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Markups and Agglomeration: Price Competition versus Externalities

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  • Liqiu Zhao

Abstract

Agglomeration can affect markups through two potential channels: agglom- erated regions toughen competition (price competition effect) and firms are more productive on average in agglomerated regions (agglomeration exter- nalities and firm selection effect). However, the literature is inconclusive on which force dominates. This paper models these two channels by in- troducing agglomeration economies to the model of Melitz and Ottaviano (2008). Under parameters from the empirical studies, I demonstrate that the price competition effect tends to dominate the others, i.e., firms in more agglomerated regions charge lower markups. Using a unique Chinese firm- level data from 2002 to 2004, I investigate the effect of spatial agglomeration on markups of firms. By addressing the potential endogeneity problems us- ing instrumental-variable method, I find that in China an increase in the number of own-industry firms in the same region has a negative causal ef- fect on markups of firms and a positive effect on productivity. But firms in agglomerated regions have higher output and profit.

Suggested Citation

  • Liqiu Zhao, 2011. "Markups and Agglomeration: Price Competition versus Externalities," Working Papers VIVES Research Centre for Regional Economics 22, KU Leuven, Faculty of Economics and Business, VIVES Research Centre for Regional Economics.
  • Handle: RePEc:ete:vivwps:22
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