The Home Market Effects with Heterogeneous Firms

Abstract

This paper examines the home market effect in the framework of heterogeneous firms. As a result, the model finds that not only trade costs but also fixed export costs cause the home market effect and the reverse home market effect can occur as the fixed trade costs are very low. In addition, the magnitude of the home market effect varies with industry characteristics. Industries with low trade costs, high fixed production costs, low fixed export costs, and high productivity dispersion will locate more in the large country. Finally, the model implies that the negative impact of trade barriers on the home market effect is dampened by the elasticity of substitution which is contrary with the result of the homogeneous firm model. An empirical model is also built to test these predictions for developed countries. The empirical results are consistent with the predictions of the theoretical model.