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TRADE LIBERALIZATION, DIVERGENCES AND REGIONAL POLICIES: THE CASE OF MEXICO Liliana López Chamorro* Abstract Mexico’s economy has put into practice the idea of regional free trade agreements, such as North America Free Trade Agreement (NAFTA). The results of this system has put Mexican commercial activity as one of the 8th most powerful ones of the World and as the first one in Latin America. NAFTA has increased trade and factor mobility between Mexico, USA and Canada significantly; however, this has also increased the divergence between poor and rich regions across Mexico. Although several papers have addressed these divergences, no studies have been undertaken a new economic geography (NEG) approach to describe and explain the spatial characteristics of Mexico. The main contribution of this paper is based on NEG framework, as the main tool for this kind of analysis since it does not only rely on pecuniary externalities but it also takes into account technological externalities on productivity, industrial location and policy. Based on different estimation strategies and taking a number of features of the regions in Mexico into account, this paper will try to find out the spatial disparities among Mexican regions, and the effect of regional policies on reducing these disparities. * Ph.D. Student, University of Antwerp, Belgium> Economics Department, Universidad Externado de Colombia Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez INTRODUCTION Mexico’s economy has put into practice the idea of regional free trade agreements, expressed in the North America Free Trade Agreement (NAFTA). The results of this system has put Mexican commercial economy as one of the 8th most powerful commercial economies of the World and as the 1st one in Latin America. The NAFTA has increased trade and factor mobility between Mexico, USA and Canada significantly. However, this has also increased the divergence between poor and rich regions across Mexico. Today, regional disparities among Mexican regions are one of the main problems of the country. There is extensive literature about Mexico and its economic disparities. Esquivel (1999), using a regression model, analyzed the divergence between Mexican regions during 1940 and 1999. Messmacher et al. ( 2000) executed an empirical work trying to analyze these divergences, and showed how the GDP per capita in Mexico DF became 6.4 times bigger than the one in Oaxaca. Messmacher also analyzed how the NAFTA and other structural reforms generated inequalities among Mexican regions. However, most of these studies were based on samples including oil regions and recession periods, and therefore, they did not explore the complete forces that may have affected negatively the convergent behavior across Mexico’s regions. This paper, using the so called “new economic geography”, (NEG), as a framework, clarifies that the divergent performance of the regions, is not only the result of the international trading systems, but it is also caused by diverse internal and external factors. Clearly, differences in exogenous factors as nature or factor endowments (what is called “first nature”) are responsible for some of the core-periphery results that we observe nowadays. However, some agglomeration results are present in regions with similar characteristics, which might imply that endogenous characteristics (“second nature factors”), such as economic organizations, are also responsible of these divergences. From the theoretical standpoint, particularly on the basis of New Economy Geography models, NAFTA could be one of the reasons that brought specialization and polarization in the Mexican regions, and also contributed to grow the core-periphery –divided regional income. The so-called “New economic geography models (NEG)”, studies how a close but imperfect integration may Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez create regional winners and losers. However, some other factors might also have influenced on these divergences. Due to these divergences among regions, regional policies exist. Governments in order to diminish this kind of disparities implement policies, which can take any form, from infrastructure spending to tax reduction. However, theoretical and empirical works argue and debate the need of these regional policies and whether they can be justified from an distributional efficiency perspective. The principal aim of this paper is to apply the NEG framework to study the spatial characteristics of Mexico, and to see whether or not regional policies can be justified on this scenario (Mexico). The NEG framework is a good tool for this kind of analysis because it does not only rely on pecuniary externalities but it also takes into account technological externalities on productivity, industrial location and policy. The outline of this paper is as follows: the first part reviews relevant literature on international trade, divergence and regional policy. Here we aim to take seriously NEG to regional policy focusing on NEG models literature, its implications in welfare and policy. Understanding how the NEG models work, its economic insights and what would be its equilibrium outcome is intended. Thereafter a review of the most important regional policy instruments are mentioned, and at the end, the relation between these instruments and the NEG models is established. The next Section presents data and some important facts of Mexico, summarizing the existing literature concerning Mexico and its regional effects after the reforms . In doing so, the next step is to relate these outcomes regarding the question about the economic divergence, the broad integration of the world market and to see whether or not regional policy has worked in diminishing these divergences. Section three describes methodology and data used to carry out an econometric analysis taking into account distinct features of Mexican regions. The methodology is based on the estimation of income, population and housing prices growth regressions over a set of explanatory variables. These regressions are a good tool to understand the evolution and the drivers of regional Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez differences in productivity levels and quality of life across Mexico. The last section provides the main findings of the model, concludes and discusses policy implications. THEORETICAL BACKGROUND This section reviews the main New Economy Geography models. This review is focused on the models’ hypothesis, its main results and relevance in terms of regional policy analysis. In order to do so, it is important to take the models literally and analyze what their exact policy implications are. Measuring the gap existing between regions, using as a framework new economic geography models, the insight to the policy domain can be explained. It is useful to start with a simple static NEG model and then build it up, adding or subtracting assumptions, following the logic and the labels of Baldwin et al. (2003). Since 1980, new theory has been developed, particularly on New Economy Geography, where there is a new perspective of the integration process, because it takes into account microeconomic foundations, the non-homogeneity of the space1 , the presence of increasing returns to scale and trade cost. For these reasons these kind of models are an essential tool to study the impact of trade liberalization. One of the main key references for New Economy Geography models is Krugman (1991). His so called core-periphery model (CP) puts together urban economics, regional economics and international trade into one framework. The model highlights the reinforcing linkage-based agglomeration; firms will allocate in the largest market. In other words, the CP model shows that competition, low trade freeness and large market will produce agglomeration. High competition, low level of freeness and small market will cause dispersion. “places differ in terms of their relative abundance of natural resources proximity to natural means communication and climate conditions” Ottaviano (2002) 1 Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez The CP model assumes initially symmetric regions, two factors of production: skilled workers and unskilled workers (agriculturist), and two sectors: agricultural and manufacturing sector. Regional supplies of both factors are fixed, but interregional distribution of labor is endogenous with labor mobility between regions due to wage differences. The difference between regions lies in their demand structure. The manufacture sector is monopolistic competitive, with increasing returns to scale, however, the agricultural sector produces an homogeneous good, produced under perfect competition and constant returns. Both sectors are traded. The CP model introduces the cost of trade in an iceberg form (for one unit of a good to arrive, τ >1 units must be shipped). The preferences of all citizens are identical. Preferences of the representative consumers are in a Cobb-Douglas form. The key factors that produce agglomeration, as mentioned above are competition, low trade freeness and large market. Taking into account these factors, the first key effects of the model are: MARKET ACCESS EFFECT. It refers in the sense that in the presence of imperfect competition an increasing returns to scale, a monopolistic firm would rather to be in the larger market. Exogenous change in the location of demand leads to a more than proportional relocation of industry to the enlarged region, this is called “HOME MARKET EFFECT REFLECTS”. COST OF LIVING EFFECT. Goods will be cheaper in the region with more industrial activity since consumers will avoid more trade costs by importing a less range of products. The combination of these two effects with interregional migration creates the potential for “CIRCULAR CAUSALITY”. When some migration process takes place, since workers spend their income locally, the region that host the new workers, becomes larger. Due to the market access effect, the changing market size tends to encourage some industrial firms to relocate in the host region. This relocation will impact on the local cost of living and therefore on real wages. The initial migration shock might be self-reinforcing since migration may alter the real wages in a way that encourages further migration. There are two cycles of causality in the CP model, one linked to demand and one linked to cost. As workers shift, it implies that expenditure shifts, even a small migration shock will change relative market size and some industrial firms will move to Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez the larger market (demand or backward linkage). This will be reinforced by the reduction of cost of living that makes this market more attractive for the workers, reinforcing the original workers movement, and further, increasing the share production carried out there (forward linkage). Compared with others, circular causality on NEG models depends on the level of trade freeness. On the NEG model the relation between these two causes what Ottaviano called “the humpp shaped agglomeration rent” which refers to the cost faced by a firm when it reallocates. On the other hand, the dispersion force is driven by large competition, low level of freeness and a small market. In terms of competition, when you compare one firm with another, maybe one firm wants to be in the small market as the unique producer. The degree of competition of one market is big relative to market size in one region if there are more firms relative to the other region, this implies that workers will move to the bigger region, and then this will have a negative impact on the manufacturing wages, acting as dispersion force, this is called “MARKET CROWDING EFFECT”. Whether the agglomeration forces are stronger or the dispersion force dominates, it depends on the parameters of the model, particularly on the degree of regional integration among the regions. Agglomeration and dispersion forces are influenced by the degree of freeness. The strength of agglomeration forces diminishes as trade becomes freer. For instance, considering the cost of living effect, if regions have very low trade costs, there will be nearly no differences in prices between the two regions whatever the spatial allocation of production is. Therefore, shifting industrial production does not have an important impact on the relative cost of living. The strength of the dispersion forces also diminishes when particular region is more open. On the one hand, if trade is almost completely free, competition from firms in the other region is as significant as competition from local firms, hence in this case, competition is not very localized. Moving firms from one region to other will not have very much impact on firm’s revenues and therefore on the wages that they pay to industrial workers. On the other hand, if freeness is low, the shifting of firms has very large impact on competition for customers and therefore an important effect on wages. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Further reductions in trade costs also diminish the power of agglomeration forces. Importance of cost of living effect is reduced because of the difference in prices between regions gets smaller, and something similar happens with the market access advantage, since the consumers are more easily reachable no matter where they are located. However, this takes place at a slower pace than the weakening of the dispersion force. As a result, there is a range of trade costs at which agglomeration forces are not strong enough to undermine a dispersed equilibrium, but they are sufficiently potent to also sustain an agglomerated equilibrium. When trade costs fall enough and pass a threshold level or break point, the industrial structures, and hence the income level of the two regions must diverge, and the result is a core hosting of all industries and a periphery without any industry2 . This process reveals the ”HOME MAGNIFICATION EFFECT” which shows that industry becomes more footloose as trade gets freer. The CP model presents two more important effects. Locational hysteresis: this feature arises when the level of freeness is such that the model presents multiple stable equilibrium. In such situation, history matters. If the economy starts out near a CP outcome, it will move to it and stay there. If a temporary shock moves the economy from a stable equilibrium to other, then the removal of the shock would not reverse the effects of such shock. Hump-Shaped Agglomeration Rents: agglomeration rents measure the loss a worker would incur by relocating from the core to the periphery when full agglomeration is a stable equilibrium. In the CP model as trade gets freer agglomeration rents first rise and then fall. When trade is completely free, agglomeration rents are zero implying equalization of real incomes in both regions. Summarizing, there are three effects that makes either agglomeration or dispersion: Market Access effect; Market crowding effect and cost of living, the last one is also a cause of agglomeration, taken the prices as given; the price index is lower in the larger market. Due to these effects, the Krugman model evidences that trade policies and labor mobility play an important role in shaping the spatial allocation between regions; both sources interact to affect spatial distribution. In this model, plausible international trade integration and labor migration 2 These results correspond to a situation of initially symmetric regions. Size and openness asymmetries, while more difficult to work with, yield qualitatively similar outcomes. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez cause divergence among regions if the measure of trade cost reduction is sufficiently important to cross the break point. In order to see how rich and poor regions may engage in a trade integration process it is important to analyze the cases where regions are not identical. The CP framework allows for asymmetries of first nature. Particularly, they come from the fact that regions may have different stock of immobile factor. The logic is as follows: the well-endowed region will present a higher expenditure level that will affect nominal wages of the mobile factor and as a consequence its real wage. Hence, the real wage gap between the rich and the poor region will be positive. This difference will give the incentive to the mobile factor to move from the less-endowed region to the well-endowed one. The CP model presents important features which help to explain the agglomeration outcome. However this model is difficult to work with. More compliant models which deal with the difficulties presented by CP model are the Footloose Capital model(FC) and The Footloose Entrepreneur Model(FE) presented by Martin and Rogers (1995) and Forslid and Ottaviano (2002) respectively. Martin and Rogers (1995), consider all the characteristics of the CP model, but it is assumed that the mobile factor is capital (nevertheless, capital owners are totally immobile between regions). Then it is plausible to interpret the two regions as different countries. The circular causality that appears in the CP model is broken if one assumes that the mobile factor repatriates all of its earnings to its country of origin. In this model, backward linkage effect and forward linkage effect disappear. The interregional capital relocation leads to production shifting without expenditure shifting, and the mobile factor (capital) is spent in the owners region of origin. The home market effect occurs, however it is not self reinforcing. The market access effect is opposed by the market crowding effect when trade costs are in place, and if we assume initially symmetric regions the result is always dispersion until completely free trade is attained. Nevertheless, as with low trade costs capital is extremely footloose, assuming slight asymmetries in the endowment of capital restores the trade-induced agglomeration in the richer country. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Forslid and Ottaviano (2002) merge the previous models and therefore display all the features of the CP model while still assuming (humpan) capital as the mobile factor. In this case, the owners move along with their factors, so backward and forward linkages are guaranteed. As in the FC model, the production technology of the industrial sector relates fixed costs only with (humpan) capital and the variable cost only with unskilled labor (immobile factor). The mobility of the skilled entrepreneurs is an assumption in line with the experience in several regions of the world. This model shares all the characteristics of the CP model, it also has the same relation between the opening of the regions to trade and an equilibrium involving first dispersion when trade costs are high, but then a divergent location of industries is reached catastrophically3 when a threshold level of trade costs is trespassed. There is also an intermediate range of trade costs in which either dispersion or symmetric equilibrium are possible stable equilibriums. Veneables (1996), shows that agglomeration could be induced by the presence of input-output linkages among firms. His model, The vertical linkages model (VL) does not rely in factor mobility but nonetheless displays agglomeration as the economies are gradually opening to trade. According to Venables, industrials firms prefer to be close to each other not only due to the market-access effect, but also because they buy and sell their goods to each other as intermediate inputs (the backward and forward linkages are then present). The VL model allows for two regions, two sectors and one primary factor of production (labor). Both regions are endowed with the same technology and labor force. The agricultural sectors as in the CP model produce an homogenous good under constant returns in a perfectly competitive environment using labor only. Its output is freely traded. Restricting parameter values, so that this sector be active in each region or country at any equilibrium, ensures that labor wage is equalized across space and sectors. The supply of labor to the manufacturing sector is perfectly elastic; the manufacturing sector produces different varieties of an horizontally differentiated product using both labor and intermediates under increasing returns. Its output is both consume 3 In order to use regional policiesn tools, in this paper catastrophically locations are not allow, otherwise there will be not effectiveness of regional policy at all. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez by final consumers and used as intermediate inputs by other manufacturing firms. In this way, firms are said to be vertically linked with each other. The key variable in this model is the share of total labor force working in the differentiated sector. As workers are mobile between sectors, they split between sectors according to the differential in nominal wages, and the industry concentration or dispersion will follow accordingly. The Scissors diagram below is an easy way to show the behavior of the model. The figure plots the north’s expenditure share se on the horizontal axis and the north’s share of industry sn on the vertical axis. (Baldwin et al 2003). Sn Eeo EE nn ½ 0 ½ 1se Looking at the diagram we can see “how a slight increase in the northern market size leads to a shift of the ee curve to the right. Presuming that trade costs are high enough for the interium equilibrium to be stable, the shock will lead to a more than proportional increase in the north’s share of industry since, and in this case, the nn line is steeper than the 45 degree line. Moreover, home market magnification also occur, the home market effect gets stronger as trade gets freer since freeing up trade makes the nn line steeper. The same rightward shift in the ee curve would lead to a higher degree of relocation” (Baldwin et at 2003). In other words, in the VL model we Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez can find the same relation as in the CP model between trade freeness and divergence in the level of industrialization, namely, there is dispersed equilibrium when trade costs are high, multiple possible stable equilibriums for intermediate trade costs, and complete agglomeration when trade costs fall below the break point can be presented. Notice that here the results are obtained without resorting to factor mobility. In particular, the role played by the cost of living effect in producing circularity as it does in the CP model; here it is obtained with the cost of production effect. Furthermore, agglomeration is driven by an entry and exit of firms, since the firms buy their inputs locally, they care about the local cost of production, this means that entry decisions will be based on real reward to production, so cost-linked circular causality come into play via the production cost effect. The fact that firms spend locally ties production shifting to expenditure shifting, so that demand-linked circular causality operates in both models. Empirically, vertical linkages are a strong explanation of international agglomeration patterns than labor migration. Agglomeration can occur without factor migration in an alternative way. In the models introducing growth, factor accumulation can play the same role as factor mobility in foster divergence between levels of industrialization and among levels of income. The dispersion force in this model as in the previous ones is the market crowding effect, and what determine the relative strength of agglomeration and dispersion forces are, again, trade costs. Krugman and Veneables, collapse the two models into one, with their Core-Periphery Vertical Linkage model (CPVL). They introduce an alternative feedback mechanism: intermediate goods drive agglomeration thought input-output linkages, so the relationships switch from vertical linkages to horizontal linkages. As in the VL model, this assumption seems to be more appropriate since inter-regional labor migration is done. Three effects are present in the CPVL model: the well-known market access effect and the production cost effect. The latter reflects the fact that the region with the larger number of firms will enjoy lower goods prices due to the possibility of consumers and firms to avoid trade costs. Both effects act as agglomeration forces. A circular causality emerges from the combination of these effects and the mobility of intermediate goods among firms. Finally, the market crowding effect also works as the dispersion force. Like all static models, agglomeration and dispersion forces weaken as the level of freeness increases. When free trade is very free, market access will be similar for firms wherever they are Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez located, production cost of imported varieties is slightly higher than that of produced locally, thus competition from foreign firms is almost as important as competition from domestic firms. Again, dispersion forces weaken faster than agglomeration ones. Baldwin 1999, created a model within the CP family models, called constructed capital model. A new R&D sector is added to the agricultural and industrial sectors (sectors that remain as in the previous models). Innovation takes place in this sector through the use of labor to invent and patent new varieties of the industrial goods. As patents are non-tradable and last forever, production takes place where the invention was produced. The existence of decreasing returns to patent accumulation implies that innovation stops at some point, which prevents the economy of growing once the equilibrium is reached4 . The CC model displays catastrophic agglomeration, as the other models, if trade is sufficiently free so that the pro-agglomeration circular causality dominates the anti-agglomeration market-crowding effect. However, the region of multiple equilibriums is absent in this setting. As the core-periphery outcome comes about as a result in a change in relative factor endowments in both regions, even at free trade a divergence between the per capita real income of the rich and that of the poor will be permanently observed. Thus, economic integration produces divergence in real per capita incomes, a result that is contrary to the neoclassical growth models’ prediction. When we allow growth, economic integration of the regions can come from a lowering of trade costs and from capital mobility. Accordingly, it is useful to add capital mobility to the CC model. Perfect capital mobility of the FC type model breaks all circular causality5 , and the outcome is a stable spatial distribution of industry for all levels of trade costs. However, if one allows for mobility of capital owners, complete agglomeration occurs at any level of trade costs, because everyone will try to avoid them. Therefore, a trade liberalization process can produce very different impacts on geography according to the barriers to capital movement that are in place. 4 The CC model can be regarded as a neoclassical growth model. The long run growth rate in these models is completely exogenous. 5 The explanation for this was proveded zhen the FC model was discussed in this section. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez The following two models take into account factor accumulation or innovation. There are different ways of factor accumulation, but the most important is the one related with technological change. There are two types of innovation: first, horizontal innovation, and second, vertical innovation. In the first one, the innovation is characterized by the expansion of new products varieties, while the vertical innovation is characterized by an improvement on the quality of the existent product. The model from Grossman and Helpman (1991) studies the horizontal innovation. Here we can have cost of innovation as a constant and the number of firms does not grow in the long run, in this case the size is important, Exogenous growth. On the other hand, when cost of innovation is decreasing with the number of firms, the more innovation is in the past the cheaper the innovation gets; Endogenous growth. Within this framework we can have spillovers and the growth will continue in the long run. Perhaps some of the richest and most interesting models, in respect to the debate about integration and divergence, are the models of endogenous growth. Two of these kind of models are discussed below, where the endogenization of the long-run growth rate comes from the fact that the cost of making new capital falls because of the assumption that capital construction follows a learning curve. Capital is viewed as knowledge capital, and it is assumed that the experience gained on past innovation spills over all present innovators. The spillovers can be perfectly transmitted between firms in different regions, giving rise to the global spillovers model (GS), or, as the localized spillovers (LS) assumes, the intensity of this technological externality could disappear with distance. The spillovers can be global when innovation on the past affect everywhere; and spillover can also be partial, in this case, innovation in the past is going to affect growth in the future only in some part, in this case the innovation is local. Martin and Ottaviano, (1999) created the so called global and local spillover models; the global spillover model shows how the agglomeration process is caused by the constant growth rate of capital knowledge. The key feature of the model is the innovation sector and its technology. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez The Global Spillover model (GS) model consists in two regions: two consumption good sectors, a traditional sector (agricultural) and an industry sector (manufacture); and two factors of production, capital and labor. The agricultural sector only uses labor to produce its homogenous output, there is perfect competition in the agricultural sector with constant returns to scale, then inter-regional trade in the agricultural sector is costless. As other models, the industry sector or manufacture sector is under monopolistic competition with increasing returns, this sector use only capital as its fixed cost and only labor as its variable cost. Continuous growth in the GS model is driven by continuous expansion of the world’s knowledge stock. Since each unit of capital knowledge is associated with a variety, the range of varieties will be continually expanding. Such an expansion is inevitably associated with a falling grate of operating profit per variety. (Baldwin et al, 2003). The marginal cost of production of one unit of capital knowledge declines as the cumulative production of ideas rises, in other words, with endogenous growth the marginal cost of innovation can go down with the amount of the number of patterns. There are stabilizing and destabilizing forces that interact affecting the stability of the equilibrium. The stabilizing force is present due to the well-known crowding market effect. The demand-linked effect reflects the destabilizing forces. An increment in the capital share of one region increases production. This production shifting leads to expenditure shifting. The enlargement of market size increases profits and the capital value creating the incentive to innovate. At high level of trade costs, stabilizing forces are stronger than destabilizing ones. But again, as trade gets freer, destabilizing forces become stronger than the stabilizing ones. Starting from a stable symmetric equilibrium, crossing a certain threshold, the equilibrium becomes unstable: spatial concentration takes place in the large region. In this region accumulation is always profitable since the value of knowledge capital is equal to its replacement cost. The small region has no incentive to innovate since the value of innovation is lower than its replacement cost. Similar adjustments are present when one considers asymmetric regions. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez The GS model displays home market effect and its magnification, demand-linked circular causalityand endogenous asymmetry. Furthermore, if knowledge capital is immobile it will cause location hysteresis, and humpp-shaped agglomeration rents. Moreover, when capital incomes are spent locally, growth can affect geography in the sense that the process of accumulation of capital can lead to catastrophic agglomeration; however, geography does not affect growth. In a symmetric scenario, capital grows at the same rate on both regions no matter which is the resulting equilibrium configuration, in the core periphery outcome, only one region built capital although the growth rate is the same. Capital continuue to exist only in regions where it earns enough to repay its owner for investing in it, and due to the global spillover assumption the cost is the same no matter where the investment is made on. The income growth is directly linked to the growth rate of capital. We know that due to an increase on the number of varieties, the price index in both regions will fall and this implies continual real income growth. The movement from a symmetric equilibrium to one of fully concentration creates faster investment, capital accumulation and growth in the favored region, called the growth pole. The other region becomes the growth sink since delocation involves low investment, capital accumulation and growth. The agglomerated region has a higher capital-labor ratio, thus income per capita is also higher. This difference does not disappear as trade gets free. THE LOCAL SPILLOVER MODEL(LS). The local spillover model is characterized by letting distance affect knowledge diffusion, the only assumption different from the ones of the GS model is that marginal cost of an innovation now are not identical in both regions, the cost of innovation also depends on the location of the capital. Agglomeration helps economy to grow faster. The firms located in the core region, which is the region that innovates, will grow faster. Faster growth is good, also for the periphery region, because there are going to be gains in terms of trade from this region. When innovation takes place, the relative prices will go down and then the periphery region can import at lower prices. This model also displays the home market and the market crowding effect, and their relative strength continues to be governed by trade costs. As in the previous models, when the level of Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez freeness is quite low the symmetric equilibrium will be stable and for trade costs sufficiently low the core-periphery result will prevail. As before, when an agglomeration result is obtained, the core region has a higher income per capita than the periphery because of the higher capital labor ratio. This difference does not disappear even when trade is completely free. In addition to the demand linked effect and the market crowding effect, a destabilizing localized spillover effect is operating in the LS model. This is independent of trade freeness, since it reflects the fact that growth raises the productivity of the innovating sector in the larger market and makes this market more attractive for innovation, given that learning spillovers are localized. This can be understood as a sort of cost-linked circular causality or intertemporal vertical linkage. After reviewing the main NEG models, its assumptions and equilibrium outcome, we can understand how NEG models give a better understanding of how the economic landscape involves as trade impediments are gradually eliminated. The agglomeration takes place when the final impact of the market expansion effect dominates the impact of the market crowding effect. To give more substance of these statements, and to see how these models can be a good tool to analyze the impact of regional policy on agglomeration and on the divergence between poor and rich regions, it is important to summarize the key properties of the models mentioned above. This will be a benchmark for the analysis. (Appendix 1). REGIONAL POLICY AND WELFARE ISSUES After reviewing the contributions of NEG models, it is important to discuss the contributions and the effects that regional policy can bring under the eyes of NEG models. Regional policy can be regarded as an active policy intervention into the economy process in favor of a certain region. According to Boden (2002), regional policy can be justified if: - An integration process produces market failure, this failure can be due to distance or to space reasons. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez - An integration process produces regional income differentially. Some factors can not move, then workers and consumers are stuck in the poor region (Midelfart 2004) causing income differentials. In other words, a lower demand of labor in a region will generate an adjustment downwards on real wages or an increase on unemployment. In an economy characterized by imperfect competition and increasing returns to scale, the government can help to reduce the divergence among regions, by promoting and accelerating the industrialization process in a region through regional policy. Theory has shown us that regional policy, such as subsidies, taxes, infrastructure, social aid, antitrust, etc., can reduce these inequalities by slowing down the agglomeration process and affecting regional income disparities and growth. Some authors emphasize on the importance of the analysis of these regional policies effects regarding equity and efficiency on the region. The effectiveness with which regional policy can slow down the agglomeration process and affect the income disparities and growth, depends on the relative size of the regions population, on the efficient level of administration for regional policies measures, and on the choice of efficient instruments. The optimal instruments of regional policy depend on the level of trade costs, on the degree of pecuniary externalities and on the magnitude of localize inter and intra industry knowledge spillovers. Regional Policy Instruments Nowadays, policy analysis tends to be specialized, for example, tax experts will look at tax policies, trade experts will look at trade policies while competition experts will look at competition policies. The optimal instrument depends on the level of trade costs, and on the degree of pecuniary externalities, as well on the magnitude of localized inter and intra industry knowledge spillovers. According to Baron (2004) it is possible to differentiate policy instruments in two types: microeconomic instruments and macroeconomic instruments. The first one is related with labor and capital mobility due to a regional policy. The second one is related to monetary and macro policies. Taking into account that geographical distribution of economic activities is endogenous to most policy interventions, the impact of a policy, whatever the policy Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez is, needs to be analyzed considering the mobility of labor and capital around the regions. For this, the need of the so called Micro-instruments6 are used. Microeconomic instruments are those instruments which affect directly labor and capital mobility among the regions. The ones that affect labor mobility can be characterized by migration policies, mobility policies and improvement efficiency policies. Migration labor policies Mobility subsidies LABOR MOBILIT Y Labor Mobility Policies Improve effectiveness of labor The other kind of micro-instruments are the ones related to mobility of capital. Within these instruments the most important ones are those related to administrative controls, the taxes and subsidies, policies that generate social development, policies that improve the efficiency of the firms and policies that improve the efficiency of capital markets. 6 Baron Juan David, Colombian Central bank (2004). Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Taxes and Subsidies Policies of social development CAPITAL MOBILIT Y Administratio n controls Policies that improve the efficiency of the firms and capital Regional Policy Implications Ottaviano (2002) using NEG literature, point out some key policy implications taking into account the policies specializations and the instruments mentioned above. These implications are: regional side effects (competition policy), trade interaction effects (trade policy), lock-in effects, and coordination effects. According to Ottaviano, regional policies need to be analyzed taking into account these kind of implications in order to have a better approach of its effects under the key features of the NEG models. The central concern of regional policy is the spatial distribution of economic activities. A regional policy can not only influence the market expansion of a region but it can influence its market crowding effect. Regional side effects refer to non-regional policies that affect the location of economic activity. For example, reducing power market of the firms is influenced by the antitrust law and this would reinforce the market crowding effect. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez From the NEG models mentioned above, it is known that firms are more footloose when the trade barriers are lower. As trade cost fall, the regional policy contracts because firms will locate wherever there is a better market access, thus the firms become more receptive to any subsidy. Within this analysis it is important to mention the agglomeration rent. It is known that firms are attracted to central regions, therefore, even these regions do not have policy attractiveness, firms will not locate there, however, if the tax competitive subsidy or any policy intervention is very high such that it rises above the threshold level (below this point nobody will move). This policy would lead the firms to reallocate. Threshold effect. Agglomeration rents Threshold point A temporally policy can have permanent location effects lock-in effects. When firms move due to a policy implementation, that policy does not need to exist any longer. Once the firms are reallocated the new agglomeration is self-enforcing. On the other hand, when reversing the effect is the objective, it is necessary to have a policy which reforms are much more sever in order to led to the initial effect. Ottaviano highlights the importance the policy instrument, due the selection effect that this will bring to the region. In order to see which instrument is an optimal one, it is important not only to look at the region environment but also at the characteristics of the key firms localized in the region, then if the instrument attracts the key firm, the rest of the firms will follow. Furthermore, using Baldwin et al. (2003), these instruments and their implications can be analyzed more deeply; especially its impact on the spatial allocation of an industry and its effects on growth. The relative size of the regions has an ambiguous effect on the equilibrium policy. For Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez example a subsidy; on the one hand, if a larger fraction of the population lives in a given region, the equilibrium subsidy to the other region tends to be reduced as more voter favor a lower value of subsidies. On the other hand due to the home market effect, an increase in a regions size increases its equilibrium share of industry, and hence, its real income for any given subsidy level. This aspect of the home market effect allows all political candidates to raise the subsidy to the other region without altering individual’s welfare. In essence, the very fact the economically bigger region is large, which means that its people is willing to accept larger taxes, the net effect of the relative population size is then ambiguous. Moreover, starting from a core-periphery situation, that is when the economy activity is concentrated in one region, subsidies can not turn an unstable dispersed equilibrium into a stable equilibrium (Iranzo). According to Iranzo and Venables(1996), and taking into account the implications mention from Ottaviano, a very good instrument that can help to reverse the agglomeration effect are the redistributive interregional transfers and the non- discriminatory consumption taxes. If a consumption tax raises more funds in the more active region and these funds are send to the poorest region the policy helps to leveraging the demand level across regions so it offsets. After reviewing some instruments and some implications of the instruments according to the theory, the next section will try to do an empirical work in order to counteract this implication with the reality. EMPIRICAL EVIDENCE This session is characterized by an empirical analysis of Mexican regions. This is done in order to see the effect of the divergences among regions and whether the regional policies implemented in Mexico had been successful or not. Before starting analyzing the regional policies implemented in the regions, it is important to see the effect and cause of divergence among the regions. To do so, this paper summarize the existing literature concerning Mexico and its regional effects after reforms, and it will focus on differentiating first nature factors that might cause divergence from the second nature ones, in order to identify the key features of divergence using NEG as a framework. After that, the identification of main policy instruments in the regions is Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez done using the microeconomic instruments. Based on an econometric model, the next step is to test the spatial disparities among Mexico, and to see the effect of regional policies on reducing these disparities. As we mentioned before, according to Ottaviano, the first nature factors can be expressed taking into account communication and climate features, therefore, this part will focus more deeply on those two aspects. Mexico is bordering the Caribbean Sea and the Gulf of Mexico, between Belize and the US and bordering the North Pacific Ocean, between Guatemala and the US. Its geographic coordinates are 23 00 N, 102 00 W. It has a total area of 1,972,550 sq km with 1,923,040 sq km of land and 49,510 sq km of territorial seas. Within its land it has boundaries land with more than 3000 km with the US and 250 km with Belize and 962 with Guatemala. Mexican climate varies from tropical to desert areas, high, rugged mountains; low coastal plains; high plateaus; desert. Its lowest point is Laguna Salada -10 m and its highest point is Volcano Pico de Orizaba with 5,700 m. Mexico’s natural resources are petroleum, silver, copper, gold, lead, zinc, natural gas and timber. The climate, the proximity to the coast, the distance between mountain and flat regions, and alsothe borders are key elements that influenced the population growth as well on the development of the region. However, the distance between the regions and the US border is a special issue due to the influence that the neighbor country has on the Mexican economy as a whole. Mexico is characterized for been a country which climate varies from tropical to desert areas; Tabasco is one of the most humpid areas in Mexico while Baja California is one of the most arid ones. Federal district and Mexico are temperate areas ( The table below shows the distributions of the federations according to climate characteristics). Approximately, t climate conditions and the coast had influenced the location of the population in Mexico as well as its development. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Humid Area Tabasco Quintana Roo Temperate Area Dry Tropic Area Arid Area 100% Distrito Federal 100% Yucatán 90.20% 92.40% Tlaxcala 90.20% Morelos 73% 63.7 Colima 69.80% Baja California Sur Baja California Coahuila de Zaragoza 97.50% Guanajuato 72.50% 79.60% Aguascalientes San Luis Potosí 67.70% 63.40% 63.10% 43.10% 35.90% 31.20% Campeche Veracruz de Ignacio de la Llave Chiapas 70.50% 50.60% Michoacán de Ocampo Oaxaca 57.8 50.3 Sinaloa Guerrero 56.10% 54.10% Chihuahua Sonora 57.50% 51.50% Colima Oaxaca 19.60% 16.50% Puebla Durango 47.1 46 47.10% 37.70% Zacatecas 28.40% 26.80% Nayarit 15.70% Hidalgo Guerrero Jalisco 41.9 41.3 41 Nayarit Jalisco Michoacán de Ocampo Oaxaca Tamaulipas Nuevo León Tamaulipas Querétaro de Arteaga Zacatecas 34.40% 28.10% 26.20% Nuevo León Sinaloa Durango 23.90% 20.50% 18.80% Hidalgo Sonora Durango Hidalgo 79.10% México Semiarid Area 14.60% 76.30% 65.40% 55.10% 50.60% The northern regions of the country have larger endowments of communication and transportation infrastructures. At the same time this distribution and these differences between regions had been reflected on the GDP percapita of the regions. During the 1970’s, the highest GDP percapita was in Mexico City and in most of the northern regions from while the lowest was in Oaxaca and in the rest of the southern regions . The northern regions were the regions with the lower concentrations of rural population and the highest level of schooling while the ones in the south had a very low development in schooling and in infrastructure. However, history has showed us (Gallup et. al. 2003) that this differentiation between the regions from the North to the South, is not only a cause of natural source differences. Since the colony period, Spanish implemented certain political power in the southern regions, such as Oaxaca, Yucatan and Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Michoacan. This power controlled the people, mainly because the land where this people worked was own by the Spanish government, therefore in order to have a job they had to do whatever the government required, while in the North side, due to land characteristics and low population during that period, this system never existed, therefore it grew faster and it was able to develop in other activities besides the agricultural ones. Before 1985, the growth performance of the Mexican regions were consistent, with a convergence hypothesis (Esquivel 2000)7 , the poorer regions were growing faster than the richer regions, it can be seen easily looking at the maps above, the highest growth rate were register in the region with lowest initial level of percapita output, in particular in those regions closed to the federal district. However, after 1985 this behavior broke down, the regions with higher growth rate were the northern ones. It is important to take into account technological, localized and pecuniary externalities, to understandwhy after 1985 the regional inequalities increased making the richest regions richer and the poorest regions poorer. Using the results found by Cikurel’s research and other researches, we can observe how before 1985 due to home market effect 7 Esquivel, using data from 1940 and 1995 developed a research in order to analyze the convergence between the Mexican regions. He found out that the convergence parameter decreased after 1960 Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez agglomeration localized in the capital of the country, where the larger demand was located, however, due to circular causality, firms also localized around the southern regions close from Mexico city, in order to have access to lower wages and to avoid congestion cost. nevertheless, after 1985, when trade became freer, localized externalities and pecuniary externalities played an important role in the localization of the firms and therefore in the growth of the region. (see appendix 2) Regions with a high level of humpan capital and a high share of transportation displayed a better subsequent growth perform while the regions with high agricultural activities showed lower growth rates. Esquivel(1999), Rivera Batiz(1997), Messmacher(2000), also studied these differences between regions taking into account the localized externalities such as trade cost, infrastructure, labor skills, etc. Esquivel and Messmacher(2002) developed an econometric model which shows the difference of the regions’8 GDP per-capita during the last decades, compared with the GDP percapita of the Federal District. They studied the evolution of the GDP per-capita during 1960 and 2000, using as explanatory variables, demographic components, labor market and productivity9 . The difference on the GDP among the regions between 1980 and 1990 was caused by the difference on labor productivity among the regions(y/l) and by the low participation on the employment rate ( emp/wap) as well as on the average of people on age to work (wap/n). During the 1990’s the high difference between the GDP per-capita among the regions was the higher difference on labor productivity between the regions (/l) and the reduction on the difference on emp/wap and wap/n. The variable that explain the main difference between the GDP per-capita during both periods studied was the difference on labor productivity among the regions(y/l) ( it explains 84% of the differences in y/n during all the periods), one more time humpan capital played an important role on the difference between the GDP per-capita growth in the regions. 8 9 During this analysis the regions of Campeche, Chiapas and Tabasco were not analyzed due to their oil production. Productivity of a person is equal to the production divided into the number of employees used. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez LOG Difference of one variable of certain State and the average of the Federal District. y/n y/l l/emp emp/wap wap/n 1960 Promedio Desviacion est. -0.986 0.444 -0.87 0.44 -0.005 0.009 -0.05 0.05 -0.07 0.046 Promedio Desviacion est. -0.857 0.4 -0.675 0.375 0.011 0.013 -0.08 0.046 -0.113 0.042 Promedio Desviacion est. -0.811 0.399 -0.652 0.388 -0.006 0.007 -0.027 0.05 -0.126 0.043 Promedio Desviacion est. -1.04 0.426 -0.832 0.343 -0.001 0.007 -0.064 0.072 -0.143 0.051 Promedio Desviacion est. -1.049 0.43 -0.961 0.408 0.014 0.005 0.013 0.057 -0.116 0.045 1970 1980 1990- 1993 1994- 2000 Gamboa and Messmacher taking into account the results from Esquivel and Messmacher research developed an econometric model in order to see that the difference and disparities among Mexican regions can not only be explained looking at the GDP per-capita. In their model, they analyzed more deeply variables such as GDP rate of each region, unemployment rate, the region population in relation with the manufacture sector, the distance, and the GDP per-capita. Change rate of the GDP, GDP per-capita, employment and population DDPIB DDPIBPC DDEMP DDPOBL c 15.593 13.04 4.397 1.146 -6.104 -5.883 -7.931 -2.248 IDIST -2.101 -1.638 -0.769 -0.427 0.745 0.718 0.968 0.274 MANUF 80 6.927 5.26 -6.781 0.872 -3.093 -2.981 -4.019 -1.139 IPIBPC 80 -0.88 -1.274 1.078 0.455 -0.948 -0.914 -1.232 -0.349 R square 0.397 0.289 0.138 0.265 R square adjusted 0.324 0.204 0.035 0.177 Number of observations 29 29 29 29 F statistics 5.482 3.387 1.336 3.007 The results found by Gamboa and Messmascher are similar than the ones found in previous studies, the difference between the GDP per-capita and the GDP of each region is similar, however the effects that variables such as distance and proportion of manufacture sector on the regions were not the expected ones. Furthermore, Cikurel (2002) developed a model allowing mobility of inputs, technology and goods across the regions. The results showed that the northern regions had more benefits from the open trade reform than the southern regions, mainly because location specific externalities: high level of humpan capital, industrial capital, better communication and transportation infrastructure. However, the fact that the northern regions of Mexico were influenced by lower Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez transport cost to reach the US markets, attracted firms to locate in those regions (but not as it was expected). After reviewing the characteristics of divergence between the regions among Mexico, the results of the different studies suggest that there is a need for some regional policies that may improve the regional distribution of output in Mexico. Transportation , communication infrastructure as well as humpan capital level are one of the main differences between northern and southern regions, and these may be improved by true regional policies. Mexican government has already implemented regional policies in order to diminish these divergences. In Mexico, there are public policies between the federal government and the regions. Since the 1980’s, Mexico has implemented the Fiscal Coordination System (SNCF), which put together all the income and liabilities of the country(Gamboa 2002). The SNCF system classified the transfers of the government into Conditional and unconditional transfers. The first ones are related with adds, “convenios”, and public investment in general. Adds are the transfer that involve investments on education, health, social infrastructure and multiple transfers. “Convenios”, are those agreements for common projects between the local government and the federal government (Ottaviano called this kind of projects inter and intra regional transaction costs). Public inversion is the transfer related with infrastructure inversion from the federal government to the regions. The so called unconditional transfers are those related with tax collection, decentralization process and privatizations10. During the last 10 years, federal spending has increased compared with the spending done during 1987-1992, specially after 1998 the spending has been focused on the inclusion of add and “convenios” in order to help the poorest regions. Different studies had evaluated these policies, Gamboa and Messmacher (2002) did a regression analysis in order to see the relation between the net refunding resources of the government from each region with the marginal index. The correlation showed that the regional policiy in Mexico is offsetting. For example, in regions such as Baja California Sur, which GDP per-capita is very high, the level of assets collect is very high but the level of resources received from the government is very low, while in regions such as 10 Taxes such as: income tax, consumer taxes, service and transactions and consumptions, add valorem tax and others. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Oaxaca, Chiapas and Guerrero, which GDP per-capita is very low, the level of resources received from the government is very high. This means that the federal system of Mexico is compensatory, it spends more in the regions with very high marginal index ( see figure below). R E IN T E G R O S Y S A L ID A S P O R E S T A D O v s . IN D IC E D E M A R G IN A C IÓ N 5 M ile s d e p e s o s d e 2 0 0 0 3 - 2 .5 -2 - 1 .5 -1 - 0 .5 0 0 .5 1 1 .5 2 2 .5 -3 -5 y = 1 .9 3 9 7 x - 1 .6 8 1 5 R 2 = 0 .2 4 2 5 -8 -1 0 R -S v s .IM A R G IN A C IÓ N L in e a l ( R - S v s . I M A R G IN A C I Ó N ) -1 3 -1 5 -1 8 -2 0 IN D IC E Furthermore, they also try to evaluate the relation between public spending and GDP per-capita, and GDP growth during 1980 and 2000. Without taking into account the regions of Campeche, Chiapas and Tabasco, (because they are oil producers) the relation of public spending and GDP per-capita was negative during 1993 and 1999, the respective correlations were -0.293, and 0.62011 ( see figures below). ii. 1999 30 30 25 25 20 20 PIB/N PIB/N i.1993 15 15 10 10 5 5 0 0 0 2 4 6 8 gasto/PIB 10 12 14 0 2 4 6 8 10 12 14 16 gasto/PIB Gamboa and Messmacher tried to see which instruments under the public spending reflect the negative relation found above. In order to do that, they did another regression analysis using 11 According to this result, it could be possible that even when the interregional transfers are compensatory, this does not mean that this reverses the agglomeration market equilibrium. It is necessary to evaluate in a more deeply way the characteristics of the public spending Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez public spending and public investment and their relation with the GDP growth. They found that the relation between public spending and growth rate is negative, and the relation between public investment and growth rate is also negative. However, they also found a positive relation between public investment and the level of employment which means that public investment help to growth the level of employment., Nonetheless, theory showed us that this is a short term effect, therefore it might be not the right policy. Within the regression analysis variables such as education spending were also used having a positive relation, but it was very low. Divergence/Convergence Estimation From the empirical evidence mention above, we can see how divergence has increased after the NAFTA, furthermore, spending on localized externalities within Mexico policies still not as big as it should be, and therefore it does not reach the benchmark or the threshold point point that help to reduce the agglomeration effect. Nevertheless, further analysis needs to be done in order to have a better picture of what has happened in the region after the NAFTA, then, it will be possible to identify the right instrument for each region in order to reduce these divergencesby applying the analytical framework of the so-called “new economy geography”. The analysis must be desegregated by region and by industry giving the opportunity to relate the instruments with technical and pecuniary externalities. As we mentioned above, the optimal instruments of regional policy depends on the level of trade costs, and on the degree of pecuniary externalities, on the magnitude of localize inter and intra industry knowledge spillovers, therefore when we are evaluating certain regional policy instrument, this kind of variables must be analyzed as well. Using as a framework the NEG’s models mention on the first part of this paper, a cross section econometric model will be discussed now.. The methodology used on this model will be based on an empirical work done by Ottaviano12 . An econometric analysis that takes into account income, population, real state value and growth regressions over a set of explanatory variables will provide a better picture on the evolution and the drivers of regional differences. Ottaviano Gianmarco and Dino Pinelli (2004) “Finish regions in the Global economy: a ‘new economic Geography’ perspective”. 12 Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez As mentioned above, the NEG framework has a new perspective of the integration process, because it takes take into account three main points that will affect the region crucially. On the first place, the presence of increasing returns to scale and trade cost generates a trade off between concentration of production in few plants, and proximity of plants to costumers and suppliers. Second, market power of the firms could beincreased due to its geographical positioning. And third, the location decision of the firms generates localized externalities that determine regional attractiveness. Within this framework, labor mobility plays an important role in given rise to cumulative processes of regional divergences. On the other hand, theory has also showed us how workers find jobs more easily where there are more firms, and viceversa. As skilled workers are more mobile than unskilled ones, cumulative causation is stronger in sectors that are intensive in humpan capital. Using data from the INGE of Mexico and covering the time between 1985 and 2003, taking the recession years and the oil regions out of the sample, this paper runs an estimation of income, population and real state value growth over a set of explanatory variables13 . These regressions allows to have a better view on productivity levels and quality of life differences between the regions, and therefore it permits to see whether or not divergence has increased after the NAFTA. Economic growth theory shows how growth regression can be a good measure of national economic performance, most of the time, per-capita income growth is used as an explanatory variable. However taking into account NEG framework and analyzing the economic growth of the regions within a country, the standard macroeconomic approach using income per-capita growth as a measure of productivity is not completely good, basically because workers and firms are not immobile. Considering this arguments, the only non trade good is land, which is used not only by firms but also by workers, then rent differential can be a good instrument to show the regional price differentials which will show the productivity and the quality of life of a region, which are good instruments to analyze convergence or divergence on the region. “Each regression on its own bear no clear information about regional economic performance, however when considered together, those regressions allow one to gain insight on the evolution and the drivers of regional differences in productivity levels and quality of life”( Ottaviano et al 2004). 13 Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez In order to understand the importance of price differentials, we must highlight the concept of market power within the NEG framework, which is attributed to geographical areas. According to Ottaviano and Pinelli, it can be nominal market power (NMP) which captures costumer/supplier proximity, and real market power (RMP) which captures customer/supplier proximity and competitor proximity. These can be related with nominal and real wages, the first (NMP) one predicts the nominal wages that a worker can obtain in certain areas, while the second one (RMP) is related with real wages that workers can make if located in that area. In the long run, if workers can freely relocate, real wages differences should eventually disappear as nominal wage differential are capitalized in local price differences. Therefore, a higher NMP should be associated with higher local prices, higher revenues and higher nominal wages. Subsequently, using the price of a land as an explanatory variable, if a region productivity grows, then both its rent and nominal wage should also grow. On the other hand, if a regional quality of life deteriorates, only the nominal wage will grow, the land price will fall. Positive Income/wage variation Population/local price variation Negative Positive higher Productivity Lower quality of life Negative higher quality of life Lower productivity ottaviano and Pinelli(2004) Then, taking into account the importance of per-capita income growth, but also the population growth and the land rent price growth, these are the dependent variables of the models. Each variable will be run separately; however, its results must be interpreted together, so as it was mention above, these will allow to gain insight on the evolution and the drivers of regional differences in productivity levels and quality of life. Economic growth theory shows how economic growth across geographical areas can be explained in two set of variables: proximity variables and wider influences. The first one refers to productive factors of growth such as, humpan capital and knowledge capital. The second one is related with other variables that can affect growth indirectly. On a NEG framework, these variables can be divided on first nature factors and second nature ones. Proximity Variables Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Humpan capital: this variable is measured by three ways: the number of population in the region with at least elementary school, the number of population of the region with at least secondary education degree, and the number of population of the region with at least university degree. Wide Influences These variables are those that affect growth indirectly by improving input allocation as well as knowledge and technology transfers, differences in exogenous factors as nature or factor endowments (what is called “first nature”) are responsible for some of these improvements. However, in regions with similar characteristics, endogenous factors (what is called “second nature”), such as advance economic interactions and economic organizations, are also responsible of these improvements. First nature factors According to Ottaviano , natural factors can be represented by communication and climate structure. Natural communication: this variable is capture by the distance between the region and the border, in this case according to Haralambides and Londoño (2002), the largest crossing points between the United States and Mexico are Nuevo Laredo border and Monterrey, therefore, these will be the points used as a distance parameter. Climate: the climate condition is measured by the average of temperature in the region, using 1 for dry areas, 2 for warm, 3 for template and 4 for humpid. Second Nature factors As it was mentioned on the first part of this paper, geographical economic present two types of localized externalities “pecuniary externalities” and technological externalities. Peculiar externalities: market power or market potential shows the market interaction among regions, and it is constructed as the weight average of economic size, which can be determined by Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez income, population, income per-capita and population density. It is determined by the size of the region and the distance of the region with the border. MPI Sizei j 1 dij Technological externalities: the variable to measure technological externalities is population density mainly because non-market interaction are mainly found in densely populated areas. There are other wide influences variables that can also affect growth: Regional policies: impact of local policies on growth can be captured by the level of government expenditure on education and infrastructure. Labor market: the unemployment rate is used to proxy the efficiency of local labor market. Descriptive Analysis The analysis is done between the period before and after 1993, the time of the analysis is divided in three periods, the first period is between 1985 and 1993, the second period between 19961999 which can show the first effect of the NAFTA, and the third period between 2000 and 2002 which will show the impact of the regional policies on the regions. The period between 1994 and 1995 are removed because of the recession of Mexico during that period. The oil regions (Campeche, Chiapas and Tabasco) are also removed from this analysis. Figure 1: Convergence in the First period: GDP per capita growth Trade Liberalization, divergences and regional policy: The case of Mexico GDP per capita growth 1985-1993 Liliana Lopez 40.00 30.00 20.00 10.00 (10.00) 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 (20.00) (30.00) (40.00) GDP per capita 1985 24 21 18 15 12 9 6 3 0 -3 0 -6 -9 -12 3 6 9 12 15 18 21 24 27 30 33 GDP per capita growth 2000-2002 GDP growth 1996-1999 Figure 2 and 3. Convergence on the 2nd and the 3rd period. GDP growth 15 12 9 6 3 0 -3 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 -6 -9 -12 -15 GDP percapita 1996 GDP per capita 2000 The figures above show very interesting results. Figure 1 shows the results on the first year, there is a positive relationship between the two variables, which indicates that initially poor regions have been growing slower. However, on next figure, the relation between the variables is not clear, and on the third period, there is a negative relationship between the GDP per capita growth and the GDP per capita from the first year of the analysis. The convergence after the NAFTA is clear; however it has been done gradually. The figures 4, 5 and 6 below show the growth rate of population on the vertical axis against its initial level in the three periods. On the first period the relation is weakly negative, although this relation becomes stronger on the second and on the third period, it starts to diminish. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Figure 4. Convergence on the first period. Population growth population growth 1985-1993 60.0 50.0 40.0 30.0 20.0 10.0 0.0 -10.0 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 -20.0 -30.0 Population 1985 16 16000 14 14000 Population growth 00-02 Population growth 1996-1999 Figure 5 and 6. Convergence on the 2nd and the 3rd period. Population growth 12 10 8 6 4 2 12000 10000 8000 6000 4000 2000 0 0 0 2000 4000 6000 8000 Population 1996 10000 12000 14000 -1 0 1 2 3 4 5 6 7 8 9 Population 2000 Figures 7 and 8 show the relation between the GDP per capita growth on the first period and the GDP Per capita growth on the second and the third period, separately. There is no evidence of persistence. Figure 7 Trade Liberalization, divergences and regional policy: The case of Mexico GDP per capita grwoth 19961999 Liliana Lopez 25 20 15 10 5 0 (40.00 (30.00 (20.00 (10.00 -5 ) ) ) ) -10 10.00 20.00 30.00 40.00 GDP per capita grow th 1985-1993 GDP per capita growth 2000-02 Figure 8 15 10 5 (40.00) (30.00) (20.00) (10.00) 0 -5 10.00 20.00 30.00 40.00 -10 -15 GDP per capita grow th 1985-1993 The same exercise is done having as an analysis variable the population growth from the first period against the population growth of the other periods. The results, show a clear positive relationship between the two variables, this implies some degree of persistence of population Population growth 1996-1999 growth differentials as the same regions grow faster in both periods. 16 14 12 10 8 6 4 2 0 0.0 10.0 20.0 30.0 40.0 Population grow th 1985-1993 50.0 60.0 Trade Liberalization, divergences and regional policy: The case of Mexico Population growth 2000-02 Liliana Lopez 9 8 7 6 5 4 3 2 1 0 -1 0.0 10.0 20.0 30.0 40.0 50.0 60.0 Population grow th 1985-1993 Previous descriptive analysis shows a clear evidence of divergence between the Mexican regions, in particular on the second period of the analysis where populations grew faster on those regions with higher market potential. Regression Analysis The regression analysis will be estimated in three periods separately, the first period is the one before the NAFTA agreement, the second one between the recession period and the beginnings of the NAFTA period and the third one is five years after the NAFTA. Income, population and house pricing growth as dependent variables, and the initial levels of a set of explanatory variables are estimated. A variable with a significant coefficient (positive or negative) implies that its initial level has a positive or negative influence on growth in the subsequent period. 1985-1993 Population regression on the first period shows how coefficients such as GDP per-capita in the initial period, education, government expenditure and education are significant on the population growth during 1985 and 1993. GDP per capita is significant at 10% and positive, which means that population growth is stronger when there is a positive GDP per capita on the initial period., This demonstrates some convergence on the period, however the significance of this variable is only at 10%. During this period, the GDP growth was more concentrated on the center part of the country than on the north, it is clear then why market potential was not significant during this period. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Regarding Income regression the results were quite similar. Income per capita, elasticity of agricultural GDP in the region and government expenditure had important impact on the GDP per capita growth. Results from house prices growth regression are also interesting, government expenditure and house prices on the initial period had a significant impact on growth. Regression 1985-1993 Population Growth pop85_93 GDP per-capita growth gdpg85_93 logpibpc85 46.605* -87.548* Income per-capita Initial period [26.050] [48.620] House Prices grwoth rent85_93 Market Potential logep85 Education -75.098*** 238.719 [24.673] [210.781] temp 0.684 1.184 -24.851* Temperature [1.337] [3.736] [12.233] logpexpend85 19.581** 51.260** 117.846* [8.229] [23.526] [59.565] Government expenditure logpo85 116.384*** 21.867 -9.092 Total employment [26.890] [64.493] [351.386] logpib85 -71.533** GDP initial period [25.932] logpiba85 -0.913 -44.520** GDP agriculture [6.022] [17.686] logpibma85 3.914 GDP manufature [4.871] dfront 0.051 19.805 Dummy USA border states [3.920] [13.758] logdistn 4.166 Distance from USA crossing borders [10.945] logipv88 36.343 -1,089.909*** House prices [69.570] [195.181] logpop85 -247.538 [378.479] Constant Observations R-squared -150.694 401.589 283.574 [102.136] [262.462] [855.226] 27 26 27 0.85 0.52 0.74 Standard errors in brackets All explanatory variables are in log terms Standard errors in brackets * significant at 10%; ** significant at 5%; *** significant at 1% Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez 1996-1999 The first column from table 3 reports the results of population regression. Population growth has been stronger in regions with lower GDP in agriculture and with higher market potential. The market potential coefficient is positive and significant showing how people tend to move to regions where there is high market potential., During this period the NAFTA started 14 , this result explains what was suggested on the NEG literature mentioned. Within this regression distance is positive and significant, which shows how transport cost effect is still significant in terms of location. An interesting result during the regression is the government expenditure coefficient, which is negative and significant. Population growth has been stronger in regions with lower initial government expenditure, this can be explained due to the fact that government expenditure may have been financed through increased taxation. Another interesting variable is the income per-capita, its coefficient is positive and significant showing the output divergence observed on the regions across Mexico, effect that confirmed the decrease of convergence after the NAFTA. Income regression results (column 2 from table 3) show three important outcomes. First, holding all other factors constant, income per capita growth has been stronger on regions close to the USA border, which explains how location promotes growth on the northern regions, specially after the NAFTA. However, education and infrastructure on those regions were also important for its growth. Second, the coefficient of GDP of the manufacture sector is also significant and positive, which indicates how income per capita growth has been stronger in regions with a higher initial level of manufacture in their GDP. Regions, such as Aguascalientes and Queretao, were able to improve their GDP per capita growth significantly as a result of their increase on manufacture export oriented activities. First nature factors are also important, although this variable is becoming less and less important within the studied period. 14 The agreement started in 1986, but it was signed in 1994. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez House price growth regression results show how market power and distance to the USA border influence growth of house prices during this period. Regresion 1996-1999 Population growth pop96_99 logpibpc96 3.123 Income per capita [6.016] logmpi00 9.719* Market Potential [5.566] logdp96 -0.989 Density of Population [0.925] GDP growth gdpg96_99 House prices rent00_02 loggexpent96 -7.668*** -5.528* Government expenditure [2.269] [2.856] logpoa96 4.115** 2.981 -4.443 agricultural employmetn [1.546] [1.817] [3.236] logpoi96 1.642 3.195** -4.680* industrial employment [0.959] [1.487] [2.433] logditsn 12.649** -13.429*** 14.638* Distance from USA crossing borders [5.665] [4.379] [7.440] logpib96 1.767 7.196 2.977 GDP initial period [3.385] [5.081] [7.961] logpiba96 -3.688* GDP in agriculture [2.051] logpibma96 1.485 10.449*** -5.026 GDP in manufacturing [1.556] [2.156] [3.672] logmpp00 -15.423*** 13.458* Market Potential [4.210] [7.046] ipv96 0.004 House prices [0.038] Constant -26.136 -22.95 66.221* [21.792] [15.872] [34.071] Observations 28 28 28 R-squared 0.75 0.76 0.34 All explanatory variables are in log terms Standard errors in brackets * significant at 10%; ** significant at 5%; *** significant at 1% Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez 2000-2002 The period 2000 and 2002 shows very interesting results. Market potential is still positive and much more significant than other periods. Initial GDP per-capita is significant and negative showing some kind of convergence on this period. However, the results from population growth and house price growth regressions are very unclear, therefore the quality of life during this period might have implications that only can be shown on future periods. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Regression 2000-2002 Population Growth pop00-02 GDP per-capita growth gdpg00-02 8.591** 8.606*** [3.001] [2.294] House Prices grwoth rent00-02 logpib00 logpiba logpibm logmpi00 logdp00 loggov_expttotal logpagri 2.892** logpindut 2.352** logdistn 10.304*** [1.219] [0.943] [3.092] dfront -6.580** [2.710] logedus00 -6.765** [2.897] logpibpc00 -14.698* [8.326] logpibindu logpibco temp 2.349* [1.270] logipv00 logedusu00 Constant Observations R-squared -34.127** 83.706* -43.73 [15.482] [40.458] [82.031] 27 28 27 0.68 0.6 0.52 Standard errors in brackets All explanatory variables are in log terms Standard errors in brackets * significant at 10%; ** significant at 5%; *** significant at 1% INTERPRETATION Taking into account the literature mentioned above, regional performance is determined by a set of explanatory variables explained on income, house prices and population regressions. If the variable presents a positive coefficient in all the regressions, then we can conclude that its impact on productivity is positive. On the other hand, if the variable presents a positive coefficient in the Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez income regression but it has a negative coefficient on the other regression, a negative impact of the variable on the quality of life is identified. The regressions results can help us to understand better the productivity and quality behavior of life across Mexican regions. During the period 1996 and 2000, Mexico presented its highest level of divergence across its regions. Table two clearly presents how the initial level of income percapita had a positive relation with the GDP per capita growth, showing how there is an impact on differences of productivity among the regions. During this same period population growth and house pricing also showed some divergences. However, on the last period, it is clear how productivity divergences stared to shrink, showing then fewer differences on productivity among regions. The government expenditure helped to increase this productivity, however, quality of life is becoming much more uncertainty than before. The distance and the advantage to be located in a region sharing borders with USA has a positive impact in the second and the third periods on populations growth, income growth and house prices growth regressions. This shows how distance helps to improve not only the productivity of the region but also the quality of life. However its effect in the third period is more dominant on productivity than on quality of life. Pecuniary externalities are explained by the market potential variable, and then, as the literature suggest, it has a positive influence on income, house prices and population in the last two periods. “In the long run regions that enjoy easier market interactions tend towards higher levels of productivity”15. CONCLUSIONS The new economy geography literature argues that trade integration tends to result in agglomeration of economic activity. Mexico regional inequalities showed this kind of effect, most of the economy activity is located in the north of the country and in the Capital; regions from the south have been badly affected, not only on their productivity but also on their quality of 15 Ottaviano (2004) Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez life. Mexican government is aware of these inequalities and they had intervened with regional policies that try to make a more proportional distribution of the economy activity, however, the effectiveness of these policies is not clear yet. Different researches about divergence between regions showed that one of the main differences is not only the distance between the region and the US, but also the communication, and the transportation infrastructure as well as the humpan capital development. Mexico’s geographical imbalances during the last 17 years can be attributed to some important facts: before NAFTA was signed, the divergence on productivity was clear, however in a very low level, but the divergence on quality of life was not present; Distance from USA border promote productivity and quality of life in a high level; productivity is also promoted by market potential, infrastructure and education. The results suggest that even when divergence on productivity among Mexican regions is decreasing, education, infrastructure and location, will always affect the terms of quality of life among the regions. Therefore in order to have an optimal scenario is important to work on policies that rely not only on productivity but also on quality of life. A new evaluation of the regional policy needs to be done, in order to find optimal instruments of regional policy that focus on these objectives, these instruments depend on the level of trade costs, the degree of pecuniary externalities and on the magnitude of localize inter and intra industry knowledge spillovers. Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez REFERENCES Baldwin R. E., Forslid R., Martin P., Ottaviano G., Robert F. ( )” Public Policy and Economic Geography” draft of a chapter for a book on public policies and economy geography. Baldwin R.E., P. Martin, and G.I.P. Ottaviano (2001) Global Income Divergence, Trade and Industrialization: The Geography of Growth Take-Offs, Journal of Economic Growth 6, 5-37 Baldwin, R.E., Forslid R., Martin P., Ottaviano G.I.P. and F. Robert-Nicoud (2003) Economic Geography and Public Policy, (Princeton: Princeton University Press), forthcoming. Baldwin. RE, and Forslid R.(1999) The core –Periphery model and Endogenous Growth: Stabilizing and Destabilizing integration. Barro , R. and X Sala-i-Martin (1995). Economic growth, Macgraw Hill. Cikurel D. (2002) “ Why Mexico’s region convergence broke down?” University of California. Biblioteca Raul Baillares Jr. www.biblioteca.itam.mx. Diaz Alejandro, (2003) “Apertura comercial convergencia regional en México” comercio exterior, vol. 53, 11, Noviembre Esquivel G., Lederman D., Messmacher M., Villoro R. ( )¿Por qué el TLCAN no llegó hasta el sur de México? Fujita, M., P. Krugman and A. Venables (1999) The Spatial Economy (Cambridge (Mass.): MIT Press). 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Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez Home Market Magnification CORE PERIPHERY VERTICAL LINKAGES GLOBAL SPILLOVERS LOCAL SPILLOVERS Exogenous change in location demand leads to more than proportional relocation of industry in the larger region Expenditure production function is not based on the physical mobility of the factor Agglomeration Forces reinforcing. Onle linked to demand One linked to cost Exogenous change in location demand leads to more than proportional relocation of industry in the larger region Richer region hosts more than proportionate share of accumulated capital Connection between production and expenditures Agglomeration Forces are selfreinforcing. Does not feature cost linked causality (factor migration is not linked to regional prices index Circular Causality Endogenous Asymmetry are self- Lower trade cost between two regions produce regional asymmetries Catastrophic Agglomeration Massive agglomeration in reaction to minor changes in trade cost. Location Hysteresis Temporary shocks have hysteric effects Arise only when the level of trade costs is such that there are multiple stable equilibrium The ultimate region of concentration is indeterminate so economy is subject to location hysteresis Growths Affect Geography Permanent Income Differences Exogenous change in location demand leads to more than proportional relocation of industry in the larger region Agglomeration Forces reinforcing. One linked to demand One linked to cost are self- Exogenous change in location demand leads to more than proportional relocation of industry in the larger region Richer region hosts more than proportionate share of accumulated capital Agglomeration Forces are selfreinforcing. There is cost linked causality , due to inter-temporal vertical linkages Lower trade cost between two regions produce regional asymmetries Partial agglomeration is not an stable outcome, Massive agglomeration in reaction to minor changes in trade cost Lower trade cost between two regions produce regional asymmetries Lower trade cost between two regions produce regional asymmetries Massive agglomeration in reaction to minor changes in trade cost Temporary shocks have hysteric effects The ultimate region of concentration is indeterminate so economy is subject to location hysteresis Does not break in a catastrophic manner, increasing trade freeness destabilizes the symmetric equilibrium. There are two locally stable equilibrium so temporary policies could have permanent effects by selecting one of the two equilibrium Capital accumulates then capital’s income is spent locally, growth can affect geography The connection between spatial distribution of income and the spatial distribution of capital implies that regional asymmetries in industrial structure cause This is caused by regional asymmetric in factor endowments Capital accumulates then capital’s income is spent locally, growth can affect geography The connection between spatial distribution of income and the spatial distribution of capital implies that regional asymmetries in industrial structure cause This is caused by regional asymmetric in factor endowments Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez APPRENDIX 2 Results from Cikurel analysis Trade Liberalization, divergences and regional policy: The case of Mexico Liliana Lopez