Technology Advantage and Home-market Effect: An Empirical Investigation

Abstract

According to the conventional home-market effect, free trade tends to shrink the market share for a small economy in differentiated manufacturing goods, and in the extreme leads to a complete hollowing-out of the industry in a small economy. This paper considers the technology difference between countries using the standard Helpmand-Krugman model. We will show that the home-market effects can be offset and even reversed if the smaller economy is characterized by better technologies. The effect of a technology advantage is compromised of two parts: a direct effect from lower unit costs that leads to a higher output level of each firm, and an indirect effect through a change of survival firms after trade. Based on theoretical results we derive the gravity equation to undertake empirical tests on the hypothesis of home-market effects, and direct and indirect technology effects using the US patent stock of 2002 for six industries ranged from the most technologyintensive semiconductor industry to the most labor-intensive of the textile and apparel industry. Empirical results support the technology effects for all the six industries, and the more the technology intensity of an industry, the higher the effect of the technology advantage to offset the home-market effect and more likely to reverse the home-market