Economic integration and industrial agglomeration

The Economic and Social Review, Vol. 26, No. 1, October, 1994, pp. 1-17

Economic Integration and Industrial

Agglomeration

A N T H O N Y J. V E N A B L E S * London School of Economics

Abstract: This paper reviews recent research on industrial location, focusing on the way i n which reducing barriers to trade may induce relocation of industry. Integration may cause industries to agglomerate i n a few locations, this causing divergence of the structure of integrating economies, and possibly also divergence of income levels. Smaller locations will have lower real wages than large ones, although i n the limit — as trade costs go to zero — factor price equalisation occurs.

H

ow does economic i n t e g r a t i o n affect t h e l o c a t i o n o f economic a c t i v i t y across space? Does i n t e g r a t i o n l e a d to convergence o f income levels across t h e i n t e g r a t i n g regions, or does i t t e n d t o p u l l a c t i v i t y i n t o some regions a t t h e expense o f others? A t t e m p t s t o answer t h i s q u e s t i o n have a l o n g h i s t o r y . O n t h e one h a n d , a neo-classical v i e w o f t h e w o r l d suggests t h a t i n t e g r a t i o n m a y encourage divergence of economic s t r u c t u r e (as c o u n t r i e s specialise according t o comparative advantage), b u t convergence o f income levels. T h e most extreme statement of t h i s p o s i t i o n is t h e factor price equal­ i s a t i o n t h e o r e m , suggesting t h a t completely free t r a d e i n goods w i l l t e n d t o equalise factor prices, even i f factor m o b i l i t y is n o t possible. O n t h e o t h e r h a n d t h e r e is a s u b s t a n t i a l l i t e r a t u r e (associated w i t h Perroux, 1955, K a l d o r , 1972, M y r d a l , 1957 a n d others) a r g u i n g t h a t c u m u l a t i v e causation m a y t a k e over, p u l l i n g a c t i v i t y i n t o some regions at t h e expense of others, a n d thereby causing, or a t least perpetuating, i n t e r - r e g i o n a l i n e q u a l i t y .

Recent r e s e a r c h has b r o u g h t t h i s second p o s i t i o n i n t o m a i n s t r e a m economics. The w o r k is based on f o r m a l i s i n g t h e "positive linkages" t h a t m a y

*Dublin Economic Workshop, Guest Lecture, Eighth Annual Conference of the Irish Economic Association, Carrickmacross, 13-15 May 1994.

exist b e t w e e n d i f f e r e n t agents i n a p a r t i c u l a r location. These linkages m a y t a k e t h e f o r m o f t e c h n o l o g i c a l e x t e r n a l i t i e s — for e x a m p l e k n o w l e d g e spillovers b e t w e e n f i r m s . O r t h e y m a y be "pecuniary externalities", i n t h e presence o f w h i c h expansion of one a c t i v i t y raises the p r o f i t a b i l i t y of others. I f these l i n k a g e s are s t r o n g enough t h e n t h e y can create positive feedbacks, w h e r e b y e x p a n d i n g a n i n d u s t r y i n one location raises the profits of f i r m s at t h a t location, encouraging f u r t h e r expansion and "cumulative causation". The outcome o f such a process is t h e s p a t i a l agglomeration of a c t i v i t y , a n d con­ sequent divergence of b o t h economic s t r u c t u r e and income across countries or regions.

I n t h i s paper I r e v i e w some o f t h e w o r k t h a t P a u l K r u g m a n a n d I have done ( b o t h separately a n d j o i n t l y ) on t h i s topic. T h e f i r s t element of research on t h e topic is t h e c o n s t r u c t i o n o f a t h e o r y o f t h e location of f i r m s . T h i s is based o n f i r m s i n i n d u s t r i e s i n w h i c h t h e r e are increasing r e t u r n s to scale a n d i m p e r f e c t c o m p e t i t i o n . I n a d d i t i o n to i t s e m p i r i c a l relevance, h a v i n g i n c r e a s i n g r e t u r n s is necessary i f a n i n t e r e s t i n g t h e o r y of location is to be constructed; w i t h o u t increasing r e t u r n s to scale firms do n o t face r e a l location decisions, since t h e y can, w i t h o u t any cost disadvantage, s p l i t i n t o p a r t s o p e r a t i n g i n a l l locations. Section I I o f t h i s paper outlines a basic model of f i r m location, a n d reviews some of i t s implications.

T h e second e l e m e n t o f t h e research is to explore t h e l i n k a g e s between agents w h i c h m a y give rise to agglomeration. O u r focus is on t h e pecuniary e x t e r n a l i t i e s t h a t are created by imperfect c o m p e t i t i o n . I t t u r n s o u t t h a t these create a g g l o m e r a t i o n forces, t h e s t r e n g t h of w h i c h depend on levels of t r a d e b a r r i e r s b e t w e e n locations. Section I I I o u t l i n e s these l i n k a g e s , a n d Section I V demonstrates how i n t e g r a t i o n — reductions i n trade costs — m a y t r i g g e r a process o f a g g l o m e r a t i o n , a n d t h e r e b y create i n t e r - r e g i o n a l i n e q u a l i t y .

M o s t o f t h e research on agglomeration has, so far, concentrated on the w a y i n w h i c h a g g l o m e r a t i o n can occur i n economies w h i c h are i d e n t i c a l i n u n d e r l y i n g s t r u c t u r e . Section V of t h e paper presents a b r i e f e x p l o r a t i o n of t h e w a y i n w h i c h these agglomeration forces operate w h e n economies are n o t i d e n t i c a l , b u t differ i n size. The t e n t a t i v e conclusion is t h a t s m a l l countries m a y experience loss of i n d u s t r y i n the early stages o f i n t e g r a t i o n , c o n f i r m i n g t h e v i e w t h a t c u m u l a t i v e causation w i l l d r a w i n d u s t r y t o w a r d s " c e n t r a l " regions. However, t h e f u l l i m p l i c a t i o n s of t h i s r e m a i n to be w o r k e d out, a n d t h e paper concludes w i t h a n agenda for future research.

I I T H E L O C A T I O N O F F I R M S

considerations. T h e f i r s t is t h e cost o f i n p u t s a t each l o c a t i o n ( s u i t a b l y adjusted for a l l i n p u t q u a l i t y differentials). T h e second is t h e cost o f m a r k e t access — i.e., t h e cost of g e t t i n g o u t p u t to consumers. O n t h e f i r s t o f these t h e r e is l i t t l e to say; o t h e r t h i n g s b e i n g equal, f i r m s go w h e r e i n p u t s are cheaper. The second is more i n t e r e s t i n g , because m a r k e t access costs i n t e r a c t w i t h trade b a r r i e r s i n a w a y t h a t is not i m m e d i a t e l y obvious.

Consider t h e f o l l o w i n g t h o u g h t e x p e r i m e n t . Suppose t h a t t h e r e are t w o locations, each w i t h t h e same costs, b u t w i t h different m a r k e t sizes. " M a r k e t size" refers to t o t a l expenditure o n t h e product i n t h e location, a n d t h e r e is a cost o f s h i p p i n g t h e p r o d u c t between locations. The l o c a t i o n w i t h t h e l a r g e r m a r k e t size can be t h o u g h t of as a "central" location, w h e r e these f i r m s have access to m a n y consumers a t l o w t r a d e costs, whereas t h e l o c a t i o n w i t h t h e smaller m a r k e t size is "peripheral" — f i r m s face t r a d e costs i n r e a c h i n g m a n y consumers.

For s i m p l i c i t y , suppose t h a t location 1 has m a r k e t size 1 a n d location 2 has m a r k e t size 2. Suppose f u r t h e r m o r e t h a t l o c a t i o n 1 has j u s t one f i r m , a n d location 2 has t w o . The t r i p l e s (a: b, b) i n t h e body of Table 1 give t h e sales o f each of these three f i r m s , t h e f i r s t element b e i n g sales of t h e f i r m located i n 1, a n d t h e second a n d t h i r d t h e sales o f each o f t h e f i r m s l o c a t e d i n 2. Columns of t h e table give sales i n m a r k e t s 1, 2, a n d t o t a l sales ( f i n a l column).

Table 1: Firms' Sales as Trade Costs Change

Location 1; Location 2;

Market Size = 1 Market Size = 2 Total Sales No. of Firms = 1 No. of Firms = '2 of Each Firm

A (1: 0, 0) (0: 1,1) (1:1,1)

I (1/2:1/4, 1/4) (2/5: 4/5, 4/5) (18/20: 21720, 21/20) F (1/3: 1/3,1/3) (2/3: 2/3, 2/3) (1: 1, 1)

T h e p o i n t t o note from t h i s example is t h e non-monotonicity of t h e t o t a l sales of f i r m s i n t h e t w o locations as i n t e g r a t i o n occurs. I n t h e i n i t i a l stages of i n t e g r a t i o n t h e f i r m i n t h e s m a l l location suffers f r o m t h e r e d u c t i o n i n t r a d e b a r r i e r s (its sales go f r o m 1 t o 18/20), a n d f i r m s i n t h e large location g a i n (sales increasing from 1 to 21/20). I n the l a t e r stages, f i r m s i n t h e large l o c a t i o n suffer a n d t h e f i r m i n t h e s m a l l location gains (as sales r e t u r n t o u n i t y ) .

T h i s n u m e r i c a l example makes t h e simple, b u t r a t h e r general p o i n t , t h a t f i r m s i n s m a l l economies are p a r t i c u l a r l y disadvantaged at i n t e r m e d i a t e levels o f t r a d e b a r r i e r s . The i n t u i t i o n is t h a t there are t w o opposing forces at w o r k as t r a n s p o r t costs f a l l . O n the one h a n d , f i r m s i n t h e s m a l l economy are more dependent o n foreign t r a d e t h a n are f i r m s i n t h e large economy, so g a i n r e l a t i v e l y m u c h from t r a d e l i b e r a l i s a t i o n . B u t on the other h a n d , t h e r e are more f i r m s i n t h e large economy t h a n i n t h e s m a l l , a n d each o f these f i r m s s t a r t s s e l l i n g i n t o t h e s m a l l m a r k e t as t r a d e costs come d o w n . I n t h e early stages of l i b e r a l i s a t i o n the l a t t e r effect dominates (since i n i t i a l trade volumes are zero), a n d f i r m s i n t h e s m a l l economy lose out to i m p o r t s . I n the l a t t e r stages t h i s is reversed, a n d t h e benefits of b e i n g able to sell i n t o t h e large m a r k e t become r e l a t i v e l y more i m p o r t a n t . T h i s emerges as a m a t t e r o f a r i t h m e t i c i n t h i s example, b u t is a property of a m u c h w i d e r range of models (see R r u g m a n a n d Venables, 1990).

The preceding example h e l d the n u m b e r of f i r m s i n each location constant. To s t u d y w h a t happens t o t h e l o c a t i o n o f i n d u s t r y we need t o m a k e t h e n u m b e r o f f i r m s endogenous, a n d t h i s can be done u s i n g a s t a n d a r d model o f t r a d e a n d i m p e r f e c t c o m p e t i t i o n . For example, consider a " D i x i t - S t i g l i t z " m o d e l o f m o n o p o l i s t i c c o m p e t i t i o n ( D i x i t a n d S t i g l i t z , 1977), w h i c h , i n i t s m u l t i - c o u n t r y f o r m , has probably become t h e benchmark model of new t r a d e t h e o r y (see for example H e l p m a n and K r u g m a n , 1985). T h e d e m a n d side of t h i s m o d e l is characterised by p r o d u c t d i f f e r e n t i a t i o n , separate p r o d u c t v a r i e t i e s each h a v i n g iso-elastic demand curves, these curves b e i n g steeper t h e more differentiated are products. The supply side has each f i r m producing a single v a r i e t y o f d i f f e r e n t i a t e d product, a n d o p e r a t i n g u n d e r i n c r e a s i n g r e t u r n s to scale. There is imperfect c o m p e t i t i o n , w i t h price cost m a r k - u p s d e t e r m i n e d by t h e slopes o f demand curves, a n d the e q u i l i b r i u m n u m b e r o f f i r m s d e t e r m i n e d by t h e c o n d i t i o n t h a t each f i r m should make zero profits. T h e m u l t i - c o u n t r y v a r i a n t of t h i s has t h e l o c a t i o n o f i n d u s t r y (i.e., t h e n u m b e r o f f i r m s o p e r a t i n g i n each c o u n t r y ) d e t e r m i n e d by zero p r o f i t conditions for each country.

location 1 d i v i d e d by the n u m b e r i n location 2. C denotes costs i n l o c a t i o n 1 r e l a t i v e t o 2, a n d S denotes country 1 expenditure on the product r e l a t i v e to t h a t i n country 2. t is t h e p r o p o r t i o n a l trade cost factor, so t = 1 is completely free t r a d e , a n d t = 1.5 means t h a t t r a d e costs a m o u n t t o 50 per cent of t h e value of o u t p u t ; these t r a d e costs measure a l l t h e costs o f s h i p p i n g between locations — tariffs, n o n - t a r i f f barriers, t r a n s p o r t costs, a n d any costs imposed by language or i n s t i t u t i o n a l differences. The e q u i l i b r i u m location o f i n d u s t r y is a f u n c t i o n o f r e l a t i v e costs, expenditures, a n d t r a d e costs, a n d we s h a l l summarise t h i s relationship by the function f, so

N = f ( C , S , t ) (1) - + ?

As expected, h i g h e r r e l a t i v e costs m e a n fewer f i r m s i n l o c a t i o n 1 r e l a t i v e to location 2; greater expenditure means more f i r m s ; a n d t r a d e costs can, as we have already seen, operate i n either direction.

The function f is i l l u s t r a t e d on F i g u r e 1. The v e r t i c a l axis is C, t h e level o f production costs i n location 1 r e l a t i v e to 2, the h o r i z o n t a l axis measures t r a d e costs, t , a n d the figure is d r a w n for the case of S = 0.1 — i.e., c o u n t r y 1 h a v i n g a m u c h smaller m a r k e t t h a n country 2. The curves are iso-N lines. T h u s N = S is t h e combination o f t and C at w h i c h i n d u s t r y is d i v i d e d between locations i n p r o p o r t i o n t o m a r k e t size, a n d so on. C l e a r l y , i f N/S < 1, t h e n t h e s m a l l country is a net i m p o r t e r of the good.

T h e effects o f economic i n t e g r a t i o n o n t h e l o c a t i o n o f i n d u s t r y a t unchanged r e l a t i v e costs are found by m o v i n g h o r i z o n t a l l y f r o m left t o r i g h t across t h i s f i g u r e . We see t h a t i f C = 1 t h e n r e d u c i n g t r a d e costs b r i n g s steady relocation o f i n d u s t r y from the s m a l l l o c a t i o n to t h e l a r g e , w i t h t h e s m a l l location l o s i n g a l l i n d u s t r y w h e n the N = 0 contour is passed. However, i n t h e l i m i t w h e n t r a d e costs are zero ( t = 1) t h e n f i r m s are i n d i f f e r e n t about t h e i r location.

I f the s m a l l economy has a cost advantage (say C = 0.95), t h e n t h e p i c t u r e t h a t emerges as t r a d e costs are reduced is one of relocation of i n d u s t r y f r o m t h e s m a l l economy to t h e large, u n t i l trade costs are q u i t e l o w ( i n t h e figure, a r o u n d 1.2) followed by a reversal of the process. The i n t u i t i o n here is t h a t i n t h e i n i t i a l stages o f i n t e g r a t i o n t h e m a r k e t access forces d o m i n a t e , p u l l i n g i n d u s t r y t o t h e l o c a t i o n w i t h t h e l a r g e r m a r k e t . B u t a t l o w enough t r a d e costs, i n d u s t r y becomes more "footloose" a n d more sensitive t o p r o d u c t i o n cost differences; i n d u s t r y t h e n moves to the lower cost location.

extreme case w h e r e t h e i n d u s t r y u n d e r consideration uses a specific factor, a n d t h e r e l a t i v e endowment of t h e factor is equal to relative m a r k e t size. F u l l e m p l o y m e n t o f t h e specific factor t h e n requires t h a t N = S, a n d the price of t h e factor m u s t therefore move so t h a t relative costs, C, follow t h e N = S locus i n F i g u r e 1. A s is clear f r o m t h e d i a g r a m , at h i g h t r a d e costs r e l a t i v e p r o d u c t i o n costs (and r e l a t i v e wages) m u s t decline for the s m a l l economy. A t lower t r a d e costs t h i s is reversed, as t h e disadvantage of the s m a l l economy is d i m i n i s h e d , a n d i n d u s t r i a l l o c a t i o n becomes i n c r e a s i n g l y sensitive t o p r o d u c t i o n cost differences. A s t goes to u n i t y (completely costless trade), so t h e N = S locus converges smoothly to t h e l i m i t i n g value i m p l i e d by factor price equalisation. T h e i n f o r m a t i o n presented i n F i g u r e 1 gives r e l a t i v e costs (or wages) measured i n t e r m s of some numeraire good. However, the message of t h e f i g u r e carries over t o r e a l wages. The s m a l l economy experiences a r e d u c t i o n i n r e a l wages i n t h e early stages o f i n t e g r a t i o n , followed by r e a l wage increase. T h e l a r g e economy experiences r e a l wage g r o w t h i n e a r l y stages o f i n t e g r a t i o n , a n d either slower g r o w t h or possibly r e a l wage decline as t r a d e costs become very s m a l l .

T h e analysis o f t h i s section teaches us t w o t h i n g s . F i r s t , t h e effects o f i n t e g r a t i o n o n s m a l l or " p e r i p h e r a l " economies are ambiguous. A t i n t e r

m e d i a t e t r a d e costs t h e s m a l l l o c a t i o n is d i s a d v a n t a g e d , a n d t h i s c a n m a n i f e s t i t s e l f i n different ways; reduced sales per f i r m , i f t h e n u m b e r o f f i r m s is h e l d constant; exit of firms, i f wages are h e l d constant; or a r e d u c t i o n i n wages, i f l a b o u r d e m a n d impacts o n wage rates. T h e second message is t h a t t h e l o c a t i o n o f d e m a n d m a y have a d i s p r o p o r t i o n a t e effect o n t h e location o f i n d u s t r y , i n t h a t locations w i t h s m a l l d e m a n d are net i m p o r t e r s o f t h e product. T h i s provides a basis for the "demand l i n k a g e " mechanism w h i c h we s h a l l see i n the next section.

I l l A G G L O M E R A T I O N FORCES

The story so far shows t h a t centre/periphery distinctions are of importance i n assessing t h e effects o f economic i n t e g r a t i o n , b u t do n o t c a p t u r e " c u m u l a t i v e causation" i n t h e development of regional i n e q u a l i t i e s . To do t h i s we need t o add "positive feedbacks" or "linkages" between t h e actions of various decision t a k e r s i n t h e system. Before discussing w h a t these l i n k a g e s m i g h t be, consider Figures 2a a n d 2b. T h e h o r i z o n t a l axis has t h e r e l a t i v e n u m b e r of f i r m s i n t h e locations, N , a n d t h e v e r t i c a l has t h e difference between t h e e q u i l i b r i u m a n d the actual value of N , i.e., i t measures f ( C , S, t ) - N . F i g u r e 2a captures t h e case we discussed i n t h e previous section. I f r e l a t i v e costs, C, a n d r e l a t i v e m a r k e t sizes, S, are independent o f N , t h e n f - N has a 45° negative gradient, as i l l u s t r a t e d . O u t of e q u i l i b r i u m dynamics are i l l u s t r a t e d b y the arrows l y i n g on the h o r i z o n t a l axis. I f f is greater t h a n N , t h e n profits are positive and e n t r y occurs, a n d i f f is less t h a n N t h e n t h e r e is e x i t , g i v i n g t h e directions of m o t i o n i l l u s t r a t e d . C l e a r l y t h e e q u i l i b r i u m p o i n t is at E , a n d t h i s e q u i l i b r i u m is stable.

I f r e l a t i v e costs and/or m a r k e t size are functions of r e l a t i v e n u m b e r s o f f i r m s t h e n t h e gap between e q u i l i b r i u m a n d a c t u a l r e l a t i v e location can be w r i t t e n as f ( C ( N ) , S(N), t ) - N . F i g u r e 2b i l l u s t r a t e s a case w h e r e these effects operate to m a k e f, t h e e q u i l i b r i u m n u m b e r o f f i r m s a n i n c r e a s i n g function o f t h e a c t u a l number, N , and, f u r t h e r m o r e , t h e effects are so s t r o n g t h a t t h e g r a d i e n t o f f - N goes from negative to positive. O u r dynamics give e n t r y w h e n f > N , t h i s now b e i n g t o t h e r i g h t of p o i n t E . E is therefore a n e q u i l i b r i u m , b u t i t is unstable. F o r t h e case d r a w n , t h e r e are t w o stable e q u i l i b r i a . One is a t p o i n t A w i t h N = 0, and the other s i m p l y has t h e c o u n t r y labels reversed, so is a t 1/N = 0. I n each o f these cases a l l f i r m s have a g g l o m e r a t e d i n a s i n g l e l o c a t i o n , a n d e n t r y i n t h e o t h e r l o c a t i o n i s unprofitable.

N

f(c,s,t) - N

Figure 2a.

A

f [ c ( N ) , s ( N ) , t ] - N

^

a n d m a r k e t size on t h e n u m b e r of f i r m s i n each l o c a t i o n , a n d can these be large enough to reverse t h e g r a d i e n t of f - N ?

K r u g m a n (1991a,b) demonstrates t h a t labour m o b i l i t y can serve t o create linkages and hence agglomeration. A s we saw, the model o u t l i n e d i n Section I I has t h e property t h a t t h e larger region has higher r e a l wages t h a n does the s m a l l region. E v i d e n t l y , i f labour is mobile, i t w i l l flow from t h e s m a l l r e g i o n to t h e l a r g e . A s l a b o u r moves i t t a k e s i t s s p e n d i n g w i t h i t , so t h e l a r g e m a r k e t gets l a r g e r a n d t h e s m a l l smaller, a m p l i f y i n g t h e wage difference, and possibly l e a d i n g to agglomeration. (Supplies of other factors w i l l stop t h e economy from e m p t y i n g a l l together.) We can relate t h i s to Figures 2a a n d 2b i n the f o l l o w i n g way. I n t h e K r u g m a n model, i t is as i f w h e n f i r m s move t h e y t a k e w o r k e r s w i t h t h e m . Relative m a r k e t size, S, is therefore a n i n c r e a s i n g function o f the r e l a t i v e n u m b e r of f i r m s (and w o r k e r s ) N . We s h a l l call t h i s a "demand l i n k a g e " — i t says t h a t the more f i r m s t h e r e are i n a l o c a t i o n t h e h i g h e r is d e m a n d for f i r m s ' o u t p u t a t the location. I f t h i s d e m a n d l i n k a g e is p o w e r f u l enough t h e n i t w i l l give c o n f i g u r a t i o n 2b, w i t h a g g l o m e r a t i o n , r a t h e r t h a n configuration 2a. Evidence i n the U S (for example B l a n c h a r d a n d K a t z , 1992) suggests t h a t m i g r a t i o n m a y be significant enough to create these forces for U S states, a l t h o u g h m i g r a t i o n i n Europe is perhaps i n s u f f i c i e n t l y responsive to economic factors for t h i s mechanism to be o f m u c h relevance to European i n t e g r a t i o n .

A n a l t e r n a t i v e possibility is t h a t there is a "cost linkage", C ( N ) . One f o r m t h i s could t a k e is positive technological e x t e r n a l i t i e s t h a t are o f l i m i t e d geographical reach. I n t h i s case C is a decreasing function of N a n d (since f is decreasing i n N ) t h i s can, i f powerful enough, give rise to agglomeration. I t is not v e r y satisfactory t o s i m p l y assume t h e presence of such e x t e r n a l i t i e s ; there m u s t be some t r a n s m i s s i o n mechanisms w h i c h creates these spillovers, a n d i t w o u l d be nice t o see t h i s modelled e x p l i c i t l y . Nevertheless, i t seems clear t h a t knowledge spillovers of some sort m a y w e l l be i m p o r t a n t i n c e r t a i n i n d u s t r i e s — h i g h technology and Silicon V a l l e y s p r i n g to m i n d .

t h i s means t h a t C ( N ) is a decreasing function. B o t h these effects w o r k i n t h e d i r e c t i o n o f agglomeration, as i n F i g u r e 2b.

W e a r g u e d i n t h e preceding section t h a t the i n t e r a c t i o n between imperfect c o m p e t i t i o n a n d i n t e r m e d i a t e goods create demand and cost linkages between f i r m s . W h e t h e r or n o t these are p o w e r f u l enough to cause a g g l o m e r a t i o n depends o n a n u m b e r o f parameters. These i n c l u d e t h e m a g n i t u d e o f t h e i n p u t - o u t p u t l i n k a g e s , t h e degree of imperfect competition, a n d the level of t r a d e costs b e t w e e n regions. I t is t h e role of t r a d e costs t h a t makes these effects i m p o r t a n t i n t h e study o f economic i n t e g r a t i o n .

P o s s i b i l i t i e s are i l l u s t r a t e d o n F i g u r e s 3a, 3b a n d 3c. A l l t h r e e are c o n s t r u c t e d w i t h t h e same i n p u t - o u t p u t linkages a n d t h e same price-cost m a r k - u p s , b u t w i t h different levels of t r a d e costs. F i g u r e 3a is d r a w n w i t h h i g h t r a d e costs, t h i s g i v i n g a n e q u i l i b r i u m at E w i t h p r o d u c t i o n diversified between t h e locations. The i n t u i t i o n for t h i s is clear. A t v e r y h i g h t r a d e costs (close to a u t a r k y ) , t h e presence of consumer demand i n each location means t h a t t h e i n d u s t r y has t o produce i n b o t h locations. F i g u r e 3c is d r a w n for a l o w level o f t r a d e costs. T h i s reduces t h e need to be close to f i n a l consump­ t i o n , m a k i n g forces for agglomeration r e l a t i v e l y more powerful. T h e

equilib-I V equilib-I N T E G R A T equilib-I O N A N D A G G L O M E R A T equilib-I O N

f-N

o

N

r i u m a t E is unstable, there is a stable e q u i l i b r i u m at A , and a f u r t h e r stable e q u i l i b r i u m at p l u s i n f i n i t y (1/N = 0). The case of i n t e r m e d i a t e trade costs is i l l u s t r a t e d i n F i g u r e 3b. The diversified e q u i l i b r i u m at E is stable, b u t so too is a g g l o m e r a t i o n — t h e e q u i l i b r i a at N = 0 a n d 1/N = 0. I n between these stable e q u i l i b r i a are unstable e q u i l i b r i a , at the points B .

The dependence of the s t r u c t u r e of e q u i l i b r i u m on trade costs is d r a w n out more e x p l i c i t l y i n F i g u r e 4 w h i c h has trade costs on the h o r i z o n t a l axis, a n d t h e absolute n u m b e r s o f f i r m s i n each location, denoted n j a n d n2, on t h e

v e r t i c a l . The n u m b e r s o f f i r m s are computed from a n u m e r i c a l example. Solid l i n e s on t h e f i g u r e r e p r e s e n t stable e q u i l i b r i a , a n d dashed l i n e s u n s t a b l e e q u i l i b r i a .

The example i l l u s t r a t e d i n t h e figure is constructed w i t h the t w o econo­ mies i d e n t i c a l i n u n d e r l y i n g preferences, technology, and endowments, i m p l y ­ i n g t h a t the d i v e r s i f i e d e q u i l i b r i u m has equal d i v i s i o n of i n d u s t r y between the locations, na = n2. A t h i g h levels of trade costs (t > 2.5) diversification is

the u n i q u e ( a n d therefore stable) e q u i l i b r i u m . W i t h trade costs i n the region 1.85-2.5 there are five e q u i l i b r i a . The symmetric diversified case = n2) , the

e q u i l i b r i u m w i t h i n d u s t r y e n t i r e l y i n location 2 (as i l l u s t r a t e d ) , the equi­ l i b r i u m w i t h i n d u s t r y e n t i r e l y i n location 1 (not i l l u s t r a t e d ) a n d t w o unstable e q u i l i b r i a . Below 1.85 there are t w o stable agglomerated e q u i l i b r i a (the one i l l u s t r a t e d has i n d u s t r y e n t i r e l y i n location 2), a n d the diversified outcome r e m a i n s a n e q u i l i b r i u m , a l t h o u g h i t is unstable. Economic i n t e g r a t i o n moves us f r o m l e f t t o r i g h t on t h i s d i a g r a m . S t a r t i n g w i t h a stable d i v e r s i f i e d

n2

,'B nl =n2

^

11)= 0

— i r 1 1 1 1 i i

1.25 1.5 1,75 2 2.25 2.5 2.75 3 3.25

trade cost

Figure 4. 40

30

firm nos.

20

e q u i l i b r i u m t h e r e is a c r i t i c a l p o i n t ( p o i n t B , a t a p p r o x i m a t e l y t = 1.85) a t w h i c h t h e d i v e r s i f i e d e q u i l i b r i u m is r e n d e r e d u n s t a b l e a n d i n d u s t r y relocates, a g g l o m e r a t i n g i n a single location. However, t h e r e is n o t h i n g i n t h e t h e o r y t h a t says w h e t h e r t h e a g g l o m e r a t i o n occurs i n l o c a t i o n 1 or i n location 2.

T h e f i g u r e is constructed u n d e r t h e a s s u m p t i o n t h a t wages — a n d t h e prices of any other p r i m a r y factors used i n the i n d u s t r y — are h e l d constant a n d equal. U n d e r these conditions i t is possible t o show t h a t t h e s t r u c t u r e of e q u i l i b r i a m u s t be q u a l i t a t i v e l y as i l l u s t r a t e d (Venables, 1993). T h a t i s , p r o v i d i n g t h e r e is b o t h imperfect c o m p e t i t i o n a n d a n i n p u t - o u t p u t l i n k a g e , t h e n i t m u s t be the case t h a t the system has a c r i t i c a l p o i n t (point B , a t w h i c h t h e d i v e r s i f i e d e q u i l i b r i u m flips f r o m b e i n g stable to u n s t a b l e ) , a t some positive level o f t r a d e costs, ( t > 1). T h i s c r i t i c a l value is greater ( a n d hence t h e range o f t r a d e costs i n w h i c h agglomeration occurs is l a r g e r ) t h e h i g h e r is the p r i c e - m a r g i n a l cost m a r k - u p generated b y imperfect competition, a n d t h e greater is the share of i n t e r m e d i a t e goods i n production.

T h e m e c h a n i s m d r i v i n g t h i s a g g l o m e r a t i o n o f a c t i v i t y is t h e i n t e r a c t i o n between increasing r e t u r n s to scale a n d i n p u t - o u t p u t linkages. A t w h a t level of i n d u s t r i a l aggregation should we expect these forces to be most powerful? Do t h e y operate a t t h e level of p a r t i c u l a r i n d u s t r i e s or groups of i n d u s t r i e s w h i c h are r e l a t i v e l y t i g h t l y l i n k e d by i n p u t - o u t p u t connections? O r are t h e linkages i m p o r t a n t for m a n u f a c t u r i n g activity, as a whole?

The former case is studied i n K r u g m a n a n d Venables (1993). A t h i g h t r a d e b a r r i e r s each i n d u s t r y operates i n each location, b u t as t r a d e b a r r i e r s come d o w n , so t h e r e is a process of a g g l o m e r a t i o n i n w h i c h some i n d u s t r i e s concentrate i n one location, and others i n other locations. A p p l y i n g t h i s to Europe suggests t h a t t h e economic geography of Europe m a y become more l i k e t h a t o f t h e U S . Regions — or countries — lose t h e i r presence i n some i n d u s t r i e s , a n d i n d u s t r i e s become m o r e g e o g r a p h i c a l l y c o n c e n t r a t e d . However, each region or c o u n t r y may have some cluster of i n d u s t r i e s so t h a t a l t h o u g h there is divergence of the s t r u c t u r e of economies, there need be no divergence o f income. The welfare economics of t h i s case are s t r a i g h t f o r w a r d . G a i n s f r o m i n t e g r a t i o n are p a r t i c u l a r l y large (as i n d u s t r i e s r e a p benefits f r o m agglomeration) and m a y be q u i t e evenly d i s t r i b u t e d across regions — each r e g i o n has l a b o u r d e m a n d f r o m i t s cluster o f i n d u s t r i e s . H o w e v e r , i n t e g r a t i o n m a y w e l l give rise to significant a d j u s t m e n t costs as i n d u s t r i e s relocate, c o u n t r i e s lose a presence i n some i n d u s t r i e s , a n d p e r h a p s also c e r t a i n types of skills become r e d u n d a n t i n some locations.

E v i d e n t l y , we can no longer continue to assume t h a t wages are exogenous, b u t m u s t now allow t h e m t o respond t o p o t e n t i a l l y w i d e l y different levels of l a b o u r d e m a n d . L i n k i n g wage r a t e s to i n d u s t r i a l l a b o u r d e m a n d modifies analysis i n t w o ways.

F i r s t , i f r e l a t i v e wages depend o n the location o f i n d u s t r y , t h e n t h i s w i l l t e n d to offset agglomeration forces, since i t w i l l make C ( N ) a n increasing n o t a decreasing f u n c t i o n . I t is possible t h a t t h i s effect m a y be large enough to p r e v e n t a g g l o m e r a t i o n f r o m o c c u r r i n g . ( I n t h e extreme case i n w h i c h each l o c a t i o n has a fixed labour supply t o i n d u s t r y , t h e n obviously agglomeration cannot occur — i n d u s t r y has t o go where the labour is). A n i n t e r e s t i n g case arises i f t h e wage effect is less powerful t h a n t h i s . The outcome w i l l t h e n look as i t does i n F i g u r e 4 u n t i l q u i t e l o w t r a d e costs are reached. However, at zero t r a d e costs i t m u s t be the case t h a t the diversified e q u i l i b r i u m w i t h nx =

n2 is u n i q u e a n d therefore stable. T h i s is because agglomeration effects are

absent ( t h e l o c a t i o n o f i n t e r m e d i a t e goods suppliers a n d f i n a l d e m a n d is completely i m m a t e r i a l w h e n t h e r e are no t r a d e costs). I n d u s t r y therefore goes t o w h i c h e v e r l o c a t i o n has t h e l o w e r wage costs, w h i c h means t h a t i n e q u i l i b r i u m wages m u s t be equal, i m p l y i n g equal labour demands and equal d i v i s i o n o f t h e i n d u s t r y . T h e o v e r a l l p a t t e r n of e q u i l i b r i a as t r a d e costs go u p w a r d s from free t r a d e is therefore as follows; at v e r y low trade costs there is a u n i q u e e q u i l i b r i u m , w i t h factor supply considerations d i v i d i n g production between locations; at somewhat h i g h e r trade costs there are five e q u i l i b r i a — s t a b l e e q u i l i b r i a w i t h a n d w i t h o u t a g g l o m e r a t i o n p l u s t w o u n s t a b l e e q u i l i b r i a ; a t h i g h e r t r a d e costs again, t h e p a t t e r n is as i n F i g u r e 4, w i t h three, t h e n five, a n d t h e n one e q u i l i b r i u m . Essentially t h e n , at very low trade costs l o c a t i o n of i n d u s t r y is d e t e r m i n e d by factor supply considerations; at v e r y h i g h t r a d e costs by f i n a l consumer demand; and at intermediate levels of t r a d e costs, agglomeration forces are d o m i n a n t .

V I N T E G R A T I O N , A G G L O M E R A T I O N A N D C O U N T R Y S I Z E

T h e preceding section looked a t possible effects of i n t e g r a t i o n u n d e r t h e a s s u m p t i o n t h a t the u n d e r l y i n g s t r u c t u r e o f t h e i n t e g r a t i n g economies is s y m m e t r i c a l . W h a t h a p p e n s w h e n t h i s a s s u m p t i o n i s removed? S u c h asymmetric cases have n o t y e t been w o r k e d out i n any d e t a i l . I n t h i s section we m e r e l y i l l u s t r a t e some possibilities for a case i n w h i c h t h e t w o economies are o f different size a l t h o u g h — b y a s s u m p t i o n — have equal a n d constant wages.

The story is given i n F i g u r e 5. The construction o f t h i s figure is s i m i l a r to t h a t of F i g u r e 4, except t h a t c o u n t r y 2 is now assumed to be twice t h e size of c o u n t r y 1. A t h i g h t r a d e costs the e q u i l i b r i u m is diversified, a l t h o u g h t h e r e are more firms i n 2 t h a n i n 1, as w o u l d be expected. Reducing t r a d e costs amplifies t h e difference between economic s t r u c t u r e , r a t h e r as we saw i n Section I I . A t f i r s t there is continuous response to l o w e r t r a d e costs, b u t a t some c r i t i c a l value, B , t h e agglomeration forces become r e l a t i v e l y p o w e r f u l enough to m a k e the diversified e q u i l i b r i u m unstable, so t h e system flips t o agglomeration. However, whereas i n F i g u r e 4 there were m u l t i p l e e q u i l i b r i a , i t now has to be the case t h a t ( i f c o u n t r y 2 is sufficiently l a r g e r t h a n 1) there is a u n i q u e e q u i l i b r i u m . The agglomeration m u s t occur i n t h e l a r g e r country, so i t is c e r t a i n l y the case t h a t n2 > 0 and nx = 0.

F i g u r e 5 describes a s i t u a t i o n i n w h i c h wages i n t h e t w o c o u n t r i e s are constant a n d equal. W e can conjecture about t h e effects of r e m o v i n g t h i s a s s u m p t i o n a n d l e t t i n g wages adjust i n response t o i n d u s t r i a l l a b o u r

40

30

-firm nos.

20

10

n2

/

1 B<

n2

1.25 1.5 1.75 2 2.25 2.5 2.75

trade cost

Figure 5.

demand. I t t h e n seems l i k e l y t h a t i n t e g r a t i o n w i l l produce a p a t t e r n of wage divergence followed b y convergence. A s i n Section I I , the s m a l l economy w i l l suffer d e c l i n i n g wages to some point, followed thereafter by increasing wages a n d , i n t h e l i m i t , factor price equalisation. However, i t is c e r t a i n l y going to be t h e case t h a t t h e presence of i n t e r m e d i a t e i n p u t s and t h e associated forces for a g g l o m e r a t i o n w i l l a m p l i f y i n t e r l o c a t i o n a l differences, c r e a t i n g l a r g e r i n t e r -locational wage differences t h a n we saw i n Section I I .

V I C O N C L U S I O N

I m p e r f e c t c o m p e t i t i o n based models of i n t r a - i n d u s t r y t r a d e have become w i d e l y accepted as a p p r o p r i a t e f r a m e w o r k s w i t h i n w h i c h to t h i n k about a l a r g e p a r t o f w o r l d t r a d e . T h e research o u t l i n e d i n t h i s paper makes one m o d i f i c a t i o n t o a s t a n d a r d m o d e l of t h i s t y p e ; i t allows for i n p u t - o u t p u t l i n k a g e s b e t w e e n f i r m s i n i m p e r f e c t l y c o m p e t i t i v e i n d u s t r i e s . M a k i n g t h i s a p p a r e n t l y m i n o r m o d i f i c a t i o n f u n d a m e n t a l l y changes the s t r u c t u r e of equi­ l i b r i a generated b y t h e model, c r e a t i n g t h e possibility of "positive feedbacks" w h i c h support agglomeration of economic activity.

The w o r k so far u n d e r t a k e n suggests m a n y directions, b o t h e m p i r i c a l a n d t h e o r e t i c a l , for f u t u r e research. O n the e m p i r i c a l side, is there evidence t h a t i n t e g r a t i o n has fostered g e o g r a p h i c a l c o n c e n t r a t i o n o f i n d u s t r y ? Some evidence, ( b o t h t i m e series a n d cross c o u n t r y comparison) suggests t h i s m a y be so, b u t w o r k needs t o be done to disentangle agglomeration effects f r o m t h e o r d i n a r y process of specialisation predicted by any t r a d e theory. I f l i n k ­ ages exist, h o w s t r o n g are they? I f a G e r m a n car component m a n u f a c t u r e r or C i t y o f L o n d o n f i n a n c i a l i n s t i t u t i o n were to relocate to I r e l a n d — or to I n d i a — how l o w w o u l d wages i n these locations have to be to offset agglomeration advantages? Perhaps case study methods can shed some l i g h t on these issues.

O n t h e t h e o r e t i c a l side, m u c h w o r k r e m a i n s to be done on i n c o r p o r a t i n g l o c a t i o n a l a s y m m e t r i e s i n t o t h e models, a n d o n d e v e l o p i n g d y n a m i c s . Perhaps m o s t f u n d a m e n t a l l y , t h e policy i m p l i c a t i o n s o f t h i s sort o f model need to be developed. The i m p l i c a t i o n s of t h i s l i n e of research for r e g i o n a l policy r e m a i n s u n c h a r t e d t e r r i t o r y .

REFERENCES

BLANCHARD, O., and L . KATZ, 1992. "Regional Evolutions", Brookings Papers on Economic Activity, 1, pp. 1-61.

DIXIT, A.K., and J . E . S T I G L I T Z , 1977. Monopolistic Competition and Optimum Product Diversity, American Economic Review, Vol. 67, pp. 297-308.

KALDOR, N., 1972. "The Irrelevance of Equilibrium Economics", Economic Journal, Vol. 82, pp. 1,237-1,255.

KRUGMAN, P.R., 1991a. "Increasing Returns and Economic Geography", Journal of Political Economy, Vol. 99, pp. 483-499

KRUGMAN, P.R., 1991b. Geography and Trade, Cambridge, Massachusetts: MIT Press.

KRUGMAN, P.R., and A.J. V E N A B L E S , 1990. "Integration and the Competitiveness of Peripheral Industry", in C. Bliss and J . de Macedo (eds), Unity with Diversity in the European Community, Centre for European Policy Research (CEPR) and Cambridge University Press.

KRUGMAN, P.R., and A . J . V E N A B L E S , 1993. "Specialisation, Integration and Adjustment", National Bureau of Economic Research Discussion Paper No. 4,559. KRUGMAN, P.R., and A.J. V E N A B L E S , 1994. "Globalization and the Inequality of

Nations", C E P R Discussion Paper No. 1,015.

MYRDAL, G., 1957. Economic Theory and Underdeveloped Regions, London: Duckworth.

PERROUX, F . , 1955. "Note sur la notion de "pole de croissance", Economie Applique, 8.