Neoclassical theory versus new economic geography: competing explanations of cross-regional variation in economic development

The Annals of Regional Science (Impact Factor: 1.03). 01/2010; 44(3):467-491. DOI: 10.1007/s00168-008-0278-z

ABSTRACT This paper uses data for 255 NUTS-2 European regions over the period 1995–2003 to test the relative explanatory performance
of two important rival theories seeking to explain variations in the level of economic development across regions, namely
the neoclassical model originating from the work of Solow (Q J Econ 70:65–94, 1956) and the so-called Wage equation, which
is one of a set of simultaneous equations consistent with the short-run equilibrium of new economic geography (NEG) theory,
as described by Fujita etal. (The spatial economy. Cities, regions, and international trade. The MIT Press, Cambridge, 1999).
The rivals are non-nested, so that testing is accomplished both by fitting the reduced form models individually and by simply
combining the two rivals to create a composite model in an attempt to identify the dominant theory. We use different estimators
for the resulting panel data model to account variously for interregional heterogeneity, endogeneity, and temporal and spatial
dependence, including maximum likelihood with and without fixed effects, two stage least squares and feasible generalised
spatial two stage least squares plus GMM; also most of these models embody a spatial autoregressive error process. These show
that the estimated NEG model parameters correspond to theoretical expectation, whereas the parameter estimates derived from
the neoclassical model reduced form are sometimes insignificant or take on counterintuitive signs. This casts doubt on the
appropriateness of neoclassical theory as a basis for explaining cross-regional variation in economic development in Europe,
whereas NEG theory seems to hold in the face of competition from its rival.

JEL ClassificationC33-O10

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