The Impact of Optimal Tariffs and Taxes on Agglomeration

case of τ = 1.02, an initial distortion of the symmetric equilibrium leads to
migration, this process continues until all skilled labor and all firms locate in
the foreign region. This so called core-periphery equilibrium is stable as long
as no real wage incentive exists to migrate back. Analogous to the breakpoint
the critical trade cost level, below which the core- periphery equilibrium is
stable is called ’sustainpoint’.

There are two agglomeration forces within this model at work, a forward
and a backward linkage. The forward linkage stems from the fact that the
more firms locate in one region the more varieties are available, which reduces
the price level and increases real wages. The backward linkage describes the
additional regional demand firms are creating since now, because of trade
costs, more expensive imports can be substituted by domestically produced
varieties. Simultaneously also dispersion forces in terms of product and la-
bor market competition exist. The relative importance of agglomeration and
dispersion forces depends on the parameters of the model. Usually parame-
ters are chosen such that prohibitive trade barriers (autarky) correspond to a
dominance of dispersion forces. This assumption rules out the possibility of a
collapse of the general equilibrium where, independent of the trade cost level,
all economic activity is always concentrated in one region (cf. the no-black-
hole condition of Fujita et al. (1999)). Therefore, under normal conditions, a
reduction of trade costs (integration) reverses the relative weight of agglom-
eration and dispersion forces such that core-periphery equilibria are stable
at least for a range of trade costs.

4 Maximizing welfare without cooperation

The general equilibrium model derived above considers two policy instru-
ments by which each regional government may affect welfare and the real
wage relation determining the long-run development of the corresponding
region. Since there are two regions with two governments it can be dis-
tinguished between non-cooperative and cooperative policies. In the non-
cooperative case each region maximizes its welfare depending on the policy

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