footloose capital and productive public services

The incorporation of public expenditures in New Economic Geography (NEG) models represents a very recent theoretical advance. Brakman et al. (2005) claim the European Cohesion Policy to be incoherent since it seems sometime targeting towards geographical agglomeration, but more often towards dispersion of economic activity. Such a criticism provides a motivation to analyse policy issues in NEG models. The impact of public expenditures on the location decisions of firms has been studied within a few variants of NEG models. In particular, in a companion paper (Commendatore et al., 2008, Èconomie Internationale, forthcoming) our main focus is on industrial location and welfare effects of productive public services provision under the assumption of endogenous capital. The government uses tax revenues to purchase capital goods to use in the production of freely available public services. Hence, public policy can affect production in the manufacturing sector, via its impact on factors productivity. We show that the interplay of two effects determines the final impact of an increase in productive public spending in one region on the spatial distribution of firms: the demand effect and the productivity effect. On one hand, an increase in the provision of public services in one region enforces agglomeration in the same region; on the other hand it favors dispersion via a change in the relative market size. As a result, whether or not higher provision of public services leads firms to relocate in the backward region will depend on the way in which the two regions contribute to the financing of public expenditure. It is shown that the demand effect will be more than offset by the productivity effect only if the government lets the richer region' tax payers contribute on the basis of their contribution capacity. In this paper we provide further insights on how the interplay of the above mentioned productivity and demand effects influence industrial location in a much simpler analytical framework which allows fully characterizing the dynamic behavior of capital movements in response to variations in the degree of trade freeness and to policy induced changes. Extending Commendatore et al. (2008), we pay attention to the dynamic structure of the model. First, we fully characterize the dynamic process underlying capital movements (the footloose capital) and analyze the long-run equilibrium given as fixed point of the capital mobility dynamics for different degrees of trade freeness. Second, we study the impact of public services provision at the long-run interior equilibrium, as well as on the long term behavior of regional shares of capital. The paper is structured as follows. Section 2 provides empirical background. In section 3 we introduce the model's assumptions; section 4 presents the short run structure, explicitly specifying the capital migration process. Section 5 deals with dynamics. Section 6 presents results on the impact of the provision of public services on the long run allocation of capital across regions. Section 7 concludes.