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Updated economic geography model incorporates heterogeneity in firm productivity, environmental pollution

Regional and urban economics employs theoretical modeling to examine how real-world factors shape regional development. These models provide a rigorous framework for evidence-based policymaking, offering insights to promote balanced economic growth and foster sustainable development.

New updates to an existing theoretical model incorporate environmental pollution and a variable called firm heterogeneity, which captures productivity distribution patterns among industrial and manufacturing firms, to better analyze how industrial clusters form, where manufacturers operate, and where workers choose to live.

The work is in the Portuguese Economic Journal.

Industrial agglomeration describes the tendency of manufacturing industries and workers to cluster in geographic space. This can have both positive and negative effects on regional development.

"Industrial agglomeration generates technological and knowledge spillover, enhances economic growth, and is considered crucial in achieving sustainable regional development. However, industrial agglomeration may also cause environmental pollution that produces negative externality and harms further agglomeration.

"This paper discloses the theoretical mechanism through which a change of firm heterogeneity in productivity (achieved by innovation or related policies) and environmental pollution endogenously determine the spatial equilibrium of a regional economy," said Yiming Zhou, associate professor at the Graduate School of Humanities and Social Sciences at Hiroshima University in Hiroshima, Japan.

Zhou's economic geography model extends the Pflüger model, a canonical model in the regional science literature. The Pflüger model used a quasi-linear upper-tier utility function to examine industrial agglomeration in the process of regional integration. The model finds that industrial agglomeration is a gradual rather than catastrophic process.

Although the Pflüger model has been widely applied across various contexts, it does not account for heterogeneity in firm productivity—a factor demonstrated by recent literature to critically shape trade patterns, firm selection mechanisms, and agglomeration. By incorporating firm heterogeneity, Zhou's model can explain how changes in firm productivity distribution and trade costs affect industrial agglomeration across regions.

Zhou also incorporates the impact of environmental pollution from industrial production on migration into the model. The results show that the agglomeration force stemmed from a higher degree of firm heterogeneity may outweigh the dispersion force caused by pollution, thereby fostering regional industrial agglomeration.

"From the perspective of policy establishment, pollution emission regulations not only protect the environment but also exert significant importance in fostering regional industrial agglomeration. Moreover, regional policies encouraging technological innovation, e.g., subsidies to firms' research and development activities, help cultivate high-productive firms and foster local industrial base," said Zhou.

This new model clarifies how changes in the distribution of firm productivity, environmental regulations, and trade costs influence industrial agglomeration and regional development. It offers a useful policy tool for governments seeking to design regional strategies that promote sustainable regional development.

Looking ahead, Zhou aims to further refine the model and enhance its applicability to real-world challenges in regional development.

"The comprehensive model developed in this paper can be further applied to analyses of regional sustainable development, labor market, and growth. Future research will focus on the impact of the carbon tax on spatial distribution of industries by further extending the model into a multi-region context," Zhou concluded.