Trade liberalization and economic geography in transition countries: Can FDI explain the adjustment patterns of regional wages?

Present paper studies the within-country regional effects of trade liberalization in transition countries. We argue that FDI inflows can be an important factor to accelerate the regional adjustment process in the home country. In order to underspin this theoretically, we first augment the new economic geography models by breaking the implied regional symmetry and by introducing capital as a second factor of production. Major contribution of our approach is that it allows for inter-regional as well as international capital mobility while labor is assumed to be immobile. Numerical simulations of our model indicate that this should contribute to faster convergence of relative regional wages in the smaller region. In addition, we examine the exact adjustment pattern of relative regional wages in five transition countries in the period 1990-2004 after they have liberalized their trade with the EU. First, we show that in four out of five transition countries there is a significant u-shaped adjustment pattern of regional wages after they opened up to foreign trade. And second, we find robust econometric confirmation that in three of the five countries FDI has contributed significantly to faster adjustment of relative regional wages.