Regional integration and the other determinants of North-South ...

The profit of a single firm in c is thus given by:
(3.5)
The equilibrium can be derived as follows: expenditure on industry output
produced in c, comes from producers and consumers located in c and from other countries l.
The product market equilibrium requires setting demand equal to supply. Summing the
expenditures of across all locations, we obtain:
∑
(3.6)
With ( the price in c and , the price index in country . Substituting the
product market clearing condition and, the profit maximizing price into the demand gives:
∑
(3.7)
Since capital is used only in the fixed cost, the reward to capital is the operating profit
of a typical variety, using the demand function and mill pricing we obtain:
∑
(3.8)
As we do not observe the potential profitability of each country, following Amiti and
Smarzynska Javorcik (2008), we rely upon the assumption that firms choose the country
yielding the highest profit. In the model, agents are short-sighted and capital moves in search
of the highest current nominal reward. Inter-country factor flows are governed by the ad hoc
equation 31 :
1 (3.9)
c 32 .
is country’s c industry share, which also represents the share of capital employed in
In the long run, capital owners employ their capital wherever it earns the highest
return. In this case, capital has no incentive to move and 0. The share of a representative
industry country c is related to profit ( ):
(3.10)
For the empirical specification, following Amiti and Smarzynska Javorcik (2008), we
assume that the function: . Thus, we obtain:
31 Note that in the FCVL model pure profits are eliminated and capital rewards are equal to operating profits. In
the long run the spatial allocation of capital takes time and hence, current operating profits might differ from the
average in the short run.
32 Remember that capital is mobile between countries whereas capital owners are immobile. Capital is only
employed in meeting the fixed costs of industrial firms. Physical capital can be separate from its owners and so,
the country in which capital’s income is spent may differ from the country in which it is employed (Martin and
Rogers, 1995).
11