Comparative advantage, agglomeration economies and trade costs

This paper contributes to the theoretical research exploring the interface between comparative advantage (locational fundamentals) and agglomeration economies. A simple model is developed which highlights costly trade of final outputs and of intermediates. We derive the novel insight that the interaction between comparative advantage and agglomeration economies involves a fundamental tension which is intricately affected by trade costs. A reduction of trade costs fosters the dispersive impact of comparative advantage in sectors governed by this force whilst the impact of agglomeration economies is enhanced by a fall in trade costs in industries where increasing returns prevail. The key implication for international trade is that the relative wage between large and small economies is not only shaped by the primitive determinants of agglomeration economies and comparative advantage but also, in a different way, by trade costs. The key implication for an economic geography setting where labor is mobile is that partial agglomeration emerges when agglomeration economies are strong relative to comparative advantage, and this is more likely when trade costs are lower (higher) in industries governed by increasing returns (comparative advantage). The model provides a foundation for an urban system in which the larger city exhibits more diversity in production.