Neoclassical Theory versus New Economic Geography. Competing explanations of cross-regional variation in economic development

This paper uses data for 255 NUTS-2 European regions over the period 1995-2003 to test the relative explanatory performance of two important rival theories seeking to explain variations in the level of economic development across regions, namely the neoclassical model originating from the work of Solow (1956) and the so-called Wage Equation, which is one of a set of simultaneous equations consistent with the short-run equilibrium of new economic geography (NEG) theory, as described by Fujita, Krugman and Venables (1999). The rivals are non-nested, so that testing is accomplished both by fitting the reduced form models individually and by simply combining the two rivals to create a composite model in an attempt to identify the dominant theory. We use different estimators for the resulting panel data model to account variously for interregional heterogeneity, endogeneity, and temporal and spatial dependence, including maximum likelihood with and without fixed effects, two stage least squares and feasible generalised spatial two stage least squares plus GMM; also most of these models embody a spatial autoregressive error process. These show that the estimated NEG model parameters correspond to theoretical expectation, whereas the parameter estimates derived from the neoclassical model reduced form are sometimes insignificant or take on counterintuitive signs. This casts doubt on the appropriateness of neoclassical theory as a basis for explaining cross-regional variation in economic development in Europe, whereas NEG theory seems to hold in the face of competition from its rival.