Welfare effects of regional policy in the constructed capital model

DISSERTATIONES RERUM OECONOMICARUM UNIVERSITATIS TARTUENSIS

29

DISSERTATIONES RERUM OECONOMICARUM UNIVERSITATIS TARTUENSIS

29

Welfare effects of regional policy in the constructed capital model

EGLE TAFENAU

The Faculty of Economics and Business Administration, University of Tartu, Estonia This dissertation is accepted for the defence of the degree of Doctor of Philosophy (in Economics) on February 5, 2010 by the Council of the Faculty of Economics and Business Administration, University of Tartu.

Supervisor: Professor Tiiu Paas (Ph.D.), University of Tartu, Estonia

Opponents: Professor Annekatrin Niebuhr (Dr.), IAB and Christian Albrechts University of Kiel, Germany

Professor Karsten Staehr (Ph.D.), Tallinn University of Technology, Estonia

The public defence of the dissertation is on March 22, 2010 at 14.15 in room B306, Narva Rd. 4, Oeconomicum, the University of Tartu.

The publication of this dissertation is granted by the Faculty of Economics and Business Administration, University of Tartu.

ISSN 1406-1309

ISBN 978-9949-19-315-8 (tr¨ukis) ISBN 978-9949-19-316-5 (PDF) Autori˜oigus Egle Tafenau, 2010

Table of contents

List of figures . . . 7

List of tables . . . 9

List of variables . . . 10

List of authors’s publications and conference proceedings . . . 12

Introduction. . . 18

1. New economic geography: ideas, examples and relevance . . . 24

1.1. Introduction . . . 24

1.2. The structure of the core-periphery model . . . 26

1.3. The basic ideas of the new economic geography and their roots . . 28

1.4. Some examples of NEG models . . . 36

1.4.1. DCI family of NEG models . . . 36

1.4.2. Alternative specifications of NEG models . . . 41

1.4.3. Further extensions of NEG models . . . 46

1.5. Criticism to NEG models . . . 48

1.6. Empirical evidence to the NEG models . . . 53

1.6.1. Empirical evidence on regional inequalities . . . 53

1.6.2. Testing the NEG models and their implications . . . 60

1.7. Conclusion . . . 66

2. Regional policy in practice and theory . . . 68

2.1. Introduction . . . 68

2.2. The aims, reasons and tools of regional policy . . . 69

2.3. Economic arguments supporting and criticising regional policy . . 74

2.4. Regional policy in NEG models . . . 79

2.4.1. Is there a need for regional policy according to the NEG models? . . . 79

2.4.2. Policies analysed in NEG models . . . 88

2.5. Conclusion and Open Issues . . . 98

3. Policy and welfare in the constructed capital model . . . 100

3.1. Introduction . . . 100

3.2. Constructed capital model . . . 101

3.2.1. Basic assumptions . . . 101

3.2.2. Short-run results . . . 104

3.2.3. Long-run results . . . 107

3.3. Taxes and subsidies in the constructed capital model . . . 112

3.4. Social welfare . . . 118

3.4.1. Welfare under market solution . . . 119

3.4.2. Welfare effects of location permits policy . . . 122

3.4.3. Welfare effects of the tax-subsidy policy . . . 123

3.5. Compensated Pareto criterion . . . 130

3.5.1. The concept of compensated Pareto criterion . . . 130

3.5.2. Compensation ability in case of the tax-subsidy and loca- tion permits policy . . . 133

3.5.3. Utility after compensation . . . 135

3.6. Effects of loosening some restrictive assumptions . . . 137

3.7. Conclusion . . . 140

Conclusions. . . 143

Appendices . . . 146

A. Welfare effects of location permits . . . 146

B. Welfare effects of the tax-subsidy policy. . . 147

References . . . 149

Summary in Estonian. . . 165

Acknowledgements. . . 180

Curriculum vitae . . . 182

Curriculum vitae in Estonian. . . 184

List of figures

1.1. The “tomahawk”-diagram for the core-periphery model with sym-

metric regions . . . 27

1.2. Demand and cost linkage . . . 31

3.1. The ‘tomahawk’ diagram for the constructed capital model with asymmetric regions . . . 110

3.2. The ‘tomahawk’ diagram for the constructed capital model with symmetric regions . . . 111

3.3. The scissors diagram for the constructed capital model with sym- metric regions . . . 112

3.4. The ‘tomahawk’ diagram for the constructed capital model with uniform taxes on consumption expenditures . . . 114

3.5. The scissors diagram for the constructed capital model with uni- form taxes on expenditures. . . 117

3.6. Utilities in case of the market solution . . . 121

3.7. Utilitarian social welfare under location permits policy . . . 123

3.8. The size of capital subsidy in case of uniform taxation of final expenditures . . . 124

3.9. Utility possibility curves . . . 126

3.10. National capital stock under the tax-subsidy policy . . . 127

3.11. Utilitarian social welfare if the small region is subsidised . . . 128

3.12. Utilitarian social welfare if the large region is subsidised . . . 129

3.13. Maximum achievable social welfare: subsidising the small vs. the large region . . . 130

3.14. Maximum achievable social welfare: subsidising the small region vs. distributing location permits . . . 131

3.15. Compensation mechanism in case of the tax-subsidy policy . . . . 133

3.16. Compensation mechanism in case of the permits policy . . . 135

3.17. Utility of the small region’s residents after compensation com- pared to market solution when a spatial distribution of firms after compensation is aimed . . . 137

A.1. Utilitarian social welfare under location permits policy: s_L=0.51 146 B.1. Utilitarian social welfare if the small region is subsidised . . . 147

B.2. Utilitarian social welfare if the large region is subsidised . . . 148 B.3. Maximum achievable social welfare: subsidising the small vs. the

large region . . . 148

List of tables

1.1. Traditional theories vs. NEG . . . 30 1.2. The effects of the main assumptions in the NEG models . . . 32 1.3. Comparison of the assumptions of the DCI type NEG models . . . 38 1.4. Comparison of the results of the DCI type NEG models . . . 39 1.5. Comparison of the assumptions of the four families of NEG models 42 1.6. Criticism of NEG models and counterexamples . . . 50 1.7. Concentration of economic activities in Europe . . . 56 2.1. Social optimality of the market outcome in the NEG models . . . 81 2.2. Effects of interregional transfers to the spatial distribution of economic

activities . . . 89 2.3. Tax competition in the NEG models . . . 94 3.1. Values of parameters . . . 121 3.2. Preference order of the alternatives in the analysis of compensa-

tion mechanism . . . 132

List of variables

The variables are listed in the order of appearance. The variables with a super- scriptwrefer to the whole economy, the variables with a star^∗to the small region, the variables without these superscripts refer to the large region if not noted oth- erwise.

Subscripts

A agricultural sector (example: LA—labour employed in the agricultural sector of the large region)

M manufacturing sector I investment goods’ sector

Main variables K stock of capital L amount of labour

sK the large region’s share of capital,sK+s^∗_K =1 sL the large region’s share of labour,sL+s^∗_L=1 x_A regional agricultural output

a labour intensity of output wL labour wage

p price of a product sold in the region of production p^∗ price of an imported product

π operating profit, return to capital x output of a manufacturing firm τ “iceberg” trade cost,τ >1

δ depreciation probability of a capital unit F production cost of a unit of capital Q_K regional output of the intermediate sector

sn the large region’s share of firms,sn+s^∗_n=1,sn= sK

U utility of a representative consumer ρ the consumer’s time preference rate CM composite of manufactured goods

σ elasticity of substitution of the manufactured goods

µ share of manufacturing goods in final consumption expenditures c_i consumption of a manufacturing varietyi

n^w mass of manufacturing varieties,n^w= K^w E regional final consumption expenditures n^w∆ consumer price index of manufactured goods V indirect utility

P the perfect price index

s_E the large region’s share of final consumption expendituress_E+s^∗_E =1

b ≡µ/σ

φ trade freeness,≡τ^1−σ Y^w national income

v present value of the expected flow of return to a unit of capital β ≡bρ/(ρ+δ)

φf the level of trade freeness above which manufacturing is fully agglomer- ated in the large region

z^∗ proportional subsidy to capital return in the small region EAT after tax final consumption expenditures

t tax rate on final consumption expenditures Superscripts in welfare analysis

M market solution P location permits policy

UT uniform taxation an subsidy policy C after compensation

List of authors’s publications and conference proceedings

I. Monographs and chapters in monographs

1. Paas, T.,Tafenau, E.(2008). Regional Integration and International Trade Clusters of the Enlarged European Union. In: B. R. Jones (ed.),Europe at the Crossroads, Nova Science Publishers, pp. 67–89.

2. Paas, T.,Tafenau, E.(2007). Regional Integration and International Trade Clusters of the Enlarged European Union. In: R. V. Weeks (ed.),Trends in International Trade Issues, Nova Science Publishers, pp. 1–23.

3. Tafenau, E.(2006). Regional policy in the context of the models of new economic geography. In: Reports-papers of the XIV scientific and edu- cational conference on economic policy(Tartu-V¨arska, June 29 – July 1, 2006). Berlin, Tallinn: Berliner Wissenschafts-Verlag GmbH, Mattimar O ¨U, pp. 375–394.

4. Tafenau, E.(2005). Mobility of People, Goods and Ideas as the Causes of Spatial Income Inequalities and Spreading: The Context of the Baltic Countries. In: C.-F. Gicquel, V. Makarov, M. Zolkos (eds.),The Challenge of Mobility in the Baltic Sea Region, Berlin: Berliner Wissenschafts-Verlag, pp. 157–173.

5. Paas, T.,Tafenau, E.(2005). Is the Baltic Sea Region a Special Economic Area within the Enlarged EU?: Theoretical Considerations and Empirical Testing. In: Reports-papers of the XIII scientific and educational confer- ence on Economic Policy(Tartu-V¨arska, June 30 – July 2, 2005). Berlin, Tallinn: Berliner Wissenschafts-Verlag GmbH, Mattimar O ¨U, pp. 266–275.

6. Paas, T.,Tafenau, E.(eds.) (2004).Modelling the Economies of the Baltic Sea Region. Tartu: Tartu University Press.

7. Tafenau, E. (2004). Modelling the Economic Growth of the Countries in the Baltic Sea Region. In: T. Paas, E. Tafenau (eds.), Modelling the Economies of the Baltic Sea Region. Tartu: Tartu University Press, pp. 54–

8. Paas, T., Tafenau, E.(2004). The Baltic Sea Region’s Role in Trade In- tegration. In: T. Paas,E. Tafenau(eds.) Modelling the Economies of the Baltic Sea Region. Tartu: Tartu University Press, pp. 92–115.

9. Paas, T.,Tafenau, E.(2004). EU Enlargement and Trade Integration: Can We Distinguish the Baltic Sea Region Cluster? In: Reports-papers of the XII scientific and educational conference Economic Policy Perspectives of Estonia in the European Union (Tartu-V¨arska, July 1–3, 2004). Berlin, Tallinn: Berliner Wissenschafts-Verlag GmbH, Mattimar O ¨U, pp. 340–349.

10. Tafenau, E.(2003). Regionaal-majanduspoliitiliste otsuste informatsioo- nilisest toetamisest. In: Estonian Economic Policy on the Way towards the European Union. Reports-papers of the XI scientific and educational conference (Tartu-V¨arska, June 26–28, 2003). Berlin, Tallinn: Berliner Wissenschafts-Verlag GmbH, Mattimar O ¨U, pp. 475–483.

II. Articles in international journals

1. Paas, T.,Tafenau, E., and Scannell, N. J. (2008). Gravity Equation Analy- sis in the Context of International Trade: Model Specification Implications in case of the European Union. Eastern European Economics, Vol. 46, No. 5, pp. 92–113.

2. Paas, T., Tafenau, E.(2005). Regional Trade Clusters in Promoting EU Eastward Enlargement. Transition Studies Review, Vol. 12, No. 1, pp. 77–

90.

3. Paas, T., Tafenau, E., and Scannell, N. J. (2004). Economic Growth in Transitional Versus Industrial Economies: A Case of the Baltic Sea Region.

Journal of American Academy of Business, Cambridge, Vol. 4, No. 1&2, pp. 9–18.

III. Other research articles

1. Tafenau, E.(2008). Can welfare be improved by relocating firms? The case of the constructed capital model.University of Tartu, Faculty of Economics and Business Administration Working Paper Series, No. 64. Tartu: Tartu University Press.

2. Tafenau, E.(2006). Ehitiste energiat˜ohususeks tehtud lisainvesteeringute majanduslik tasuvus. Roose, A. (Toim.). Keskkonnas¨a¨astlik planeerimine ja ehitus 2. Publicationes Instituti Geographici Universitatis Tartuensis 100, lk. 62–63.

3. Paas, T., Tafenau, E. (2005). European trade integration in the Baltic Sea Region - A gravity model based analysis. HWWA Discussion Paper No. 331.

IV. Conference publications

1. Tafenau, E., Paas, T. (2009). Regional Income Disparities and Sustainable Economic Growth. In: Proceedings of the Modern Management Research Conference (MMRC) “Insights into the Sustainable Growth of Business”, November 19–21, 2009, Vilnius, Lithuania (CD-ROM).

2. Herwartz, H., Schneider, F., Tafenau, E.(2009). Shadow economy in the EU NUTS–2 regions. In: Papers presented at the Annual Conference of the Estonian Economic Association, January 30–31, 2009, Toila, Estonia (CD-ROM).

3. Tafenau, E.(2007). The effect of taxes and subsidies on the spatial distribu- tion of economic activity and welfare. In:Local Governance and Sustain- able Development: Papers of the 47th Congress of the European Regional Science AssociationAugust 29 – September 2, 2007, Paris/Cergy–Pontoise, France (CD-ROM).

4. Tafenau, E.(2007). Tax policies and their impact on the spatial distribution of economic activities and welfare. In: Papers of the 3rd international conference “Baltic Business and Socio–Economic Development”, June 17–

19, 2007, Tallinn, Estonia (CD-ROM).

5. Paas, T., Tafenau, E. (2005). European trade integration in the Course of EU Enlargement Processes. In: Proceedings of the 31st EIBA (Euro- pean International Business Academy) Conference “Landscapes and Mind- scapes in a Globalized World”, December 10–13, 2005, Oslo, BI Norwe- gian School of Management (CD-ROM).

6. Paas, T., Tafenau, E.(2005). European Enlargement and Regional Eco- nomic Clusters: The Recent Trends and New Challenges. In: Eesti Euroo- pas: uued v¨aljakutsed sotsiaalteadlastele: Eesti sotsiaalteadlaste V aasta- konverents, 12.–13. november 2004, Tartu. Estonian Social Science Online, No. 3.

7. Paas, T.,Tafenau, E.(2005). A Gravity Model Analysis of Regional Trade Integration in the Context of EU Enlargement. In: J. W. Owsinski (ed.), MODEST 2004: Integration, Trade, Innovation &Finance: From Conti- nental to Local Perspectives. Warsaw: Polish Operational and Systems Research Society, pp. 97–121.

8. Tafenau, E.(2004). Regionaalsed sissetulekute erinevused Eestis: ruumi- line anal¨u¨us. Eesti Statistikaseltsi teabevihik nr. 14 “Statistika majanduses ja majandusteaduses”, Tallinn, lk. 67–78.

9. Paas, T.,Tafenau, E.(2004). Regional Integration and its Role in Promot- ing East–West Integration in the Context of EU Enlargement. In:Proceed- ings of the 30th EIBA (European International Business Academy) Con-

and Management”, December 5–8, 2004, Ljubljana, University of Ljubl- jana (CD-ROM).

10. Paas, T., Tafenau, E. and Scannell, N. J. (2003). Economic Growth in Transitional Versus Industrial Economies: A Case of the Baltic Sea Region.

In:The Economics&International Business Research Conference, Miami, Florida. Research Forum Vol. 2, No. 1, pp. 2–11.

11. Tafenau, E. (2002). Economic Growth in the Context of Transition and Integration Processes: The Case of the Baltic Sea Region. In:Proceedings of the 8th International Conference “Economic Growth and Competitive- ness in Europ”, October 3–5, 2002, University of Macedonia, Thessaloniki, Greece, pp. 45–60.

V. Conference presentations

1. Regional Income Disparities and Sustainable Economic Growth (with T. Paas). Modern Management Research Conference (MMRC) “Insights into the Sustainable Growth of Business”, November 19–21, 2009, Vilnius, Lithuania.

2. One Share Fits All? Regional Variations in the Extent of the Shadow Econ- omy in Europe (with H. Herwartz, F. Schneider). The Shadow Economy, Tax Evasion and Social Norms, July 23–26, 2009, M¨unster, Germany.

3. Shadow economy in the EU NUTS–2 regions (with H. Herwartz, F. Schnei- der). The Annual Conference of the Estonian Economic Association, Jan- uary 30–31, 2009, Toila, Estonia.

4. Can Welfare be Improved by Relocating Firms? The example of the Con- structed Capital Model. GfR Summer Conference Modelling the Spatial Economy, July 3–5, 2008, Kiel, Germany

5. The effect of taxes and subsidies on the location of economic activity and welfare. Joint Congress of the European Regional Science Association (47th Congress) and ASRDLF (Association de Science R´egionale de Langue Fran¸caise, 44th Congress), August 29 – September 2, 2007, Paris, France.

6. Tax policies and their impact on the spatial distribution of economic activ- ities and welfare. The 3rd international conference “Baltic Business and Socio-Economic Development”, June 17–19, 2007, Tallinn, Estonia.

7. The Effect of Taxes and Subsidies on the Spatial Distribution of Economic Activity and Welfare. EcoMod International Conference on Regional and Urban Modelling, June 1–2 2007, Brussels, Belgium.

8. The effect of taxes and subsidies on the location of economic activity and welfare. Eesti Majandusteaduse Seltsi ja Majandusteaduse alase doktori- kooli noorte majandusteadlaste 3. kevadseminar, 20.–21. aprill 2007, P¨uhaj¨arve, Eesti.

9. The effect of taxes and subsidies on the location of economic activity and welfare. 25th SCORUS Conference on Regional and Urban Statistics and Research Globalization Impact on Regional and Urban Statistics, August 30 – September 1, 2006, Wrocław, Poland.

10. Regional Trade Integration in the Course of EU Enlargement Processes.

31st EIBA annual Conference: Landscapes and Mindscapes in a Globalized World, December 11–13, 2005, Oslo, Norway.

11. Is the Baltic Sea Region a Special Economic Area within the Enlarged EU?:

Theoretical Considerations and Empirical Testing. 13th Scientific Confer- ence on Economic Policy, June 30 – July 2, 2005, Tartu–V¨arska, Estonia.

12. EU Enlargement and Trade Integration: Can We Distinguish the Baltic Sea Region Cluster? The XII scientific and educational conference “Economic Policy Perspectives of Estonia in the European Union”, July 1–3, 2004, Tartu–V¨arska, Estonia.

13. Mobility of People, Goods and Ideas as the Causes of Spatial Income In- equalities and Spreading: The Context of the Baltic Countries.The second YouREC conference, June 3–5, 2004, Riga, Latvia.

14. The Baltic Sea Region’s Role in Integrating the Transitional Economies into the Western Economic System. Changes, Challenges and Chances.

Conclusions and Perspectives of Baltic Sea Area Studies, May 27–29, 2004, Berlin, Germany.

15. Regionaalne sissetulekute ebav˜ordsus Eestis. Ruumi¨okonomeetriline ana- l¨u¨us.Eesti Statistikaseltsi 15. konverents “Statistika majanduses ja majan- dusteaduses”, 5.–6. veebruar 2004, Tallinn, Eesti. Tallinn, February 5–6, 2004.

16. The Causes of Spatial Income Inequalities and Spill-Overs: The Context of the Baltic Countries.International Ph.D. conference: Challenge of Mobil- ity in the Baltic Sea Region. October 23–26, 2003, Gdansk, Poland.

17. Veeb sunnib suhtlema. Posterettekanne Eesti e- ¨Ulikooli asutamiskonve- rentsil, 21. veebruar 2003, Tartu, Eesti.

18. Economic Growth in the Context of Transition and Integration Processes:

The Case of the Baltic Sea Region. 8th International Conference of the Economic Society of Thessaloniki: Economic Growth and Competitiveness in Europe: Trends and Prospects. October 3–5, 2002, Thessaloniki, Greece.

19. Economic Growth and Modelling of it: the Example of the Transition Eco- nomies. The 3rd research workshop “Transformation of Economic and Political Systems in the Baltic Sea Region”, October 27–28, 2000, Tartu,

20. The Factors of Economic Growth in Central and Eastern European Coun- tries.The 2nd research workshop Transformation of Economic and Political Systems in the Baltic Sea Region, October 29–31, Tartu, Estonia.

Introduction

Disparities are characteristic to the world at a wide variety of regional levels.

Starting from the most aggregated level, the existence of the north-south divide is well known: the northern countries of the world are wealthier than the countries locating in the south. On the other extreme, within cities there are districts popu- lated by rich people and slums whose inhabitants have difficulties to match their basic needs. In between are firstly disparities between countries, take for instance the Western and the Eastern Europe, and secondly disparities within countries.

As an example the Eastern European countries can be taken: there are often large differences between the incomes per capita in the capital city region and in the rest of the country.

Such observations are not unknown for economists and politicians. The latter have implemented since the middle of the 20th century various regional policies for alleviating regional disparities. Currently, also several international organisa- tions pay a lot of attention to the regional issues. For example, a third of the bud- get of the European Union is spent on regional development objectives (European Commission, 2009). The Organisation for Economic Co-operation and Develop- ment acknowledged the importance of regional aspects of development by estab- lishing the directorate Territorial and Development Service (OECD, 2001). The World Bank devoted the latest World Development Report (World Bank, 2009) on regional issues.

Even though there is a long tradition of locational and trade economics, starting in the 19th century with von Th¨unen (1921/1842), handling the issues of regional disparities and agglomeration of economic activity, describing and explaining re- gional disparities was for a long time rather a topic of geographers than that of economists. It has been argued, that the way of analysing the regional issues did not fit into the framework of neoclassical mainstream economics (Kopp, 1999;

Puu, 1983).

However, since the beginning of 1990s, starting from the works of Krugman (1991a,b), economists have shown more interest in the regional issues. The field, named new economic geography (NEG) has achieved a wide acknowledgement, though it is of course not free from criticism. Examples of influential reliance on the insights from the NEG models are the recent World Development Report (World Bank, 2009) and the accompanying issue on East Asian economies (Huang and Magnoli Bocchi, 2009b) that concentrate on regional development issues,

The NEG models explain the emergence of large spatial disparities even if there are initially no inherent differences in the endowments of the resources and applicable technologies across the regions. In most of the models, in the course of falling trade costs the initially symmetric regions can develop to have completely different industrial structures (Baldwin, 1999; Forslid, 1999; Fujita et al., 1999;

Krugman, 1991a,b; Ottaviano et al., 2002). The endogenous agglomeration pro- cess is influenced on the one hand by centripetal forces like access to demand and supply and on the other hand by centrifugal forces like immobility of part of the demand or congestion, resulting from increasing returns to scale, factor mobility and trade costs.

It has been noticed in the NEG literature that any policies can have side ef- fects on regional development if they influence somehow regional distribution of expenditures (Ottaviano, 2003). Also, there has been a wide discussion on the de- sirability of the spatial distribution of economic activity arising spontaneously in response to the working of market forces from the social welfare viewpoint (Bald- win et al., 2003; Charlot et al., 2006; Ottaviano et al., 2002). The results show that the market outcome does not always correspond to the welfare maximising spa- tial distribution of economic activity. Despite the approval of the insights from the NEG models these models have not been used a lot to analyse different re- gional policy issues though this has been seen as one of the field’s most important potential contributions (Neary, 2001).

The only exception here is supporting regional development through infras- tructure investments. The effect of changes in trade costs to the location of eco- nomic activity is the most exploited topic in the NEG literature, following the example of Krugman (1991a,b). Until now, it is done mostly in an exogenous fashion, that is the costs for improving the trading conditions are not included in the models. Though there are a couple of studies with opposing results (the most prominent one among those is Helpman, 1998), it is usually concluded that low trade costs support the emergence of agglomerations, while in case of high trade costs economic activities are distributed more evenly in the space. Depending on the dispersion forces included in the model the economy can return to a balanced spatial distribution of economic activities in case of very cheap trade.

Considering policies that aim more directly spatial relocation of production, the literature has much less to offer. Dupont and Martin (2006) analyse the ef- fects of subsidies to capital and labour in the poorer region, financed by global (national) or local income taxes based on the model of Martin and Rogers (1995).

Though such subsidies are able to motivate the firms to move from the affluent region to the poor region, it is not necessarily good for the residents of the lat- ter. Rather, the authors conclude that such a tax-subsidy system can result in poor workers financing the increased profits of capital owners, especially if capital is subsidised. They show the welfare changes due to the policy for different groups of economic agents, distinguishing them based on factor ownership and the region of residence and come to the result, that there is no Pareto improvement possible by applying such policies. Related literature considers the effects of tax compe- titions (Andersson and Forslid, 2003; Baldwin and Krugman, 2004; Kind et al., 2000; Ludema and Wooton, 2000).

However, alternative approaches for analysing changes in the social welfare have not been applied in the paper of Dupont and Martin (2006). As mentioned above, there is a bunch of research done on the social desirability of the spatial distribution of economic activities resulting from market forces. These analyses rely mostly on the utilitarian welfare function. Only in a few cases it can be shown that that one distribution Pareto dominates alternative distributions of economic activities. A third option is the application of the concept of compensated Pareto optimality as done in Charlot et al. (2006). However, as most of the other studies, it analyses just the preference order of full agglomeration and completely symmet- ric distribution of economic activities between two inherently identical regions.

Though it is known for the NEG models based on the different types of welfare analysis that the market outcome might not correspond to the socially preferred one, the ways of achieving it have remained until without much attention (an exception is here the aforementioned paper of Dupont and Martin, 2006). More- over, it is unclear, whether it is possible to increase welfare when market based instruments are implemented for influencing the spatial distribution of economic activity. These questions have practical relevance as regional policy analysis relies nowadays often on the NEG models, but the effects of different policy instruments have not been studied in this framework.

The aim of the thesis is to fill this gap. Specifically, the thesis focusses on eval- uating the desirability of regional policies from the viewpoint of the society as a whole based on the constructed capital model with asymmetric regions. For eval- uating the desirability of the regional policy several concepts of welfare are used like Pareto criterion, social welfare function and compensated Pareto criterion.

The effects of two policies are compared: the first is a simple location permits policy in case of which the benevolent planner decides how much capital may be constructed in each region. The second policy is a tax-subsidy system, where a capital subsidy is financed by taxes that are imposed at a uniform rate on the final consumption expenditures.

The constructed capital (Baldwin, 1999) model is chosen from the available NEG models based on the following considerations. Firstly, it is one of the sim- plest models featuring endogenous agglomeration process and is analytically solv- able. The NEG literature has been accused on relying extensively on numerical examples and therefore, the generality of their results has been doubted. Ana- lytical solvability is a feature that avoids this problem. However, in the welfare analysis it is still necessary to rely on numerical approaches. Compared to the more complicated NEG models, the analysis based on a simple model can serve as a basis for further research. The results from the simple model help to interpret the results of more advanced models, enabling to understand the effects of differ- ent assumptions. Secondly, the constructed capital model is the only one among the simple NEG models with the possibility to increase the stock of production inputs (specifically, the capital stock). In other simple models without such a fea- ture the perspectives to improve on the welfare level by implementing policies that influence the location of economic activity are rather pessimistic. Thus, the constructed capital model has a higher potential for positive influence on social

Clearly, the welfare effects of regional policies can be analysed also in alter- native frameworks like for example the computable general equilibrium (CGE) models that also rely on the NEG models in case of multi-regional setting. The choice for the NEG models has fallen firstly as those effects have not been anal- ysed in the context of them, such that until now it is not possible to give theoret- ically grounded policy recommendations based on the NEG models. In spite of that, the models are extensively used in practical regional policy analysis. Thus, there is obviously a practical need for such an analysis. Secondly, to implement a NEG based welfare analysis into a CGE model, the theoretical set up for it has to be derived at first. Moreover, the insights gained from the theoretical analysis help to predict and understand the results of a more comprehensive analysis which includes the smaller model.

The asymmetric setting (with size differences of the regions) of the constructed capital model has been chosen as it corresponds rather to the reality than he case of symmetric regions. In real world the regions are of different size. Moreover, in reality the economy does not agglomerate at a catastrophic rate if the trade costs decrease. Instead in the asymmetric model the trade costs dependent path of stable equilibria of the spatial distribution of economic activity is continuous and features also partial agglomeration.

The following research tasks are necessary for achieving the aim.

1. Critical overview of the NEG models to analyse the generality of their im- plications.

2. Assessment of the empirical relevance of the NEG models, based on em- pirical literature. Together with the first task this enables to evaluate the practical relevance of a policy analysis based on the NEG models.

3. Review of the economic arguments for and against policy interventions and the practice of regional policy. This task gives motivation for policy inter- ventions and helps by the choice of policy tools in order to keep the analysis relevant for practice.

4. Comparative review of the social optimality of the market outcome in the NEG models, with the aim of substantiating the case for regional policy.

5. Review of literature on policy effects in the NEG models. This task helps to detect gaps in the literature.

6. Formal presentation and discussion of the basic constructed capital model in comparison to alternative approaches in the NEG literature. In this task the market outcome is analysed, which is the reference point for the following policy analysis.

7. Extending the constructed capital model with the tax-subsidy policy and analysis of the effects of regional policy on the location of economic activ- ities compared to the market outcome.

8. Critical assessment of methods for evaluating changes in the social welfare.

The aim of this task is to motivate the usage of the chosen methods for welfare analysis.

9. Analysis of the social optimality of the market outcome in the constructed capital model by implementing the location permits policy.

10. Analysis of the welfare effects of the tax-subsidy policy.

11. Comparison of the welfare effects of the location permits and tax-subsidy policy.

12. Discussion of potential effects of some alternative model assumptions to the results of the analysis.

13. Generalisation of the results and policy recommendations.

It is argued in the thesis that the implications of the NEG models are suffi- ciently general for drawing policy conclusions from them. Moreover, the models have empirical support, assuring the relevance for practice. Considering the case for regional policy, it is shown that regional policies are highly relevant in the practice with investments into human capital and infrastructure and measures for attracting capital into the backward regions. Moreover, from the theoretical view- point governmental intervention into regional development is justified as acting in its main functions in order to reduce inequality and react to the effects of exter- nalities. The analyses available in the literature show that both of these arguments are also relevant in case of the NEG models.

The regional policy analysis based on the constructed capital model delivers that the government can achieve any spatial distribution of economic activities by implementing a tax-subsidy policy. In choosing the subsidy rate it is necessary to adjust the rate of subsidy if trade costs change if a specific distribution of eco- nomic activity is aimed over the whole range of trade costs or if it is to be avoided that economic activity agglomerates in the small region. Based on the location permits policy it is shown that there is a case for regional policy in the constructed capital model: in certain ranges of trade costs it is possible to achieve a higher welfare level even if the stock of production inputs does not change. Also with the tax-subsidy policy it is possible to improve on the welfare.

However, when implementing regional policy some caution is needed. The maximum achievable social welfare level depends on the chosen political mea- sures. Related to this, depending on the society’s preferences in trading offequal- ity and average real incomes, it can be recommendable to aim more agglomera- tion in the larger and richer region instead of aiming a shift of the industry to the smaller region. Moreover, the potential to increase social welfare by implement- ing some political measures depends on the level of trade costs. Finally, the ability of the analysed regional policies to increase social welfare is quite limited.

In the literature overview part of the thesis, comparative and esemplastic anal-

regional policy is analysed theoretically. The basic results considering the loca- tion of economic activity are shown analytically and illustrated with numerical examples. As for the welfare analysis, it has to be relied on numerical analysis due to the complexity of the underlying model.

The thesis contributes to the existing literature in several ways. Firstly, to the author’s knowledge there is until now no comprehensive overview on the social optimality of the market outcome in different NEG models. Secondly, also an overview of policy effects is missing in the literature. Thirdly, it is the first time that a welfare analysis is applied to the constructed capital model. Fourthly, there has been no former analysis of a tax-subsidy policy based on the constructed cap- ital model. Fifthly, the welfare effects of that type of regional policies are until now not well analysed in the NEG models. Sixthly, the welfare analysis is done in the context of asymmetric regions with the possibility of partial agglomerations and by applying several methods for evaluating the welfare effects of them. Sev- enthly, there are no analyses in the literature comparing the effects of alternative regional policies. Finally, covering several novelties mentioned above, the analy- sis contributes to the NEG literature by answering the question which policy tools enable to achieve a higher welfare level.

The main part of the thesis is divided into three chapters. The first chapter aims to show the applicability of the NEG models for regional policy analysis.

Thus, the idea of the NEG models is explained, an overview of the basic NEG models is given as well as of their extensions and differences in their conclusions.

Moreover, criticism and empirical evidence to the NEG models are discussed. The second chapter expands upon the reasons and methods of regional policy, looking both into the practice and theory of regional policy and relating the issues to the literature of NEG. This chapter serves as the reference point for justifying inter- ventions into regional development and for finding the gaps in the NEG literature, considering regional policy and welfare. The third chapter introduces taxes and subsidies into the constructed capital model and analyses their effects to the loca- tion of economic activities and welfare. Moreover, the potential effects of some characteristics of the real world that are excluded from the model are discussed.

The final chapter concludes.

1. New economic geography: ideas, examples and relevance

1.1. Introduction

Regional issues like for example location of economic activity, transportation net- works, fostering regional development and land use are highly relevant in policy.

Regional science, the branch of social sciences that concentrates on such topics, has, however, been a marginal field in economics. Even though there were several important contributions in the field since the mid-19th century, analysis of location of economic activities did not manage for a long time the step into the mainstream economics.¹ This is shown by the concern raised by Christaller (1933): he regrets that theoretical economists do not show much interest in the spatial issues, even though economic activities necessarily take place in space. Since mid-1950s the field of regional science became its own standing, mainly through the efforts of Walter Isard (Boyce, 2004).² An important role in it was played by the publication of Walter Isard’sLocation and Space-Economy(1956). Shortly before, in 1954 the Regional Science Association was established, which also started in 1955 to issue the oldest journal in the field,Papers in Regional Science(Florax and Plane, 2004).³ However, in 1963 Meyer still felt that in general economic studies loca- tion theory had deserved too little attention.

Since the beginning of 1990s, starting with the seminal works of Krugman (1991a,b), the interest in the theory of location of economic activities has risen.

The earlier lack of interest was caused by several issues. Firstly, the dominating neoclassical approach relied on perfect competition framework but in locational analysis scale economies, circular causation and imperfect competition play im- portant roles. This made also a mathematical representation of the models im- possible while in mainstream economics formal presentation gained importance

1Up to the World War II, the regional issues were discussed mainly by German-writing economists. Important early works are Christaller (1933); Launhardt (1885); L¨osch (1962/1943);

Ohlin (1933); Palander (1935); Pred¨ohl (1925); Roscher (1878); von Th¨unen (1921/1842); Weber (1909). Beckmann (1999) presents an overview of problems discussed in the early works of the field.

2A history of regional science as a scientific field is given in Isard (2003).

3Until 1990 the journal was calledPapers of the Regional Science Association, consisting of

(Krugman, 1999).¹ Secondly, as argued in Puu (1983), the earlier researchers interested in regional issues took a too narrow approach. Most of the early lo- cation theorists analysed which location would be optimal for a specific activity (Weberian approach) as contrasted to looking for optimal activities for a specific location (von Th¨unen’s approach). The Weberian, narrower approach did not fit into the mainstream economics. Thirdly, the early models were presented in a partial equilibrium framework, as opposed to rising dominance of general equi- librium analysis in mainstream economics.

In the models of the NEG the spatial distribution of economic activities is not influenced by exogenous factors, but arises endogenously due to increasing returns and circular causality. Endogenous organisation of the economic space is described also by Christaller (1933) and L¨osch (1962/1943), though in partial equilibrium framework. The use of the model of monopolistically competitive economy by Dixit and Stiglitz (1977) enabled Krugman to include increasing re- turns and imperfect competition into the general equilibrium framework analyti- cally, such that in the NEG models endogenous agglomeration arises in response to self-interested behaviour of economic agents: through utility and profit max- imisation by consumers and producers, respectively. However, Giersch (1949) had constructed a verbal model of endogenous formation of agglomeration very similar to that of Krugman (1991b).

The Dixit-Stiglitz model was first used in the mainstream fields of economics like trade theory (giving rise to the new trade theory: Krugman, 1979, 1980) and economic growth (leading to the endogenous growth models or the new growth theory: Romer, 1987). It is not surprising that the new economic geography mod- els where developed by trade theorists, as trade can take place both between coun- tries and regions.² Krugman (1991a, p. 1) states himself: “[...] I have spent my whole professional life as an international economist thinking and writing about economic geography, without being aware of it.” The main difference between the models of the two fields is related to factor mobility. While in the trade models the production factors are assumed to be internationally immobile, in the geography models factor mobility plays a crucial role, enabling endogenous emergence of agglomerations.³

The main questions of interest of the geographical economists are related to the location of economic activities: why do we observe agglomerations at very different regional scales, why the agglomerations are of different size, why does the spatial pattern of location of economic activities change. The questions are

1Of course, mathematical discussion was also used in earlier works, for example by von Th¨unen (1921/1842) in determining the optimal land rent, Launhardt (1885) in the analysis of the effects of transportation costs or Hotelling (1929) in discussing optimal pricing given the locations of two competitors.

2Also before Krugman several trade economists had paid attention to regional issues. An ex- ample is Bertil Ohlin.

3In traditional trade models also trade costs are often neglected. However, there are also some models in the NEG tradition where factor mobility is not necessarily allowed,an example is Baldwin (1999).

clearly not new, but it is the first time that the answers to them are formulated analytically in the context of a general equilibrium framework.

The aim of the chapter is to understand the processes working in the NEG models and to analyse the appropriateness of the NEG models for the analysis of policy relevant questions. Thus, first the basic idea of the NEG models is in- troduced on the example of the Krugman (1991b) model. Then, the relevance of the assumptions for the results of the models are discussed, whereby the issues at hand are related to the historical roots of regional science. As the fourth section of the chapter an overview of the basic NEG models, their typology and extensions follows for showing the generality of the results as opposed to a dependence on some specific assumptions. In the fifth section the criticism to the NEG models, as well as counterarguments and counterexamples are presented. Here the argu- ment that the NEG models are not overly sensitive to some specific assumptions is reasserted. After that the empirical relevance of the models is discussed. That section serves for showing that the predictions of the NEG models are not unre- alistic but rather confirmed by empirical analysis. The final section concludes by arguing that based on the previous discussion, the NEG models are suitable for analysing real world issues.

1.2. The structure of the core-periphery model

The new economic geography models explain why initially identical regions might develop to have completely different economic structures. I start the overview of the new economic geography models with the verbal description of the original model from Krugman (1991b).

There are two identical regions in the model, as well as two sectors, called agricultural and manufacturing sector (sometimes those are called traditional and modern sector, respectively). The homogeneous agricultural good is produced solely by employing unskilled labour (peasants) with a constant returns to scale production technology. Its trade between the regions is costless and the good is sold at a perfectly competitive market. The manufacturing sector uses only skilled labour (workers) as its input, and the production function of a manufacture is characterised by increasing returns to scale due to fixed costs. There are sev- eral varieties of manufactures produced, each of them produced by one firm and each firm producing just one variety. The manufacturing firms face Dixit-Stiglitz monopolistic competition (Dixit and Stiglitz, 1977) and incur trade costs if the good is sold in another region than the region of production. The trade costs are assumed to be of iceberg-type: if a manufacture is transported from one region to another, part of it “melts” on the way.

The unskilled labour is immobile. Due to the assumptions of constant return to scale production technology and costless trade of the agricultural good, the price of it has to be equal in the two regions. This implies also identical nominal wage for the peasants, independent of their region of residence. The skilled labour is mobile between the regions and thus, prefers to reside in the region with higher

The consumers derive utility both from the agricultural good and the manu- factures, whereby the utility function implies preference for variety: the more varieties of the manufacturing good are available, the higher is the utility. Each consumer consumes all available varieties and spends her whole income. As the prices are lower in the regions with more local firms, the utility of consumers re- siding in such a region is higher as compared to the residents of the other region.

This model set-up brings to the result that the equilibrium distribution of man- ufacturing firms (and skilled labour) between the regions depends on the size of the trade costs, as shown in Figure 1.1. In case of very high trade costs each region has exactly one half of the manufacturing production. If the trade costs decrease, at some pointτ^S—called sustain point—also the agglomeration equi- librium where all of the industry has concentrated into one region turns stable.

The range of trade costs, where both the core-periphery and the symmetric equi- librium are stable, is called overlap. In the course of continuing decrease of the trade costs the so-called break pointτ^Bis passed, at which the symmetric equilib- rium loses stability. In that point it is sufficient that just one firm or worker decides to relocate to start the catastrophic agglomeration process. Thus, in case of very free trade, the only stable equilibria are those where all of the manufacturing firms and skilled labour have agglomerated in one of the regions. Which region receives the agglomeration, depends on an “accident” or expectations.

Figure 1.1:The “tomahawk”-diagram for the core-periphery model with symmet- ric regions. Notation:τ^B—trade costs below which the symmetric equilibrium is unstable,τ^S—trade costs below which the core-periphery equilibrium is stable, sn—share of firms and mobile factor in a region. Solid lines: stable equilibria, dashed lines: unstable equilibria.

Next I explain the processes bringing the model economy to the described pattern.

1.3. The basic ideas of the new economic geography and their roots

As stated above, the NEG models explain the spatial distribution of economic activities without relying on exogenous factors like natural advantages. That is, in those models the spatial distribution of economic activities arises endogenously.¹ The aim in developing these models was to construct a model that would deliver an explanation to the spatial distribution of economic activities and agglomeration, based on microeconomic foundations (Pfl¨uger and S¨udekum, 2005). According to Fujita (2007), NEG is applicable to urban, regional and trade issues, which each used to constitute a separate field, as agglomerations can be observed at very different spatial scales. Examples are here co-location of shops within cities, the emergence of towns and cities, regional disparities within countries, but also the so-called north-south divide in the world (Fujita and Thisse, 2009).

The NEG is closely related to location and trade theories, as well as urban economics in its questions of interest. Fujita et al. (1999) is the first example where the urban, regional and international trade questions are analysed within the unifying framework of NEG. However, the close relation between location and trade theory was recognized much earlier. Already Ohlin (1933) stated as one of his aims “To demonstrate that the theory of international trade is only a part of a general localisation theory” (p. vii). Also Isard and Peck (1954) study the interrelations of trade and location theories. These trials were responses to the criticism of trade theory’s restricting assumption of no trade costs. Since the 1950s the trade costs have been included in the trade models (Andersson, 1983).

It was observed long ago that economic activity is not distributed evenly across space. For example, Marshall (1997/1920) discusses in his Principles of Eco- nomicsthe reasons of localisation: why similar firms tend to locate close to each other. He mentions physical conditions as the most important reason for this observation, but he discusses also spillovers, scale economies and thick labour markets—as these phenomena are called nowadays. He explains that the loca- tion in the neighbourhood of firms producing similar products enables to learn from them by observing how they produce their products and have organized their work; together the firms are large enough for creating sufficient demand for spe- cific inputs; and firms like to locate where they expect to find workers with neces- sary skills, but these are easiest to be found where other similar firms locate, and skilled workers expect to find employment exactly in the locations where several firms demand their skills.² In fact, the advantages of agglomerations with respect to more efficient division of labour and availability of specific intermediate inputs was discussed already in Roscher (1878).

1Br¨ocker (2007) proposes calling the field the theory of endogenous economic landscape, men- tioning Christaller (1933) and L¨osch (1962/1943) as the first ones to develop such a theory. How- ever, in contrast to the NEG models of Krugman (1991a,b), they use a partial equilibrium frame- work.

2The relevance of such agglomeration forces have also been confirmed empirically, for example

Location theories ask why economic agents choose specific locations in the space and analyse the resulting spatial patterns of economic activity (Nijkamp et al., 2003). This can be observed in the works of the German location theo- rists. As the earliest contribution, von Th¨unen (1921/1842) explained why land rents differ and which agricultural products are most profitable depending on the distance from the market, assuming, however, existence of an exogenously given central city.¹ Christaller (1933) states as his leading questions why cities of dif- ferent size can be observed and why those are irregularly distributed in the space.

L¨osch (1962/1943) discusses both the optimal location of enterprises as well as the emergence of cities, and the organization of market areas. However, their work did not manage to advance into mainstream economics. Kopp (1999) sug- gests that the partial equilibrium framework used in the analysis hindered this step, since general equilibrium is praised in mainstream economics.

Over a long period the neoclassical world with perfect competition and con- stant returns to scale in production prevailed in theoretical economics, including the traditional trade theories. In the regional context this means that economic activities should be distributed uniformly in the space in case of no exogenous comparative advantages, such that each region would find itself in autarky, hav- ing no trade with other regions. In line with this, the traditional trade theories assumed exogenously given differences in the abundance of production factors or productivity for explaining the existence of trade, such that each country or re- gion specialises in a different product. Therefore, only inter-industry trade can take place. Moreover, as the factor prices equalise in this framework, there will never be a problem of regional inequalities, which is a prevalent characteristic of the real world.

An intuitive way to explain the existence of agglomerations would be the as- sumption of increasing returns to scale and indivisibilities in production. Com- bined with the assumption of perfect competition Starrett (1978) derived a result that has become known as the spatial impossibility theorem: there would exist no equilibrium under perfect competition if the assumption of constant returns to scale was replaced with assuming increasing returns to scale. Under these con- ditions, there is always an economic agent for whom it would be beneficial to relocate.

Increasing returns and imperfect competition are characteristics of the new trade models (e.g. Helpman and Krugman, 1985). As argued by Br¨ocker (2007), this group of models is also closest to the NEG models, sharing the above assump- tions. This is not self-evident as in the NEG models similar questions are posed as done by the location theorists. Another important assumption of the new trade and NEG models is a wide variety of differentiated goods, enabling to explain the existence of intra-industry trade.

The new trade theory shows that some regions can be preferred as the loca- tion of production due to their large market size or good market access (Nijkamp et al., 2003). This result is known as the home market effect. The same result

1Fujita and Krugman (1995) have built a model in the tradition of NEG showing the conditions under which exactly one city arises on an otherwise featureless isolated plane.

holds in the models of the NEG. The main difference between the new trade and the NEG models is that in the latter some production factors are assumed to be mobile between regions (which can be defined as countries), while in the former the factors are immobile between the countries (Pfl¨uger and S¨udekum, 2005). The mobility of the production factors enables the endogenous agglomeration process to occur. In response to a shift in the location of firms and supply a shift of the mobile production factor takes place, meaning mostly also a shift in demand. This means that the location of demand is endogenous, depending on the location of firms and enabling to break the initial symmetry (Head and Mayer, 2004a). As stressed by Robert-Nicoud (2006, p. 102), endogenous market sizes are “certainly thedistinctive feature of NEG models.”

The NEG models are based on the utility and profit maximization of individual agents differing as such from the traditional location theories (Christaller, 1933;

L¨osch, 1962/1943; von Th¨unen, 1921/1842), where it is ad hoc stated that the ag- glomerations arise due to increasing returns in the production of industrial goods or spillover effects, without modelling explicitly the emergence of agglomeration due to these forces (Krugman, 1998b). Moreover, it is assumed that trade between regions is not costless—an important fact that was long neglected in trade theo- ries. An overview of traditional trade models is given in Feenstra (2004). The differences between the traditional theories used for explaining international trade or regional patterns of economic activities and the NEG framework are presented in Table 1.1.

Table 1.1:Traditional theories vs. NEG.

Traditional international/ New economic geography regional economics

Constant returns Increasing returns Perfect competition Imperfect competition

Uneven distribution of resources Endogenous agglomeration forces

(first nature) (second nature)

Borders Transport costs

Static/long-run equilibrium Self-organization/evolutionary Source: Fujita (2007).

Krugman (2000, p. 54) states the basic idea of the new economic geography models to be the following: “there is a tension between centripetal forces, which foster concentration, and centrifugal forces that oppose it.” The relative strength of those counteracting forces determines the regional distribution of economic ac- tivities. From the three agglomeration forces suggested by Marshall (1997/1920), the NEG relies on the scale effects or market size effects, as Krugman (1998b) calls them. The market size effects motivate economic agents to locate close to bigger markets. They arise due to supply (cost) and demand linkages (see Fig-

Hirschman (1958). In the NEG models, exactly this type of agglomeration forces emerge due to the underlying assumptions. As the result, there occurs a circu- lar causation process: agglomeration causes agglomeration. The idea of circular causality is clearly not a new one. It was the main argument of Myrdal (1957) in explaining the economic development in its several aspects. Also Harris (1954) and Pred (1966) argued that circular and cumulative processes are behind urban growth.

A firm moves to A

Higher demand for labour Market size

increases

Higher nominal wages

Lower price index in A

More workers/

firms attracted to A

Lower cost-of- living or producing Workers

attracted to A

Nominal wages decrease

A firm moves to A

Figure 1.2:Demand and cost linkage. The demand linkage (left panel) and the cost linkage (right panel), based on the discussion in Neary (2001).

The demand-linked circular causality (backward linkage) comes from expendi- ture shifting due to production shifting, and this expenditure shifting results again in production shifting. If a firm moves from one region to another (production shifting), some of the production factors move along due to the higher demand for their products in the receiving region, and start spending their incomes there instead of the original region of residence (expenditure shifting). Increase of ex- penditures in a region means an increase in demand and thus, it motivates more firms to move to the region with enlarged market.

The cost-linked causality (supply or forward linkage) results from cost shift- ing due to production shifting, resulting in further production shifting. If a firm decides to relocate its production to another region, the prices in the new home region decrease due to increased competition on the one hand and due to avoiding trade costs on the other hand. The lower price index makes the location attractive for mobile workers and for firms if they use the products of other firms as inputs.

The relocation results in a further decrease in the local price index.

The key elements which give rise to the agglomeration forces and influence the interplay of agglomeration and dispersion forces are related to the increas- ing returns within firms, transport costs and factor mobility (Krugman, 2000, see Table 1.2). Firstly, the increasing returns to scale in the production of the manu- factures implies that each firm produces only in one location and exports a part of its output to the other region. Secondly, the trade is costly and the Dixit-Stiglitz

Table 1.2:The effects of the main assumptions in the NEG models

Assumption Effect

Increasing returns at the plant level

Producers motivated to produce only in one location

Transport costs Producers prefer to locate close to a large market

Factor mobility Movement with producers increases de- mand in the receiving region and makes that location more attractive for the producers Source:Based on the discussion in Krugman (2000).

monopolistic competition combined with constant elasticity of substitution (CES) preferences implies mill pricing. As a result of these assumptions, the manufac- tured goods are cheaper and, thus, demand for those is larger by individual agents if sold in the home market as opposed to selling those in the foreign market. This effect is even stronger if the home market is larger than the foreign market. There- fore, the firm is able to sell larger quantities of its production in the home market, earning in such a way higher profits, since in the Dixit-Stiglitz model the prof- its are proportional to the sales. Thirdly, as some production factors are mobile, they can respond to the regional price difference. The lower price index due to the smaller share of imported goods in the region with more firms attracts mobile workers to there.

Thus, instead of pure externalities or natural advantages on which the classical location theories often rely in explaining regional inequalities, comparative ad- vantages arise endogenously in the NEG models. The endogenous comparative advantages are generated through pecuniary externalities: other economic agents and their location decisions are influenced by the effects of each firm’s location decision on prices.¹ The decision of an economic agent to move to another region influences prices in both regions: in the region that receives more industry the price index decreases due to a smaller share of imported goods. The “sending”

region will experience an increase of the price index. This process is reinforced due to the above described circular causality processes.

All together, the NEG models’ assumptions concerning the production and market structure of the manufactures are behind the emergence of the circular causality process. Specifically, the increasing returns in the production of the manufactures, the Dixit-Stiglitz monopolistic competition at the market of them

1The term “pecuniary external economies” goes back to Scitovsky (1954), who distinguished those from technological externalities. He defines pecuniary externalities as “interdependence among producers through the market mechanism” (Scitovsky, 1954, p. 146). They are distinguished from the pure technological externalities as they do not enter the production function, though affect profits.

and the trade costs arising if a good is sold in another region than the region where it was produced are responsible for the emergence of the market size effect.

As for the dispersion forces, immobile production factors, land and housing rents and pure external diseconomies (congestion costs like pollution, traffic prob- lems etc.) are the phenomena preventing complete agglomeration. In most of the NEG models only immobile production factors are used as the dispersion force, in Krugman (1991b) in the form of the immobile agricultural workers. The assump- tion of immobile production factors means on the one hand that part of the demand does not move together with the firms and has to be satisfied in the immobile fac- tor’s region of residence as all consumers demand all goods, being produced in the home or in the foreign region. If there is lots of competition in the larger region (market crowding), at some point it might be profitable to locate in the smaller region as one could ask a higher mark-up there. On the other hand, the immo- bility of production factors means that they can cheapen in the smaller region in an extent that weights up the closeness to the large market. In some models also the effect of the housing prices is taken into account (Helpman, 1998; Tabuchi, 1998). Thus, an additional or an alternative dispersion force is introduced in those models.

How evenly economic activities are distributed in the space depends on the rel- ative strength of the agglomeration and dispersion forces. If agglomeration forces dominate, the spatial distribution of economic activities will be uneven; if the dis- persion forces dominate, each region has an equal share of economic activities in case of the assumption of two regions with initially identical endowments. The relation between the agglomeration and dispersion forces, and thus, the spatial dis- tribution of economic activities depends on the model parameters, including the size of trade costs. As trade costs are related to the extent of economic integration of the two regions, the changes in the spatial distribution of economic activities are analysed in the context of decreasing trade costs (deepening integration).

The trade costs for the manufactures are usually assumed to be of the so-called iceberg form, introduced into international trade theory by Samuelson (1954), but existing in fact already in the work of von Th¨unen (1921/1842). This assumption means that if transporting a good from a region to another, a part of it “melts down”: in order to supply in the other region one unit of a good,τ >1 units of it have to be shipped sinceτ−1 units of it “melt” during the transport. These costs comprise all kinds of trade costs: beside transport costs also tariffs, other formal trade barriers like regulations and costs due to cultural differences. Of course, the transport costs are the most important ones if the model is considered to work in the context of the regions of one country. In international context—if the two regions are interpreted as two countries—also other trade impediments may have considerable importance. Thus, integration can mean a removal of trade barriers if the model is placed into international context, or a decrease in transport costs, applicable also if the regions are part of one country.

It has been shown that in case of high trade costs the dispersion forces are usually stronger than the agglomeration forces in the NEG models (e.g. Baldwin,