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Scale and Scope Externalities in Growth of IT Industries in India: An Agglomeration Perspective

Robert J. Kauffman Director, MIS Research Center and Professor of Information and Decision Sciences

rkauffman@csom.umn.edu

Ajay Kumar Doctoral Program

akumar2@csom.umn.edu

MIS Research Center, Carlson School of Management, University of Minnesota Minneapolis, MN 55455

Last revised: January 17, 2007

______________________________________________________________________________________

Abstract Externalities occur among agglomerated firms. Scale externalities occur between firms in an

industry with similar activities. Scope externalities occur when heterogeneous activities are placed in proximity. Combined scale-and-scope externalities exist when the scale of one industry is beneficial to the growth of another collocated industry. We use the agglomeration perspective to explain the growth of IT industries in India. We study growth patterns of four IT industries: computer and peripheral equipment manufacturing, semiconductor and other electronic components manufacturing, software and IT-enabled services. Our analysis suggests the existence of scale, scope and combined scale-and-scope externalities in IT industry growth. We also find that the growth of IT industries has had a significant positive effect on national development.

Keywords: Agglomeration, collocation, economic analysis, scale/scope economies, India, IT industry, knowledge spillovers. __________________________________________________________________________________

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1. INTRODUCTION

Information technology (IT) is viewed as a fast-growing strategic sector with capabilities to

transform a developing country into a modernized global economy ([Hanna, 1994). The literature has

mostly focused on the use of IT for development, but India presents an example where production of

ITs has driven the economic development of the country. The growth of the IT industries in India has

been the subject of active research and scholars often tend to associate it with the engineering

education in India. We look at growth through the lens of agglomeration and provide a new

perspective on IT industrial growth. We highlight the effects of agglomeration and identify growth

patterns in IT industries, which suggest beneficial effects of collocation. Further, using the framework

proposed by Sein and Harindranath (2004), we relate the growth in IT industries to second and third-

order effects on national development. Second-order effects arise from increased scale of production,

while the third-order effects emerge from new technology-related businesses and societal change due

to IT industrial growth. Our results have policy implications for countries intending to use IT

industrial growth as an engine for broader development.

IT industrial growth, the world over, has been characterized by the agglomeration of a

heterogeneous mix of IT industries (e.g., semiconductors, computer hardware, software, IT services

and others). Silicon Valley, Route 128 in Massachusetts, and Austin, Texas in the U.S., Kista Park in

Finland, Stockholm in Sweden, Taiwan, Singapore are examples of such clusters. In India, the growth

of IT industries has been clustered around cities (e.g., Bangalore, Hyderabad, Mumbai, Delhi and

others) and each city has a heterogeneous mix of IT industries. This raises a question: Why do

information-intensive industries, including software and data processing, which do most of their

business over networks, cluster (Cairncross, 2001; Clemons et al., 1993) ? This points to positive

externalities between collocated industries.

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Externalities occur among firms located in close proximity (Henderson, 1986; Marshall, 1920).

Externalities may occur within or across industries, leading to endogenous growth (Aghion and

Howitt, 1997). Marshall, Arrow and Romer posit that externalities occur within industries as MAR

externalities (Arrow, 1962; Marshall, 1920; Romer, 1987). They suggest regional specialization as a

source of agglomeration. Jacobs (1969) says externalities occur between industries as Jacobs

externalities (Glaeser et al., 1992). MAR externalities represent economies of scale: specializing in

one activity has advantages. Jacobs externalities come from economies of scope: it pays to have

diversity and variety (Harhoff, 1999). Audretsch (1995) showed that an industry’s grow th is linked to

underlying technological conditions. Growth rates incorporate the externality effects of innovation

and can be used to study the externality effects of local industry (Glaeser et al., 1992; Feldman,

1999).

Scope externalities have been examined in the context of urbanization and overall diversity. For

instance, Glaeser et al. (1992) and Henderson et al. (1995) estimate scope externalities for city

industries in terms of variety of industries in the city. Kauffman and Kumar (2006) study the nature

and existence of externalities across collocated IT industries in the United States: computer and

peripheral equipment manufacturing, semiconductors manufacturing, software and data processing

and find existence of both scale and scope externalities. They also find that these externalities are

different for different industries. They also discuss existence of combined scale-and-scope

externalities between collocated IT industries, where the scale of one IT industry influences the

growth of another. This effect is different from Jacobs scope externalities which arise due to the

diversity of collocated industries. Instead, combined scale-and-scope effects refer to the impact of one

industry on another, regardless of the presence of other collocated industries.

We examine externalities between collocated IT industries in India and how they explain industry

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growth. Does collocation of different IT industries influence growth? What roles do scale, scope and

combined scale-and-scope externalities play? We study four IT industries: computer and peripheral

equipment manufacturing, semiconductor and other electronic components manufacturing, software,

and IT-enabled services (ITES). ITES includes computer processing and data services, from entry to

processing of reports from data provided by clients, call centers, transcription services, process

outsourcing etc.

In §2, we provide an overview of our theoretical perspective and prior research. In §3, we analyze

growth of IT industries in India and relate it to our agglomeration perspective. In §4 we look at

different explanations for the results and why there are contradictions. §5 concludes.

2. THEORY: IT FIRM COLLOCATION

2.1. Evolution of IT Industry Structure

The computer manufacturing industry underwent a change from the vertical industry structure of

the 1970s and 1980s to a horizontal industry structure in the 1990s. The vertically integrated structure

saw players like IBM and Digital Equipment Corporation dominating the international market. These

computer firms provided the whole spectrum of computing services. In India also, prior to the

economic reforms, the IT industry was largely vertically integrated. The initial computer

manufacturers in the public sector, Electronics Corporation of India Ltd. (ECIL), and Computer

Maintenance Corporation (CMC), were vertically integrated. But this gave way to horizontal structure

with specialized industries for computer manufacturing, software development and services, IT-

enabled services etc. Today, most companies operate in one of these layers (Breshnahan, 1998). Each

of these is now recognized as a distinct industry, having distinct processes and involving use of

different knowledge. The historical evolution of these industries from one vertically-integrated

industry suggests innovation and growth synergies between them.

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2.2. Location Proximity and Externalities

Ellison and Glaeser (1997) compare the degree of geographic concentration across industries in the

U.S. and found that almost all, including electronics, have been somewhat localized. Lall et al. (2003)

find similar results for eight different industries in India. Prior research has also supported the

existence of scale externalities (Arthur, 1989; Beardsell and Henderson, 1999; Henderson et al., 1995)

as well as scope externalities (Glaeser et al., 1992; Henderson et al., 1995; McDougall, 2005) as

different means to understand industry growth.

Studies and real-world observations suggest the presence of economies of scale (or MAR

externalities) in IT industries. The dominant players within each are indicative of scale-size effects:

Intel, AMD and Motorola within semiconductors; Compaq, Dell and IBM in computer

manufacturing; and Microsoft and Apple in operating systems. Similar domination is visible in the

Indian IT industry. In 2003, the top five software firms in India accounted for 32% of industry

revenues (Khanna and Palepu, 2004). Arthur (1989) also found evidence for agglomeration effects in

the computer chip industry. Rosenkopf and Almeida (2003) demonstrated the localization of

knowledge in semiconductors. Beardsell and Henderson (1999) reported on significant own-industry

externalities for single-plant firms but also found that corporate plants for computers are more self-

reliant and less influenced by externalities.

Scope economies (Jacobs externalities) may influence IT industry growth too. Glaeser et al. (1992)

compared six two-digit industries in the U.S. and found that diversity helps employment growth.

Chen (2002), who studied city-industry externalities in Taiwan, reported similar results. Van Oort

and Atzema (2004) looked at factors that determined new IT firm formation in the Holland and found

significant heterogeneity for localized firm formation.

These studies show that externalities vary across industries. Some show greater benefits, others

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less. Different IT industries use different kinds of knowledge for their processes and innovations,

differ on product characteristics, and cater to different customers. So IT industries should experience

different externalities. This suggests that collocated IT industries experience scale (scope)

externalities between their firms which facilitate their growth. Also the extent of scale (scope)

externalities for different IT industries is different.

2.3. Combined Scale-and-Scope Externalities between IT Industries

To recognize the scale-and-scope externalities between different IT industries, recall the vertical

disintegration of computer manufacturing industry into computer manufacturing, semiconductors

manufacturing, software and IT-enabled services, w ith each of these industries becom ing a ―general

specialty‖ (Breshnahan and Gambardella, 1998). Even though the IT industries are now specialized,

they continue to have linkages. The semiconductor industry continues to have backward linkages and

forward linkages with computer and peripheral equipment manufacturing, and the software industry.

Innovation in the semiconductor industry led to exponential growth in the memory capacities of

chips. This had a direct impact on the number of lines of code which a chip could contain. With

increased semiconductor capacities, the software complexity and performance abilities increased

(Schaller, 1997). Innovation in semiconductors also made computers more powerful, able to process

more information faster. Edquist (2005) associated increases in labor productivity in semiconductors

and microprocessors to growth in the radio, television and communication equipment industry in

Sweden.

Overall, the semiconductor industry has become more vertically-specialized between design and

marketing firms, and their manufacturing counterparts. This vertical separation led many firms to

specialize in design of integrated circuits used in fabrication of semiconductors and other electronic

components (Macher et al., 2002). Chip design has become increasingly similar to software design

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(DeMicheli and Gupta, 1997). Hardware circuits are described using modeling or programming

languages, and they are validated and implemented by executing software programs, which are

som etim es conceived for the specific circuit design. T he integrated circuits represent ―systems on

silicon‖ w hich exhibit a sizable am ount of em bedded softw are, and provide flexibility for product

evolution and differentiation. Thus the design of semiconductors requires designers to be

knowledgeable in the hardware and software domains to make good design tradeoffs. These synergies

also suggest externalities between these industries.

Marshall (1920) posited three sources of externalities between collocated firms: shared inputs,

labor pooling and knowledge spillovers. Adoption behavior is affected by industry features (Forman

et al., 2005). Externalities flows are also affected by industry features like trade, human resource

profile etc. Knowledge spillovers take place through trade (Almeida and Kogut, 1999; Autant-

Barnard, 2001; Feldman, 1999), and since semiconductors are inputs to computer and peripheral

equipment, the trade between semiconductor manufacturers and computer and peripheral equipment

manufacturers provides opportunities for knowledge spillovers. Besides, spillovers also take place

through movement of employees, especially engineers and scientists (Almeida and Kogut, 1999;

Autant-Barnard, 2001; Zucker and Darby, 1996). Engineers and scientists are among the most mobile

segments of the workforce (Angel, 1989; Mincer, 1978). Mobility of engineers and scientists

between these industries results in externalities through labor pooling and knowledge spillovers.

The underlying rationale for combined scale-and-scope effects from one IT industry to another is

that these industries have evolved from a single vertically-integrated industry and have synergies with

each other. This influence is heightened when the assets are collocated and experience local

externalities.

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The combined scale-and-scope effects are shown as in Figure 1 (See Figure 1). Kauffman and

Kumar (2006) empirically show combined scale-and-scope effects between the computer and

peripheral equipment manufacturing and semiconductor manufacturing industries in the U.S. They

also find evidence for beneficial effect of software industry on semiconductor manufacturing and data

processing.

2.4 Role of IT industries in National Development

Many developing countries recognize the potential of IT industries in national development and

have therefore focused on their promotion (Kraemer and Dedrick, 2001; Sein and Harindranath,

2004). The strategic importance of IT producing sector extends to the developed world also

(Haltiwanger and Jarmin, 2000). DeVol (1999) posits that in similar metropolitan areas in the U.S.,

growth in the high-tech industry explains nearly 70% of the variation in relative economic growth.

Fig. 1. Combined Scale-and-Scope Effects in IT Cluster Growth

Sein and Harindranath (2004) propose a three-tier framework to understand the role of IT in

national development. The first-order or primary effect relates to new technology replacing the old.

The second-order or secondary effect refers to the intensification of the phenomenon affected by the

Scope effect

Combined Scale-and-scope effect

Scale effect

Scale of relevant IT industry

Scale of beneficiary IT industry

Scope (diversity) of other

industries

Beneficiary IT industry

Beneficiary IT industries include: Computer and peripheral equipment

manufacturing Semiconductors and other electronic

components manufacturing Software publishing Data processing

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technology. The third-order or tertiary effect arises when the technology leads to some new

technology-related businesses and structural changes in the society. In the context of production of

ITs, the first- order effect relates to production of IT goods and services. This effect is first-order

because at this stage the IT industries act as a substitute for capital and labor used by other industrial

sectors and thereby substitutes old technology with new technology products. The second-order

effects arise when the IT industries grow faster than other industrial sectors increasing the size of IT

production in the total economic kitty of a country. The third-order effects arise when growth in IT

industries results in emergence and growth of other industries, improvements in employment and

quality of life, etc.

A link of the scale, scope and scale-and-scope externalities with the second and third-order effects

of IT industries on development may suggest that both scale externalities and scope externalities

result in increases in size of the reference industry and therefore have second-order effect. On the

other hand, scale-and-scope externalities which induce the growth of another industry have the third-

order effect.

In this section we provided a theoretical basis for the existence of externalities between collocated

industries and briefly described the Sein and Harindranath (2004) framework for relating the growth

of IT industries to national development. We next discuss the growth of IT industries in India to

examine the role of externalities.

3. EXTERNALITIES IN IT GROWTH

3.1 Growth of IT Industries in India

India witnessed remarkable growth in its IT sector in the last two decades. The common belief is

that India’s IT industry focused on exports, but we note that the industry has seen high growth in the

domestic sector. (See Table 1.) We next provide a historical perspective of the sector, since the recent

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growth is related to the past events.

Table 1. The Growth of the IT Industry in India

YEAR

(19XX,

20XX)

ITES

TOTAL

ITES EX-

PORTS

ITES

DOM-

ESTIC

SW

TOTAL

SW EX-

PORTS

SW

DOM-ESTIC

HW

DOM-

ESTIC

96-97 NA NA NA 1.9 1.1 0.8 NA 97-98 5.0 NA NA 2.9 1.8 1.1 NA 98-99 6.0 NA NA 4.0 2.6 1.4 NA 99-00 8.4 4.0 4.4 5.3 3.4 1.9 2.4 00-01 12.4 6.2 6.2 7.8 5.3 2.5 3.4 01-02 13.7 7.6 6.1 8.7 6.2 2.5 3.2 02-03 16.1 9.9 6.3 9.9 7.1 2.8 3.6 03-04 21.5 13.3 8.2 12.8 9.2 3.6 4.8 04-05 28.2 17.9 10.3 16.5 12.2 4.3 6.0 Source: NASSCOM. All figures in US$ billions. NA= not available

Historical Perspective. Prior to 1985, India’s IT sector was highly regulated. Institutional factors

(e.g., compulsory licensing, tariffs, purchase preferences, and public sector-led manufacturing

strategies) marked the industry. State-level electronic development corporations were set up and

incentives were instituted for lagging districts to achieve dispersed regional growth in the sector. To

create greater employment, the government reserved 50% of the manufacturing capacity for small-

scale enterprises. The 1969 Monopolies and Restrictive Trade Practices Act specified firm size

ceilings. This prevented firms from achieving scale economies. Apart from the public sector, only a

few international (IBM, DEC, Honeywell and ICL) and domestic companies (NELCO, Hinditron and

Tata Infotech) existed in the private sector. They were in computer and other electronic hardware

assembly. In 1977, the 1973 Foreign Exchange Regulation Act was implemented, forbidding foreign

firms from holding more than 40% equity. This led to IB M ’s exit from India (Das, 2004). However,

the restrictive policies of India’s government started to ease in 1984 and 1985. The IT sector

gradually opened, leading to freer and faster growth.

IT industry growth has concentrated around city centers (Heeks, 1996). Haug (1991) says that

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availability of good IT infrastructure, manpower and quality of life are important reasons for

clustering. One government initiative taken in the post-reform period also contributed to the

formation of clusters. This was the setting up of ―IT parks.‖ Initially these parks were set up by a

government agency, Software Technology Parks (India) Ltd. They provided necessary infrastructure

facilities for the IT industries which became immensely successful. Their success prompted several

state governments and private firms to set up similar parks. The IT park model has contributed to the

formation of IT industry clusters in India. Apart from firms located inside the parks, surrounding

areas also were location targets for a number of firms. The Indian cities which first emerged as hosts

to clusters of IT industries had their IT park facilities set up early in the post-reform period.

Another significant explanation for regional IT industry concentration is path dependence.

Clustering is most prominent in cities which had IT industries in the pre-reform era. The main public

and private sector units in the mid-1980s, indicated in Tables 2 and 3 show the domination of cities

such as Bangalore, Mumbai, Hyderabad and Delhi. Bangalore had major public sector units,

including Bharat Electronics Ltd. (BEL), Indian Telephone Industries Ltd. (ITI), Hindustan

Aeronautics Ltd. (HAL), the Indian Space Research Organization (ISRO), the National Center for

Software Technology (NCST) and private sector units, such as Texas Instruments (TI), Wipro, PSI

Data Systems, DEC, HP, etc. Mumbai had more private sector units, with various Tata companies

(later merged to form Tata Consultancy Services, TCS), Citicorp Overseas Solutions, Hinditron, Patni

Computer Systems, Datamatics, and Burroughs. Hyderabad had two major public sector units, ECIL

and CMC, and a few private sector units like Satyam. The National Capital Region of Delhi had

public sector units, with BEL, CMC, National Informatics Center (NIC), Telecommunication

Consultants of India Ltd. (TCIL), Center for Development of Telematics (C-DOT) and private sector

units Hindustan Computer Ltd. (HCL), DCM-Data Products, etc. Heeks (1996) says proximity to a

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prior employer and residence are important reasons for intense software industry clustering in these

cities. From the agglomeration perspective, the presence of these companies provided scale benefits

for subsequent growth of industry around these centers. Scale effects in the growth of IT industries in

India seem to present overall.

3.2 Scale and Scope Effects for Indian IT Industries

Removal of restrictions led to growth. The late 1980s saw growth in computer manufacturing in

India while the PC market witnessed price wars and new product launches.

Table 2. Public IT Sector Units in India, 1980s

PUBLIC SECTOR YEAR LOCATIONS ACTIVITIES Indian Telephone Industries Ltd. (ITI) 1950 Bangalore Manufacture telecom

equipment NA Other Bharat Electronics Ltd. (BEL) 1954 Bangalore Design, develop,

manufacture sophisticated electronic components

1974 Ghaziabad 1979 Pune 1986 Hyderabad

Hindustan Aeronautics Ltd. (HAL) 1964 Bangalore Design, develop, mfg., repair aircraft Electronics Corp. of India Ltd. (ECIL) 1967 Hyderabad Design, develop, mfg. computer, control, comm. sys.

Indian Space Research Org. (ISRO) 1972 Bangalore Develop satellites, launch vehicles, etc. 1972 Other

Processor System India Pvt. Ltd. 1973 Bangalore Technology R&D Central Electronics Ltd. (CEL) 1974 Ghaziabad (NCR) Manufacture solar

cells/modules Computer Maintenance Corp (CMC) 1975 Hyderabad Maintain IBM, foreign computers NA Delhi

Natl. Ctr. for Software Technology 1975 Bangalore Software development Natl. Informatics Center 1977 Delhi and state capitals Network, software

solution support Telecomm Consultants India (TCIL) 1978 Delhi Telecomm consulting, engineering Semiconductor Complex Ltd. (SCL) 1983 Chandigarh Design, mfg. VLSI systems, subsystems Center for Development of Telematics

(C-DOT) 1984 Delhi Design, develop

telecom products, services

NA Bangalore, Kolkata Videsh Sanchar Nigam Ltd. (VSNL) 1986 Mumbai International telecom

services Ctr. for Development of Advanced Computing (C-DAC)

1988 Pune Design, develop, deploy advanced IT solution

NA Bangalore, Noida, Delhi, Chennai, Chandigarh, Hy-derabad, Kolkata, Trivandrum

Source: Company, government and other Web sites; NASSCOM and other publications. NA = not available

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The semiconductor industry did not grow though and most semiconductors and other electronic

components were imported. The software industry also started to grow with many product launches,

some of which (like Tally for accounting software) survive.

The 1986 Rangarajan Committee Report, which recommended computerization of the banking

industry on UNIX systems, provided further impetus for the growth of computer manufacturing and

software (Dataquest, 2002b). However, in this initial period of growth, the impacts of IT industries

were typically second-order, which resulted in increased scale of production of IT industries in India

(Sein and Harindranath, 2004). T he early years’ policy to protect the com puter m anufacturing

industry had a serendipitously beneficial effect for growth. It forced Indian computer manufacturing

firms to shift focus from mainframes, which were technologically challenging to manufacture, to

producing PCs. This led to a generation of software engineers with great experience in programming

PCs, on operating systems like MS-DOS and UNIX, an operating system for non-IBM-compatible PC

with Intel and Motorola chips. The computerization of the banking industry was also based on

UNIX-based systems. Three Indian companies, HCL and DCM Data Products in Delhi and Wipro

Information Technologies Ltd. in Bangalore perhaps became first in the world to build 386 systems

on UNIX. When the computer policy was liberalized post-1984, learning in the domestic industry

provided a competitive edge for Indian software engineers (Heeks, 1996, pp. 214-6]. At that time,

mainframes also gave way to PC technology, supporting the growth of the global software industry.

Engineers in computer manufacturing could easily adapt to the requirements which the export-driven

software service industry would put on them. This reflects the scale-and-scope effects between the

computer manufacturing and software industry early in the post-reform period.

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Table 3. Private IT Sector Units in India, 1980s

PRIVATE SECTOR YEAR LOCATION ACTIVITIES Nelco (Tata Group) 1940 Mumbai Electronic hardware Hinditron Computers 1966 Mumbai Computer hardware Tata Consultancy 1968 Mumbai PSI Data Systems Pvt. Ltd. (Aditya Birla Gr.)

1976 Bangalore Computer hardware

Tata Infotech Ltd. 1977 Mumbai Harware, integration DCM Data Products 1972 Delhi IT services Datamatics 1975 Mumbai Software solutions Hindustan Comp Ltd 1976 Delhi Computer mfg. Tata Burroughs Ltd 1978 Mumbai Computer hardware Patni Comp Sys Ltd 1978 Mumbai IT services, solutions Systime 1979 Mumbai ITES Wipro Systems Ltd 1980 Bangalore IT, software services Infosys Tech Ltd 1981 Bangalore Software, solutions NIIT Ltd 1981 Delhi,

Mumbai, Chennai

IT education, training

Adv Micro Dev Ltd 1982 Bangalore Software, health IT Citicorp Overseas Software Ltd.

1985 Mumbai Software exports

Texas Instruments Ltd. (TI)

1985 Bangalore Semiconductor, elect. components R&D

Peutronics 1986 Bangalore Software ICIM (Intl Comp) NA Pune Computer mfg. DEC India Ltd NA Bangalore IT services Honeywell CII NA Bangalore Computer mfg. Satyam Comp. Serv 1987 Hyderabad ITES Mahindra British Telecom 1988 Pune Develop software Hewlett-Packard India Software Op Pvt Ltd

1989 Bangalore Software solutions

Tata Elexi Ltd 1989 Bangalore Software solutions Source: Company, gov’t and other Web sites, NASSCOM and other publications and studies. NA = not available

U.S. demand for programmers began to spill over to India in the late 1980s and this led to the spurt

in the growth of the software industry. The export-oriented software industry was initially for low-end

software services. This phase is identified w ith ―body-shopping‖ (Desai, 2003). Body-shopping is

positioning a programmer or other software personnel on the site of the customer for their software

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needs. But an externality of a different form would help the industry to leapfrog to the next level of

delivery. Texas Instruments (TI) set up a development center in Bangalore in 1985 and a satellite link

to headquarters in Dallas, Texas. TI was the first private company to be permitted international

connectivity, which was then the monopoly of the government, operated by Videsh Sanchar Nigam

Ltd. (VSNL). Since TI did not need it, it sold bandwidth to local industry. This revealed the benefits

that connectivity could bring. In 1989, VSNL commissioned a high-bandwidth link to the U.S.

(Dataquest, 2002b). Then in 1993, the first earth stations were commissioned for Bangalore and

Hyderabad. A s India’s connectivity improved in the early 1990s, software services could be provided

from India itself, without foreign personnel having to physically go there. This led to large-scale

growth in software services. It also marks the evolution of IT industries in India, where their scale

grew to a level where it impacted complementary sectors of economy (e.g., telecom and HR

development, etc.). This represents the third-order impacts of IT industries on development (Sein and

Harindranath, 2004). The connectivity also opened up opportunities for data processing and the ITES

industry. ITES grew in India as the software service industry showed that services could be provided

from offshore locations. The ability of ITES to grow from software was partially because the software

industry in India, unlike that in Israel, was developed around software services and not around

software products (Athreye, 2005). ITES growth from the software industry points to scale-and-scope

effects between these industries.

Huge export demand for software services and ITES led many companies (e.g., Wipro, PSI Data

systems, HCL) previously in computer manufacturing to diversify into software services and ITES.

Digital Equipment India Ltd., a subsidiary of Digital Equipment Corporation, also switched to

developing software for its own systems. This diversification from hardware to software and ITES

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shows the scale-and-scope effects between computer and peripheral equipment manufacturing, and

the software and ITES industries.

Growth of the ITES industry also led to entry by smaller players into the industry. In the 1990s,

some smaller Indian firms in Bangalore and other IT cluster cities tried to start in the software

industry through data entry and transcribing activities (Latheef, 1997). With passage of time, foreign

software vendors, including IBM, Microsoft, Oracle, and SAP, moved from using units in India to

crank out code to helping to design and develop commercial software (McDougall, 2005; Zhao,

2006). The software industry climbed the value chain, and part of this was aided by the presence of

scale economies in the ITES industry, another reflection of scale-and-scope effects between ITES and

software industries.

A more recent trend has been the growth of the semiconductor and other electronic components

industry, which had been lagging compared to growth of other IT industries. This industry has shown

signs of growth, especially around Bangalore and Hyderabad. Motorola set up a design center in

Bangalore and Hyderabad. Intel India Development Center, set up in Bangalore, has more than 3000

employees, and is in the process of designing new chipsets for small form-factor notebook and low

cost notebook (Indo Asian News Service, 2006). A US$3 billion semiconductor complex by AMD-

SemIndia consortium now is being set up in Hyderabad. We argue that the growth of the

semiconductor and other electronic components industry has been induced by the growth of the

software industry due to synergies between the software industry and the design and planning aspects

of semiconductors (De Micheli and Gupta, 1997). Heeks (1998) recognizes that growth in the

software industry can lead to induced growth in services and hardware industry. The scale-and-scope

effects between different IT industries are examples of the third-order impacts of IT industries on

national development in the framework proposed by Sein and Harindranath (2004).

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3.3 Scale-and-Scope Effects: City-Level Analyses

Having outlined the overall synergies, we next examine how the scale, scope and the combined

scale-and-scope effects translated into industrial growth at the city level. We focus on IT industry

growth patterns in two cities: Bangalore and Hyderabad. These cities themselves are evidence of

economies of scale in IT industries, or else such large-scale IT clusters would not be possible. More

evidence of scale effects is that many foreign companies, which started with small operations in these

IT clusters, have expanded over time. A similar trend is visible for domestic companies as well. Still

we will emphasize how one IT industry has facilitated growth in another IT industry in these cities.

Bangalore. According to a cliché, Bangalore is the ―Silicon Valley of India.‖ In the m id -1980s,

Bangalore was home to several electronic hardware and computer manufacturing firms. (See Tables 2

and 3.) The Bangalore-based public sector firm, BEL, led the development of semiconductor and

electronics hardware technology in the early 1960s and 1970s. More significantly, BEL provided the

first training ground for engineers in IT. BEL’s Bangalore location, thus, had to do with the city’s

eventual success in the IT sector (Dataquest, 2002a). ITI, ISRO, HAL were other major public sector

units, employing thousands and manufacturing electronic hardware. In addition, major private sector

computer and peripheral equipment manufacturers were also located in Bangalore. The pool of

knowledge resources and social capital existing in Bangalore in the mid-1980s helped in the growth

of the software and ITES industries in the 1990s. This reflects a scale-and-scope effect from the pre-

existing hardware and computer and peripheral equipment manufacturing industry to growth of the

software and ITES industries.

Major computer and peripheral equipment manufacturers in Bangalore, including Wipro, PSI Data

Systems, and multinationals, DEC and Honeywell, diversified into the software services and ITES

industries. Motorola, which manufactured electronic components for pagers, diversified into software

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development in its research center in Bangalore (Latheef, 1997). Many top software companies in the

world set up wholly-owned subsidiaries or joint ventures with Indian companies in Bangalore

(including IBM, Oracle, Novell, Fujitsu, NEC, HP and Sun Microsystems). Many other

multinationals (e.g., Siemens, Deutsche Bank, Motorola, Citicorp, and VeriFone) set up software

development centers in Bangalore for their entire systems. CISCO also set up a software solutions

center for enterprise network management products. And Dell set up a development center in

Bangalore for development and management of applications used in its operations. Bangalore also

became headquarters to a large number of Indian software companies. Wipro and Infosys are

specifically notable. By 1995, 56 of the top 200 software companies were located in Bangalore

(NASSCOM, 1995). Likewise, other companies entered the ITES industry. In the ITES industry,

Bangalore specialized in call center, transcription, and back-office operations services. The city also

had a reasonable number of companies in database management, development, data processing,

management and engineering, design, and geographical information system (GIS) services. (See

Table 4.)

Another scale-and-scope effect w itnessed in the grow th of B angalore’s IT industry is the im pact of

the ITES and software industries on computer and peripheral equipment manufacturing. With the

growth of ITES and software in the 1990s, the scale of these industries induced growth in the

com puter and electronics hardw are. T he ―S im puter,‖ a com puter for R s10,000 (~ U S $230) w as

launched by Pico Peta Simputer Pvt. Ltd. and Encore Software Ltd. in 2001. And then PARAM

Padma, a supercomputer with the computing power of one teraflop, was launched in 2003 by CDAC.

In 2003, IBM launched its low-end e-server in Bangalore. The export level from the electronic

hardware industry in the Electronic Hardware Park there is a good indicator for growth in computer

and peripheral equipment. (See Table 5.)

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Table 4. Export of Software and ITES, Bangalore

YEAR # FIRMS EXPORTS US$ MILLIONS

EXPORT GROWTH

1991-92 13 2.17 NA 1992-93 29 7.10 227% 1993-94 53 29.57 316% 1994-95 79 63.76 116% 1995-96 125 136.29 114% 1996-97 163 272.22 100% 1997-98 207 432.57 59% 1998-99 267 752.59 74% 1999-00 782 1010.33 34% 2000-01 928 1598.93 58% 2001-02 1038 2029.30 27% 2002-03 1154 2570.24 27% 2003-04 NA 3975.66(a) NA 2004-05 NA 6366.78(a) NA Source: Department of IT and Biotechnology, Govt. of Karnataka and IndiaInfo.com (May 11, 2005). Exchange rate as of January 1 each year. (a) Includes exports from other cities of Karnataka. NA = not available.

Bangalore has become a design hub in the Asia-Pacific region for Intel and Motorola in

semiconductors and electronic components. In 2001, Intel set up an R&D center with 1,200

employees and expanded to 3,000 employees in 2003. It provides R&D for very large scale

integration (VLSI) and microprocessors, and e-business solutions. The presence of firms like BEL

and TI, which arrived in Bangalore in 1985, also provided scale effects to the growth of this industry.

Also, semiconductor and electronic component design has similarities to software industry activities.

So semiconductor growth in Bangalore can be attributed to scale-and-scope effects from the software

industry’s scale.

Hyderabad. Referred to as ―C yberabad,‖ the IT cluster here traces its history to the base built by

two national-level public sector undertakings, ECIL and CMC. ECIL was the major computer and

peripheral equipment manufacturer in the pre-reform period responsible for government and public

Page | 20

sector installations in the 1970s. ECIL nurtured the best engineering talent in the country when the IT

industry was in its infancy (Dataquest, 2002a). CMC was responsible for maintaining 800-odd IBM

installations when IBM left the country in 1978, and other computers made by foreign suppliers. It

developed expertise on 40 foreign platforms and in hardware and software maintenance (Dataquest,

2002c).

Table 5. E-Hardware Park Exports, Bangalore

YEAR EXPORTS US$ MILLIONS

EXPORT GROWTH

1999-00 45.05 NA 2000-01 78.55 74% 2001-02 173.63 121% 2002-03 292.16 68%

Source: Department of IT and Biotechnology, Government of Karnataka. Based on exchange rate as on January 1 each year.

The growth of IT industries in Hyderabad is similar to Bangalore. Hyderabad witnessed growth in

software services and ITES in the 1990s, after an earth station was commissioned. Satyam Computer

Services Ltd. set up in 1987, and was a forerunner of major IT firms in Hyderabad. Others soon

followed. The city now boasts a software industry with major players, including Satyam Computer

Services, Infosys, Microsoft, Oracle, Wipro, iGate, Deloitte, HSBC, IBM, Baan, TCS, Amazon,

Google, Accenture, Cisco, IBM India Ltd., LG Soft India, Novell, Nokia, and Netscape

Communications. The ITES industry followed software services. Apart from software services, other

companies which set up ITES units include Dell and General Electric. The growth of the software

services and ITES industries in Hyderabad can be inferred from the growth of exports in these

industries. (See Table 6.) As in Bangalore, the software industry in Hyderabad has also shown that it

is climbing up the value chain.

Page | 21

Growth in the R&D and software industries has led to growth of the semiconductor industry in the

city. Motorola was first to expand from Bangalore to Hyderabad. Establishment and growth of a large

number of embedded systems and VLSI design companies occurred in the past two years also (Jafri,

2004). In February 2006, plans for Fab City, a silicon chip facility, were finalized there with a US$3

billion investment by the AMD-SemIndia consortium. Fab City will have multiple units making

silicon wafers, solar power and liquid crystal displays (LCD), and thin film transistor (TFT) chips.

Intel Technologies will partner with others in the Fab City project.

Growth patterns in Hyderabad show scale-and-scope effects like B angalore’s. S uch effects m oved

from the pre-reform computer and peripheral equipment industry to software services initially, in

software services to ITES in the 1990s, and now from software to semiconductor manufacturing.

A lthough our analysis doesn’t provide a basis to generalize from , it supports the idea that one IT

industry’s scale m ay benefit a collocated IT industry.

Table 6. Software & ITES Industry Exports, Hyderabad

YEAR TOTAL SOFTWARE AND ITES EXPORTS

ITES EXPORTS

SOFTWARE EXPORT

2002-03 763.4 293.7 469.7 2003-04 1100.0 513.8 586.2 2004-05 1907.7 NA NA Source: Indiainfo.com, May 11, 2005. All figures in US$ millions. Conversion via January 1 exchange rate. NA = not available

4. DISCUSSION

Porter, stressing the importance of collocation, posits that even as old reasons for clustering (e.g.,

proximity to markets, labor, or capital) have diminished in importance with the growth in

globalization, new influences of clusters on competition have become key in a knowledge-based

Page | 22

economy (Porter, 2000). Tan and Leewongcharoen (2005) also point out the importance of

geographical location in the development of IT industries in developing countries. As an industry

becomes leaner and more flexible, lateral inter-firm relationships take higher policy priority. Our

analysis of the growth of IT industries also points towards benefits of locating in clusters. Similar

growth patterns for IT industries in Bangalore and Hyderabad support existence of agglomeration

externalities.

In India, the software service industry influenced growth of the ITES industry, and both software

and ITES induced growth in semiconductors. The software services industry in India also benefited

from the scale of computer and peripheral equipment manufacturing. The software industry in U.S.

did not show similar results (Kauffman and Kumar, 2006). One reason could be because in India

software services are a dominant component of the industry, whereas in the U.S. software

development is the principal part. Another possible reason is the exogenous effect of outsourcing.

Although outsourcing has caused diminution in software growth in the U.S., it has enhanced the

growth of software industry in India (Dutta and Roy, 2005). In addition, there may be country

specific differences which may account for the differences in knowledge externalities (Appleyard,

1996).

Some scholars question whether knowledge spillovers have relevance to Indian IT industry growth

(D ’C osta, 2002a; 2002b) and argue that growth is totally export-driven. We argue that local

externalities cannot be ignored. Multinational firms are increasingly conducting R&D related

activities in India (Zhao, 2006). Todo and Miyamoto (2006) study the knowledge spillovers due to

foreign direct investment (FDI) to domestic firms in less developed countries and finds that local

R&D by foreign-owned firms in the host country enhances knowledge spillovers from R&D. Bwalya

(2006) shows that there are significant inter-industry knowledge spillovers in Zambia occurring

Page | 23

through linkages due to FDI. Patibandla and Petersen (2000) showed knowledge spillovers between

collocated foreign and Indian firms. Leading software vendors like Adobe. are releasing products in

the U .S w ith labels ―M ade in India‖ indicative of brand value associated w ith such labeling (S axena,

2006). A study by Indian government agency, National Institute of Science, Technology and

Development Studies (NISTADS) shows that between 1990 and 2002, most patents registered in US

from a foreign country were from India— 266. These patents primarily belonged to the

pharmaceutical, electronics and other hi-tech sectors. While more than half of these patents were

owned by foreign companies operating in India, remaining were by Indian organizations (Chauhan,

2006). as Part of these spillovers may be due to weak intellectual property protection and partly due

to labor pooling between different IT industries. Lal (1996) reports that the electronics industry in

India was R&D intensive, indicating that firms attached importance to innovation for growth.

International trade involves competition among nations, so innovation is needed for the Indian IT

industries to grow. By climbing the value chain, the Indian software industry has shown its success

with innovation. So knowledge spillovers in collocated industries are likely to be present.

Additionally, the impact of knowledge spillovers is only one of the reasons for local externalities

(1920) and externalities could arise due to other factors such as input sharing or labor pooling as well.

The study has implications for economic development, especially in developing countries. We

show that collocation of IT industries supports accelerated growth. A policy implication is that

support for the ―IT park‖ model should also encourage proximate collocation. In addition, since there

are scale-and-scope effects between different IT industries, governments should consider placing

electronic hardware IT parks close to software parks.

There are indirect policy implications that result from the second and third-order effects of IT

industry growth on national development (Sein and Harindranath, 2004) . IT industry does not merely

Page | 24

augment GDP. Kraemer and Dedrick (2001) refer to effects of IT industrial growth on

complementary sectors, including manpower, R&D and infrastructure, for eleven Asia-Pacific

countries. In India, we discern evidence of both second and third-order effects of IT industries.

Consider the second-order effects first. The increased-scale export-oriented IT industries brought in

foreign exchange, crucial in 1980s India. The country also experienced third-order effects as growth

in IT industries boosted employment opportunities, which in turn had multiplier effects on overall

economic growth. Another complementary effect was the growth of IT education to cater to the

increase in demand for IT manpower. Growth also led to better telecom infrastructure and overall

infrastructure (roads, housing, etc.) in cities with concentrations of IT industries.

IT industrial growth also has other third-order effects (Sein and Harindranath, 2004). We have

discussed how scale-and-scope effects between different IT industries led to ITES growth in the early

1990s and, more recently, to semiconductor growth. Furthermore, the growth of IT exports facilitated

globalization of the economy, which boosted other sectors (e.g., tourism, financial services and

manufacturing). Venture capital and stock markets became stronger and FDI inflows increased.

Outsourcing had spillover effects on clinical trials and biotech industries. The second and third-order

effects that we have mentioned above are not comprehensive, but corroborative of the growth of IT

industries. They have multi-dimensional effects on the development of a developing country.

Our qualitative analysis of the growth of Indian IT industries shows that combined scale-and-scope

effects have played a role in India’s IT industrial growth. These effects also show some degree of

robustness across two different developmental contexts: India and the U.S., as described in Kauffman

and Kumar (2006). This raises opportunities to explore the reasons why synergies exist between

different industries which result in combined scale-and-scope effects.

5. CONCLUSIONS

Page | 25

Our agglomeration perspective based on scale, scope and combined scale-and-scope externalities,

provides a new understanding of growth patterns for IT industries in India. Previous research has not

provided a suitable lens on this interesting research phenomenon. We report qualitative evidence of

combined scale-and-scope effects in collocated IT industries in India. We find that the ITES industry

gained from the scale effects of software and computer and peripheral equipment manufacturing, and

the semiconductor industry gained from the scale of the software and ITES industries.

Our research also explains how externalities (scale, scope and combined scale-and-scope) lead to

second and third-order effects in national development. This underlines the need for greater focus on

planning and promotion of the IT-producing sector. Scale and scope economies can also have

implications for firm performance (Macher, 2006), so this work provides firms with guidance about

selecting locations for new IT firms. The study also has important implications for the regional

planners and technology research park developers.

The study makes contributions to the IS literature for developing countries (Walsham and Sahay,

2006). Hanna (1994) argues that IT is a strategic sector with capabilities to transform a developing

country into a modernized global economy. Haltiwanger and Jarmin (2000) also say that although e-

commerce and IT-related production is credited with one-third of economic growth, yet the economic

literature offers very little coverage at the macroeconomic level. Kauffman and Walden (2001) also

have argued that there is need for better understanding of IT-related industry growth and

performance. This study addresses this issue.

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Acknowledgments. We benefited from input offered by the co-chairs of the IT and International Development Mini-Track at HICSS 2007, Sajda Qureshi, Maung Sein and Peter Wolcott, several

Page | 30

anonymous reviewers, and participants in our research presentations in Applied Economics and the Carlson School of Management of the University of Minnesota. Rob Kauffman thanks the MIS Research Center at the University of Minnesota, and its Assistant Director, Donna Sarppo, for partial support.