Knowledge spillovers, congestion effects, and long-run location patterns

We introduce an evolutionary two-country model to characterize long run location patterns of the manufacturing activities of competing multinational enterprises. Firms located in country 1 can decide to offshore their manufacturing activities to country 2. The profitability of production in a country depends on several factors: unitary costs of production, the number of firms that are located in each country, within-country spillovers, and cross-border spillovers. Furthermore, profits in country 2 are influenced by congestion costs. Country 1 is assumed to be technologically advanced and has an advantage in terms of internal spillovers. In contrast, country 2 offers lower production unit cost which, however, may be offset by congestion costs. The firms’ (re)location choices are based on a simple comparison of current production costs obtained in the two countries and the dynamics of switching is modeled by a simple replicator dynamics. The global analysis of the resulting one-dimensional dynamical system reveals that a large advantage in terms of unitary production costs encourages the firms to off-shore manufacturing activities to country 2. This off-shoring process stops when congestion costs offset this advantage of country 2, even though congestion costs do not cause all manufacturing activities to be re-shored to country 1. The re-shoring process can be accelerated by an increase of within-country spillovers in country 1, while cross-border spillovers tend to favor a geographic dispersion of manufacturing activities and make location patterns that lead to suboptimal long run outcomes less likely.