Working Paper: CEPR ID: DP4908
Authors: Keith Head; Thierry Mayer
Abstract: Recent theoretical work on economic geography emphasizes the interplay of transport costs and plant-level increasing returns. In these models, the spatial distribution of demand is a key determinant of economic outcomes. In one strand, it is argued that higher demand gives rise to a more than proportionate increase in production, a result known as the home market effect. Another strand emphasizes the effects of market sizes on factor prices. In this paper we highlight the theoretical connection between these two strands. We use data on 57 European regions to show how wages and employment respond to differentials in what we call real market potential, a discounted sum of demands derived from the theory.
Keywords: Gravity equation; Home market effects; New economic geography; Wage equation
JEL Codes: F12; F15; R11; R12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regions where wages are initially lower than their market potential (F16) | wage adjustment (J31) |
| wages (J31) | employment (J68) |
| real market potential (RMP) (R20) | wages (J31) |
| real market potential (RMP) (R20) | employment (J68) |