Home Market Effect

What is the Home Market Effect?

The Home Market Effect is a notion that states goods with large economies of scale and high transport costs will most likely be produced in countries with high domestic demand for said goods and will be exported by said countries as well.

It was first conjectured by Staffan Linder in 1961 and then finalized by Paul Krugman in 1980. It is a part of the 'New Trade Theory' by Krugman. 

This theory emphasizes the role of increasing returns to scale and network externalities as compared to the 'Old Trade Theory' that focused only on comparative advantage. 

Since enormous fixed and transport costs exist in the real world, trade cannot only be based on factors like comparative advantage. 

So, if a country already has a booming production of certain popular goods and is a significant exporter, it would be difficult for other countries to start producing and exporting those goods.

It is because entering the market would be a challenge. The costs of producing and exporting, which the home country has managed to overcome and has started incurring an increasing economy of scale, shall be a significant hurdle for the foreign country. 

Hence, it only makes sense that the home country has a particular monopoly over this good. "In Krugman's model, the cross-country differences in the demand composition are due to exogenous cross-country variations in tastes."

Implications of the Home Market Effect Model

Of course, like any other economic model, this model also has implications and assumptions. 

Theoretically, if we only focus on two countries, one large and one small, we shall observe the following effect: 

The effect would be demonstrated in the large country in industries with more differentiated products, implying a lesser substitution elasticity and higher transport costs.

With it being concentrated here, compared to the small country with industries with homogeneous products, a higher substitution elasticity and lesser transport costs would be established. While the above implication only focuses on bilateral trade, the implications worldwide would be as follows: 

• If economies of scale and high transport costs prevail, countries with extensive product consumption will have a trade surplus of that good/industry.
• Affluent countries with higher demand for good quality goods will trade with other wealthy countries with similar needs (these countries will also have higher wages). 
• Developing countries will tend to produce goods with weak economies of scale and low transport costs (here, lower wages tend to counteract other factors). 

This effect is not only centered on countries. It can also explain why specific geographic locales are economically rich in the production and consumption of a particular industry within a country. 

Home Market Effect Examples

As stated before, we know that production of increasing economies of scale and enormous transport costs tend to be more concentrated in locations with a high local demand for these goods.

What does this mean for businesses and investors? Let's take a look at some examples which will aid in understanding the same: 

• In detailed research called, 'The More We Die, The More We Sell,' conducted by Arnaud Costinot, Dave Donaldson, Margaret Kyle, and Heidi Williams. A simple model test was devised using detailed drug sales data from the global pharmaceutical industry. 
• The core motive of the study was to observe a country's population and find out what diseases typically affect their lives and then, based on this information, figure out the drugs they will most likely demand. 

The sample used was Japan. A prevalent drug, famotidine, or Pepcid in the US, used to treat peptic ulcers and gastroesophageal reflux, was developed in Japan. 

Japan is known for its high incidences of ulcers; the Japanese population was more than twice as likely to die from digestive issues as compared to the rest of the world (0.266% in Japan, 0.170% in other countries on average). 

After studying Japan's import and export data, it was concluded the sales of this Japanese drug were the highest (10.35% of world sales) than sales of other Japanese drugs for different disease categories (4.54% of world sales). 

• It is observed that while quite a lot of countries dabble in the production of automobiles, only Japan, the United States, and European countries have a good export market of cars.

It is because it is known that these countries produce high-quality automobiles, and historically, the first automobile industries were established here. 

By studying these examples, we can conclude that businesses and investors tend to and should concentrate their production facilities/investments in these local markets/countries.

These are where geographic demand is high, and increasing economies of scale exist.

FDI And Home Market Effect

What if Foreign Direct Investment and Foreign Portfolio Investment act as channels for international capital flows? How will that affect the home market effect, or will it affect it at all? 

The 'Capital Flow, Foreign Direct Investment and Home Market Effect' is significant research by Naohisa Hirakata and Mitsuru Katagiri. 

State of Financial Autarky

Let us first assume that the two countries' economies do not have any capital flows or are in a state of financial autarky. 

Trade and income balances are balanced, and both countries' current accounts are balanced. 

If the terms of labor (the relative real wage adjusted by the real exchange rate between two countries) were first to increase and then drop, the real wages in the home country would fall, and relative real wages will also be lower in a new steady state. 

The phenomenon of real wages being lower in a small country than in a large country signifies the HME. 

The effect of increases in the capital-labor ratio on the terms of labor will dominate the HME in the short run. However, in theory, the HME is usually observed in the long run. 

So, if there were no international capital flows, the HME would tend to prevail. 

Economy with FDI and FPI

Now, if we study an economy where both FDI and FPI are implemented as channels of international capital flows, how will trade patterns change, and will there be a home market effect or not? 

Since FDI has more considerable costs than FPI, households accumulate foreign capital through FPI. Home country firms fail to attract sufficient capital as capital outflows through FPI. Inward FDI increases, and there is a decline in labor endowment. 

Home country firms cannot raise funds, and foreign country firms have an abundance of funds due to increased FPI. Foreign firms will expand their business to home country firms through inward FDI. 

It will encourage financial activity in the home country but discourage home-country firms from entering the market. It increases labor in the home country, as the number of foreign firms in the home country market has expanded.

Now, these new firms hire home-country labor and produce in the home country, which increases their labor demand through inward FDI. 

Krugman's initial argument was that decrease in the number of firms in a country will lead to a decrease in their real wages, which he then termed the home market effect. 

However, the possibilities of FDI and FPI open up many frontiers for the home country. Therefore, we can conclude from the above theory that FDI and FPI will have the opposite effect.

That is, the real wages in the home country will increase. 

Validity of the Home Market Effect

When this theory was first hypothesized, much empirical research was conducted. 

The research on this theoretical concept depicted a cause-and-effect relationship between cross-country differences in demand and led to the thesis of the home market effect. 
Before this, the existing international trade theories focused only on rich countries and their labor-intensive approach. 

After diligent research, it was observed that this theory occurred as a recurring phenomenon in countries whose market is affected by high transport costs and increasing returns to scale. 

One of the main studies was done in the pharmaceutical sector to solidify the validity of the effect. 

Much of this research has been discussed in the subheading example of the home market effect.

The gist was that countries whose demographic suffers from certain diseases would tend to produce and export medicines curing those diseases at increasing returns to scale, thus proving the theory of the home market effect. 

Another such example can be given of Silicon Valley, where not only comparative advantage comes into play.

But increasing returns to scale also ensures that many new technological ideas are produced and exported in that region, where demand for such goods and services is high. 

It shows that the sector-level economies of scale significantly influence the demand elasticity, as opposed to a low elasticity of demand. 

Conclusion

Rounding off this discussion of the home market effect, it can be said that in today's world, it is practical and can efficiently deduce trade patterns or help explain the common 'proximity-concentration trade-off' for foreign direct investment. 

The old trade theory was impractical, as it only concentrated on comparative advantage between two countries, ignoring essential factors like increasing returns to scale and high production costs. 

The home market effect, given under the new trade theory by Krugman, highlights the above factors and devises trade patterns that can be seen in today's economy. 
However, there are certain conditions under which this model fails to act. 

When foreign investments come into play, it can be seen that even though the interaction between FDI and FPI reduces the number of firms, it increases relative wage and welfare, contradicting the home market effect. 

When multinational corporations or firms replicate production facilities in foreign countries with large consumers or make horizontal FDIs, they trade off between exports and FDI. 

Only large-scale firms go for FDIs instead of exports due to high fixed costs. 

Researched and Authored by Antra Sharma | LinkedIn

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