Lecture 3d ECONOMIC GEOGRPAHY AND INTERNATIONAL TRADE By Carlos Llano, References for the slides: Fujita, Krugman y Venables: Economía Espacial. Ariel Economía, Materiales didácticos de diferentes autores: Baldwin; Allen C. Goodman; Bröcker; J. Sánchez

1.Introduction:  the role of borders  Border effect: a summary. 2.The Core-Periphery model and international trade  An intuitive view.  The model.  Simulations.  Breaking and sustain points.  Implications. 3.Conclusion 4.Applications Index

Tema 5 -EE 3 1.What is a country? Some space separated by borders. What is a border? Edges behaving as obstacles to movement and information. 2.What is a region? A space separated by “weak borders” inside the “strong” borders. There is more factor, goods and service mobility between regions. 3.Has distance died?, Is the transport cost insignificant? 4.What’s the importance of borders as barriers for trade?; and to migration? 1. Introduction

Tema 5 -EE 4 The World is flat 1. Introduction Cross Borders in a World where differences still matter

Tema 5 -EE 5 1.McCallum (AER, 1995): 1.On average, the exports of Canadian provinces to other Canadian provinces are 20 times larger than their exports to an equivalent state in the U.S. (same size and distance). 2.Engels and Rogers (AER, 1996): 1.Evidence from urban price movements suggests that the border imposes barriers to arbitrage comparable to miles of physical space. 3.Gil et al (World Economy, 2005): 1.The Spanish CCAA trade between them is 20 times the trade with other countries. 1.Border effect?, physical differences, accessibility, cultural, legal differences…?, specific effects of sector agglomeration (clusters)? 1. Introduction: Border Effect

Tema 5 -EE 6 Basic Model: Until now the Core-periphery Model (FKV, 1999): –2 regions (north-south); 2 sectors (A agriculture. & Manufacturing) –1 factor. 2 specializations: agricultural L A and manufacturing L M. Only L M is mobile; migration is driven by differences in wages. –There are only transport costs for M: iceberg costs ( T rs ) Valid view to explain inter-regional trade and manufacturing agglomeration in certain regions of a country: –High labor mobility between regions. –Manufacturing can easily reallocate. 2. The CP Model and International Trade

Tema 5 -EE 7 Basic Model: An alternative Core-Periphery Model (FKV, 1999, Chap14): –2 countries; 2 sectors (A agriculture & M manufacturing) –2 factors: labor + intermediate goods. There is no labor mobility between countries ( L r is fixed). There is mobility between sectors Lr can move from agriculture to manufacturing, seeking for differences in wages. –There are only transport costs for M: iceberg costs ( T rs ) Valid view to explain the manufacturing agglomeration in one country against another one: specialization + international trade 2. The CP Model and International Trade

Tema 5 -EE 2. Density: stylized facts. II-Dynamics

Tema 5 -EE 9 Without labor mobility: no agglomeration in the C-P Model. For it to be possible: –We assume that manufacturing firms produce intermediate and final goods. –We allow L mobility between sectors. The agglomeration in manufacturing in a country provides “intermediate goods” in abundance and more diversity ( Forward Linkages ): –Firms that produce final goods that use intermediate goods, buy cheaper and with more variety. Agglomeration of “final goods” in manufacturing in a country attracts “intermediate goods” manufacturing, ( backward linkages) : –It can lead to a process of specialization that concentrates manufacturing or particular industries in each of the countries, but not an agglomeration of labor in a single country. 2. The CP Model and IT: an intuitive view

Tema 5 -EE 10 How does “intermediate goods” work? –Input-Output Model (IOM). –Simply view. Hypothesis: Manufacturing only uses itself as an input. The manufacturing good is uses both as an intermediate/final good. The new production function : –2 factors: labor + intermediate goods 2. The CP Model and IT: the model CES sum of the intermediate goods inputs l s : factor labor in s; X rs : input of each variety produced in r demanded by the sectors in s

Tema 5 -EE 11 The “intermediate goods” are introduced through the price index: 2. The CP Model and IT: the model Price index of the intermediate goods produced in r : –The input composite is a Cobb-Douglas function of labor and intermediate goods. α (alpha)= share of the intermediate goods. Price of the input n s = number of varieties produced in s. p s = FOB price of the variety. T sr : transport cost. σ(sigma)= elasticity of substitution among varieties of manufacture is the same for firms as it is for consumers The more > agglomeration in manufacturing: + abundance of varieties, < price index of producing intermediate goods and therefore < production costs for manufacturing.

Tema 5 -EE The CP Model and IT: the model Sales in manufactures : –Now part of each firm’s output goes to consumers as final consumption (final demand) and part to firms for intermediate usage (intermediate demand). –E r = location r’s expenditure on manufactures Sales in the intermediate demand Sales equal the total value of production in region r. The higher > the number of firms in r, > the larger the intermediate goods demand and > the larger the total expenditure on manufactures Sales in the final demand μ= % that manufactures represent in the expenditure

Tema 5 -EE 2. The CP Model and IT: the model Labor mobility between sectors (A, M). –2 countries. –L r = 1. Labor is mobile between sectors. –λ r = share of country r’s labor force in manufacturing. –n r p r q* r = total value of manufacturing output in country r. – The manufacturing wage bill in country r is a share (1-α) of the previous quantity: –We choose units such that q* r = 1/ (1-α) so that:

Tema 5 -EE The CP Model and IT: the model Now we want to focus on the allocation of labor among sectors (λr), and wages: –Now the price indices in r=1 depend not just on wages in r=1 but also on the price indices of the manufactured goods (G) that are also used as intermediate for other manufactures. Price index in r=1 Price index in r=2

Tema 5 -EE 2. The CP Model and IT: the model Wages: Firms make zero profit when the price they charge is such that they sell 1/(1-α). The wage equations are now: Wages in r=1 Wages in r=2 Income in r=1 Income in r=2 Agricultural production depends on agricultural employment (1-λ). With this, the income in each country is:

Tema 5 -EE 2. The CP Model and IT: the model The agricultural wage is the labor marginal product A’(1-λ r ). The difference in wages between sectors (v r ) will be : Diff. in wages in r=1 Diff. in wages in r=2 Labor moves from agriculture to manufactures if there are differences in wages ( v1>0) and vice versa. The long run equilibrium occurs when there are no differences in wages: Long-run equilibrium manufacturing wages therefore satisfy:

Tema 5 -EE The CP Model and IT: el modelo The equilibrium: how does the differences in wages and movements between A↔M influence the variation in the agglomeration of M in a country (λ r )? : FOUR FORCES: 2 Stabilizing forces (they induce symmetry; avoid agglomeration) The response of the marginal product function in agriculture: if the agricultural production function is concave, then ▼ L A ▲ the marginal product [A’(1-λ r )] and the W a. This ▼ the incentive for a further movement of labor into manufacturing. Product market competition: a ▲ λ 1 is associated with the supply of more varieties in the country and it reduces the price index G 1, this shifts the demand curve for each firm’s output downward and reduces the manufacturing wage.

Tema 5 -EE The CP Model and IT: the model There are also 2 agglomeration forces (“vertical linkages”: FL + BL) 3.FL (supply): a ▼ G 1 induced by the ▲ λ r reduces the cost of intermediates, tending to increase the instantaneous equilibrium wage. 4.BL (demand): a ▲ λ r rises the expenditure on manufactures in country 1, shifting firms’ demand curves up and tending to rise the manufacturing wage. 1er ASSUMPTION: Simplifications for equilibrium: ¡¡¡¡¡IMPORTANT¡¡¡¡¡ The agricultural production function is lineal in output: A(1-λ)= (1-λ), therefore the agricultural wage =1 and so it is the equilibrium manufacturing wage. μ<1/2. This is, the level of demand for manufactures is small enough for all of manufacturing to fit in one country, and thus ensures that, even if all manufacturing is concentrated in a single country, this country also has some agriculture. Both assumptions together ensures that equilibrium wages in both countries are =1.

Tema 5 -EE 19 “wiggle diagram” High transport costs; T=3 0,8 λ 1 = = percentage that represents manufacturing in country 1 2. The Core-Periphery Model: implications 0 W 1 Curve It shows combinations of (λ 1, λ 2 ), with wages=1 in country1. To the right, w 1 1. λ 2 = percentage that represents manufacturing in country 2 W 1 =1 W 2 =1 0,8 λ 1 increases λ 2 increases w 2 >1 w 1 <1 λ 1 decreases λ 2 decreases w 2 <1 w 1 >1

Tema 5 -EE 20 “wiggle diagram” Low transport costs; T=1,5 0,8 λ 1 = = percentage that represents manufacturing in country 1 2. The Core-Periphery Model: implications 0 λ 2 = = percentage that represents manufacturing in country 2 W 1 =1 W 2 =1 0,8 λ 1 Increasesλ 2 Increases

Tema 5 -EE 21 “wiggle diagram” Intermediate transport costs; T=2,15 0,8 λ1λ1 2. The Core-Periphery Model: implications 0 λ2λ2 W 1 =1 W 2 =1 0,8 λ 1 Increases λ 2 Increases

Tema 5 -EE 22 “wiggle diagram” 2. The Core-Periphery Model: implications 1. When is symmetry sustainable (sustain point)? We assume that manufacturing is concentrated in country 1 (λ 2 =0) and (λ 1 =2μ). The concentration of manufacturing in country 1 will be stable as long as this agglomeration is less or equal to the agricultural wage (=1). 2. When does symmetry breaks and agglomeration is sustainable (break point)? At the symmetric equilibrium, manufacturing wages in each country equal the agricultural wages (which are = to the marginal product of labor in agriculture). The equilibrium is stable if increasing manufacturing employment drives manufacturing wages below agricultural, (the DISPERSION economies defeat) causing the movement of labor towards agriculture. The equilibrium is unstable when AGGLOMERATION economies defeat.

Tema 5 -EE 23 T(S) “wiggle diagram” 2. The Core-Periphery Model: implications Solid lines: stable equilibriums ; dashed lines: unstable equilibrium. With high transport costs: there is an stable equilibrium (λ 1 = λ 2 ) ,5 T T(B) 1 λ 1 = λ 2 λ1λ1 λ2λ2 λ1,λ2λ1,λ2 Making the hypothesis flexible: (1/2) The agricultural production function is lineal. But now μ>1/2. The level of manufactures demand is large. Not all the manufacturing fits in a country if we want wages to be equal in both countries: –If it is attempted to concentrate manufacturing in 1, wages in the country with low manufacturing will rise. When this wage gap arises, some part of the manufactures will remain in 2. Notice that the curve (λ2) is above 0. The Tomahawk

Tema 5 -EE 24 “wiggle diagram” 2. The Core-Periphery Model: implications History of the World, Part I (KV, 1995): 1.From an initial position in which the two countries are identical (North and South), an international division of labor spontaneously arises through a process of uneven development. North immediately gains from this division of labor, while South, which suffers deindustrialization, initially loses. The world economy tends to a Core-Periphery structure. 2.Eventually, further reductions in transport cots move the world into a globalization phase : the value of proximity to customer and supplier firms (intermediate L and c) diminishes as transport costs fall, and so the sustainable gap between N and S narrows. The world tends again to symmetry and to price equalization.

Tema 5 -EE 25 ω 1, ω 2 T 1 1 ω 2ω 2 2. The Core-Periphery Model: implications The concentration in manufacturing in 1, rises the country1 wages and drives the decline of the ones in 2. Two causes: Demand in L in 1 increases wages in1. Country 1 with more manufacturing varieties have lower prices. Eventually, the wage gap declines with transport costs. ω 1ω 1 ω 1 =ω 2 Globalization phase

Tema 5 -EE 26 λ 1, λ 2 T 1 1 λ2λ2 2. The Core-Periphery Model: implications What happen if agriculture has decreasing returns? When T is high (autarky): manufacturing is dispersed. Equilibrium is symmetric and stable. With intermediate levels of T: there is agglomeration. Symmetric equilibrium is unstable. When T is low: the symmetric equilibrium is stable again. λ 1 λ 1 = λ 2 Making the hypothesis flexible: (2/2) The agricultural production function is decreasing. μ>1/2. –An increase of manufacturing labor increases the manufacturing wage but also it increases the agricultural one. The Bell-shaped curve

Tema 5 -EE T The Core-Periphery Model: implications ω 1, ω 2 ω 2ω 2 ω 1ω 1 ω 1 =ω 2 Making the hypothesis flexible: The agricultural production function is decreasing. μ>1/2. The Bell-shaped curve

Tema 5 -EE 28 “wiggle diagram” 2. The Core-Periphery Model: implications According to these assumptions (when manufacturing is large and agriculture tends to decreasing returns): by reducing transport costs, the equilibrium goes through 3 phases: 1.At high transport costs, the dominant force in determining location is the need to be close to final consumption, preventing any strong geographical concentration of manufacturing. 2.At low transport costs, the dominant determinant of location is wage costs, again mandating dispersed manufacturing to keep labor costs down (it makes that the centripetal forces rule over the centrifugal, the opposite of having intermediate transport costs). 3.The bifurcation is continuous and smooth pitchfork shaped.

Tema 5 -EE 29 “wiggle diagram” 2. The Core-Periphery Model: implications With no labor mobility between countries, but with mobility between sectors, the concentration in manufactures is possible: specialization 1.Vertical linkages (FL and BL) between industries can lead to a concentration in manufacturing. This concentration can also vary with the transport costs ( and other factors). 2.Not only an uneven distribution of manufactures can rise but also inequalities in wage rates and living standards. 3.Questions: 1.Do these processes have something to do with the division between rich and poor countries while T has reduced?; 2.Can we expect that a higher European integration leads to a (at least initially) inequality growth?

Tema 5 -EE 2. Density: stylized facts. II-Dynamics

Tema 5 -EE Alternative Models IncludesOmitsLimitations Krugman-80  Love for varieties,  Monop. comp.  IRS,  Transport costs.  Factor mobility  Circular causation  1 agglomeration mechanism at a time.  Factors-countries- products: 2x2x2.  Non-linear.  No analytical solution.  Neutral space.  Symmetric transport cost between r-s.  Non congestion costs (land, environment…)  Still lack of “geography” Krugman-91  Love for varieties,  IRS  Monop. comp.  Transport costs.  Circular causation  (+) Factor mobility between regions (-) Factor mobility between sectors (-) DRS in agriculture Krugman- Venables-95  Krugman-91 (1-5) (+) Factor mobility between sectors (+) DRS or IRS in agriculture (-) Factor mobility between regions FKV-99 Puga-99  Krug-91+K&Venb, 95  2 agglomeration mechanism together.  The rest…

Tema 5 -EE  2x2 NEG main models predict 2 extreme outcomes: – Tomahawk: 1 break point, after which C/P structure (inequality in income) is stable for low transport costs. – Bell-shaped curve: equal distribution of economic activity and convergence in income is possible with high integration. Where on the Tomahawk/Bell-shaped curve are we? = 2 1, 2 1 = T T(S) 0 1 0,5 T T(B) 1 λ1= λ2 λ1λ1 λ2λ2 λ1,λ2 The two main models and the generalized model

Tema 5 -EE Hypothesis of the model: –2 countries (Home, Foreign). –2 factor of production: Labor + Intermediate products. –Both countries produce only 2 goods A and M. –Transport costs (Trs), same technology, relative factor endowments (L/T ratios). New: –Now labor force is mobile between regions and sectors. –Both agglomeration forces at play: inter-sectoral linkages, interregional migration. –Agriculture with DRS + Inelastic Labor Demand The generalized model (Puga, 1999) Puga (1999) investigates 2 situations: –With interregional labor mobility: tomahawk diagram. –Without interregional labor mobility: bell-shape curve.

Tema 5 -EE Puga (2002) analyze the EU cohesion policy in the light of NEG: Profound regional income disparities in the European Union. 1/4 of its citizens live in regions eligible for EU Structural Funds. –GDP per capita < 75% of the EU average. –Applying this criterion to the US, only Mississippi and West Virginia, would qualify. The Structural Funds = 30% of total EU budget; 0.4% of total EU GDP. Despite this sizable intervention, regional inequalities in Europe have not narrowed substantially. Over the past fifteen years income differences across Member States have fallen, but inequalities between regions within each Member State have risen. –EU States have developed increasingly different production structures. Its regions have also become increasingly polarized in terms of their unemployment rates. The generalized model (Puga, 1999)

Tema 5 -EE Geographical Eligibility for Structural Funds Support

Tema 5 -EE Testing the generalized model in EU (Brakman et al, 2005)

Tema 5 -EE Figure 6.3 Break points and threshold distances (in km) Brakman et al, 2005: EU regions The generalized model (Puga, 1999; Brakman et al, 2005)

Tema 5 -EE Freeness of trade and a multiregional simulation: Brakman, Garretsen and Marrewijk, 2010: Using a multi-region model (194 EU regions) with non-neutral space, which considers: small spatial-cells, hubs, 3 dimensions (altitude), They simulate 2 NEG models in search of a long-run equilibrium for the allocation of economic activity in Europe depending on T and ε. – 1 st experiment: they simulate Krugman Results: for high levels of freeness of trade, just 5 regions allocate all the industrial activity: London, Paris, Madrid, Ruhrgebiet, Lombardia. – 2 nd experiment: they simulate Puga 1999 General Model. Are we in a Tomahawk or in a Bell-shape curve? How are the multi-region equivalents of these 2 paradigmatic diagrams? The generalized model (Puga, 1999; Brakman et al, 2010)

Tema 5 -EE Figure 6.11 Similarity between actual distribution and simulated distribution 6.11a: actual distribution 6.11b: simulated distribution, T = The generalized model (Puga, 1999; Brakman et al, 2010)

Tema 5 -EE Figure 6.12 The peak of agglomeration: a simulated blue banana The generalized model (Puga, 1999; Brakman et al, 2010)