Capital Market Frictions and Economic Geography

Economic geography aims to explain agglomeration primarily through the channels of increasing returns, monopolistic competition and international factor mobility. By contrast, this paper constructs a theoretical model based on capital market frictions. Monopolistically competitive firms are run by managers who are subject to moral hazard. Endogenously, the impact of capital market frictions is smaller in industrialized regions, which makes it cheaper to incentivize managers. Consequently, firms can pay higher interest rates on capital in these regions, which in turn attracts more capital. This simple mechanism leads to a host of effects and, therefore, predictions in terms of economic development and corporate governance