By introducing the idea of intimacy between geographical proximity and arm’s-length transactions, the framework can explain the simultaneous development of the firm-level fragmentation of production processes and the industry-level formation of agglomeration. Arm’s length transactions are accompanied with extra transaction costs, compared with intrafirm transactions, which are here interpreted as service link costs in the disintegration-type fragmentation. Such costs may be particularly high when a firm does not perfectly trust its counterpart. Short distance helps such transactions by cutting down the cost of identifying and monitoring business partners as well as the cost of trouble-shooting. Such forces in turn formulate industrial agglomeration in East Asia. At such a sophisticated stage of development of the formation of production networks, SMEs play a crucial role. SMEs are essential components of production networks with arm’s length fragmentation in various forms including subcontracting arrangements and OEM contracts.
SMEs are also essential
components of industrial agglomeration. In this context, not only multinational SMEs but also local SMEs can be important participants in vertical arm’s length division of labor. In ASEAN and surrounding East Asia, international trade in parts and components has explosively been expanded, and the international division of labor in terms of production processes has developed to an unprecedented degree. At the same time, economic agglomeration or industrial clusters have grown in several notable places where dense vertical supply chains are formulated. The fragmentation of production processes and the formation of economic agglomeration, however, are rather new phenomena starting from the late 1980s or the early 1990s. To understand the mechanism of agglomeration and fragmentation, the new economic geography and the fragmentation theory, are extremely useful. New economic geography explains the formation of economic agglomeration in geographical space. The spatial structure of economic activities is considered to be the outcome of a process involving two opposing types of forces, that is, agglomeration forces and dispersion forces. The theoretical formulation analyzes the balance of these two opposing forces that generate a variety of location patterns of economic activities. A key property of agglomeration forces resides circular causality of economic activities. For example, an automobile assembler would attract a number of upstream suppliers, and then the resulted productivity enhancement and market expansion might in turn attract another assembler. Such circular causality would generate a sort of economies of scale in a geographical sense.
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