Localization of knowledge flows has been extensively examined in the literature on innovation. However, almost all previous research has focused on technological knowledge. This study examines why knowledge of demand can also be tacit and localized. We provide a detailed empirical study of the global pharmaceutical industry and find not only that demand is as important as technological knowledge in determining the pattern of innovation in this industry but also that innovation is a locally determined phenomenon. These findings contribute to research regarding determinants of innovations and provide an explanation for geographic patterns of innovation that is distinct from technological knowledge spillovers. Copyright © 2011 John Wiley & Sons, Ltd.