DP4908 Regional Wage and Employment Responses to Market Potential in the EU

Author(s): Keith Head, Thierry Mayer
Publication Date: February 2005
Keyword(s): gravity equation, home market effects, new economic geography, wage equation
JEL(s): F12, F15, R11, R12
Programme Areas: International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4908

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.