Environmental policy, first nature advantage and the emergence of economic clusters

We explain the spatial concentration of economic activity when the cost of environmental policy – which is increasing in the concentration of pollution – acts as a centrifugal force, while positive knowledge spillovers and a site with natural cost advantage act as centripetal forces. We study the agglomeration effects caused by trade-offs between centripetal and centrifugal forces which eventually determine the distribution of economic activity across space. The equilibrium solution with spatially myopic environmental policy results either in a monocentric or in a polycentric city with the major cluster at the natural advantage site. The regulator's optimum results in a bicentric city, which suggests that when environmental policy is spatially optimal, the natural advantage sites do not act as attractors of economic activity. In general, our results suggest that sites with inherent advantages can lose their comparative advantage when social costs at these spatial points are taken into account.

► We study the industrial and residential location decisions under pollution diffusion.
► Knowledge spillovers and natural advantages interact with environmental policy.
► Myopic environmental policy promotes clustering around the natural advantage site.
► Optimal environmental policy forms two clusters away from the natural advantage site.
► Social costs can weaken the agglomeration effect of inherent advantage sites.