This is a copy of the slide I presented at the Irish Society of New Economists Annual Conference in UCD on the 19th of August 2011. Please contact me if you are interested in obtaining a copy of the working paper.

1. Irish Society of New Economists– 19th August 2011
Competing Explanations of Economic
Growth: Comparing New Economic
Geography (NEG) and
Neoclassical Growth Theory for EU
Regions
Justin Doran and Robert Butler
Department of Economics,
University College Cork,
Ireland

2. 1. Introduction
2. What are
a. New Economic Geography Theory
b. The Solow Growth
3. Growth Models
a. New Economic Geography
b. The Solow Growth
4. Empirical Methods
5. Data & Results
6. Policy Implications

3.  This paper examines the explanatory power of two competing
growth hypotheses for a sample on European NUTS2 regions.
◦ New Economic Geography (NEG) Theory
◦ Neoclassical Growth Model.
 The research provides an empirical estimation of the NEG
wage equation and the Solow growth model to provide a
comparative test as to which theory can best provide an
explanation of European regional growth performance.
 The comparative explanatory power of these competing
hypotheses is assess through the utilisation of a J-test.

4.  New Economic Geography (NEG) is based on increasing
returns to scale emerging from microeconomic
foundations (Fujita et al. 1999; Fingleton, 2007). NEG
models are grounded in the Dixit-Stiglitz model of
monopolistic competition.
 The authors identify two sectors
Perfectively competitive, Monopolistic competition with
displays diminishing returns increasing returns to scale
to scale and produces a and provides a large variety of
single, homogenous good. differentiated goods.

5.  From Fujita et al. (1999) analyse a number of non-linear
simultaneous equations which are central to NEG
theory. The key equation derived is typically referred to
as the wage equation.
 The wage equation relates the wages in a region to the
market potential available to firms within that region.
 The market potential can essentially be thought of as a
weighted measure of the income in other regions
adjusted by transport costs.

6. • The Neoclassical growth model focuses on four key
factors which are expressed in a constant returns to
scale production function (Solow 1956).
 Capital, labour, savings and knowledge.
 Output of a worker depends on the amount of capital
that worker possesses and the technological capacity of
this capital and not the size of the economy overall.
 The accumulation of capital stock per worker is
dependent on the rate of depreciation of capital, the
rate of population growth and the rate of technological
progress in the economy.

7.  NEG theory relates the economic activity of a given region to
that region‟s market access. It is based on a series of
simultaneous equations which describe the relative prices,
market potential, income and wage rate of a given region.
 In the NEG model two sectors are envisaged operating across
„r‟ regions with transport costs existing between all regions.
 Transport costs are assumed to follow Samuelson‟s iceberg
form, where a proportion of the value of the good “melts”
away as the good is transported from one region to another.

8.  A Cobb-Douglas function is assumed where
U  M  C 1
 For our empirical analysis the key equation is the wage
equation which relates the wages in sector M, in region i
to Pi, the market access of region i.
 The wage equation can be expressed as:
1
wiM  Pi 
 The market access of a region depends on a number of
critical factors and Pi can be specified as
  T 
1
P i   Yr GM  1
r ir
r

9.  Nominal income in region i is given as:
Y r r wrM  1   r wrC
 The M price index for region r Gr
M
  is given as:
1
G  
  
1 1
M
r   r wrM e ln Dir 
 r 
 Where are the transport costs between region i and region r
and all other variables are defined as before.
 Finally transport costs are defined as:
Tir  e ln Dir

10.  Solow‟s (1956) growth model specifies that output is a
function of capital and labour, such that:
Y  f K , L 
 The model assumes constant returns to scale. This
results in:
y  f k 
 It is possible to define the growth in the capital stock
as: k  sf k     n  g k

11.  The capital stock at a given time period as a function of
the capital stock in the previous period adjusted for new
capital, depreciation, population growth and
technological advancement can be expressed as:
kt  kt 1  sf kt     n  g kt 1
 These series of equations imply that the rate of
economic growth in a region depends on the rate of
capital accumulation within that region.

12.  Estimating the Wage Equation is done by converting the
original wage equation into a double log form resulting
in:
1
ln w  M
ln Pit   it

it
 Including technological advancement potential and
labour efficiency across regions our equation yields the
following: M 1
ln wit  ln Pit   0  1S it  2t   it


13.  Estimating the Solow Model we once again take the
natural logarithm of the original production per worker
equation resulting in
ln yit   ln kit  vit
 Solow equation is augmented to incorporate labour
efficiency and technological progress. The proportion of
the workforce employed in high technology sectors is
again used as a measure of labour efficiency, while a
time trend allows for technological advancement. This
results in the following:
ln yit   ln kit   0  1Sit   2t  vit

14. 1 
H 0 : ln wit 
M
ln Pit   0  1Sit   2t   1 yit   it

 Where π1 are the predicted values from the estimation of the
Solow equation.
M
H1 : ln yit  ln kit   0  1Sit   2t   2 wit  it
 Where π2 are the predicted values from the estimation of the
NEG equation.

15.  If π1 is found to be statistically insignificant , then it is
possible to reject H1. This would imply that the NEG model
provides a better explanation of economic output than the
Solow model.
 It is also necessary to test π 2. If π 2 is found to be
statistically insignificant, then it is possible to reject H0. This
would imply that the Solow model provides a better
explanation of economic output than the NEG model.
 If neither hypothesis can be rejected, both can be deemed
valid explanations of output across regions. In order to
control for possible spatial dependence in the estimation of
the models, all equations are estimated as specified above
and include a spatial lag of the dependent variable.

16.  The data utilised by this paper is the Cambridge Econometrics
Dataset from 1980 to 2009. Data on regional Gross Value
Added (GVA), population, employment and capital flows are
used.
 Due to the presence of significant gaps in data for some of
the new accession states it was decided to exclude some
economies from the analysis so as to provide the maximum
possible time frame for analysis. This resulted in the dataset
being reduced to cover what had traditionally been referred
to as the EU-15 countries, with the exception of Luxembourg
and East Germany. Hereafter, the composite regions and
countries are referred to as the EU-14.

21. Table 1: Fixed Effects Estimation of Equations (12) and (14)
Variable NEG Solow
Constant -10.0794*** -13.8540
(0.5647) (0.2922)
Market Potential (lnP) 0.1124***
(0.0060)
Capital per Worker (lnk) 0.3809***
(0.0096)
Labour Efficiency (S) 0.4354*** 0.2047*
(0.1208) (0.1105)
Technological Advancement (t) 0.0067*** 0.0099***
(0.0005) (0.0002)
Spatial Lag (Wy) 0.0140* 0.0102
(0.0077) (0.0070)
Obs 5910 5910
F 4460.10 5635.82
Prob > F 0.0000 0.0000
R2 0.3599 0.4297
Note 1: *** indicates significant at 99%, ** indicates significant at 95%
and * indicates significant at 90%.

22. Table 2: Fixed Effects Estimation of J Test equation (15) and (16)
Variable NEG Solow
Constant 7.2803 2.5803
(0.6688) (0.9465)
Market Potential (lnP) 0.0969***
(0.0053)
Capital per Worker (lnk) 0.3683***
(0.0094)
Labour Efficiency (S) -0.0461 -0.2237**
(0.1079) (0.1100)
Technological Advancement (t) -0.0066*** -0.0027***
(0.0005) (0.0007)
Spatial Lag (Wy) 0.0001 -0.0021
(0.0068) (0.0068)
ln Solow 0.9668***
(0.0247)
ln NEG 0.8625***
(0.0474)
Obs 5910 5910
F 4835.83 4835.83
Prob > F 0.0000 0.0000
R2 0.4592 0.4592
Note 1: *** indicates significant at 99%, ** indicates significant at 95%
and * indicates significant at 90%.

23.  This paper has provided an analysis of two competing
growth models; new economic geography (NEG) theory
and the neoclassical growth model. Both models are
estimated using data for fourteen EU countries for the
time period 1980 to 2009.
 The paper indicates that both NEG theory and
neoclassical theory can be used to explain regional
economic output with competing predictions for EU
regional convergence/divergence.

24.  Under NEG theory, the potential to promote regional equality is
constrained by transport costs and the advantages associated
with agglomeration. The development of better infrastructure
and integrated markets will reduce these, if not removed them
entirely.
 The accumulation of capital may be viewed as a more promising
potential mechanism through which regional convergence can be
achieved. This could be developed through the use of policy
incentives directed towards the incentivisation of the investment
of capital in poorer European regions.
 It is noteworthy that labour efficiency is found to have a positive
effect on economic output. This suggests yet another
mechanism through which convergence can be pursued. The
investment in human capital throughout EU regions should
provide another route through which convergence can be
achieved.