Productivity Growth and Patterns of Industry Location
Without Scale Effects
Colin Davis
Doshisha University∗

Ken-ichi Hashimoto
Kobe University†

June, 2011
Abstract
This paper investigates the relationship between geographic patterns of economic activity and productivity growth in a two region model of trade andendogenous growth without scale effects. At the core of the model is the production and in-house innovation activities of manufacturing firms and, in aworld of transport costs, imperfect knowledge dispersion and perfect capital
mobility, these activities are located independently in the region that provides
the lowest associated cost. In contrast to the existing literature, we remove scaleeffects by shifting the focus from aggregate research and development activity
to innovation at the level of individual product lines and find that althoughindustry concentration raises the level of product variety, it reduces the rateof productivity growth so that the pace of economic growth is highest whenindustry is equally dispersed across regions. We also study the effects of greater
economic integration between regions and find that increases in the freenessof trade and the level of knowledge dispersion both have negative effects on
productivity growth while raising the level of product variety. These opposing
effects for growth and product variety lead to mixed results for the impacts ofeconomic integration on regional welfare.
Key Words: Industry Concentration, Industry Share, Productivity Growth,
Scale EffectJEL Classifications: F43; O30; O40; R12∗

Institute for International Education, Doshisha University, Karasuma-Higashi-iru, Imadegawadori, Kamigyo, Kyoto, Japan, 602-8580, cdavis@mail.doshisha.ac.jp.
†
Graduate School of Economics, Kobe University, 2-1 Rokkodai, Nada, Kobe, Japan, 657-8501,
hashimoto@econ.kobe-u.ac.jp.

1

Introduction

In recent years there has been considerable interest in understanding the implicationsof the geographic distribution of industrial activity for patterns of economic growth atthe local, regional, and international levels. Indeed, a general consensus that industry
concentration promotes economic growth appears to have developed within the theoretical literature of the “new economic geography” (Baldwin and Martin, 2004). The
available empirical evidence is often at odds with this consensus, however, as many
empirical studies report a negative relationship between the pace of economic growthand industry concentration (Abdel-Rahman et al. 2006; Bosker, 2007; Gardiner et al.
2010). One possible source of this discrepancy is the close connection between a scaleeffect, whereby growth is positively linked with the size of the labor force, and thepositive relationship between industry concentration and growth derived by existing
theoretical models. In this paper we re-examine the relationship between industry
concentration and economic growth using a novel approach that shifts the focus fromaggregate research and development (R&D) activity to innovation at the level of individual product lines thereby sterilizing the scale effect. Within this framework wefind that while industry concentration raises the level of product variety, it reduces
the rate of productivity growth so that the pace of economic growth is highest whenindustry is equally dispersed across regions.
More specifically, we develop a two region model of trade and endogenous productivity growth that focuses on the production and in-house innovation activities ofmanufacturing firms. In a world characterized by perfect capital mobility, firms arefree to locate these activities independently across regions with the objective of minimizing associated costs in order to raise profits on the margin. As a result, aggregate
patterns of production and innovation activity are determined endogenously according
to the freeness of trade and the level of knowledge dispersion between regions. The
equilibrium pattern of economic activity features a concentration of production and1the full agglomeration of innovation in the larger of the two regions, as measured bylabor endowments. Moreover, the level of product variety and the rate of productivity
growth are closely linked with this distribution of industrial activity. In particular, arise in industry concentration improves knowledge dissemination from production to
innovation in the larger region and thus lowers the cost of process innovation. With
this cost reduction, however, the total number of manufacturing firms and associatedfixed costs increase thereby lowering the firm-level of innovation employment that canbe supported by the overall economy. This mechanism leads to a negative relationshipbetween industry concentration and productivity growth. In addition, we find that
increased regional integration arising from either a decrease in transport costs or an
increase in knowledge dispersion has effects similar to greater industry concentration.
This paper contributes to the theoretical literature investigating the relationship between geography and economic growth using key elements of the varietyexpansion model of innovation-based endogenous growth (Grossman and Helpman,1991).1 Within this literature, our paper is most closely related to Martin and Ottaviano (1999; 2001) in that they also assume “footloose” production and productdevelopment–firms locate these activities independently in the region that provides
the lowest cost. These studies find that agglomeration economies promote economic
growth by raising the productivity of labor in R&D when knowledge spillovers are
local in scope. As discussed above, however, a key aspect of the variety-expansion
models adopted in this literature is the existence of a strong scale effect. This is problematic in that empirical evidence does not support a significant relationship between
growth and population (Jones, 1995a; Dinopoulos and Thompson, 1999; Barro andSala-i-Martin, 2004).
In a recent paper, Mittini and Parello (2011) extend the model of Martin and Ottaviano (1999) to correct for the strong scale effect by introducing population growth1

See Baldwin and Martin (2004) for a review of this literature.

2

and diminishing returns to knowledge according to Jones (1995b). Under this modification, the long-run growth rate is proportionate to the exogenous population growthrate and determined independently of the distribution of industry. This positive relationship between economic growth and population growth is referred to as the weak
scale effect, however, and is also not supported by empirical evidence (Barro and Salai-Martin, 2004; Ha and Howitt, 2007). In contrast, the in-house process innovation
framework (Smulders and van de Klundert, 1995; Peretto, 1996) allows for the endogenous determination of both the pattern of economic activity and the growth rate.
Further, recent evidence suggests that the method adopted in this paper for removing
the scale effect is supported empirically (Lainez and Peretto, 2006).
The remainder of the paper is organized as follows. In the following section we
introduce a two region model of trade and endogenous productivity growth withoutscale effects. Then, Section 3 investigates the effects of changes in relative market
size, transport cost, and knowledge dispersion for the level of product variety and thepace of productivity growth. Section 4 provides brief concluding remarks.

2

The ModelThis section introduces our two region model of trade and productivity growth. We
refer to the regions as the North and South, and within each region labor is employedin three activities: traditional production (Y ), manufacturing (X), and process innovation (R). The traditional sector produces a numeraire good for sale in a perfectlycompetitive market characterized by free trade. The manufacturing sector, on theother hand, consists of monopolistically competitive firms that produce differentiatedproduct varieties for sale in a market that features transaction costs on shipments
between regions. Productivity growth arises as a result of in-house process innovation
undertaken by manufacturing firms with the objective of raising profits by lowering
production costs. Each manufacturing firm can relocate its production and innova3

tion activities independently across regions. The labor endowments of the North andSouth are respectively L and L∗ , where an asterisk denotes variables associated with
the Southern region. There is perfect labor mobility across sectors but no migration
between regions. In the following subsections we focus on introducing the model setup
for the North, but analogous conditions can also be derived for the South.
2.1

Households

The demand side of the market consists of dynastic representative households thatmaximize utility over an infinite time horizon. The lifetime utility of a representative
Northern household is

U=

Z ∞

e−ρt [α ln CX (t) + (1 − α) ln CY (t)] dt,(1)0

where CX (t) and CY (t) respectively denote the consumptions of a manufacturingcomposite and a traditional good, ρ is the subjective discount rate, and α ∈ (0, 1) isthe share of expenditure allocated to manufacturing goods at each moment of time.
The manufacturing composite takes the following form

CX =

Z n

ci

σ−1
σ

di +

Z n∗
0

0

cj

σ−1
σ

dj

σ
 σ−1

,

(2)

where ci is the demand for variety i of the n varieties produced in the North, and cj
is the demand for variety j of the n∗ varieties produced in the South. The elasticity
of substitution between any two varieties is denoted by σ > 1.
Households choose an expenditure-saving path with the objective of maximizing(1) subject to the following liquidity constraint:
Z ∞0R− 0t r(s)dse

E(t)dt ≤

Z ∞
0

4

Rt

e− 0 r(s)ds w(t)Ldt + B(0),where E(t) is household expenditure, r(t) and w(t) are respectively the interest andwage rates at time t, and B(0) is initial asset wealth.2 The solution to this intertemporal optimization problem is the following Euler equation:Ė(t)= r(t) − ρ,
E(t)

(3)

where a dot indicates differentiation with respect to time (time notation is suppressed for the remainder of the paper). Southern households solve a symmetricutility maximization problem and, as we assume perfect capital mobility, interest
rates equalize across regions (r = r ∗ ) leading to a common motion for expenditure:
Ė/E = Ė ∗ /E ∗ = r − ρ.
At each moment in time households allocate constant shares of expenditure to
traditional goods and the manufacturing composite:PX CX = αE,

PY CY = (1 − α)E,

(4)where PY is the traditional good price. The price index associated with the manufacturing composite is

PX =

Z n
0

pi

1−σ

di +

Z n∗
0

(τ p∗j )1−σ dj

1
 1−σ

,

(5)

where pi is the price of variety i produced in the North, p∗j is the price of variety j
produced in the South, and τ > 1 denotes an iceberg transport cost whereby τ units
must be shipped for every unit sold in the export market (Samuelson, 1954).
Regarding the composite price index (5) as the household’s unit expenditure function on manufacturing goods, the Northern demands for varieties produced respec2

We will find that the value asset wealth (B) is zero in equilibrium as free entry drives the valueof manufacturing firms to zero. See Section 2.5 for more details.

5

tively in the North and South can be obtained using Shephard’s Lemma:

σ−1ci = αp−σ
i PX E,

cj = α(τ p∗j )−σ PXσ−1 E.

(6)Southern households face a similar utility maximization problem and therefore havesymmetric demand conditions.
2.2

Traditional production

Traditional firms employ a constant returns to scale technology whereby one unit oflabor is required for each unit of output. The competitive nature of the market thus
ensures that the price of a traditional good equals the wage rate and, as there areno transport costs associated with inter-regional transactions, both prices and wage
rates are common across regions. The traditional good is set as the model numeraireand hence PY = PY∗ = w = 1 at all times.
2.3

Manufacturing

Firms in the manufacturing sector produce horizontally differentiated product varieties and compete according to monopolistic competition (Dixit and Stiglitz, 1977).
Although there are no costs associated with product development and market entry,
incumbent firms face a fixed per-period labor cost (lF ) related to product marketingand the management of production and innovation activities.
A representative firm employs labor (lX ) with the following production technology:

x = θlX ,(7)

where x is output and θ is a firm-specific productivity coefficient. While each firm
employs a production technique that is unique to its product line, we suppose that the
productivity levels (θ) associated with production techniques are symmetric across all
6

firms regardless of the location of production.
Firms maximize profit on sales using the well known constant markup over unit
cost pricing rule associated with monopolistic competition, and given our assumption of symmetric productivity levels, a similar price is set by firms producing inboth regions, p = p∗ = σ/(σ − 1)θ. Profit on sales is calculated as the difference
between revenues and labor costs and accordingly the optimal profit on sales for arepresentative firm is

π = px − lX =

lX
,
σ−1

(8)

where we have used the pricing rule and the production function (7).
The firm-level scale of employment in production (lX ) is set to meet the combined
demands from local and export markets. For example, the total demand for a productproduced in the North is ci + τ c∗i , where the iceberg transport cost τ > 1 captures
the addition units that must be shipped for every unit sold to Southern households.
Equating this demand with firm supply, x = ci + τ c∗i , and combining the production function (7) with the demand functions (6), the equilibrium firm-level scale ofemployment in Northern-based production isα(σ − 1)p1−σ PXσ−1 E + ϕPX∗ σ−1 E ∗
,
lX =
σ

(9)

where ϕ = τ 1−σ describes the freeness of trade with ϕ = 0 implying prohibitively
high trade costs and ϕ = 1 implying free trade. We assume that the market share ofeach firm is small enough that it perceives the composite price indexes PX and PX∗
as constant when evaluating the effects of changes in its price on production scale (9)and thus profit on sales (8).

7

2.4

Process Innovation

The in-house process innovation of incumbent manufacturing firms drives economic
growth. A representative firm employs labor lR in process innovation with the aimof raising firm value through productivity improvements that lower production costs
and raise profit on sales (8). Firm-level productivity evolves according toθ̇ = KlR ,(10)

where K captures knowledge spillovers from production to R&D.
Following the in-house process innovation framework developed by Smulders andvan de Klundert (1995) and Peretto (1996), we model knowledge spillovers into inhouse innovation as a function of the weighted average productivity of technical knowledge observable by the R&D department of the firm:

K = (s + δs∗ )θ,(11)

where s ≡ n/(n + n∗ ), and s∗ ≡ n∗ /(n + n∗ ) are the respective shares of firms locatingproduction in the North and South. Under this specification, technical knowledge
accumulates within the firm as a side product of process innovation and can be proxied for using the productivity coefficient θ. It is this intertemporal externality thatgenerates perpetual growth in long-run equilibrium. Although firm-level productivity
is symmetric across firms, each firm’s production technology is unique and comprises
technical knowledge that includes both codifiable aspects which can be conveyed easily
across large distances and tacit aspects which can only be transferred through face-toface communication (Keller, 2004). The parameter δ ∈ (0, 1) describes the imperfectnature of spatial knowledge dissemination: δ = 0 indicates knowledge spillovers thatare completely local in scope and δ = 1 indicates perfect inter-regional knowledge8dispersion.3
The total per-period profit of a firm equals operating profit on sales less the costof investment in process innovation and the per-period fixed labor cost:Π = π − lR − lF .

(12)

A representative firm invests lR in process innovation with the objective of maximizing
RtR∞
firm value, V = 0 Π(t)e− 0 r(s)ds dt, subject to the technological constraint (10).
We solve this optimization problem using the following current value Hamiltonian
function: H = Π+µKlR , where µ denotes the current shadow value of an improvementin the technology of the firm. As each firm perceives itself as small relative to theoverall market firms ignore the impact of R&D investment on knowledge spillovers
when maximizing firm value, that is, ∂K/∂θ = 0.
The solution to the firm’s intertemporal profit maximization problem is captured
by a static efficiency condition µ = 1/K that equates the value of a marginal improvement in technology with the marginal cost of process innovation, and a dynamic
efficiency condition ∂π/∂θ = rµ− µ̇ that equates the internal rate of return to in-houseprocess innovation with the rate of return that can be earn on a risk free asset.4 Combining these conditions we derive the following no-arbitrage condition for in-house
R&D investment:r≥(σ − 1)πK K̇
− .
θ
K

(13)

This no-arbitrage condition binds whenever there is active process innovation.
3

The imperfect nature of knowledge spillovers has been well documented by a number of empiricalstudies, for example, Jaffe et al. (1993), Mancusi (2008), and Coe et al. (2009). Our theoreticalformulation for imperfect spillovers is adapted from Baldwin and Forslid (2000).
4The solution to the firm’s intertemporal optimization problem must also satisfy the following
tranversality condition limt→∞ e−ρt µθ = 0, where with free entry r = ρ at all moments in time as
discussed in Section 2.5.

9

2.5

Equilibrium

Equilibrium is characterized by the shares of production taking place in each region.
With negligible product development costs, free entry drives total per-period profits(12) to zero, Π = 0, ensuring that households earn income from wages alone. As
a result, given our choice of labor as the model numeraire, E = L and E ∗ = L∗ .
Therefore, referring to (3) we have r = ρ at all moments in time.5
Next, following Martin and Rogers (1995), we assume that manufacturing firms arefree to shift their production and innovation activities independently between regions
at negligible cost. As firms relocate production with the aim of increasing profit on themargin, profit on sales is equalized between the North and South, π = π ∗ , whenever
there is active production in both regions. Consequently, inspection of (8) indicates∗that the production scale of all firms will be the same, lX = lX
. Combining theconditions introduced above with the pricing rule, p = σ/(σ − 1)θ, we can solve forthe share of firms locating production in the North ass=

L − ϕL∗.
(1 − ϕ)(L + L∗ )(14)

This condition describes a home market effect whereby the region with the larger
market, represented here by labor endowment, hosts the larger share of manufacturing
activity (Krugman, 1980).6 In addition, (14) can be substituted with the pricing rules
into (9) to obtain the long-run scale of production for all firms as∗
lX = lX=α(σ − 1)(L + L∗ )
,
σN

(15)

where N = n + n∗ is the total number of incumbent firms.
5

In particular, total household wealth is zero in equilibrium, B = 0, as free entry drives firm value
to zero, V = 0.
6
The Northern share of production activity is increasing in ϕ for L > L∗ , that is, ds/dϕ =(L − L∗ )/(1 − ϕ)2 (L + L∗ ) > 0. A closer examination of (14) shows, however, that increases in ϕbeyond the threshold L∗ /L have no further impact on patterns of production activity as s = 1.

10Turning next to innovation activity, we can now show that all process innovation
takes place in the region with the larger market and thus the greater share of industry.
First, we set (12) to zero and use (8) in the result to obtain the following free entry
conditions for the manufacturing industry:lX = (σ − 1) (lR + lF ) ,∗∗lX= (σ − 1) (lR+ lF ) .

(16)

These conditions show that if there is active R&D in both regions, firm-level employment in innovation must be the same for all firms regardless of location as it is∗determined proportionally with the scale of production, lR = lR
. Returning to (13),however, we can use r = ρ with (8), (10), (11), and (16) to rewrite the no-arbitrage
conditions for process innovation in the North and South respectively asρ = (s + δs∗ )(lX − lR ),ρ > (s∗ + δs)(lX − lR ).

(17)

With asymmetric market sizes, L > L∗ , the no-arbitrage condition only binds for thelarger Northern region as it hosts the larger share of industry from (14). Accordingly,
innovation activity concentrates fully in the larger region.
Before concluding this section we discuss the requirements necessary for a positive
level of innovation activity. Combining the free-entry condition (16) and the Northernno-arbitrage condition (17), firm-level employment in innovation can be solved for aslR =ρ − (σ − 1)(s + δs∗ )lF.
(σ − 2)(s + δs∗ )(18)

Active innovation requires that the return to in-house process innovation (r = ρ)exceed the fixed per-period labor cost by a sufficient margin. Since we are interested
in equilibria with positive growth rates, we assume that ρ > (σ − 1)(s + δs∗ )lF .7
7

Note that we also require σ > 2 for both positive market entry and productivity growth. The
average elasticity of substitution estimates reported by Broda and Weinstein (2006) for various levels

113

Equilibrium Product Variety and Productivity Growth

The proceeding section introduced a simple model in which geographic patterns of
production and innovation are determined endogenously according to regional laborendowments, and the level of transport costs. In this section, we investigate theimplications of these patterns for the overall level of product variety and the paceof productivity growth. In addition, we consider the growth effects of greater economic integration through lower transport costs and greater inter-regional knowledge
spillovers. To simplify our discussion, we focus on the case where the Northern shareof labor is larger than that of the South (L > L∗ ), and all innovation activity occurs
in the North.
3.1

Industry Concentration

Beginning with the overall level of product variety, (15), the first equation of (16),and (18) can be combined to yield the total number of manufacturing firms as−1ρα(σ − 2)(L + L∗ )
− lF
.
N=
σ
δ + (1 − δ)s(19)

A comparison of (19) with (18) indicates that active process innovation ensures apositive level of market entry. Moreover, the total number of firms is determined as anegative function of the discount rate and a positive function of the fixed per-period
labor cost. For example, an increase in lF causes a larger decrease in the cost ofinnovation, dlR /dlF = −(σ − 1)/(σ − 2) < −1, and total per-period fixed costs fall.
As a result, positive per-period profits induce market entry until firm value is driven
back to zero: Π = 0.
Figure 1a provides an illustration of N(s) for s > 1/2. With the long-run level ofproduct variety determined as an increasing function of the relative level of knowledgeof industry disaggregation suggest that this assumption is reasonable within the context of our simple
model.

12

Figure 1: Product Variety and Productivity Growth
g

N
N (s)

g(s)

1/2

1
(a) Product Varietys(ϕ, L/L∗)s(ϕ, L/L∗ )1
1/2(b) Productivity Growth Rateobservable by innovation workers employed in the Northern region, K/θ = δ +(1−δ)s,a rise in the Northern share of production activity raises the labor productivity of inhouse innovation thereby reducing per-period costs (lR ) and raising the number offirms that the overall market can support. Consequently, the level of product variety
is positively related to the level of industry concentration.8
The relationship between industry concentration and product variety has interesting implications for the pace of productivity growth. Substituting r = ρ, (8), (11),and (15) into (13) and using (19) in the result, the productivity growth rate isg≡θ̇α(σ − 1) (δ + (1 − δ)s) (L + L∗ )
ρ − (σ − 1)(δ + (1 − δ)s)lF=−ρ=. (20)θσN
σ−2

From (20) we can see that productivity growth is not biased by a scale effect as anincrease in the overall labor endowment (L + L∗ ) is fully absorbed by a rise in thenumber of manufacturing firms (N). As discussed above, an increase in the fixed perperiod labor cost (lF ) causes a greater decrease in firm-level R&D employment (lR ),8

The second-order derivative of (19) with respect to s isd2 N
2ρ(1 − δ)2 lF N
> 0.
=
2
ds
(δ + (1 − δ)s) (ρ − (δ + (1 − δ)s)lF )2

Thus, N is a convex function of s as depicted in Figure 1a.

13and therefore depresses the rate of productivity growth. In contrast, an increase in thesubjective discount rate (ρ) accelerates productivity growth. This result stems fromthe balance between a negative direct effect whereby a rise in the market rate of return
to investment raises the opportunity cost of in-house R&D, and a positive indirect
effect whereby a fall in the number of incumbent firms shifts aggregate employment
away from the fixed per-period labor requirement (lF ) into production and innovation.
The positive indirect effect always dominates the negative direct effect and hence anincrease in ρ has a positive impact on productivity growth. These results accentuate
the tension between market concentration and productivity growth that arise in thistype of endogenous growth model and can also be found in the close economy modelof Smulders and van de Klundert (1995).
We are particularly interested in the negative relationship that arises between thelevel of industry concentration (s) and the productivity growth rate. As shown in
Figure 1b, the rise in the total number of firms that coincides with an increase in
the relative level of knowledge available in the North, K/θ = δ + (1 − δ)s, leads tolower profit on sales thereby reducing the firm-level of employment in innovation thatcan be supported by the overall economy. On this account, the rate of productivity
growth falls. We summarize the relationships between industry concentration, productvariety, and productivity growth in the following proposition:
Proposition 1 (Industry concentration, product variety, and productivity growth):
An increase in the concentration of industry in the larger region raises the level productvariety (N) and lowers the rate of productivity growth (g).
Proof: From (19) and (20),(1 − δ)ρN
dN
=
> 0,
ds
(δ + (1 − δ)s)(ρ − (δ + (1 − δ)s)lF )(σ − 1)(1 − δ)lF
dg
=−
< 0,
ds
σ−2

14

for s > 1/2 with L > L∗ as assumed. 
While at first glance a negative relationship between industry concentration andeconomic growth appears to contradict the positive relationship generally derived
using variety expansion models of innovation-based growth (Martin and Ottaviano,
1999; 2001), in fact our results complement the existing literature in that an increase
in industry concentration coincides with a rise in the level of product variety. In
addition, Proposition 1 is supported by empirical studies such as Bosker (2010) andGardiner et al. (2010) which find a negative relationship between various measuresof agglomeration and the rate of GDP growth for several levels of aggregation using
European regional data.
3.2

Regional Integration

We now briefly discuss the effects of greater regional integration stemming from adecrease in transport costs or an increase in the level of knowledge dispersion. Given
that the impact of a change in relative market size on productivity growth reflects thehome market effect (see (14)), trade liberalization has an effect similar to that for achange in relative market size:
Proposition 2 (Transport costs, product variety, and productivity growth): A decrease in transport costs (an increase in ϕ) raises product variety (N) and lowers therate of productivity growth (g).
Proof: From (14), (19), and (20),dN(1 − δ)(L − L∗ )ρN
=
> 0,
dϕ
(δ + (1 − δ)s)(ρ − (δ + (1 − δ)s)lF )(1 − ϕ)2 (L + L∗ )(σ − 1)(1 − δ)(L − L∗ )lF
dg
=−
< 0,
dϕ
(σ − 2)(1 − ϕ)2 (L + L∗ )for 1 > s > 1/2, where L > L∗ by assumption. 

15

Figure 2: An increase in the degree of knowledge dispersion (δ)
g

N
N (s)

g(s)

1/2

1
(a) Product Varietys(ϕ, L/L∗)s(ϕ, L/L∗ )1
1/2(b) Productivity Growth Rate

An increase in the freeness of trade makes the larger market more attractive as a
production base since firms gain better access to the larger market and incur lower
transport costs on exports to the smaller market. Hence, under the assumption L >L∗ , the Northern share of production rises causing an increase in the level of productvariety and a decrease in the rate of productivity growth as indicated by the arrows
provided in Figure 1.
Finally, we investigate the effects of greater economic integration through an increase in the degree of inter-regional knowledge dispersion. The result is provided in
the following proposition.
Proposition 3 (Knowledge spillovers, product variety, and productivity growth): An
increase in the degree of inter-regional knowledge dispersion (δ) raises product variety(N) and lowers the rate of productivity growth (g).
Proof: From (19) and (20),dN(1 − s)ρN=> 0,dδ(δ + (1 − δ)s)(ρ − (δ + (1 − δ)s)lF )(σ − 1)(1 − s)lF
dg
=−
< 0,
dδ
(σ − 2)(1 − ϕ)2
for s > 1/2 which is the case when L > L∗ as assumed. 
16Proposition 3 is illustrated in Figure 2 where an increase in the degree of interregional knowledge dispersion δ raises the level of product variety and lowers therate of productivity growth for all levels of industry concentration. An increase in the
degree of knowledge dispersion raises knowledge spillovers into innovation (K) causing
a reduction in firm-level R&D employment (lR ). This in turn lowers fixed costs andnew firms are attracted into the market by positive profits (N rises). As a consequence,
aggregate labor employment shifts away from production and innovation to cover
the increase in fixed per-period labor costs (lF ) and the rate of productivity growth
falls. Once again, this outcome appears to be at variance with the standard result forvariety expansion models where an increase in the level of knowledge dispersion always
accelerates the rate of growth (Baldwin and Martin, 2004), but actually supports theexisting literature in that greater knowledge spillovers are associated with a higher
level of product variety.
3.3

Regional Welfare

Finally, we discuss the welfare implications of greater regional integration. Recallingthat both traditional and manufacturing firms earn zero profits, regional welfare levels
can be obtained by substituting (2), (5), (10), and (14) into lifetime utility (1):αLα ln [(1 + ϕ)N] g
ln [θ(0)α A1 L]
,
+
ln
+
+
U0 =
ρ
ρ(σ − 1) L + L∗
ρ
σ−1
ρ


ln [θ(0)α A1 L∗ ]αL∗
α ln [(1 + ϕ)N] g
∗
U0 =
,
+
ln
+
+
ρ
ρ(σ − 1) L + L∗
ρ
σ−1
ρ

(21)
(22)

where A1 = [(α(σ − 1)/σ)α (1 − α)1−α ] is a constant. As we are interested in theeffects of improved regional integration arising from an increase in ϕ or δ, the third
term on the right-hand side of each of these conditions will be our main focus. Moreover, given the symmetric nature of the marginal impacts of greater integration forhouseholds residing in both regions, we focus on Northern households in what follows.
17

Table 1: Welfare Effectss

ϕ = 0.4
δ = 0.4
0.73

ϕ = 0.5
δ = 0.4
0.8

ϕ = 0.6
δ = 0.4
0.9

ϕ = 0.5
δ = 0.5
0.8

ϕ = 0.5
δ = 0.6
0.8

ϕ = 0.5
δ = 0.7
0.8

dU0 /dϕ
dU0 /dδ

2.535
0.126

2.681
-0.1773.014-0.3302.507-0.1892.304-0.2012.131-0.213

Parameter values: L = 0.6, L∗ = 0.4, α = 0.5, σ = 3, lF = 0.01, and ρ = 0.1.
Beginning with the effects of greater economic integration that arise through areduction in transport costs we have
(1 − ϕ)2 (L + L∗ )
ρ(1 − δ)(σ − 1)2 (1 − δ)lF
1 dU0
=
+
−
,
A2 dϕ
(L − L∗ )(1 + ϕ)(δ + (1 − δ)s)(ρ − (δ + (1 − δ)s)lF )ρ(σ − 2)where A2 = α(L − L∗ )/ρ(σ − 1)(1 − ϕ)2 (L + L∗ ). The first term on the right-handside captures the positive impact of lower prices on transported goods arising fromfreer trade between regions. The second term describes a positive love of variety effectwhereby households benefit from a greater level of product variety in consumption.
The third term denotes the negative effect associated with a slower decline in the priceof goods as productivity growth is retarded by the fall in transport costs. As freer
trade coincides with an increase in the concentration of industry, the opposing love ofvariety and productivity growth effects suggest a trade-off between welfare level andwelfare growth. The simple numerical examples provided in Table 1 show, however,that the negative growth effect is always dominated by positive effects suggestingthat the greater concentration of industry that occurs with a fall in transport costs isbeneficial to the residents of both regions even it depresses the rate of growth.
Next, we examine the effects of greater economic integration stemming from an
improvement in the level of knowledge dispersion between regions:α(1 − s)α(σ − 1)(1 − s)lF
dU0
=
−
.
dδ
(σ − 1)(δ + (1 − δ)s)(ρ − (δ + (1 − δ)s)lF ) (σ − 2)(1 − ϕ)2 ρ218

The first term on the right-hand side captures the positive love of variety effect andthe second term describes the negative productivity growth effect. In this case, either
effect may dominate depending on parameter values as shown in numerical examples ofTable 1 where an increase in the level of knowledge dispersion actually has a negative
impact on regional welfare in a number of cases.

4

Concluding Remarks

In this paper we have investigated the relationship between geographic patterns of industrial activity and economic growth in a two region model of trade and endogenous
productivity growth that corrects for scale effects. The production and innovation
activities of monopolistically competitive manufacturing firms assume a central rolein the model and, faced with transport costs, imperfect knowledge dispersion and perfect capital mobility, firms locate these activities independently across regions withthe objective of minimizing cost. This framework produces several interesting results.
First, we find that although an increase in the concentration of industry raises theoverall level of product variety, it has a negative impact on the rate of productivity growth. This result contrasts with the positive relationship derived by existing
theoretical models in the “new economic geography” literature but is supported byrecent empirical evidence. Second, investigating the implications of greater economic
integration between regions, we find that a decrease in inter-regional transport costs
or an increase in inter-regional knowledge spillovers both raise the level of productvariety but lower the overall rate of economic growth.
Although our framework provides several novel results, a key simplification is theassumption of free entry into the manufacturing sector. One possible extension istherefore the inclusion of product development costs. This extension would allow foran examination of the dynamics of entry and exit and provide a richer description of
the link between economic growth and the evolution of inter-regional inequality.
19

Acknowledgements: We wish to thank Tatsuro Iwaisako, and seminar participantsat Kobe University and the Japanese Society of International Economics (Ryukoku
University, 2011). All remaining errors are our own.

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