Aspiring to Be the Next Silicon Valley? Think Twice

By Roberta Kwok

Policymakers often aspire to transform their regions into “the next Silicon Valley.” After all, the Bay Area boasts thriving businesses, a deep talent pool, and plenty of venture capital funding. But this economic success has brought other challenges, such as skyrocketing real estate prices and higher operating costs for firms.

“Is Silicon Valley really what we want to emulate?” asks Olav Sorenson, the Frederick Frank ’54 and Mary C. Tanner Professor of Management at Yale SOM. “Are there pieces of it that are attractive, but also downsides?”

In a new study, Sorenson and Doris Kwon, a PhD student at Yale SOM, analyzed the pros and cons of a Silicon Valley-like boom on other industries. The researchers found that when venture capital poured into a metropolitan area, some businesses did appear to benefit. Local services such as medical care and restaurants fared better, presumably because more wealthy customers were around. But companies that provided “tradable” goods and services—those primarily sold to customers outside the region—suffered.

And even among local establishments, the benefits weren’t equally distributed. Wages for workers at high-end firms increased, but those at low-end companies declined.

“There needs to be some caution in thinking that Silicon Valley is the model,” Sorenson says. While a high-growth sector can generate a lot of value, “it’s important to have a stronger safety net. Because without that, you’re likely to increase inequality.”

Read the study: “The Silicon Valley Syndrome”

Silicon Valley today echoes a situation in the Netherlands in the 1960s. When natural gas was discovered in the North Sea, petroleum exports boomed. The value of Dutch currency increased, effectively raising the prices of products exported by manufacturing firms and making it harder for them to compete with companies in other countries. In addition, the manufacturing firms’ operating costs rose, and they lost workers to the natural gas extraction industry. The economy was left more vulnerable overall—a phenomenon called the “Dutch Disease.”

Similarly, a small group of companies in Silicon Valley is generating huge amounts of value. While the Bay Area doesn’t have its own currency, local costs such as real estate prices are rising, which increases the salaries that companies must pay. And other industries are losing employees to tech firms. “A lot of talent that used to go to other places is getting sucked into a handful of businesses,” Sorenson says.

To investigate this phenomenon, Sorenson and Kwon examined economic data from 359 U.S. metropolitan areas from 2003 to 2012. The researchers wanted to find out how venture capital infusions affected both non-tradable and tradable industries.

Non-tradable industries are those in which the customer lives in the same area where the good or service is produced—for example, restaurants, hair salons, clothing stores, and medical centers. In contrast, tradable industries can serve customers remotely. For instance, the cars assembled at an auto manufacturing plant could be sold nationwide, or an auditing firm could provide services to customers in other cities.

Sorenson suspected that tradable industries might suffer because their higher operating expenses placed them at a disadvantage compared to competitors in lower-cost areas. But non-tradable industries might thrive because “now you have bunch of high-income individuals who have more money to spend,” he says.

The data bore out those predictions. When the amount of VC funding in a metropolitan area doubled, the number of establishments, number of jobs, and average weekly income in the non-tradable sector increased by 1.6%, 1.7%, and 1.1%, respectively. But in tradable industries, those figures declined by 1.4%, 1.7%, and 0.7%.

“There does seem to be some crowding out in terms of venture capital leading to a reduction overall in the traded sector,” Sorenson says.

Next, the team wondered how benefits were distributed in the non-tradable sector. Did high- and low-wage employees get similar boosts in income?

To find out, the researchers divided companies into four income tiers. Higher-paying firms included medical centers and banks, while lower-paying ones included casual restaurants and convenience stores. They found that “almost all the benefits in terms of increased wages are going to the high end,” Sorenson says. When VC funding in an area doubled, average wages in the top tier increased by 2%, while those in the bottom tier decreased by about 1%.

That doesn’t mean that an influx of tech money causes an individual restaurant worker to have their income cut by 1%. But it may be that skilled workers who are able to leave lower-end companies for other jobs do so, Sorenson says. Those who remain tend to be less educated, on average, and thus command lower salaries. Those workers are “stuck at low wage, in a region where everyone else gets paid more,” he says.

The study isn’t a condemnation of the tech industry. “I’m not saying we don’t want tech or don’t want VC,” Sorenson says. But he recommends that policymakers work to protect people who are likely to be hurt by the boom—for instance, by raising the minimum wage or building more housing.

“If we don’t plan for that, it can create a great deal of inequality at the same time that it’s creating wealth,” he says.