Trade Costs and Income in European Regions: Evidence from a regional bilateral trade dataset

Using a New Economic Geography (NEG) model, this study estimates the relationship between regional per capita income and the market accessibility of regions. This accessibility cannot be observed directly, so it has to be constructed. We follow a two-step-procedure as suggested by Redding and Venables (2004) and use results of a gravity-type model to infer \real market potential". To this end, we make use of a novel dataset of bi-regional trade flows between (and within) 254 European NUTS-2 regions (for 26 European countries excluding Bulgaria and Romania) for the year 2010. In a second step we test the hypothesis that access to domestic as well as to large foreign markets increases factor incomes. We find evidence that supports this hypothesis on a regional level. This also holds when we control for other potential income determinants. In order for the estimates to be unbiased, we additionally take the spatial structure of the data into account. Our findings indicate that, although the specification derived from theory should be able to capture some spatial spillovers, additionally controlling for spatial autocorrelation in the residuals is necessary to fit the European data. (authors' abstract)