Markups and Agglomeration: Price Competition Versus Externalities

Agglomeration can affect markups through two potential channels: agglomerated regions toughen competition (price competition effect) and firms are more productive on average in agglomerated regions (agglomeration externalities and firm selection effect). However, the literature is inconclusive on which force dominates. This paper models these two channels by introducing agglomeration economies to the model of Melitz and Ottaviano (2008). Under parameters from the empirical studies, I demonstrate that the price competition effect tends to dominate the others, i.e., firms in more agglomerated regions charge lower markups. Using a unique Chinese firm-level data from 2002 to 2004, I investigate the effect of spatial agglomeration on markups of firms. By addressing the potential endogeneity problems using instrumental-variable method, I find that in China an increase in the number of own-industry firms in the same region has a negative causal effect on markups of firms and a positive effect on productivity. But firms in agglomerated regions have higher output and profit.