The paper presents a model that can explain how regional differences emerge in a country as a consequence of foreign trade. The model is based on the widely used increasing returns/transportation costs framework. In addition to the conventional elements, heterogeneous households and imperfect labor mobility are added. The results indicate that for a small economy international trade leads to human capital reallocation, and thus more regional inequality than without labor heterogeneity. Even small migration ows can lead to large inequalities in per capita incomes, if the most skilled workers move. The model also sheds some light on the relative importance of fundamentals and historical factors.
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