Increasing Returns and Economic Geography Redux © Allen C. Goodman, 2002

cw AC MR D  cw/(  (  F/c Equilibrium (1) MR = MC (2) Profits = 0 (2’) Price = AC

Transport Costs – Iceberg Key assumption Transport cost = (T-1) * Producer Price So, if T = 1, transport cost is 0. The higher T is, relative to 1, the more is lost, and the higher the transport cost. It costs $ to transport manufactured goods; it costs 0 to transport agricultural goods.

Impacts (8) n 1 domestic varieties cost p 1 n 2 imported varieties cost p 2 T Since each firm sells in both markets the price index is decreasing in the number of firms in both markets (because greater variety benefits consumers), and increasing in trade costs (9) So, if you produce a good at home rather than importing it, the domestic price P 1 , because n 1  and n 2 

Assume Labor Mobility When will eq’m exhibit diversification with manufacturing taking place in both countries, and when will it exhibit agglomeration? Assume a new mfg. firm enters in Country (region) 1 (and a firm exits in Country 2). If  1 falls, firm leaves and initial eq’m returns. If  1 rises, initial equilibrium is unstable. There are three effects of entry.

cw AC MR D  cw/(  (  F/c Three Effects of Entry 1 Price Index Effect Demand and MR 2 Demand or Backward Linkage Demand and MR 3 Cost or Forward Linkage AC and MC

Three effects (1) Price index – An extra firm lowers the industry price index which reduces the demand facing each existing firm. This is arrow 1. This is always stabilizing.

Three effects (2) Demand (backward linkage) – An extra firm raises demand for labor in Country 1. This puts upward pressure on local money wages, which encourages foreign workers to migrate. This in turn raises demand for local varieties. This is arrow 2 and tends to  ,  more inmigration, etc. Agglomeration is more likely when share of mfg in national income is high and transportation costs are low.

Three effects (3) Third effect – Remember that P 1  in Country 1. This tends to raise real wages As people come in, the supply of labor increases and money wage w may fall, increasing profitability. This further increases migration. This is arrow 3. It leads to more instability.

Putting them together Stability is affected by: T – transportation costs m - share of nominal income spent on mfg.  – elasticity of substitution between varieties Higher T always encourage stability. For sufficiently low T, diversification is always unstable since the countries are ex ante identical. Somewhere in between is a threshold level of trade costs, a “break” point at which the diversified equilibrium is on the brink of instability.

In sum With high transport costs, you get local agglomeration, but expensive foreign goods. Local wages may fall  to regional convergence. With low transport costs, you get local agglomeration, and cheaper foreign goods. Local wages may rise  regional divergence.