Introduction

As has already been mentioned in the preface, Bertil Ohlin (1933) observed long ago that the fields of trade theory on the one hand and regional and urban economics on the other had in principle the same research objectives. Both areas want to answers the questions: who produces what, where, and why. Despite Ohlin's observation, each field has continued to go its own way since the nineteenth century. Chapter 2 showed that trade theory assumes that countries are dimensionless points in space. Trade theorists are mostly interested in how market structure, production techniques, and consumer behavior interact. The resulting factor and commodity prices determine the pattern of international trade flows. Location is at best an exogenous factor and usually does not play a role of any significance. Regional and urban economics, instead, take market structure and prices as given and try to find out which allocation of space is most efficient. The underlying behavior of consumers and producers, central in trade theory, is less important (Fujita and Thisse, 1996). Although both strands of literature produce valuable insights in their own right, trade theory and regional and urban economics are productively combined in geographical economics.

This chapter discusses and explains the core model of geographical economics, a small general equilibrium model developed by Krugman (1991). As we shall see, the equilibrium equations of this model are non-linear. This means that small changes in parameters do not always produce the same effects; sometimes the effects are small, sometimes they are large.