Volkswagen than it did from
any other company in Shanghai.
An industry also provides a frame of reference
to all firms in it. It is a social structure that affects
the flow of information and legitimacy from one
firm to another (Guillen, 2002). Firms also measure
their internal processes and performance against
others in the same industry (Porac and Rosa, 1996).
Therefore, firms tend to imitate other firms in
the same industry to gain legitimacy or to reduce
uncertainty, revealing another type of trait-based
imitation. Guillen (2002) found that Korean firms
are more likely to invest in China when more of
their domestic competitors have already invested
in China. Henisz and Delios (2001) showed sim-
ilar results for Japanese firms. We thus expect
that marginal benefits from agglomeration will be
higher when firms in the same industry co-locate
investments than they are when firms in different
industries co-locate.
2
Henisz and Delios (2001), Guillen (2002), and Chung and Song
(2004) argue that network externalities could be stronger for
firms that had little or no international investment experience.
They propose that network externalities from other firms would
be weaker or non-existent after firms had such experience. We
experimented with various interaction effects between a firm or
group’s prior entry experience and the count of other types
of firms. The interaction terms were generally insignificant,
suggesting that our sample firms derived substantial network
externalities from other firms even after they had investment
experience.
Strat. Mgmt. J., 26: 595–615 (2005)
 Types of Firms Generating Network Externalities
On the other hand, negative network externali-
ties, such as groupthink and competition in product
and factor markets, may be also industry spe-
cific, and thus shift marginal costs upward. It
is not clear whether the marginal benefits and
marginal costs schedules would intersect at a
higher level of agglomeration for firms in the same
industry or firms in different industries. Porter
(1998) and Porter and Stern (2001) argue that
intensified rivalry among firms in the same region
actually promotes innovation, and cite regional
clusters such as Silicon Valley for semiconduc-
tors as an example. We argue that the innovation-
promoting effects of intensified rivalry among
firms of the same industry within a regional clus-
ter are greater than the negative consequences of
intensified competition in the factor and product
markets are. We thus propose:
Hypothesis 4: Network externalities are stronger
among firms in the same industry than they are
across industries.
RESEARCH METHODS
Sample
Korean firms’ investment activities in China pro-
vide an interesting empirical setting to study our
research questions. First, Korea ranked as the
fifth largest investor in China, after the United
States, Japan, Taiwan, and Singapore.3 Second,
compared to U.S., European and Japanese multi-
nationals, Korean firms entered China relatively
late. Most Korean investments in China took place
after China and Korea established a diplomatic
relationship in 1992. As a late entrant, Korean
firms had many opportunities to evaluate network
externalities when they decided which locations
to enter. Third, Korean firms have a reputation
for being ethnocentric and often emulating each
other (Guillen, 2002). Thus, China provides a good
setting to test whether network externalities are
stronger among Korean firms than they are for
other foreign firms. Fourth, many Korean firms
3
According to the official statistics, investments from Hong
Kong and the U.S. Virgin Islands exceeded those from Korea. A
large portion of these countries’ investments, however, actually
came from firms in other nations that used Hong Kong and U.S.
Virgin Islands as tax havens or as a beachhead for entry into
China.
Copyright  2005 John Wiley & Sons, Ltd.
601
are associated with business groups, also known
as chaebols. Within chaebols, individual affiliates
share considerable know-how and expertise. Thus,
Korean firms provide an interesting setting to
gauge how strong network externalities are within
the boundaries of a firm or a group.
The sample for this study consists of Korean
firms’ direct investments in China between 1988
and September 2002. Korean firms started to invest
in China through Hong Kong in 1988. Over
time, Korean firms have increased their invest-
ments in China. By September 2002, Korean
firms had invested 6000 times in China, for a
total of $4.1 billion in the manufacturing sec-
tor.4 When Korean firms invest overseas, they
are required by law to report their investments
to the government-owned Import–Export Bank of
Korea, which maintains a database on the names of
investors, dates, amounts, and locations of invest-
ing firms’ activities. For our sample, we selected
Korean firms’ investments in China in the manu-
facturing sector whose declared investment amount
exceeded $1 million. We focused only on man-
ufacturing investments since manufacturing and
non-manufacturing sectors require rather differ-
ent types of experience, knowledge, workers, and
other inputs. We also dropped small investments
(i.e., those less than $1 million) since we wanted
to have investments of comparable size by Korean
firms and the other foreign firms, as well as local
firms in our database. During 1988–2002, there
were 661 investments that met our criteria. Among
these cases, we dropped 121 cases from our sample
since the identities of investors were either individ-
uals, rather than firms, or could not be confirmed
due to bankruptcies or closures. We also deleted
cases where the intended investment amount was
reported but did not materialize into an actual
investment by September 2002. The 540 invest-
ments in our sample were worth $3.2 billion, rep-
resenting more than 78 percent of Korean firms’
total investment in the manufacturing sector in
China, as reported to the Import–Export Bank of
Korea.
Several firms in our sample invested in China at
least twice during our time study period. Samsung
Electronics and LG Electronics each invested 10
times, LG Chemical invested nine times, Hyundai
4
This figure excludes announced but unrealized investments and
those that were liquidated or bankrupt from the Export-Import
Bank of Korea statistics, as of September 2002.
Strat. Mgmt. J., 26: 595–615 (2005)
602 S.-J. Chang and S. Park
Motors invested six times, etc. Many of the firms
in our sample were associated with large business
groups (Chang, 2003). The Export–Import Bank of
Korea uses the Korean Fair Trade Commission’s
definition of affiliation with a business group to
determine whether individual firms belonged to
such groups.5 If we use this definition, for instance,
affiliates of the LG Group, such as LG Electronics
and LG Chemical, made a total of 27 investments
in China.
China is officially organized into 22 provinces,
four special cities (Beijing, Tianjin, Shanghai, and
Chongqing), and five autonomous regions, such as
Inner Mongolia and Xinjiang. We adopted China’s
classification of regions since all vital statistics
in China are organized by region. Our sample of
firms invested in 18 of these 31 regions. Figure 2
shows the geographic distribution of Korean firms’
investments in China. Korean firms show some
agglomeration in regions such as Beijing, Tian-
jin, Liaoning, Shangdong, Jiangsu, Guangdong,
and Shanghai. Compared to other foreign firms,
which concentrated heavily in Shanghai, Guang-
dong, Beijing, and Tianjin, Korean firms dispersed
more into the northern provinces and other inner
regions.
Although Koreans and Chinese are culturally
similar, Korean firms are not free from the liabili-
ties of foreignness. These firms reported various
difficulties, such as their relationships with the
government, motivating workers, and protecting
their intangible resources (Export–Import Bank of
Korea, 2002). Therefore, transfers and spillovers
of experience-based knowledge were critical to
improving the performance of these firms’ oper-
ations.
Measures
In order to reflect the location choices faced by
Korean firms at the time of investment, we col-
lected descriptive data for each region. We mea-
sured the population of each region (in increments
of 10 million), expecting that firms would pre-
fer locations with large markets. We included the
average wage in the manufacturing sector (in thou-
sands RMB) to reflect the relative attractiveness
5
The Korea Fair Trade Commission legally defines a business
group as ‘a group of companies, more than 30% of whose shares
are owned by some individuals or by companies controlled by
those individuals, or those that are practically controlled by them
despite lower ownership control.’
Copyright  2005 John Wiley & Sons, Ltd.
of a region as a manufacturing base. Although
we acknowledge that highly skilled workers can
be expensive in China and that wages are less
important in the capital and technology-intensive
industries, we assume that wages of skilled labors
will correlate with those of unskilled labors across
regions. We thus expect that average wages are
a proxy, albeit an imperfect one, for the relative
cost of regional labor in China. Our Highway/area
variable denotes the length of the highways in a
region in km divided by the size of the region
in km2 in order to gauge the quality of physical
infrastructure. We expect the more well developed
the highway system is, the more likely it is that
a firm prefers the location. The number of patents
(in thousands) granted by the Chinese patent office
was included to reflect the technical skills of orga-
nizations in a region. As documented by Sun
(2000), state and local research institutes as well
as corporations in China have aggressively filed
for local patents. Foreign firms are more likely to
favor a location where there are a large number of
local patents. We collected all vital social statistics
for the above variables from the China Statisti-
cal Yearbook, 1988–2001, and matched these data
with the year that each investment occurred. Since
there are many ethnic Koreans in China who have
worked as translators and middle-level managers
for the Chinese subsidiaries of Korean firms, we
included the number of ethnic Koreans in a region
(in thousands). We expect that the more ethnic
Koreans there are in a region, the more attractive
those regions are to Korean firms. We collected
the distribution of ethnic Koreans from the Popu-
lation Survey. Not all statistics were available for
every year. The length of highway was not avail-
able until 1995, and the number of ethnic Koreans
was available only for 1990 and 1998. We substi-
tuted data for these variables with data from the
closest year.
In order to gauge the degree of network external-
ities, we measured the cumulative counts of prior
investments by different types of firms at the time
of each investment. Prior studies using count vari-
ables noted that the level of locally accumulated
experience, not just the binary variable noting the
mere presence of experience, was more critical to
subsequent location decisions (Song, 2002). Count
of a firm’s own prior entry measured the number
of a focal firm’s own prior entries into each region
up to the time of an entry event. Count of entry by
Strat. Mgmt. J., 26: 595–615 (2005)
 Types of Firms Generating Network Externalities 603

Distribution of Korean, foreign, and local firms in China

Figure 2.

Copyright  2005 John Wiley & Sons, Ltd. Strat. Mgmt. J., 26: 595–615 (2005)
604 S.-J. Chang and S. Park
firms within the same group reflected the cumu-
lative count of entries by firms associated with
the same business groups in each region up to the
time of each entry event. For firms with no group
affiliation, this variable is coded as zero. Count of
other Korean firms was measured as the number
of Korean firms not associated with the same busi-
ness groups that were operating in each region at
the time of each entry.
It is hard to keep track of how many foreign and
local Chinese firms existed in each year. During
the last decade, the number of foreign firms setting
up their operations in China exploded. There was
also substantial restructuring among local firms in
China. Many formerly state-owned firms and coop-
eratives were transformed into joint stock compa-
nies and were privatized. During this transforma-
tion process, there were many mergers and acqui-
sitions among local firms. At the same time, the
Chinese government encouraged foreign firms to
form joint ventures with local firms in order to
transfer technology or know-how and to maintain
employment. We collected data for prior entries by
non-Korean foreign firms and local firms from Dun
& Bradstreet’s Major Corporations in P.R. China
2001. This directory consists of two volumes. Vol-
ume 1 contains a total of 2953 major foreign firms’
own subsidiaries and their joint ventures in the
manufacturing sector in China. Volume 2 contains
information on a total of 1341 major Chinese firms
in the manufacturing sector. The directory does
not supply any other information apart from the
number of employees, the names of parent firms,
the year of entry, and the addresses and contact
information of operations.6 The average number
of employees of foreign firms in this directory was
246, while it was 1580 for local firms. The average
number of employees for the 540 Korean firms in
our sample was 817, suggesting that the Korean
firms in our database were somewhat larger than
the foreign firms but smaller than the Chinese firms
listed in Dun & Bradstreet’s directory. Count of
other foreign firms and count of local firms were
measured as the number of manufacturing oper-
ations of non-Korean multinationals and Chinese
local firms, respectively, operating in each region
at the time of each entry.
6
According to our telephone interview with managers at Dun
& Bradstreet, this publication used various criteria such as sales
and number of employees to select ‘major’ foreign and local
firms to be included in the directory.
Copyright  2005 John Wiley & Sons, Ltd.
We further classified our count measures into
two parts, reflecting the number of firms in the
same industry and those in different industries.
We used the Korean 2-digit Standard Industry
Classification (SIC) code to determine whether
firms were in the same industry as a focal firm.
Dun & Bradstreet classified foreign and local firms
in China according to the 2-digit U.S. SIC, which
we converted to the 2-digit Korean SIC. In some
models, we used variables that aggregated the
various count variables defined above. Count of
all unrelated firms is defined as the sum of count
variables for other Korean firms, other foreign
firms, and local Chinese firms in a region. Count
of all firms in a regional network adds a firm’s
own entries and entries by firms affiliated with the
same group on top of count of all unrelated firms,
thus comprising all types of firms in a regional
network. In order to measure the joint effects of
positive and negative network externalities, we
measured the monotonic and squared terms of
these count variables. If a squared term has a
negative coefficient and a monotonic term has a
positive one, that discrepancy may indicate an
inverted U-shaped relationship.
Methodology
This study uses a conditional logit model to test
our hypotheses (McFadden, 1974). Our sample
firm faces a set of location choices, each of which
has different attributes. Since the conditional logit
model requires all choices to be selected at least
once, we included only 18 regions, all of which
were invested in at least once.7
The conditional logit model has been widely
used to analyze how agents choose from a large
set of alternatives. It is relevant for location
choices in foreign direct investment (Head et al.,
1995; Shaver and Flyer, 2000). It focuses on
the attributes of each location in the choice set.
Attributes for each region, including population,
average wage, highway/area, ethnic Koreans, and
number of patents, were the same for all Korean
firms investing in China at time t. Count variables
reflecting the number of incumbent firms that were
sources of network externalities were measured
according to the identities of investing firms. This
7
Refer to our discussion of the robustness tests in which we
examined the independence of irrelevant alternatives in the
results section.
Strat. Mgmt. J., 26: 595–615 (2005)
 Types of Firms Generating Network Externalities
model estimates how each attribute increases or
decreases the chance that a location will be cho-
sen rather than all other potential locations. Let
us define an underlying latent variable, Vij t , to
represent the utility a firm i derives from open-
ing a manufacturing operation in region j at time
t. Since there were m regions where firms could
enter during our time study period, each observa-
tion (i.e., a firm choosing a location) has m rows
of data, each corresponding to a specific region.
Assuming a linear relationship with the latent vari-
able, we can write:
Vij t = βXij t + eij t
X is a vector of independent variables that affect
choices. If a firm makes choice j in particular, then
we assume that Vij t is the maximum among the m
utilities. Hence, the statistical model is driven by
the probability that choice j is made, which is:
Prob(Vij t > Vikt ) for all other k = j
Let Yit be a random variable that indicates a choice
made by firm i at time t. Assuming independence
of irrelevant alternatives, the probability that a firm
i chooses j location at time t can be written as
follows:
Prob(Yit = j ) = exp(βXij t )/
[k=1...m exp(βXikt )]
The maximum likelihood method is used to esti-
mate β, which we can use to test whether various
independent variables significantly affect the prob-
ability that one region will be chosen among all
the regions in the choice set. In this conditional
logit model, β cannot be interpreted as marginal
effects as it could be in a linear regression. The
marginal effects can be derived by differentiating
Equation 3 with respect to the independent vari-
ables, X. In order to interpret the magnitude of the
coefficient, we can calculate the ‘average probabil-
ities elasticity,’ as reported in Head et al. (1995),
which referred to an independent variable’s proba-
bility elasticity for the average option in the choice
set.8 The elasticity of the probability of a partic-
ular firm i choosing region j with respect to an
8
See the appendix of Head et al. (1995) for more details about
how to derive for the average probability elasticity.
Copyright  2005 John Wiley & Sons, Ltd.
605
independent variable, Xl , can be calculated by dif-
ferentiating Equation 3:
∂ Prob (Yit = j ) Xl
Elasticity1ij t =
∂Xl Prob (Yit = j )
= βl [1 − Prob (Yit = j )] (4)
Summing over all firms and choices, the relation-
ship between the average probability elasticity and
the coefficient estimate, βl , is:



m−1
Elasticity1 = Elasticity1ij t = βl
i j t m
(1) (5)
The above expression discounts the coefficient
by (m − 1)/m. Since we have 18 regions in our
dataset, we have to multiply individual coefficients
by 0.94 (=17/18) to calculate the average proba-
bilities elasticity.
RESULTS
(2)
Tables 1 and 2 show, respectively, descriptive
statistics and results from conditional logit models.
The odd-numbered models in Table 2 include only
monotonic variables, while the even-numbered
models include both monotonic and squared terms
to test for curvilinear relationships. Model 1 shows
a baseline model, in which the count of all firms
in a regional network was included in addition
(3) to regional attributes such as population, average
wage, highway/area, number of ethnic Koreans,
and patents. The results showed that Korean firms
preferred regions that were characterized by large
populations, low wages, a well-developed high-
way system, a large population of ethnic Kore-
ans, and a large number of patents. The count
of all firms in a region was positive and signifi-
cant, suggesting the existence of positive network
externalities. The chi-square statistic shows the
model to be highly significant, with p < 0.001.
The pseudo R 2 is 0.1826, suggesting reasonable
model fit.9
In Model 2, we added a squared term of the
count of all types of firms in a region to test for a
curvilinear relationship. When we added this term,
both the monotonic and the squared terms of the
9
Pseudo R-squared is defined as one minus the ratio of the
maximum likelihood functions of a model without any explana-
tory variable divided by the model that includes all explanatory
variables.
Strat. Mgmt. J., 26: 595–615 (2005)
606 S.-J. Chang and S. Park
Table 1. Descriptive statistics

Mean S.D. Minimum Maximum

(1) Population (10 million) 4.05 2.32 0.64 9.04

(2) Average wage (thousands RMB) 5.68 3.05 1.34 20.41
(3) Highway (km)/area (km2 ) 40.38 48.35 1.06 277.27
(4) Ethnic Koreans (thousands) 105.03 284.45 0.07 1181.96
(5) Patents (thousands) 2.13 2.32 0.01 18.26
(6) Count of all firms in a regional network 182.96 334.97 0.00 1965.00
(7) Count of a firm’s own prior entry 0.002 0.19 0.00 4.00
(8) Count of entry by firms within the same group 0.01 0.45 0.00 10.00
(9) Count of all unrelated firms 182.85 334.91 0.00 1963.00
(10) Count of other Korean firms 13.28 26.53 0.00 185.00
(11) Count of other Korean firms in the same industry 1.06 3.11 0.00 34.00
(12) Count of other Korean firms in different industries 12.22 24.54 0.00 184.00
(13) Count of other foreign firms 117.25 292.71 0.00 1651.00
(14) Count of other foreign firms in the same industry 6.71 21.44 0.00 206.00
(15) Count of other foreign firms in different industries 110.53 277.04 0.00 1651.00
(16) Count of local firms 52.31 56.59 0.00 281.00
(17) Count of local firms in the same industry 3.24 5.74 0.00 55.00
(18) Count of local firms in different industries 49.07 53.43 0.00 281.00

Correlation matrix

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18)

(1) 1.00
(2) −0.13 1.00
(3) −0.30 0.65 1.00
(4) −0.15 −0.14 −0.20 1.00
(5) 0.32 0.54 0.32 −0.11 1.00
(6) −0.16 0.63 0.62 −0.17 0.35 1.00
(7) 0.05 0.08 0.09 −0.02 0.08 0.06 1.00
(8) 0.04 0.14 0.16 −0.03 0.14 0.08 0.61 1.00
(9) −0.16 0.63 0.62 −0.17 0.35 0.99 0.06 0.08 1.00
(10) 0.38 0.26 0.34 −0.07 0.37 0.24 0.13 0.15 0.24 1.00
(11) 0.23 0.20 0.28 −0.06 0.28 0.18 0.18 0.26 0.18 0.67 1.00
(12) 0.38 0.25 0.33 −0.07 0.36 0.24 0.12 0.13 0.24 0.99 0.60 1.00
(13) −0.30 0.59 0.60 −0.14 0.26 0.98 0.03 0.06 0.98 0.07 0.07 0.07 1.00
(14) −0.23 0.45 0.46 −0.11 0.20 0.73 0.06 0.08 0.73 0.05 0.13 0.04 0.74 1.00
(15) −0.30 0.59 0.60 −0.14 0.26 0.97 0.03 0.06 0.97 0.07 0.06 0.07 0.99 0.71 1.00
(16) 0.40 0.51 0.42 −0.22 0.57 0.73 0.11 0.12 0.73 0.57 0.37 0.57 0.59 0.43 0.59 1.00
(17) 0.25 0.30 0.22 −0.13 0.38 0.41 0.11 0.14 0.41 0.31 0.34 0.29 0.33 0.38 0.32 0.58 1.00
(18) 0.39 0.51 0.42 −0.22 0.56 0.73 0.10 0.11 0.73 0.58 0.36 0.58 0.59 0.42 0.59 0.99 0.51 1.00

N = 9720 (= 540 × 18).

count variable lost significance. We performed a
log-likelihood test by taking the ratio of the maxi-
mum probability under the constraint of the null
hypothesis (i.e., the coefficient for the squared
term equals zero) to the maximum likelihood
with that constraint relaxed. The −2 log-likelihood
has an asymptotic distribution of chi-square. The
difference in chi-square at the bottom of Table 2
Copyright  2005 John Wiley & Sons, Ltd.
was very small, indicating that we could not reject
the null hypothesis. Thus, Hypothesis 1 was not
supported when we lumped all different types of
firms into a single category and measured net-
work externalities. The network externalities from
all types of firms combined into a single measure
seemed monotonic rather than curvilinear.
Strat. Mgmt. J., 26: 595–615 (2005)
 Types of Firms Generating Network Externalities
Models 1 and 2 assumed that the firms consti-
tuting a regional network were homogeneous. In
subsequent models, we relaxed this assumption by
disaggregating firms into different types and test-
ing hypotheses that corresponded to these types.
Models 3 and 4 tested Hypothesis 2 by identifying
within a region a focal firm’s own prior entries,
entries by affiliated firms, and entries by firms not
related to a focal firm in any way. In Model 3,
which assumes linear relationships, all three count
variables were significantly positive, suggesting
positive network externalities. The coefficients for
a firm’s own entry and the count of firms affiliated
with the same business group were much greater
than was the count of all unrelated firms. When
we calculate the average probability elasticity, a
100 percent increase in the number of a firm’s
prior entries in a region increases the likelihood of
choosing that region by 46.6 percent (i.e., 0.496 ×
0.94 × 100). Similarly, a 100 percent increase in
the number of prior entries within a region by
affiliate firms increases the likelihood of choosing
that region by 47.7 percent (0.508 × 0.94 × 100).
In contrast, a 100 percent increase in the num-
ber of unrelated firms in that region increases the
likelihood that a focal firm chooses this region by
only 0.1 percent (= 0.001 × 0.94 × 100). We per-
formed a log-likelihood test to determine whether
these differences in the size of coefficients were
statistically significant by positing Model 1 as a
null hypothesis, where coefficients for these three
types of firms were constrained to be equal. The
log-likelihood test comparing Models 1 and 3
rejected the null hypothesis at p < 0.001, suggest-
ing that the differences in coefficients were signif-
icant. Thus, we found strong support for Hypoth-
esis 2.
Model (4) added the squared terms of three
count variables to test for curvilinear relationships.
The results for it showed that the coefficient for
count of entries by affiliate firms was positive and
significant, while the coefficient for its squared
term was negative and significant, suggesting a
curvilinear relationship. Both the monotonic and
the squared terms for the count of a firm’s own
prior entries and the count of unrelated firms in that
region were insignificant in Model 4, suggesting
monotonic rather than curvilinear relationships.
The log-likelihood test comparing Models 3 and
4 rejected the null hypothesis that coefficients
for all squared terms were zero. Thus, Model 4
provided some support for Hypothesis 1. It is
Copyright  2005 John Wiley & Sons, Ltd.
607
somewhat tricky to test Hypothesis 2 in a non-
linear model such as Model 4. Since only the
count of entry by firms affiliated with the same
business groups turned significant in a curvilinear
model, we found some support for Hypothesis 2
in Model 4.
It is worth noting that network externalities from
a firm’s own prior entries seemed monotonically
positive, while the impact of entries by firms affil-
iated with the same business groups was inverted.
The results may suggest that a firm does not
expect much conflict or competition among its own
investments in the same region. In contrast, affili-
ated firms, which transfer their own local managers
to other affiliates or share other resources with each
other, may incur some costs. It is also possible that
business groups discourage too much agglomera-
tion from occurring in any one region in order to
guard against the harmful effects of agglomeration
and achieve a well-balanced approach to the entire
Chinese market. LG Group’s actions provide some
anecdotal evidence for this conjecture.
Models 5 and 6 subdivided the category of
unrelated firms by the national origin of firms in
order to test Hypothesis 3. Model 5 showed that the
counts of other Korean firms and local firms in a
region were positively related to the likelihood that
a firm located in this region, suggesting positive
network externalities. In contrast, the count of
other foreign firms was negative and significant,
suggesting negative network externalities. When
we calculate the average probability elasticities,
a 100 percent increase in the number of other
Korean firms in a region increases the likelihood
that a firm located in this region by 0.8 percent,
while the same increase in the number of foreign
firms decreases the likelihood that a firm located
in this region by 0.1 percent. The log-likelihood
test comparing Models 3 and 5 rejected the null
hypothesis that coefficients for these three count
variables were equal. Thus, we found support for
Hypothesis 3.
Model 6 added the squared terms of count
variables. Compared to Model 4, curvilinear pat-
terns emerged more strongly when we disag-
gregated the category of unrelated firms. Both
the count of other Korean firms and local Chi-
nese firms showed inverted U-shaped relation-
ships, consistent with our expectation, while the
count of other foreign firms showed a U-shaped
relationship, contrary to our expectation. The log-
likelihood test comparing Models 5 and 6 rejected
Strat. Mgmt. J., 26: 595–615 (2005)

Table 2. Conditional logit model of location choices by Korean firms in China
Copyright  2005 John Wiley & Sons, Ltd.
Variables
Population (10 million)
Average wage (thousands
RMB)
Highway (km)/area (km2 )
Number of ethnic Koreans
(thousands)
Patents (thousands)
Count of all firms in a
regional network
Count of a firm’s own prior
entries
Count of entry by firms in
the same group
Count of all unrelated firms
(other Korean, foreign,
locals)
Count of other Korean firms
—in the same industry
—in different industries
Count of other foreign firms
—in the same industry
—in different industries
Count of local firms
—in the same industry
—in different industries
Count of all firms in a
regional network2
Count of a firm’s own prior
entries2
Count of entry by affiliate
firms2
Count of all unrelated firms2
Strat. Mgmt. J., 26: 595–615 (2005)
608
(1) (2) (3) (4) (5) (6) (7) (8)
S.-J. Chang and S. Park
0.406 (0.027)∗∗∗ 0.404 (0.029)∗∗∗ 0.383 (0.028)∗∗∗ 0.382 (0.029)∗∗∗ 0.149 (0.043)∗∗∗ 0.060 (0.047) 0.139 (0.043)∗∗ 0.059 (0.047)
−0.156 (0.043)∗∗∗ −0.156 (0.043)∗∗∗ −0.195 (0.045)∗∗∗ −0.194 (0.045)∗∗∗ −0.027 (0.055) −0.085 (0.063) 0.019 (0.056) −0.079 (0.063)
0.025 (0.002)∗∗∗ 0.025 (0.001)∗∗∗ 0.022 (0.002)∗∗∗ 0.023 (0.002)∗∗∗ 0.015 (0.002)∗∗∗ 0.013 (0.002)∗∗∗ 0.014 (0.002)∗∗∗ 0.013 (0.002)∗∗∗
0.001 (0.000)∗∗∗ 0.001 (0.000)∗∗∗ 0.001 (0.000)∗∗∗ 0.001 (0.000)∗∗∗ 0.001 (0.000)∗∗ 0.001 (0.000)∗ 0.001 (0.000)∗∗ 0.001 (0.000)∗
0.136 (0.027)∗∗∗ 0.132 (0.033)∗∗∗ 0.138 (0.027)∗∗∗ 0.135 (0.033)∗∗∗ 0.101 (0.028)∗∗∗ 0.130 (0.034)∗∗∗ 0.098 (0.028)∗∗ 0.132 (0.034)∗∗∗
0.001 (0.000)∗ 0.001 (0.001)
0.496 (0.195)∗ 0.571 (0.369) 0.387 (0.197)∗ 0.320 (0.371) 0.393 (0.198)∗ 0.239 (0.368)
0.508 (0.108)∗∗∗ 0.899 (0.192)∗∗∗ 0.542 (0.108)∗∗∗ 0.941 (0.193)∗∗∗ 0.495 (0.106)∗∗∗ 0.920 (0.193)∗∗∗
0.001 (0.000)∗∗∗ 0.001 (0.000)
0.009 (0.002)∗∗∗ 0.033 (0.004)∗∗∗
0.062 (0.014)∗∗∗ 0.127 (0.030)∗∗∗
0.005 (0.002)∗ 0.025 (0.004)∗∗∗
−0.001 (0.000)∗ −0.002 (0.001)∗
0.006 (0.003)∗ 0.012 (0.007)†
−0.001 (0.000)∗∗ −0.003 (0.001)∗∗
0.008 (0.002)∗∗∗ 0.015 (0.004)∗∗∗
0.010 (0.009) 0.024 (0.026)
0.008 (0.002)∗∗∗ 0.015 (0.005)∗∗
0.000 (0.000)
−0.085 (0.131) −0.035 (0.130) −0.008 (0.126)
−0.064 (0.026)∗ −0.069 (0.026)∗∗ −0.075 (0.026)∗∗
0.000 (0.000)
 Count of other Korean −0.133 (0.025)∗∗∗
firms2 /1000
—in the same −3.085 (1.103)∗∗∗
industry2 /1000
—in different −0.123 (0.029)∗∗∗
industries2 /1000
Count of other foreign 0.001 (0.001)∗
firms2 /1000
—in the same −0.031 (0.038)
industry2 /1000
—in different 0.002 (0.001)∗∗
industries2 /1000
Count of local firms2 /1000 −0.046 (0.020)∗

Copyright  2005 John Wiley & Sons, Ltd.

—in the same −0.872 (0.765)
industry2 /1000
—in different −0.048 (0.022)∗
industries2 /1000
Log-likelihood −1275.8 −1125.8 −1245.2 −1240.2 −1219.0 −1188.1 −1210.0 −1175.7
Chi-square (d.f.) 569.9(6)∗∗∗ 570.0(7)∗∗∗ 631.2(8)∗∗∗ 641.3(11)∗∗∗ 683.5(10)∗∗∗ 745.3(15)∗∗∗ 701.5(13)∗∗∗ 770.1(21)∗∗∗
Pseudo R 2 0.1826 0.1826 0.2022 0.2054 0.2190 0.2388 0.2247 0.2467
Log-likelihood test: (2) vs. (1) (3) vs. (1) (4) vs. (3) (5) vs. (3) (6) vs. (5) (7) vs. (5) (8) vs. (7)
Comparing models
Differences in chi-squares 0.1 (1) 61.3 (2)∗∗∗ 10.1 (3)∗ 7.3 (2)∗ 61.8 (5)∗∗∗ 18.0 (3)∗∗∗ 64.6 (8)∗∗∗
(d.f.)

∗∗∗ ∗∗
p < 0.001; p < 0.01; ∗ p < 0.05; † p < 0.10. Standard deviations are in parentheses. N = 9720
Types of Firms Generating Network Externalities

Strat. Mgmt. J., 26: 595–615 (2005)

609
 Table 3. Robustness tests of the independence from irrelevant alternatives

Excluding Shanghai Excluding regions with 610

less than 3 entries
Variable (1) (2) (3) (4)

Population (10 million) 0.123 (0.047)∗∗ −0.042 (0.055) 0.130 (0.044)∗∗ 0.066 (0.048)
Average wage (thousands RMB) −0.044 (0.084) −0.327 (0.092)∗∗∗ −0.015 (0.056) −0.101 (0.063)
Highway (km)/area (km2 ) 0.018 (0.003)∗∗∗ 0.011 (0.003)∗∗∗ 0.012 (0.002)∗∗∗ 0.011 (0.003)∗∗∗
Number of ethnic Koreans (thousands) 0.001 (0.000)∗∗ 0.001 (0.000)∗ 0.000 (0.000)† 0.000 (0.000)
Patents 0.134 (0.042)∗∗ 0.107 (0.038)∗∗ 0.081 (0.029)∗∗ 0.122 (0.034)∗∗∗

Copyright  2005 John Wiley & Sons, Ltd.

Count of a firm’s own prior entry 0.432 (0.203)∗ 0.264 (0.375) 0.369 (0.197)† 0.218 (0.368)
Count of entry by firms in the same group 0.502 (0.112)∗∗∗ 0.876 (0.197)∗∗∗ 0.491 (0.106)∗∗∗ 0.913 (0.193)∗∗∗
S.-J. Chang and S. Park

Count of other Korean firms in the same 0.058 (0.015)∗∗∗ 0.130 (0.031)∗∗∗ 0.067 (0.014)∗∗∗ 0.125 (0.030)∗∗∗
industry
Count of other Korean firms in different 0.003 (0.003) 0.020 (0.005)∗∗∗ 0.004 (0.002)† 0.024 (0.005)∗∗∗
industries
Count of other foreign firms in the same 0.013 (0.006)∗ 0.002 (0.019) 0.007 (0.003)∗ 0.012 (0.007)†
industry
Count of other foreign firms in different −0.002 (0.001)∗ 0.003 (0.003) −0.001 (0.000)∗ −0.003 (0.001)∗
industries
Count of local firms in the same industry 0.006 (0.010) 0.036 (0.031) 0.009 (0.009) 0.018 (0.026)
Count of local firms in different industries 0.009 (0.003)∗∗∗ 0.035 (0.007)∗∗∗ 0.007 (0.002)∗∗∗ 0.011 (0.004)∗
Count of a firm’s own prior entry2 −0.001 (0.126) 0.001 (0.126)
Count of entry by the same group firms2 −0.071 (0.027)∗∗ −0.075 (0.026)∗∗
Count of other Korean firms in the same −3.085 (1.103)∗∗∗ −2.845 (1.112)∗∗
industry2 /1000
Count of other Korean firms in different −0.123 (0.029)∗∗∗ −0.121 (0.029)∗∗∗
industries2 /1000
Count of other foreign firms in the same 0.270 (0.344) −0.028 (0.038)
industry2 /1000
Count of other foreign firms in different −0.009 (0.006) 0.002 (0.001)∗
industries2 /1000
Count of local firms in the same industry2 /1000 −1.510 (0.957) −0.669 (0.756)
Count of local firms in different −0.121 (0.029)∗∗∗ −0.035 (0.022)
industries2 /1000
Log-likelihood −1081.8 −1038.8 −1162.0 −1131.8
Chi-square (d.f.) 720.6(13)∗∗∗ 806.6(21)∗∗∗ 579.1(13)∗∗∗ 639.4(21)∗∗∗
Pseudo R 2 0.2498 0.2797 0.1995 0.2467
N 8653 8653 8040 8040

∗∗∗ ∗∗
p < 0.001; p < 0.01; ∗ p < 0.05; † p < 0.10. Standard deviations are in parentheses.

Strat. Mgmt. J., 26: 595–615 (2005)

 Types of Firms Generating Network Externalities
the null hypothesis that all the coefficients for
squared terms equaled zero. Model 6 provided sup-
port for Hypothesis 1.
The results for Model 6 showed that the number
of unrelated Korean firms initially increased the
likelihood of co-location up to a certain level (the
estimated inflection point seemed to be around 124
entries) but depressed it after that level. Korean
firms may compete with each other for some
Korean-specific inputs. For instance, Korean firms
may compete to hire managers who understand
the local culture and speak Korean. The intensified
competition in factor markets associated with in-
creased co-location could outweigh any additional
positive externalities derived from agglomeration.
On the other hand, the results for foreign firms
were initially negative, but turned positive after a
certain level (the estimated inflection point seemed
to be around 1000 entries). Again, it is hard to
test Hypothesis 3 in a non-linear model. Yet the
fact that network externalities from other Korean
firms were positive up to 124 entries but were
negative for other foreign firms up until 1000
entries provides some support for Hypothesis 3.
This result seemed consistent with the distribu-
tion of Korean and foreign firms. Korean firms
entered both regions where many foreign firms
were present and regions where very few foreign
firms entered.
Models 7 and 8 used industry classification to
distinguish firms. For Model 7, where monotonic
relationships are assumed, the coefficient for the
count of Korean firms in the same industry was
much larger than that of Korean firms in differ-
ent industries was. If we calculate the average
probability elasticities, a 100 percent increase of
other Korean firms in the same industry in a region
increases the likelihood that a firm locates in this
region by 5.8 percent. On the other hand, the same
increase in other Korean firms in different indus-
tries increases the likelihood a firm locates in that
region by only 0.5 percent. This result suggests
that Korean firms in the same industries created
large network externalities among themselves by
sharing technology or know-how and providing
legitimacy.
The results for Model 7 also demonstrated that
the negative coefficient for the count of other
foreign firms in Model 5 was driven by foreign
firms in different industries. Korean firms derived
positive network externalities from foreign firms in
the same industries. These firms derived negative
Copyright  2005 John Wiley & Sons, Ltd.
611
network externalities by co-locating with foreign
firms from different industries, perhaps because
of increased competition in factor markets. In
contrast, the presence of local firms in the same
industry did not seem to attract Korean firms in
China. Since many local Chinese firms trailed
Korean firms in terms of technological know-how,
the net flow of knowledge was from Korean firms
to local firms. A Korean firm might derive more
benefits from locating in a region where local
firms in industries different from the Korean firm’s
had already created an industrial infrastructure and
an ample supply of workers. The log-likelihood
test comparing Models 5 and 7 rejected the null
hypothesis that the coefficients for count variables
were the same regardless of industry. Thus, we
found support for Hypothesis 4.
Model 8 tested for curvilinear relationships by
adding the squared terms of the count variables
in Model 7. All these variables showed inverted
U-shaped relationships in Model 6 except for the
count of foreign firms in different industries, which
showed a U-shaped relationship, the count of for-
eign firms in the same industry, which was mono-
tonically positive, and the count of local firms in
the same industry, which was insignificant. The
log-likelihood test comparing Models 7 and 8
rejected the null hypothesis that the coefficients for
all squared terms were zero, providing additional
support for Hypothesis 1.
In order to check the robustness of our results,
we implemented several alternative formulations.
The conditional logit model relies on the assump-
tion of independence of irrelevant alternatives,
which means that the relative probability of choos-
ing two alternatives does not depend on the avail-
ability of other alternatives (McFadden, 1974;
Hausman and McFadden, 1984). To demonstrate
robustness regarding the assumption of indepen-
dence from irrelevant alternatives, we experimen-
ted with different subsamples. Models 1 and 2 of
Table 3 showed the same specifications as Models
7 and 8 of Table 2, while we dropped Shanghai
from our choice set. Shanghai received a total
of 1651 foreign entries, which represented more
than 55 percent of all foreign entries. We dropped
Shanghai from the choice set in order to see
whether negative network externalities from for-
eign firms in different industries might disappear.
As in Model 1 of Table 3, the negative impact
of foreign firms in different industries was sus-
tained even after we dropped Shanghai from the
Strat. Mgmt. J., 26: 595–615 (2005)
612 S.-J. Chang and S. Park
choice set. The relationship between the count of
foreign firms in different industries and the likeli-
hood of co-location seemed to be monotonic rather
than curvilinear after we dropped Shanghai. We
also experimented with different cut-off points in
determining the number of regions to be included
in the choice set. For instance, when we dropped
regions that received fewer than three entries, Xin-
jian, Anhui, and Hubei were excluded from this
choice set. Models 3 and 4 showed results with
only 15 choice sets. These results seemed consis-
tent with the ones in Table 2.
We also tested whether multiple entries by the
same firms could affect our estimations. In a linear
regression, it is relatively easy to include either
fixed effects or random effects to account for
such panel data. Including such effects is trickier,
however, for the conditional logit model, as this
model calculates the conditional likelihood for
each choice set. We therefore experimented by
dropping firms that invested more than once in
China. The results of this test were consistent with
those reported in this study. We also experimented
with a model where we grouped multiple entries
and their other alternatives in the choice sets by the
same firm (or group) into a single choice set and
calculated the conditional likelihood. For example,
when a firm (or group) invested twice during the
time study period, there were two regions that the
firm (group) entered and 34 (i.e., 2 × 17) regions
that it did not enter in the new choice set. Such
specification generated results very similar to those
reported in this study.10
DISCUSSION
Multinational corporations’ location choices within
a foreign country have only recently received
10
We also experimented with alternative specifications of attri-
butes. Several prior works that studied agglomeration patterns,
such as Head et al. (1995) and Chung and Song (2004), included
‘alternative specific constants’ instead of various attributes for
each region, which we used in this study. Alternative specific
constants are equivalent to region-specific dummy variables.
Although such regional dummy variables may be able to cap-
ture unspecified regional attributes other than the five attribute
variables specified in this study, they have the great limita-
tion of being time-invariant. In a dynamic country such as
China, such variables seemed inappropriate. When we added
these region-specific dummy variables to the regional attributes
in our study, however, most of these regional attribute variables
turned insignificant. Since we were interested in observing which
attributes explained location choices, we preferred using attribute
variables rather than regional dummy variables.
Copyright  2005 John Wiley & Sons, Ltd.
attention. Our study confirmed a regional agglom-
eration pattern for our sample of Korean firms
in China. It is consistent with prior research that
observes the agglomeration of Japanese firms in
the United States (Head et al., 1995; Shaver and
Flyer, 2000; Chung and Song, 2004), and the
innovation-promoting aspects of regional clusters
(Porter, 1998; Porter and Stern, 2001). Those
works treated network externalities as location spe-
cific but not as firm specific. By doing so, they
might have erred in treating all firms within the
network as homogeneous. This study enhances our
theoretical understanding by defining and measur-
ing network externalities as specific to a focal firm
in question. It highlights the fact that investing
firms derive levels of network externalities that
vary according to firm boundaries, nationality, and
industry affiliation. This new perspective on net-
work externalities as firm specific generates several
implications for further research.
First, we empirically confirmed that the compo-
sition of a network influences what network exter-
nalities exist. The types of firms that constituted a
regional network were heterogeneous and created
varying degrees of network externalities. We found
that network externalities were stronger among
firms in the same business group, among firms
of the same nationalities, and among firms in the
same industries.
Second, while prior work portrayed network
externalities as monotonic, we found they were
curvilinear, especially when we defined network
externalities as firm specific and classified the
types of firms constituting a regional network more
precisely. We argued that negative network exter-
nalities occur when firms have spillovers of their
own technology or knowledge, when there is inten-
sified competition in factor markets, and when the
potential for groupthink exists, and that these costs
outweighed any positive network externalities after
a certain level. It is interesting to note that agglom-
eration of firms of the same type is subject to a
curvilinear relationship, suggesting that agglom-
eration of the same type of firms is not benefi-
cial beyond a certain point. On the other hand,
agglomeration of other foreign firms in the same
industry shows a monotonically increasing pattern.
This finding is consistent with Porter and Stern’s
(2001) argument that agglomeration of firms with
diverse backgrounds facilitates innovation.
Third, this study found that a firm’s own prior
entry, as well as entries by firms associated with
Strat. Mgmt. J., 26: 595–615 (2005)
 Types of Firms Generating Network Externalities
the same business groups, created the greatest net-
work externalities. The impact of a firm’s own
prior entry or entries by firms in the same busi-
ness groups, gauged by average elasticity, was 470
times higher than that of an unrelated firm’s entry
(i.e., 46.7–47.7% vs. 0.1%). This result suggests
that experience-based knowledge is best trans-
ferred or spilled over within the boundaries of a
firm, confirming that it is difficult to transfer tacit
knowledge across firm boundaries (Kogut and Zan-
der, 1992; Szulanski, 1996). The results may also
indicate that firms imitate other firms in the same
business group to gain legitimacy or reduce uncer-
tainty. This study therefore provides a rationale
for the regional patterns of agglomeration by busi-
ness groups that have been observed for Japanese
vertical keiretsu in the United States (Head et al.,
1995). This study also reconfirms the findings of
Chung and Song (2004) that agglomeration occurs
more within firms than between firms.
Fourth, it advances our understanding of network
externalities by integrating literature from orga-
nizational theory and economics. Our hypotheses
reflected economists’ arguments that agglomera-
tion occurs because of phenomena like knowledge
spillovers and the sharing of various infrastructures
(Marshall, 1920; Krugman, 1991). Our hypothe-
ses were also consistent with organizational the-
ory, namely in arguing that network externali-
ties occurred because firms wished to gain legit-
imacy and reduce uncertainty through imitation
(DiMaggio and Powell, 1983; Levitt and March,
1988; Guillen, 2002; Henisz and Delios, 2001). We
argued that the curvilinear relationship between the
number of firms and the likelihood of co-location
would be more apparent when agglomeration was
motivated by a desire to gain legitimacy rather
than by real economic gains. In demonstrating this
relationship, our study improves understanding of
co-location.
This study has several limitations. First, we
could not empirically distinguish economic rea-
sons for agglomeration from reasons proposed by
organizational theorists, such as uncertainty avoid-
ance and legitimacy. Researchers should develop
measures that can empirically distinguish these two
sets of reasons other than simple count-based mea-
sures. Second, it is possible that the results of this
study may reflect idiosyncrasies of Korean firms.
Korea is closely located to China, and Koreans
use Chinese characters, so it is easier for them to
Copyright  2005 John Wiley & Sons, Ltd.
613
learn Chinese and absorb Chinese culture. Kore-
ans also share some cultural heritage with China.
Korean firms might thus feel more confident about
operating in China relative to firms from other
countries, which may explain why Korean firms
spread into many geographic regions while foreign
firms tended to concentrate in a few locations.
Third, there might be strong network externali-
ties among Korean firms because of ethnocentrism.
Future research should examine whether MNCs
originating in other countries show similar patterns
of strong network externalities with firms of the
same nationalities. Fourth, this study lumped all
other foreign companies into one category. MNCs
from other nations may derive stronger network
externalities from firms of similar culture than they
do from those of dissimilar ones. Disaggregating
the ‘foreign firms’ category into subgroups accord-
ing to cultural similarities may show much stronger
relationships from foreign firms than the ones we
documented. Similarly, this study did not explicitly
consider relatedness/complementarities of indus-
tries. Considering industries at a more disaggre-
gated level and examining relatedness among them
would help capture network externalities more
precisely.
Fifth, this study focused only on the hetero-
geneity of firms that were already in China and
had created network externalities, but it did not
address the heterogeneity of investing firms them-
selves. Shaver and Flyer (2000) and Chung and
Song (2004) argued that investing firms’ hetero-
geneity also affects co-location decisions. Further
studies to assess the effects of such heterogeneity
are warranted.
This study demonstrated that firms tended to co-
locate with others to benefit from network external-
ities. Our results suggest, however, that this gen-
eralization is misleading. Because network exter-
nalities showed curvilinear patterns as we defined
types of firms within the network more narrowly,
above a certain threshold, negative network exter-
nalities could outweigh positive ones. Since a
regional network comprises many types of firms,
managers who make location decisions should bal-
ance between positive and negative network exter-
nalities.
Furthermore, this study showed that some firms
coordinated location decisions to hedge against the
possible negative impacts of agglomeration in a
few locations. LG Group’s strategy to spread the
operations of its individual affiliates over many
Strat. Mgmt. J., 26: 595–615 (2005)
614 S.-J. Chang and S. Park
regions is a good example. Business divisions in
an affiliate may be attracted to the immediate ben-
efits from locating near its own previous invest-
ment. Since most diversified MNCs are organized
into semi-autonomous business divisions that make
their own foreign entry decisions, the hazards of
negative network externalities that come from too
much agglomeration can be substantial. Thus, our
results suggest that managers of MNCs should
develop an overall foreign entry strategy to guard
against the hazard of too much agglomeration in a
few popular locations.
ACKNOWLEDGEMENTS
We thank Jemo Chung, John Lafkas, Panseop Lee,
Chunkyu Park, Hweonjung Park, Jaehyuk Rhee,
seminar participants at National University of Sin-
gapore, New York University, London Business
School, Copenhagen Business School and Norwe-
gian School of Management, and two anonymous
reviewers for helpful comments and suggestions.
Financial support from the Korea Research Foun-
dation (2004-041-B00246) is gratefully acknowl-
edged. Additional support from Korea Univer-
sity Business School through an SK Distinguished
Research Award is also gratefully acknowledged.
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