Heterogeneous Firms, Agglomeration and Economic Geography: Spatial Selection and Sorting

A Melitz-style model of monopolistic competition with heterogeneous firms is integrated into a simple New Economic Geography model to show that the standard assumption of identical firms is neither necessary nor innocuous. We show that re-locating to the big region is most attractive for the most productive firms; this implies interesting results for empirical work and policy analysis. A 'selection effect' means standard empirical measures overestimate agglomeration economies. A 'sorting effect' means that a regional policy induces the highest productivity firms to move to the core while the lowest productivity firms to move to the periphery. We also show that heterogeneity dampens the home market effect.