Trade and urbanization: Evidence from Hungary

I study how trade affects urbanization and real income. To this end, I exploit large-scale exogenous changes in trade stemming from the redrawing of Hungary's borders after the First World War. I show that, after the border change, urbanization in counties near the new border decreased significantly relative to counties farther away. This is despite the fact that these counties exhibited similar economic characteristics and urbanization trends prior to the border change. I rationalize these findings in a spatial model of trade and urbanization. In the model, benefits from trading drive agglomeration around locations where trading activity takes place. As a result, increasing trade leads to urbanization and real income gains. To measure real income changes after the redrawing of Hungary's borders, which are unobserved in the data, I structurally estimate the model using the border change as a source of exogenous variation. I find a 15.55% decrease in average real income after the redrawing of borders, with the largest losses concentrated in border regions.