The core-periphery structure
It is by marrying the Dixit and Stiglitz (1977) model of monopolistic competition with the iceberg transport technology that Krugman (1991) may find out when and why Myrdal’s prediction materializes.
The Dixit-Stiglitz model of monopolistic competition relies on product differentiation and increasing returns at the firm’s level, as in spatial competition. Unlike spatial competition, however, monopolistic competition involves weak interactions among firms, which respond to aggregate market statistics only. The iceberg cost means that only a fraction of good shipped between two places reaches the destination, the missing share having “melted” on the way. This ingenious modeling trick allows one to integrate positive shipping costs without having to deal explicitly with a transport sector.As for the other ingredients of his model, Krugman considers a standard setting that involves two regions, two sectors, and two types of labor. The former sector produces a homogeneous good under constant returns and perfect competition, using one type of labor which is spatially immobile. The latter sector supplies a horizontally differentiated good under monopolistic competition and increasing returns, using the other type of labor which is mobile across space. Shipping the homogeneous good is costless. This assumption, which guarantees the equalization of earnings across regions, is made for the immobile workers to have the same demand for the differentiated good. In contrast, shipping the differentiated good requires scarce resources, and thus the demand for this good varies with the location choices made by those workers.
When workers move to a new region, they bring with them both their production and consumption capabilities. As a result, their movements affect the size of labor and product markets in both the origin and destination regions.
These effects have the nature of pecuniary externalities because migrating workers do not take them into account in their decisions. Moreover, such externalities are of particular importance in imperfectly competitive markets, where prices fail to reflect the true social value of individual decisions. Hence, the effects of migration are best studied within a general equilibrium framework, where one can capture not only the interactions between spatially separated (product and labor) markets, but also the dual role of individual-as-worker and individual-as-consumer. The great accomplishment of Krugman (1991) was to integrate all these effects within a single framework and to determine precisely the conditions under which the cumulative process predicted by Myrdal occurs or not. Turning next to the specific conditions for agglomeration, Krugman has shown that the value of transport costs is the key determining factor.If transport costs are sufficiently low, then all footloose firms will concentrate in a single core region, whereas the peripheral region supplies only the standardized good. In this way, firms are able to exploit increasing returns by selling more goods in the larger market without losing much business in the smaller market. It is worth stressing here that the core-periphery structure is the involuntary consequence of decisions made by a large number of economic agents pursuing their own interests. By contrast, if transport costs are sufficiently high, then interregional shipments of goods are discouraged. Hence the economy displays a symmetric regional pattern of production that focuses on local markets. The core-periphery model thus allows for the possibility of convergence or divergence between regions, whereas the neo-classical model, based on constant returns and perfect competition in the two sectors, would predict convergence only. Consequently, it is fair to say that Krugman has presented a synthesis of the polarization and standard neo-classical theories.