Agglomeration Effects and the Competition for Firms

A two-region economy consists of a given but different number of immobile workers in each region, and a given number of mobile firms. Firms create jobs where they locate, but there is frictional unemployment. Two sorts of agglomeration effects arise: those from economies of scale in matching, and those from production economies external to the firm. Regions may either be part of a unitary state in which case all regional policies are decided by the central government, or they may be part of a federal state in which case some policies are determined by the regional governments. We characterize the resource allocations in both a unitary and a federal state, and identify the set of instruments that are required to replicate the social optimum in each state.