What Is the Home Market Effect?
Let me explain the home market effect to you directly: it was first hypothesized by Staffan Linder in 1961 and then formalized by Paul Krugman in 1980. The core idea is that if a country has larger sales of certain products at home, it will also have larger sales of those same products abroad.
Key Takeaways
- The home market effect states that goods with large economies of scale and high transport costs will be produced in and exported by countries with strong domestic demand.
- This effect belongs to New Trade Theory and explains global trade patterns that don't fit with comparative advantage.
- Studies have confirmed home market effects and the economic factors that shape them.
- You, as a business owner or investor, should factor in potential advantages from home market effects when deciding where to locate operations.
Understanding the Home Market Effect
You need to know that the home market effect is part of New Trade Theory, which focuses on economies of scale and network effects instead of traditional comparative advantage models.
Here's what it describes: large countries tend to be net exporters of goods with high transport costs and strong economies of scale. With fixed costs leading to economies of scale in production, it makes sense to concentrate manufacturing in one location.
When transport costs are involved, you should locate that production where demand is high. Richer countries or those with large populations have higher demand, and they also have higher GDPs, so larger countries end up with big production bases.
This effect explains connections between market size and exports that comparative advantage can't account for. It also shows why manufacturing clusters in specific spots, even within a country.
One key implication is that countries with high consumption of an item will often have a trade surplus in that industry, assuming economies of scale and high transport costs.
Another is that rich countries with demand for high-quality goods will specialize in them and trade more with other rich countries.
A third is that goods with weak economies of scale or low transport costs will be produced by smaller countries, where lower wages can offset other disadvantages.
Plenty of empirical research supports this, and by the mid-20th century, old trade models based on comparative advantage were questioned because capital-rich countries like the U.S. exported labor-intensive products.
The home market effect was developed to explain this. After Krugman formalized it, studies tested it against data and found it holds true, with factors like returns to scale and transport costs affecting its strength in specific countries or industries.
Implications for Business and Investment
The home market effect means production of goods with high economies of scale and transport costs is more efficient in areas with high local demand, not just where comparative advantage is strongest. If you're in business, take this into account when picking production sites; the perks of being near large markets might outweigh other location costs. As an investor, keep this in mind for the current and future locations of companies you're considering.
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