Undertstanding the Home Market Effect and the Gravity Equation: The Role of Differentiating Goods

Abstract

This paper argues that the theoretical foundations for the gravity equation are general, while the empirical performance of the gravity equation is specific to the type of goods examined. Most existing theory for the gravity equation depends on the assumption of differentiated goods. We show that the gravity equation can also be derived from a 'reciprocal dumping' model of trade in homogeneous goods. The different theories have different testable implications. Theoretically, the gravity equation should have a lower domestic income elasticity for exports of homogeneous goods than of differentiated goods because of a 'home market' effect that depends on barriers to entry. We quantify the home market effect empirically using cross-sectional gravity equations and find that domestic income export elasticities are indeed substantially higher for differentiated goods than for homogeneous goods.