Economic integration in Europe and the renewal of interest in regionalism elsewhere have prompted re-examination of firms' choice of location and possible agglomeration effects. In Discussion Paper No. 802, Research Fellow Anthony Venables develops a model of upstream and downstream industries facing increasing returns in two locations between which trade incurs costs. Firms in both industries benefit from proximity to one another, even when there are no direct technological externalities between them. If either industry is perfectly competitive, its division between locations has no bearing on location decisions of firms in the other; if both are imperfectly competitive, downstream firms will locate where there are many upstream firms and vice versa. The resulting incentives to agglomerate are mitigated, however, since the locations of final consumer demand and labour supply are fixed.

Venables finds that very high trade costs imply that both industries will divide between locations to meet final consumer demand. With moderate trade costs, there are multiple equilibria: agglomeration may cause both industries to produce in one location, while divided production may prove an unstable equilibrium. Low trade costs cause both industries to divide, as location decisions' high sensitivity to labour cost differences rules out equilibria based on concentration in a single location.
These results illustrate the fundamentally ambiguous effects of economic integration on industrial location. Moving from high to intermediate-level trade costs entails both geographical concentration and divergence of regional economic structures and wage rates, but such differentials are not sustainable as trade costs fall further. These findings also shed light on the idea of a location's `industrial base', which gives equilibrium locations a certain inherent stability and creates multiple equilibria. This also implies that changes in one industry will affect others, so severe damage to just one part of the chain may affect the whole vertical structure of production, causing a set of vertically related industries to switch location.

Equilibrium Locations of Vertically Linked Industries
Anthony J Venables

Discussion Paper No. 802, May 1993 (IT)