Reductions in tariffs (and extensive use of duty drawbacks) and improvements in transportation infrastructure in East Asia have certainly played a key role in the expansion of production networks in the region (see figures 1 and 2). Yet, import taxes and transport costs are by no means the only barriers to trade. High information and search costs also impede trade. Some firms attempt to reduce these costs by using middlemen located in the region’s entrepôts. These middlemen act as intermediaries for transactions between buyers and sellers. Where production involves multiple stages and where exchanges between suppliers and buyers are subject to informational problems at each stage, there are gains in allowing traders to manage entire supply chains. Feenstra and Hanson (2004) find that the markups Hong Kong (China) traders charge on Chinese reexports are higher in industries in which processing trade accounts for a higher share of China’s exports. Another reason firms may ship exports from China through Hong Kong (China) is to take advantage of shipping hubs. The distribution networks of traders in Hong Kong (China) and Singapore (and, increasingly, other major cities in the region, such as Shanghai) are an important factor in promoting the economic integration of East Asia and give the region an advantage over other developing regions, such as Africa and Latin America, which lack major entrepôts.

**Figure 1 Freight Costs among Developing Countries: Figure 2 Low Protection** **<u>Asia Is Doing Well</u>**

<!-- Start of picture text --> 14freight costs as % of import value Vietnam early 2000s<br>late 1980s<br>13 Thailand<br>12 Singapore<br>Africa<br>11 Philippines<br> America<br>10 Asia M alaysia<br> Europe<br>9 Korea<br> Oceania<br>8 Japan<br>7 Indonesia<br>6 China<br>0 10 20 30 40<br>import-weighted average tariff (%)<br>Source: UNCTAD, various. Source: World Bank 2005.<br>Note: Freight costs are typically around 4 percent of import<br>value in developing countries.<br><!-- End of picture text -->

**_Increasing returns to scale and firm location._** In the model presented so far, factor prices and trade costs drive the decisions of firms about their own locations. If increasing returns to scale are important, access to markets may influence these decisions in a manner not captured by standard models of comparative advantage (in which technology exhibits constant returns to scale). Scale economies create an incentive for firms to cluster spatially. If average production costs decline as the scale of production rises at the firm, industry, or regional level, then there are advantages to concentrating production in a particular location. The link between scale economies and agglomeration has long been recognized by urban and regional economists. In the last decade, trade economists have begun to apply the insights to the global economy. Scale economies represent an incentive for the formation of regional production networks.

Consider the model in Venables (1996) in which the agglomeration of economic activity results from input-output linkages between firms.<sup>4</sup> Suppose there are fixed costs in production. Suppose also that production requires intermediate inputs that are also subject to fixed costs, as well as raw factor inputs, whereby the shipment of inputs or outputs is subject to transport costs and other trade barriers. All else being equal, to minimize the transport costs and the fixed production costs, input suppliers and output producers have an incentive to serve the global market by choosing to produce in a single, common location. The agglomeration of economic activity drives up wages in the emerging industry cluster, 6