Contracting Externalities and Multiple Equilibria in Sectors: Theory and Evidence

Abstract

We consider an economy where the production technology has constant returns to scale but where in the descentralized equilibrium there are aggregate increasing returns to scale. The result follows from a positive contracting externality among firms. If a firms is surrounded by more firms, employees have more opportunities outside their own firm. This improves employees' incentives to invest in the presence of ex post renegotiation at the firm level, at not cost. Our leading result is that if a region is sparsely populated or if the degree of development in the region is low enough, there are multiple equilibria in the level of sectorial employment. From the theoretical model we derive a non-linear first-order censored difference equation for sectoral employment. Our results are strongly consistent with the multiple equilibria hypothesis and the existence of a sectoral critical scale (below wich the sector follows a delocation process). The scale of the regions' population and the degree of development reduce the critical scale of the sector.