For labor in each cell i, L� �∑�∈��,�� L�� . The total value demand in cell i for sector s output is E�� � � � � �� e�� �e�� �e�� �e�� , which must equal the value produced in the cell net of any exports out of the cell and imports into the cell. Land market clearing within each cell is given by K<sup>�</sup> �� �K�� , K<sup>�</sup> �� �K�� �∑�∈��,�� K��� and K<sup>�</sup> � �K<sup>�</sup> �� �K<sup>�</sup> �� . Together these market clearing conditions determine r��, r��, w�, P��, P��, and P�� .

Lump sum transfer payments, m� , are determined through splitting total land rents nationwide equally among all the population within the country, regardless of where they live, such that, for cells i ε country c, m� �∑�∈��K<sup>�</sup> ��r�� �K<sup>�</sup> ��r��� ⁄L<sup>�</sup> � .

# **_Calibration_**

The model’s equilibrium is calibrated to the base data set by choice of productivity parameters, z�� _,_ and country origin‐destination shift parameters, A��� . The z�� are calibrated to match observed employment levels in each sector‐cell and per capita income levels across countries. A��� are calibrated to match the international trade data.

The calibration proceeds in three main steps. First, we calibrate relative z�� within each country, so that equilibrium employment in each sector and cell matches the employment data. Second, the absolute levels of z�� in each country are scaled to match income per capita at a country level. Finally, we calibrate preference parameters A��� such that the share of country _i_ output being sold in country _j_ is consistent with international trade data.

# **_Simulations_**

The calibrated model is ‘shocked’ with new transport time matrices, and firms and households adjust their decisions to optimally respond to the new connectivity of the region. We look at four different levels of economic response (1) The direct trade value of the transport cost reduction. We take the base value of exports of each cell according to the destination and calculate the reduction in costs in shipping the same amount of goods and services that results from the decreased travel times. No demand or supply response occurs.

(2) Armington assumption; the number of firms/ varieties of products produced in each cell is held constant. Output per firm adjusts, as do equilibrium prices and demands.

(3) Monopolistic competition in manufacturing production, where the number of firms in each cell in sectors 2 and 3 adjusts in response to profit opportunities until equilibrium is restored (4) Monopolistic competition with increasing returns to scale in manufacturing (localization economies) and some intra‐country labor mobility.

In setting (4), under increasing returns, z�� , the calibrated productivity of sector s in cell i is composed of two elements. First, a base productivity of sector‐cell, z̅�� , and second, an additional component which represents potential increasing returns to as a function of the density of firms in the sector‐cell (denoted by n��� ) and taking the form z�� �z̅���1 �α�n��⁄L<sup>�</sup> ���<sup>�</sup> . The density of firms in expressed as a density per population in the cell in the base period, capturing the effective size of the space in which the firm is located.

If, following the transport investment, the number of firms increases (or decreases), then returns to scale change productivity, where ρ > 0 if there are increasing returns. We assume that ρ > 0 only in setting (4) and in sector 2. Parameters α and ρ are chosen such that areas with average firm density are 20% more productive than comparable areas with no firms, and that the cell will the mean value n��⁄L<sup>�</sup> � has an elasticity of productivity with respect to the number of firms equal to 0.08, these two restrictions implying parameter values α� 6.67 and ρ� 0.093. This translates into a point elasticity of productivity with respect to the number of firms that ranges from 0 in cells with no initial manufacturing to a maximum of 0.088.

35