The
home market effect is a hypothesized concentration of certain
industries in large markets. The home market effect became part of New Trade
Theory. Through trade theory, the home market effect is derived from models
with returns to scale and transportation costs. When it is cheaper for an
industry to operate in a single country because of returns to scale, an
industry will base itself in the country where most of its products are
consumed in order to minimize transportation costs. The home market effect
implies a link between market size and exports that is not accounted for in
trade models based solely on comparative advantage.
The home market effect first
proposed by Corden and was developed by Paul Krugman in a 1980 article.
Krugman sought to provide an alternative to the Linder hypothesis. Based on
recent research, the home market effect confirms Linder's sentiment that a
nation's demand is a predicate for its exports, but does not support
Linder's claim that differences in countries' preferences impede trade.
Krugman’s model yields two related
predictions regarding the effects of market size asymmetries on the
geographic distribution of industry activity. Krugman (1980) demonstrates
that a country with larger consumers of an industry’s goods will run a trade
surplus in that industry characterized by economies of scale. Helpman and
Krugman (1985) show that the larger country’s share of firms in that
increasing returns industry exceed its share of consumers. Thus, a further
development in the literature has been to examine the robustness of the home
market effects(HMEs) under different modeling assumptions.
In the empirical literature, Head
et al. (2001) show that, from a panel of U.S. and Canada, an increasing
returns model where varieties linking to firms predicts HMEs. In contrast, a
constant returns model with national product differentiation predicts
reverse HMEs. Feenstra et al. (2001) also find reverse HMEs in a
‘reciprocal-dumping’ model. Behrens et al. (2005) further apply to a
cross-section of OECD and non-OECD countries, and their main finding
strongly backs the HMEs prediction, especially between OECD countries. Huang
et al. (2007) derive the gravity equation, using the U.S. patent stock of
2002 for six industries, and find that the more the technology intensity of
an industry, the higher the effect of the technology advantage to offset
HMEs and more likely to reverse the HMEs.
On theoretical side, Davis (1998)
shows that if both homogeneous and differentiated goods have identical
transport costs, then the HMEs disappear. Head et al. (2002) considers four
kinds of horizontal product differentiation models to examine the
pervasiveness of the HMEs. Reverse HMEs are found based on the
Markusen-Venables (1988) model that varieties are linking to nations rather
than firms. Behrens (2005) discusses the HMEs in the context of regional
economics. When non-traded goods are taken into consideration, the HMEs may
be offset, whereas a reverse HME may arise. Yu (2005) shows that if consumer
preference follows the form of a constant demand elasticity of substitution
between the homogeneous and the composite of differentiated goods, then the
reverse HMEs may occur depending on the level of elasticity.
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