R&D-Based Location Model

Martin and Ottaviano (1999) extended the variety expansion model, which accounted for households’ preferences for varieties of goods, to a firm location model. In this case, an agricultural sector that produces numerous goods is introduced and the wage rate is standardised to 1. When goods firms export goods to the partner country, they incur additional transport costs. Hence, through the home market effect in Krugman (1980), good firms are concentrated in countries with larger market sizes between the North and South. Transport cost reduction due to trade liberalisation leads to the concentration of firms in the North, with a large market size. The amount and direction of foreign direct investment, defined as the difference between the number of firms located in a country and the number of shares held in that country, is affected by trade liberalisation. In global spillovers, where global variety lowers fixed R&D costs, trade liberalisation and the number of firms in a country do not affect economic growth rates. In local spillovers, where the variety in the North lowers fixed costs, trade liberalisation increases economic growth rates through an increase in the number of firms in a country. This growth-enhancing effect is called the location effect.