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Working Paper Summaries (WP/94/1 - WP/94/76)
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Working Paper Summaries 94/16: Geography, Trade Patterns, and Economic Policy

Author(s):
International Monetary Fund
Published Date:
August 1994
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This paper presents a geographical theory of location and interregional trade patterns. Location is treated as an endogenous variable by firms, consumers, and perfectly mobile workers in a two-sector economy. Space plays a central role owing to transportation costs, market access, and distance from polluting industrial centers. The model is used to examine (1) a compensating-differential theory of regional unevenness, (2) the theoretical formulation for a gravity theory of trade patterns, (3) the geographic basis of industrial and environmental policy, and (4) the interaction among transportation costs, location, and technological improvements.

The model determines the potential range of locations of industrial centers and land-use patterns; unevenness in measured real wages arises according to geographic location. However, under perfect labor mobility, compensating differentials in nonmarket variables, such as the intensity of pollution, lead to an equilibrium in which there is no incentive to relocate. These compensating differentials are location specific. Measured differentials in regional income and observed geographic dispersion of economic activities reflect the equilibrating role of nonpecuniary compensating differentials. Even in otherwise fully convergent processes, this form of unevenness remains as a residual divergence.

Explanations of bilateral trade flows frequently rely on the so-called gravity model, which stresses that economic size relates positively to trade and that transportation costs cause distance to relate negatively to bilateral trade flows. The basic notions of the gravity model are formalized and extended by examining the roles of distance and transportation costs in a model in which space and distance enter explicitly. The positive roles of economic size and associated specialization in trade are validated in our analysis, but the impact of distance is shown to be more complicated--”unnatural” trade between distant partners emerges endogenously from factor endowments and regional location decisions.

Technological change in this model can arise from the agricultural, manufacturing, and transportation sectors. For certain parameter values, reductions in transportation costs promote industrial expansion; for other values, reductions in transportation costs result in less industrial variety up to a certain point, after which industrial variety increases. At very low levels of transportation cost, a paradox emerges: advances in communications enhance the mass of industrial concentration but also give rise to greater dispersion in agriculture. Finally, the model’s comparative static results show that the source of technological change cannot be determined simply by looking at the measured expansion of sectors’ sizes and productivities.

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