This article investigates the catalyst effect of industrial cluster formation on innovation propensity using as a basis small and medium enterprises (SMEs) located in two regions of transformation and structural change: Brandenburg in Eastern Germany (the former German Democratic Republic) and Lubuskie in Poland. Based upon Porter's (1990a) Diamond of Competitive Advantage of Regions, which is empirically applied in an explorative manner, this article aims to develop a better understanding of the necessity for interaction between enterprises and policy makers and looks at the rationale of establishing industrial and service clusters as the motor for sustained regional development.