Brixen Workshop and Summer School on International Trade and Finance - PowerPoint PPT Presentation

Brixen Workshop and Summer School on International Trade and Finance Part 4: Quasi-Experimental Geography Daniel Sturm London School of Economics 1

Brixen Workshop 2012 - 2 - Daniel Sturm 1 Introduction • This part of the workshop starts from the old question what determines the spatial distribution of economic activity. • Economic activity is highly unevenly distributed across countries and also across regions within countries. • A key question is what causes these differences in the level of economic activity. • We will focus mainly on the distribution of economic activity across regions or cities within countries.

Brixen Workshop 2012 - 3 - Daniel Sturm • There are at least two broad explanations for the unequal distribution of empirical activity across space within countries: – Fundamentals: differences in the fundamental productivity of locations. – Agglomeration Forces: Proximity to other economic agents increases the attractiveness of a location. • These two mechanisms are obviously not exclusive and can both operate at the same time. • The key empirical question is to what extent observed patterns of activity are explained by these two mechanism.

Brixen Workshop 2012 - 4 - Daniel Sturm • Whether fundamentals or agglomeration forces are responsible for the pattern of economic activity has important implications for the persistence of spatial equilibria. • Suppose for example that only agglomeration forces are operating. • In this case the location of economic activity is rather arbitrary - a location is attractive because other workers are locating there. • This is a bit like choosing a nightclub: club A is “cool” because all the “cool” people go to club A rather than club B. • If instead only fundamentals are operating then the distribution of activity is determined by the distribution of fundamentals.

Brixen Workshop 2012 - 5 - Daniel Sturm • If agglomeration forces rather than fundamentals dominate the spatial distribution of activity this also has key policy implications. • In this case regional policy could try to move the distribution of activity between different equilibria. • With a temporary subsidy regions could try to attract a “critical mass” of economic activity. • Once this critical mass has been established, the location remains attractive even when the subsidy has ended.

Brixen Workshop 2012 - 6 - Daniel Sturm 1.1 Overview • The theoretical roots of economic geography • Fundamentals versus agglomeration forces • Empirical evidence: Bombing • Empirical evidence: German division • Empirical evidence: Portage • Outlook for future research

Brixen Workshop 2012 - 7 - Daniel Sturm 2 The Origins of Economic Geography • Krugman (1979) started the new trade theory. • This paper already contains almost all the ideas necessary for the new economic geography model of Krugman (1991). • We will briefly review the key building blocks of Krugman (1979) before looking at what economic geography has added to this model.

Brixen Workshop 2012 - 8 - Daniel Sturm 2.1 Basic Assumptions of Krugman (1979) • There are two countries. • Labor is the only factor of production. Endowments L and L ∗ . • Many firms, which produce differentiated products i ∈ [ 1, n ] . • Preferences are: n ∑ U = v ( c i ) (1) i = 1 with v ′ > 0 and v ′′ < 0 . These preferences incorporate “love of variety”.

Brixen Workshop 2012 - 9 - Daniel Sturm • Technology is: l i = α + β x i (2) with α , β > 0 . • Note that this production function has increasing returns to scale. • Firms are monopolistically competitive, i.e. they ignore the effects of their decisions on others and set prices like a monopolist. • For now assume that there is no trade between the two countries.

Brixen Workshop 2012 - 10 - Daniel Sturm 2.2 Equilibrium • In autarky the equilibrium in each country is a simply trade-off: – Love of variety means that ceteris paribus consumers want as much variety as possible. – However, increasing returns mean that each new variety requires the fixed labor requirement α . • The number of varieties that a country produces in equilibrium depends entirely on its labor endowment. • Key result: the larger country will produce more variety in equilibrium and offer higher real wages.

Brixen Workshop 2012 - 11 - Daniel Sturm 2.3 Allowing Migration • Krugman points out at the end of his 1979 paper that if migration is allowed people will want to move from small to large countries. • We can also interpret “countries” as regions or cities. • This incentive for people to agglomerate in the large country or region continues to exist even if we allow trade in goods. • The migration incentive only disappears if the “world is flat” and there are zero trade costs. • You have already learned earlier this week that empirically the earth is anything but flat.

Brixen Workshop 2012 - 12 - Daniel Sturm 3 Fundamentals versus Path Dependence • The simple Krugman (1979) model with migration can capture the basic idea of multiple equilibria and path dependence. • Consider a situation in which initially the two regions have the same population. • Now suppose some workers move from region one to region two. • This shift increases real wages in region two and induces further migration into region two. • This cumulative causation will draw the entire population of region one into region two.

Brixen Workshop 2012 - 13 - Daniel Sturm • If instead workers had moved from region two to region one, then region one would have ended up with all workers. • The model therefore predicts that there are multiple equilibria. • Which region becomes the large region depends on potentially small historical accidents.

Brixen Workshop 2012 - 14 - Daniel Sturm 3.1 The Role of Fundamentals • In the simple model considered above the two regions are equally “good” locations for workers ex-ante. • Apart from the number of workers locating in a region there are no other factors that determine the attractiveness of a location. • An alternative reason why workers locate in a region are differences in fundamentals that determine the productivity of regions. • A very basic way of capturing this idea in our framework are differences in the marginal labor requirement β between regions.

Brixen Workshop 2012 - 15 - Daniel Sturm • Suppose for example that β is lower in region one because of a favorable climate or access to navigable waterways. • If such a difference in productivity is large enough it will eliminate the possibility of path dependence. • The more productive region will attract all workers even if a temporary shock has displaced many or all workers to the less productive region.

Brixen Workshop 2012 - 16 - Daniel Sturm 3.2 Jargon: First versus Second Nature • The forces of cumulative causation are in the literature often referred to as “second nature” advantages of a location. • In contrast differences in the fundamental attractiveness of locations are referred to as “first nature” advantages of a location.

Brixen Workshop 2012 - 17 - Daniel Sturm 3.3 Jargon: Multiple Equilibria • Macroeconomists typically reserve the term “multiple equilibria” to models where expectations determine which equilibrium is selected. • Cases in which historical accidents determine which of several potential equilibria is selected are called “multiple steady-states” or “path-dependence”. • Other fields are less religious about this and refer to any situation where there are several potential equilibria as “multiple equilibria”. • We will follow this more relaxed definition of multiple equilibria.

Brixen Workshop 2012 - 18 - Daniel Sturm 3.4 Policy Implications • Whether location patterns are determined by fundamentals (first nature) or agglomeration forces (second nature) has important policy implications. • Governments spend considerable amounts of money trying to shift economic activity from one location to another. • Implicitly, a key rational for such policies is that agglomeration forces and path dependence are important.

Brixen Workshop 2012 - 19 - Daniel Sturm • The hope is that temporary subsidies can create a “critical mass” of economic activity in a location that makes the location self-sustaining. • If instead location patterns are mainly determined by fundamentals temporary interventions are futile.

Brixen Workshop 2012 - 20 - Daniel Sturm 3.5 The Key Empirical Question • To what extent is the observed distribution of economic activity determined but fundamentals or agglomeration forces and path dependence? • This question has generated a lot of discussion over the last decades. • For some proponents of economic geography the answer to this question is almost self-evident (see the quote on the next slide):

Brixen Workshop 2012 - 21 - Daniel Sturm “[T]he dramatic spatial unevenness of the real economy - the disparities between densely populated manufacturing belts and thinly populated farm belts, between congested cities and desolate rural areas; the spectacular concentration of particular industries in Silicon Valleys and Hollywoods - is surely the result not of inherent differences among locations but of some set of cumulative processes, necessarily involving some form of increasing returns, whereby geographic concentration can be self-reinforcing.” (Fujita et al., 1999, p. 2)