When Geography Matters for Growth: Market Inefficiencies and Public Policy Implications

We propose a unique market and social planner solution for a generalized New Economic Geography and Growth model to highlight the importance of taking account of the existence of agglomeration externalities in an analysis of market inefficiencies, which allows us to provide some important implications for public policy. This framework among other things, allows us to disentangle an insufficient growth condition from an under-investment in R&D condition which in turn allows us to explain various market steady state situations. For instance, it provides an explanation for situations where the market economy grows too slowly and over-invest in R&D (as opposed to an a-spatial model). By evaluating the effects of two strategic policies, namely innovation policy and industrial policy, on market inefficiencies, we show that (1) the efficiency of a policy evolves strongly with the market economy situation and no policy is the most efficient in all situations, (2) the geography of economic activities and the question of over or underagglomeration of the market economy plays a central role on the relative efficiency of policies and (3) industrial and innovation policies are only partially complementary but policy-mixes can be justified if some market gaps are more important than others.