The Home Market Effect and Bilateral Trade Patterns
By Gordon H. Hanson and Chong Xiang*
Abstract.

We develop a monopolistic-competition model of trade with many industries to

examine how home-market effects vary with industry characteristics. Industries with hightransport costs and more differentiated products tend to be more concentrated in large countries
than industries with low transport costs and less differentiated products. We test this prediction
using a difference-in-difference gravity specification that controls for import tariffs, importingcountry remoteness, home bias in demand, and the tendency for large countries to export more of
all goods. We find strong evidence of home-market effects whose intensity varies acrossindustries in a manner consistent with theory. (JEL F1, R1)
Much recent theoretical work in international trade is based on imperfect competition andincreasing returns to scale. This includes models of intra-industry trade (Paul Krugman, 1979,
1981; Elhanan Helpman, 1981), multinational firms (Helpman, 1984; James R. Markusen, 1984),
and economic geography (Krugman, 1991; Anthony J. Venables, 1996). These efforts haveproduced compelling explanations for why similar countries may gain from trade, why foreign
direct investment tends to flow between rich countries, and why manufacturing activity tends toagglomerate spatially within countries.
For purposes of empirical work, however, these new trade theories pose a challenge.
Their predictions for trade flows are similar to those of models based on comparative advantage(Helpman and Krugman, 1985; Donald R. Davis, 1995). This complicates testing trade theory(Helpman, 1999) and may account for why attempts to estimate the importance of imperfectcompetition and increasing returns for trade have yielded mixed results (Helpman, 1987; David
Hummels and James Levinsohn, 1995; Peter Debaere, 2001).1

1

Recently, empirical researchers have begun to test new trade theories by exploiting thehome-market effect, as derived by Krugman (1980). Standard treatments of the home-market
effect (e.g., Helpman and Krugman, 1985; Robert C. Feenstra, 2003) are based on amonopolistic-competition model of trade that has one homogeneous-good industry (with zero
fixed costs and zero transport costs) and one differentiated-product industry (with positive fixed
costs and positive transport costs).

The home-market effect is the tendency for thedifferentiated-product industry to concentrate in the large country, making it a net exporter ofthese goods.2 The logic of the result is that fixed costs induce firms manufacturing differentiatedproducts to locate their operations in a single country and transport costs make the economy withthe larger market the optimal site. The homogeneous good is produced by the smaller country.
The home-market effect implies a link between a country’s market size and its exports that
doesn’t exist in trade models that are based solely on comparative advantage.
One approach to identify home-market effects uses the correlation between industry
supply and industry demand across countries. In Krugman (1980), the demand for individual
goods varies across markets because of differences in consumer preferences (e.g., German
consumers prefer beer, French consumers prefer wine), leading production of a good toconcentrate in markets with high levels of demand. Davis and David E. Weinstein (1999, 2003)
find that for manufacturing industries in either OECD countries or Japanese regions industry
production increases more than one-for-one with local demand for a good. Keith Head and John
Ries (2001) find evidence of similar patterns of industry production and consumption in Canada
and the United States. Both sets of results are interpreted as evidence of home-market effects.
One potential problem with this approach is that it relies on industry demand shocks being

2

uncorrelated with industry supply shocks. If this condition fails, estimation results may be
inconsistent.
A second approach to estimate home-market effects is to examine how the income
elasticity of exports varies across goods. In theory, the elasticity of export supply with respect tonational income should be higher for differentiated products (James E. Rauch, 1999). Feenstra,
Markusen, and Andrew K. Rose (1998) estimate gravity models of bilateral trade flows for an
aggregate of differentiated products (which are primarily manufacturing industries) and for an
aggregate of homogeneous products (which are primarily non-manufacturing industries). Theyfind that the elasticity of export supply with respect to exporter GDP is higher in the former
sample than in the latter, which they take as evidence of home-market effects.3 One issue withthe gravity model, raised by James E. Anderson and Eric van Wincoop (2003), is that somespecifications do not control for the ‘remoteness’ of importing countries and so may be subject toomitted-variable bias.
Empirical work on home-market effects is based on a two-industry model, which is thestandard setting in which these effects are derived. The industry presumed subject to homemarket effects is manufacturing. In testing for home-market effects Davis and Weinstein (2003)
pool across manufacturing industries,4 and Feenstra, Markusen, and Rose (1998) aggregate overa large subset of manufacturing industries. In actuality, we know manufacturing is a composite
of many differentiated-product industries. Do we expect that all of these industries will display
home-market effects? Unfortunately, there is little theoretical work on this question.5 But
intuition would suggest that the strength of home-market effects will vary with industry
characteristics, such as transport costs and the extent of production differentiation. If this is thecase, then it is difficult to say whether existing empirical results are consistent with theory.

3

In this paper, we extend the monopolistic-competition model of trade to allow for acontinuum of differentiated-product industries. In section two, we show that industries with hightransport costs and low substitution elasticities (i.e., more product differentiation) tend toconcentrate in the larger country and industries with low transport costs and high substitution
elasticities (i.e., less product differentiation) tend to concentrate in the smaller country. Thissuggests that within manufacturing home-market effects will vary in a manner that issystematically related to industry characteristics.
Then, we develop a framework to test the predictions of our model based on a“difference-in-difference” gravity specification. This approach, presented in section three, has
three steps: (i) we select pairs of countries that are likely to face common trade barriers inmarkets to which they export, (ii) we select two groups of industries, one with high transport
costs and low substitution elasticities (high product differentiation) and one with low transport
costs and high substitution elasticities (low product differentiation), and (iii) we examine
whether, across exporter pairs, larger countries tend to have higher exports of high-transport cost,more-differentiated goods relative to their exports of low-transport cost, less-differentiatedgoods.
To see the value of this difference-in-difference gravity specification, consider exports by
Belgium and Germany of steel (high transport cost, low substitution elasticity) and radios (lowtransport cost, high substitution elasticity). Our test of the home-market effect is, in essence, tosee whether German-Belgian relative exports of steel are larger than German-Belgian relative
exports of radios. The first “difference”–log German steel exports minus log Belgian steel
exports–sweeps out of the estimation determinants of bilateral exports that are specific to theimporter (e.g., importer remoteness, importer GDP, importer industry tariffs). This addresses the4Anderson-Van Wincoop (2003) criticism of the gravity model.

By then subtracting off thesecond “difference”–log German radio exports minus log Belgian radio exports–we control forthe tendency of larger countries to export more of all goods. The importance of this second
difference is that, in a many industry world, theory has strong predictions about which industries
will be relatively more concentrated in the larger country, but only weak predictions about which
industries will concentrate in the larger country in absolute terms.6
To preview the empirical results, presented in section four, there is strong evidence ofhome-market effects.

Larger countries have high exports of high-transport cost, more-differentiated goods relative to their exports of low-transport cost, less-differentiated goods.
Importantly, we identify these effects only in the difference-in-difference gravity specification.
When we look at industries individually – rather than match high-transport cost, moredifferentiated goods against low-transport cost, less-differentiated goods – larger countries havehigher exports of all goods, suggesting naively that all industries exhibit home-market effects.
And when we pair industries randomly we find no evidence of home-market effects.

I. Theory and Empirical Specification
In this section, we extend the standard model of trade under monopolistic competition(Helpman and Krugman, 1985; Feenstra, 2003) to the case of a continuum of differentiatedproduct industries and then use the results from this framework to develop an estimation strategy
for identifying home-market effects.

A. Home-Market Effects in a Many Industry World

5There is a large country and a small country. Each has one factor of production, labor.
The small country’s labor endowment and wage are normalized to 1. The large country haslabor endowment, L > 1, wage, w, and income, Y = wL.
There is a continuum of Dixit-Stiglitz monopolistically competitive industries indexed byz ∈ [0, 1]. Consumers have identical Cobb-Douglas preferences, where α(z) is the consumption
1

share on industry z and ∫ α ( z )dz =1. For industry z, let n(z) denote the number of product varieties,0

σ(z) denote the elasticity of substitution between varieties, and τ(z) > 1 denote the iceberg transport
cost incurred in shipping one unit of output from one country to the other. Let x(z) ≡ τ(z)σ(z)-1
denote the effective trade cost for industry z.

As is standard in models of monopolisticcompetition, the importance of trade costs in an industry depends on the degree of productdifferentiation, as captured by the elasticity of substitution (Richard Baldwin et al., 2003; Headand Theiry Mayer, 2003). We will assume that there is no international specialization at theindustry level (although there is specialization at the product-variety level),7 and that there aremany industries with high values of σ and low values of x, and vice-versa. This latter assumption
is necessary for there to be variation in the degree of production differentiation and effective trade
costs across industries.
Given that the varieties of industry z are symmetric, let q(z) denote the output per variety,p(z) denote the price of each variety, and c(z) denote the fixed labor requirement. We normalize
the variable labor requirement for each variety to 1. It is well known that the price is a constantmark-up over marginal cost, and that, because free entry drives profits to zero, output is fixed
and revenues are proportional to fixed costs:(1)p(z) =σ ( z)w, q(z) = c(z)[σ(z) – 1], and p(z)q(z) = wc(z)σ(z)σ ( z) − 1

6With no sectoral specialization, both countries produce varieties of industry z and we can write
the aggregate-shipments-equals-aggregate-expenditures condition as,
np1−σ
np1−σ + n* ( p* )1−σ x −1

npq = α Y Γ + αΓ* , Γ =
(2)

np1−σ
n p q = α Y (1 − Γ) + α (1 − Γ ), Γ = 1−σnp + n* ( p* )1−σ x
*

*

*

*

where we drop the industry index z and use a “*” to denote small-country values.
Since the large country’s income equals the sum of sales from all industries:(3)

1

Y = ∫ n( z ) p( z )q( z )dz0

We can substitute out p(z) and q(z) from (3) using (1), solve for n(z) from (2) and then substitutethe solution into (3) to obtain,(4)

1

0 = ∫ α (z)g(z)dz,
0Ywσ ( z )−]g(z) = [x( z ) wσ ( z ) − 1 x( z ) − wσ ( z )a solution to which always exists. Details on deriving (4) are in an appendix. Once we solve forw using (4), we can solve for all other endogenous variables using (1) and (2).
Lemma 1 Equation (4) has a unique solution of w, such that 1 < w < min [ x( z )]1/ σ ( z ) .
Proof: See appendix.
Thus, wages are higher in the large country.
Following the literature (e.g., Helpman and Krugman, 1985), we define industry z to be
subject to a home-market effect if n(z)/n*(z) > L, or if the large country’s share of varieties of z
produced globally is greater than its share of world factor supplies. For analytical convenience,
we state results on the home-market effect not in terms of n(z)/n*(z) but in terms of g(z). As itturns out, industry z exhibits a home-market effect if and only if g(z) > 0.

To see this, let

n% ( z ) ≡ n( z ) w and h( z ) ≡ n% ( z ) / n% * ( z ) , in which case we can show that g(z) = (1+Y)[h(z)/(h(z)+1)

7

– Y/(Y+1)] (see appendix for details). It follows that g(z) > 0 if and only if n(z)/n*(z) > L (or,equivalently, h(z) = n% ( z ) / n% * ( z ) > Y). Since h(z)/(h(z)+1) represents the large country’s share inworld shipments of industry z and Y/(Y+1) represents the large country’s share in world income,g(z) is increasing in the concentration of industry z in the large country.
In general, the distribution of g(z) across industries will depend on the distributions ofα(z), σ(z) and τ(z) across industries. We cannot obtain analytical solutions for the distribution ofg(z) without making assumptions about the distributions of these parameters. However, evenabsent such assumptions, we can compare values of g(z) between two industries, z0 and z1. The
results we can obtain are in terms of the factors that make some industry, z1, relatively moreconcentrated in the large country than some other industry, z0. That general results about homemarket effects are limited to such pair wise industry comparisons has important implications for
empirical work.
To motivate the results, note that the home-market effect reflects a trade-off between
trade costs and production costs. It is clear that g(z) > 0 if and only if(5)Y[x( z )− 1 ] > [x(z)wσ(z) – 1]σ (z)wConsider whether relocating from the small country to the large country might be profitable for afirm. The large country has a higher production cost (represented by wσ(z)), but producing there
offers savings in trade costs (represented by x(z) = τ(z)σ(z)-1) associated with having access to alarger market. The left-hand side of (5) summarizes the benefits of relocating to the large
country.

Meanwhile, the right-hand side of (5) summarizes the costs of relocation since

supplying the small country from the large country results in higher trade and production costs(relative to supplying the small country from within its borders). Naturally, an industry will
exhibit a home-market effect if and only if the benefits of the relocation outweigh the costs.88

For industries with higher trade costs and/or a lower substitution elasticity, relocatingfrom the small to the large country yields larger savings in trade costs and smaller increases in
production costs. Thus, high-x and low-σ industries are the ones that we expect to be most likely
to show home-market effects.9 To be rigorous:(6)g ( z) > 0 ⇔Ywσ ( z )wσ ( z )2σ ( z )
Y
w
>
⇔
>
+
(Y − 1)wσ ( z ) x( z ) − 1 x( z ) − wσ ( z )x( z )

Since the right-hand side of (6) increases with σ(z) and decreases with x(z), we obtain:
Proposition 1 If g(z0) > (<) 0 for some z0, then g(z1) > (<) 0 for all z1 such that x(z1) ≥ (≤) x(z0)and σ(z1) ≤ (≥) σ(z0).
Proposition 1 states that if some industry z0 exhibits a home-market effect, then so will all
industries that have higher effective trade costs and lower elasticities of substitution.
Furthermore, by looking at how g(z) varies with x(z) and σ(z), we obtain the following:
Proposition 2 (a) If x(z1) = x(z0) and σ(z1) < σ(z0), then g(z1) > g(z0). (b) If σ(z1) = σ(z0) andx(z1) > x(z0), then if g(z0) < 0, g(z1) > g(z0), and if g(z0) > 0, then g(z1) > g(z0) if both z0 and z1 aresuch thatY [ x( z ) / wσ ( z ) − 1] 2 w2σ ( z )
)
1- (
> 0.
x( z ) wσ ( z ) − 1
YProof: See appendix.
Proposition 2 states that (a) for two industries with the same effective trade costs, the industry
with the lower substitution elasticity (or the higher transport cost) will exhibit stronger homemarket effects, and (b) for two industries with the same substitution elasticity, the industry withthe higher effective trade costs will exhibit stronger home-market effects, provided that bothindustries’ effective trade costs are not too high.10
Propositions 1 and 2 suggest an approach to identifying home-market effects empirically.
Given that α(z), τ(z) and σ(z) vary across industries, it is difficult to characterize the distribution

9

of g(z) across industries and thus to obtain general results for which industries will concentrate inwhich country. However, if we select high-τ and low-σ industries as “treatment industries” andlow-τ and high-σ industries as “control industries”, then by Propositions 1 and 2 the treatment
industries will be more concentrated in larger countries than the control industries.11
To implement this approach, we need to derive precisely how h(z) = n% ( z ) / n% * ( z ) varies
with relative country size. The solution for h(z) is nonlinear in Y and the preference andtechnology parameters (equivalently, n(z)/n*(z) is nonlinear in L). For purposes of empiricalwork, we obtain approximations for ln[h(z)] that are linear in polynomials of (Y-1) or ln(Y).
Details on the derivation are in an appendix.

B. Empirical Specification
To specify the model empirically, we move from a world with a continuum of industries,
one factor of production, and two countries to a world with a discrete number of industries, manyfactors and many countries. We assume that iceberg transport costs between countries j and k inindustry m, τmjk, are a function of the distance between j and k, djk, such that τ mjk = d γjkm , where
γm>0. Consider the demand by country k for varieties of m produced in country j. Given CES
preferences and the symmetry of product varieties in preferences and technology, total sales inindustry m by country j to country k equal,
1−σ m

(7)

⎛ Pmjk ⎞S mjk = α mYk nmj ⎜⎜ P ⎟⎟⎝ mk ⎠

where Pmjk is the delivered (c.i.f.) price in country k of a good in industry m produced by country j
and Pmk is the CES price index for industry m products in country k. Consider the variation in
product prices across countries. Pmjk can be written as

10

(8)

⎛ σ ⎞
Pmjk = Pmj tmjk (d jk )γ m = ⎜ m ⎟ wmj tmjk (d jk )γ m
⎝ σ m −1 ⎠where Pmj is the f.o.b. price of a product in industry m manufactured in country j, tmjk is one plus thead valorem tariff in k on imports of m from j, wmj is unit production cost in industry m and country j,
and the second equality replaces Pmj with a markup over marginal cost.12 We allow wmj to varyacross industries within a country because industries might require multiple factors of production
and vary in their factor intensities.
To apply the logic of the home-market effect, compare country j’s exports of good m tocountry k with some other country h’s exports of good m to country k. Combining equations (7) and(8), these relative export sales are expressed as,
(9)

1−σ m

nmj ⎛ wmj ⎞=⎜⎟S mhk nmh ⎝ wmh ⎠S mjk⎛ d jk ⎞⎜⎟⎝ d hk ⎠(1−σ m )γ m

n%mj ⎛ wmj ⎞=⎜⎟n%mh ⎝ wmh ⎠−σ m⎛ d jk ⎞⎜⎟⎝ d hk ⎠(1−σ m ) γ m

where n%mj = nmj wmj and we assume countries h and j have common technology and face common
tariffs in country k. Expressing sales in relative terms removes the price index and the tariff incountry k from the expression. Since σm > 1, equation (9) shows that for industry m and destination
market k, country j’s exports relative to country h’s exports are increasing in the relative number of
product varieties produced in j, decreasing in relative production costs in j, and decreasing in
relative distance from j to the destination market.
From theory, we do not know whether n%mj / n%mh will be increasing or decreasing in Yj/Yh, therelative market size of the two countries. This relationship will depend in part on the distribution ofpreference and technology parameters across industries. From Propositions 1 and 2, what we cansay is how n%mj / n%mh will compare to the ratio of product shipments by the two countries in someother industry o, n%oj / n%oh , as long as we choose industries m and o appropriately. In particular, we

11choose industry m such that it has a low value of σ (high production differentiation) and a highvalue of γ (high transport costs), and choose industry o such that it has a high value of σ (lowproduction differentiation) and a low value of γ (low transport costs). In what follows, we will referto industry m as the “treatment” industry and industry o as the “control” industry. The ratio ofrelative sales of m versus o goods by countries j and h to country k is,(10)n%mj / n%mh ( wmj / wmh ) −σ m(d jk / d hk )(1−σ m )γ m −(1−σ o )γ o=−σ oSojk / Sohk
n%oj / n%oh ( woj / woh )Smjk / Smhk

Propositions 1 and 2 suggest that the ratio ( n%mj / n%mh ) /(n%oj / n%oh ) will be increasing in the relative
market size of the two countries.13 In words, for two countries, j and h, the ratio of their relative
exports of good m (high transport costs, low substitution elasticity) to their relative exports ofgood o (low transport costs, high substitution elasticity) will be higher the larger is the market ofcountry j relative to country h.
To search for evidence of home-market effects empirically, we specify equation (10) in log
terms using the following regression:(11)⎛ S mjk / S mhk ⎞ln ⎜= α + β f (Y j / Yh ) + φ(Xj – Xh) + θln(djk/dhk) + εmojkh⎜ Sojk / Sohk ⎟⎟⎝⎠where f() is an increasing function, Yj/Yh is relative exporter market size, Xl is a vector of control
variables that determine relative production costs for industries m and o in country l, and εmojkh is anerror term. The function f() captures our approximation results on ln[ n% ( z ) / n% * ( z ) ] being linear inpolynomials of (Y-1) or lnY. We try several alternative functional forms to find the specification off() that yields the best fit. Our test for home-market effects is whether β > 0, or whether larger
countries export relatively more of high-transport cost, low-substitution elasticity goods.

12In the estimation, we use national factor supplies to measure the vector X, which controls
for industry production costs. In general equilibrium, national factor supplies map into national
factor prices and these factor prices map into industry production costs. The latter mapping is likely
to vary with industry factor intensity. We control for this in the estimation by allowing the vector of
coefficients, φ, to vary across industries. This is clearly a reduced-form treatment of production
costs, but one that is necessitated by a lack of detailed cross-national cost data on the industries inour sample.
To summarize, the advantage of the difference-in-difference specification is that (a) it
removes from the estimation importing-country tariffs, price indices, and home bias effects, allof which are hard to measure, (b) for exporter pairs with similar production costs, it differencesout of the estimation all determinants of relative exports, except relative distance and relative
country size, and (c) it allows us to test for home-market effects in a world with manydifferentiated-product industries.
Estimation of equation (11) requires that we place restrictions on the set of industries andcountries included in the sample and that we define the set of regressors. First, we choose pairs ofexporting countries that face common trade policy barriers in the countries that import their goods.
It is an added advantage if these country pairs have similar production costs, such that comparativeadvantage plays a small role in determining their relative exports (i.e., in (11), (Xj-Xh) ≅ 0). We
choose exporting country pairs that belong to a common preferential trade area and that haverelatively similar average incomes.

Second, we identify a set of high-transport cost, low-

substitution elasticity industries and a set of low-transport cost, high-substitution elasticity
industries. To do so, we use data on freight rates and estimation results on substitution elasticities
from the trade literature.

13

II. Data and Estimation Issues
The data for the estimation come from several sources. For country exports by product,
we use the World Trade Database for 1990 (Feenstra, Robert Lipsey and Charles Bowen, 1997).
This source gives bilateral trade flows between countries for three- or four-digit SITC revision 2
product classes. At this level of industry classification (chemical fertilizers, woven cotton
fabrics, gas turbines) product classes are better seen as industrial sectors than as individual
product varieties, as is consistent with our model.
For data on GDP, we use the Penn World Tables. For country characteristics related toindustry production costs, we use nonresidential capital per worker from the Penn World Tables,
available land supply relative to the population and average education of the adult populationfrom Robert J. Barro and Jong-Wha Lee (2000), and the average wage in low-skill industries(apparel and textiles) from the United Nations Industrial Development Organization (UNIDO)
Industrial data base. For distance and other gravity variables (whether countries share a common
border, whether countries share a common language), we use data from Jon Haveman(www.eiit.org). Table 1 gives summary statistics on the regression variables.
There are several estimation issues to be addressed. First, we need to select pairs ofexporting countries under the constraint that both members of a pair face common trade policy
barriers in importing countries.

To ensure that exporters have diversified manufacturingindustries (and are not specialized in commodities or low-skill goods), we limit the sample ofexporters to OECD countries.14 Within this group, we form country pairs from sets of countries
that belong to a preferential trading arrangement of some kind. These include the members of
the European Economic Community (now European Union),15 Canada and the United States(U.S.-Canada Free Trade Area), and New Zealand and Australia (British Commonwealth). This14

yields a potential number of 107 exporter pairs per importer and industry. Figure 1 shows the
cumulative distribution of log relative exporter GDP (in which the larger country of a pair is in
the numerator) for all country pairs in the sample. There is considerable variation in country
size. For 65 percent of the observations one country is at least 75 log points larger than theother.
Second, we need to choose the set of importers. One might presume that we should
include all countries in the importer sample. A problem with this approach is that many small
countries have zero imports from many of their bilateral trading partners. In many contexts,
having the dependent variable take zero values can be addressed with standard techniques, suchas the Tobit. In our case, however, the dependent variable is constructed from four separate
export values (since it is a double log difference). Modeling the joint probability that two or
more of these values are zero, as would be necessary to employ a Tobit-style estimator, isbeyond the scope of this paper. Instead, we limit our sample to the 58 largest importing
countries, which in 1990 accounted for 97 percent of world imports of manufacturing goods.
Restricting the sample in this way greatly reduces the number of observations with zero export
values.16 Since the theory applies to importers on a case-by-case basis, there is no loss infocusing on large importers. To check the sensitivity of the results to zero values of trade, we
also report results using samples of either the 15 largest importers (69 percent of 1990 world
imports) or the 7 largest importers (52 percent of 1990 world imports).
Third, we need to identify industries with low transport costs and high substitution
elasticities and industries with high transport costs and low substitution elasticities.17 Since
industry transport costs are often unobserved, we estimate these costs using data on freight rates
for U.S. imports in Feenstra (1996). We take the implicit U.S. industry freight rate (insurance

15and freight charges/import value) and regress it on log distance to the origin country, where weallow both intercepts and slopes to vary across industries.18 We then use the projected industry
freight rate from these coefficient estimates (at median distance for our sample of importerexporter countries) as the transport cost for an industry.19 For the elasticity of substitution (σ) byindustry, we draw on estimates in Hummels (1999), who uses data on bilateral trade flows,
import tariffs, and transport costs to estimate a specification similar to (7). While others haveestimated σ for all manufacturing industries or for select manufacturing industries (see Feenstra
2003 and Head and Mayer 2003 for surveys), Hummels’ provides the only comprehensive
estimates of σ by two-digit SITC industry of which we are aware.20
For the control group, we select industries with freight costs in the bottom two deciles of
the industry distribution of freight costs and with substitution elasticities in the top three decilesof the industry distribution of this variable. For the treatment group, we select industries withfreight rates in the top three deciles of the industry distribution of freight rates and with
substitution elasticities in the bottom three deciles of the distribution of this variable. We use
asymmetric cutoffs for high and low-transport cost industries because estimated freight rates
have an asymmetric distribution with a long upper tail and a short lower tail, as seen in thedeciles for freight costs shown in Table 3. Using symmetric cutoffs would result in having too
many low-transport cost industries or too few high-transport cost industries. This criterion yields
the following approximate cutoffs: for the treatment (high-transport cost, low-σ) industries,
freight rates greater than 0.10 and substitution elasticities less than 4.5, and, for the control (lowtransport cost, high-σ) industries, freight rates less than 0.05 and substitution elasticities greaterthan 7.5. We also present results for alternative industry-selection criteria.
Figure 2 shows the joint distribution of our estimates of three-digit industry freight rates

16and Hummels’ estimates of two-digit industry substitution elasticities. Three-digit industry
identifiers appear for treatment and control industries; other industries are indicated with zeros.
Treatment industries occupy the upper-left of the distribution and control industries occupy thelower-right. There appears to be a weak negative relationship between industry freight rates andσ’s.
A final estimation issue is how to measure market size. In equation (11), we use relative
GDP to capture relative size for a pair of exporters. This is appropriate for a world with twocountries, but with many countries, neighborhood effects may also affect industry location(Masahisa Fujita, Krugman, and Venables, 1999). The relative size of two economies may depend
not just on their GDPs but also on the GDPs of their neighbors.

In theory, the impact ofneighborhood effects on the home-market effect is ambiguous and will depend on the distribution of
GDP across countries. Consider Belgium and Sweden. In 1990, they had similar GDPs, but
Belgium’s immediate neighbors had a larger combined GDP than did Sweden’s. One possible
outcome is that Belgium’s large neighbors create high demand for its goods, leading to a greater
concentration of high-transport cost, low-σ industries in the country than in Sweden. A second
possible outcome is that Belgium’s large neighbors offer such attractive markets that they pull hightransport cost, low-σ industries out of Belgium, casting an agglomeration shadow over the country.
Which outcome obtains will depend on realizations of taste and technology parameters and the
distribution of national factor supplies and so is a question that can only be resolved empirically.
In recent literature, neighborhood effects are captured by a market-potential function, in
which demand for a country’s goods is a function of income in other countries weighted bytransport costs to those economies.21 Following Fujita, Krugman, and Venables (1999), we define
the market potential for country i as the distance-weighted sum of GDP in other countries:

17

(12)

J

MPi = ∑ Yl dli − λl =1Using market potential for country size is similar in spirit to Davis and Weinstein (2002), who testfor home-market effects with a gravity-based measure of industry demand.22
We estimate equation (11) by matching industries from the first group in Table 2 toindustries from the second group in Table 2. The high-transport cost, low-σ industries are thetreatment group that theory suggests will be subject to home market effects; the low-transportcost, high-σ industries are the control group.

III. Estimation Results
A. Preliminary Results
Before we present the main estimation results, it is useful to consider a simple
specification in which the dependent variable is for a pair of exporters log relative exports of agood. This is equivalent to taking the numerator of the regressand in equation (11) as thedependent variable and keeping the same independent variables. We want to see whether the
results of this ‘single-difference’ specification are consistent with standard gravity models, whichshow an elasticity of bilateral exporters with respect to exporter GDP of about one. The results
will also reveal whether the coefficient on relative exporter size is larger for treatment (hightransport cost, low-σ) industries than for control (low-transport cost, high-σ) industries, as would
be consistent with home-market effects.
Table 4 shows single-difference gravity estimation results for the 21 treatment and 13
control industries in our sample. The regressors are, for a pair of exporters, log relative exporter
size, dummy variables for whether an exporter and importer share a common border or acommon language (in level differences for an exporter pair), log relative capital per worker, log

18

relative land area per capita, log relative average schooling, and log relative wages in low-skill
industries.23 The variable of interest is log relative exporter size, which we measure as log
relative exporter GDP.
Coefficients on relative exporter GDP are all positive and precisely estimated. Largecountries export more of all kinds of goods, both those with high transport costs and those with
low transport costs. This is consistent with results for standard gravity models, in which bilateralexports are increasing in exporter income.
More illuminating is to compare results on log relative exporter size for treatment andcontrol industries. The average coefficient on exporter GDP is 1.48 for the treatment industries
and 1.06 for the control industries. This is suggestive of home-market effects: larger exporters
have high exports of high-transport cost, low-σ goods relative to their exports of low-transportcost, high-σ goods.

B. Pooled Industry Sample: Main Results
Table 5 shows estimation results for equation (11). The dependent variable is, for two
countries, log relative exports of a treatment (high-transport cost, low-σ) industry minus log
relative exports of a control (low-transport cost, high-σ) industry. We begin by pooling data
across the 273 (21x13) treatment and control industry matches in the data. Pooling imposes theunrealistic assumption that coefficients are constant across industry matches, but is useful for
gauging overall support for home-market effects. Below, we relax this restriction. The sample
for each industry match is exports by 107 country pairs to 58 large importing countries. Eachregression includes dummy variables for the industry match and adjusts standard errors to allow
for correlation in the disturbances across observations of the same exporter pair.
The specifications in Table 5 differ in terms of their functional form. In Section I.A (and19the appendix), we show that we can approximate for the log relative number of product varieties
produced by two countries, the term ( n%mj / n%mh ) /( n%oj / n%oh ) in equation (10), with an increasing
function that is linear in polynomials of (Yj/Yh -1) or ln(Yj/Yh). This approximation result gives us
the specification in equation (11), in which relative exports are a function of relative exporter
size. In Table 5, we experiment with functional forms for f() in equation (11). Column 1
includes ln(Yj/Yh) and its square as regressors, column 2 includes (Yj/Yh -1) and its square as
regressors, and columns 3 and 4 include ln(Yj/Yh) or (Yj/Yh -1) alone.
In all regressions, relative exports are increasing in relative exporter GDP. This implies
that larger countries export more of high-transport cost, low-σ goods relative to their exports of
low-transport cost, high-σ goods and is consistent with a home-market effect as stated in
Propositions 1 and 2. The square terms on relative exporter size are statistically insignificant (asare higher order polynomials) and we drop them in later regressions. The coefficient estimate onln(Yj/Yh) is precisely estimated in all specifications and the coefficient estimates on (Yj/Yh – 1) is
precisely estimated when its square is excluded as a regressor. Since the specification with log
relative exporter GDP is closest to the standard gravity model, we adopt column 3 as ourpreferred specification. In this specification, log relative exporter GDP has a coefficient estimateof 0.42. This implies that if one exporter is 10 percent larger than another exporter, then thelarger country will on average have export shipments of high-transport cost, low-σ goods that are
4.2 percent higher than the shipments of the smaller country, where these values are normalized
by the two countries’ relative shipments of low-transport cost, high-σ goods.
Coefficient estimates on other regressors are consistent with results from gravity model
estimation. Relative exports of high-transport cost, low-σ goods are decreasing in relative
distance and higher for neighboring countries. This suggests, quite sensibly, that exports of20

high-transport goods are more sensitive to distance than are exports of low-transport goods. That
coefficients on log relative capital stocks, log relative average education levels, and log relative
land area are positive suggests that relative exports of high-transport cost, low-σ goods are also
higher for countries that are more abundant in physical capital, human capital, and/or land. This
makes sense if low-σ goods (e.g., iron, steel, non-metallic minerals) tend to be intensive in theuse of capital relative to high-σ goods (e.g., consumer electronics, machinery).

C. Pooled Industry Sample: Additional Results
In Table 6, we continue with the pooled sample of industry matches and experiment withadding additional regressors, changing the sample of importer countries, and redefining theselection criterion for treatment and control industries. Column 1 includes the market potential
variable as a regressor (see note 22).

While relative GDP remains positive and precisely

estimated, market potential is negative and precisely estimated. This is consistent with an
agglomeration shadow: all else equal, home-market effects appear to be weaker in countries thathave larger neighbors. Large countries may pull high-transport cost, low-σ industries out of theirsmaller neighbors, leaving such industries less concentrated in these countries than in other small
countries. However, unreported results suggest that the results on market potential are sensitive
to which industries are included in the sample. If we drop the 5 treatment industries in SITC 66(non-metallic minerals), the coefficient on market potential rises from -1.02 to -0.69 and is nolonger statistically significant (the coefficient on log relative exporter GDP falls slightly to 0.38
and remains highly significant). While there is some evidence of an agglomeration shadow, it
appears to be confined to a subset of the treatment industries.
Columns 2 and 3 in Table 6 restrict the sample of importing countries to be either the 15
or 7 largest importers. In either case, log relative exporter GDP remains positive and statistically21significant, with coefficient estimates of 0.42 to 0.49. These samples contain fewer zero tradevalues than the sample of 58 large importers. That results are similar for these different samplesof importers suggests that zero industry trade values are not having excessive influence on the
results.
Columns 4-6 in Table 6 change the selection criterion for treatment and control
industries. The original treatment group was industries with freight rates in the top 30 percent
and substitution elasticities in the bottom 30 percent.

We now impose a more-restrictive

selection criterion for the treatment industries, requiring freight rates to be in the top 20 percent
and substitution elasticities in the bottom 15 percent. This leaves 9 treatment industries (666,678, 625, 676, 677, 672, 673, 661, 662). The original control group was industries with freightrates in the bottom 20 percent and substitution elasticities in the top 30 percent. We also imposea more-restrictive selection criterion for the control industries, requiring freight rates to be in thebottom 15 percent and substitution elasticities in the top 15 percent (where we again use
asymmetric cutoffs on freight rates for treatment and control industries). This leaves 6 control
industries (541, 752, 761, 764, 762, 759). In column 4, we match the more-restrictive groups oftreatment and control industries. For comparison, in column 5 we match the more-restrictive
treatment industries to the original control industries and in column 6 we match the original
treatment industries to the more-restrictive control industries.

In all three regressions, thecoefficient on log relative exporter GDP is positive and precisely estimated, ranging in value
from 0.43 to 0.46. For the pooled industry sample, the results on home-market effects areunaffected by making the industry-selection criterion more restrictive.
So far, we have seen that the evidence of home-market effects is robust to changes in
specification, the sample of importers, and the industry-selection criterion. The coefficient22estimate on log relative exporter GDP is positive for industry matches in which theory suggests itshould be positive. By extension, the logic of Propositions 1 and 2 suggests that were we toestimate equation (11) on a sample of randomly matched industries, the coefficient on relative
exporter GDP should be zero. To verify this, we perform an additional exercise, which isreported in the final two columns of Table 6. First, we construct a data set of all 561 matches of
the 34 industries (21 treatment, 13 control) in our sample. Second, we randomize which industry
is the “treatment” industry (industry m, which is in the numerator of the dependent variable inequation (11)) and which industry is the “control” industry (industry o, which is in the
denominator of the dependent variable in (11)). Third, we estimate equation (11) on this sample
of industry matches with randomly selected treatment industries. Fourth, we repeat steps twoand three 1,000 times (yielding 1,000 coefficient estimates on relative exporter GDP).
Table 6 reports the mean and standard error of coefficient estimates on relative exporter
GDP for these 1,000 regressions. Column 7 shows results for 1,000 repetitions on all industry
matches. Column 8 shows results where we only match original treatment industries to originalcontrol industries and randomize which industry is the “treatment” industry (i.e., which industry
is in the denominator of the dependent variable). In either case, the mean coefficient estimate on
relative exporter GDP is effectively zero (less than 0.00003) with relatively large standard errors(greater than 0.00006). For randomly matched industry pairs, we find no evidence of homemarket effects.
To summarize the results of this section, for a pooled sample of treatment and control
industry matches we find strong evidence of home-market effects. For a range of specificationsof equation (11), log relative exporter GDP is positive and precisely estimated. Larger countries
have higher exports of high-transport cost, low-σ industries than they do of low-transport cost,23

high-σ industries.

D. Industry-by-Industry Samples
We also estimate equation (9) separately for each of the 273 (21x13) treatment andcontrol industry matches in the data;24 i.e. we allow the coefficients to vary across industry
matches. The dependent variable remains, for a pair of countries, log relative exports of atreatment industry minus log relative exports of a control industry and the independent variables
are as in Tables 4-6. For expositional ease we summarize in Table 7 the coefficient estimates onlog relative exporter GDP for all the 273 regressions as well as for the 4 subsets of regressions
with more- and less-restrictive treatment industries matched to more- and less-restrictive control
industries. The detailed results for each industry match are available upon request. The sample isexports by 107 country pairs to the 58 largest importing countries. Results using the sample ofeither the 7 or 15 large importers are very similar to those we report below.
Of the 273 regressions the coefficient on relative exporter GDP is positive in 234 (86percent) of the cases and positive and statistically significant at the 10 percent level in 159 (58percent) of the cases. Sample sizes for the industry-by-industry regressions are much smaller
than those for the pooled industry regressions in Tables 5 and 6, and there is a corresponding loss
in the precision of coefficient estimates. Among the 4 subsets of regressions, evidence for homemarket effects is strongest for the matches of more-restrictive treatment and control industries.
These are the matches for which the theoretical case for home-market effects is clearest. For
these more-restrictive industry matches, the coefficient estimate on relative exporter GDP ispositive in all cases and statistically significant at the 10 percent level in 74 percent of the cases.
Results are similar for matches between less-restrictive treatment industries and more-restrictive
control industries. Coefficient estimates on relative exporter GDP are positive in 99 percent of24

cases and statistically significant at the 10 percent level in 75 percent of cases.
Evidence of home-market effects is weakest for matches involving the less-restrictive
control industries. Of these industries, there are two, Camera Supplies (SITC 882) and Watches
and Clocks (SITC 885), for which there is little or no evidence of home-market effects. Matches
involving these two industries account for nearly all of the negative coefficient estimates on
relative exporter GDP in the 273 regressions. In the remaining industries, evidence of homemarket effects is much stronger. Table 8 summarizes results for these remaining 231 (21x11)
industry matches. Of these matches, the coefficient estimate on relative exporter GDP is positivein 98 percent of cases and positive and statistically significant in 68 percent of cases.

E. Discussion
Previous empirical literature tests for home-market effects either by (a) comparing
gravity-model estimation results for aggregates of differentiated- and homogeneous-productindustries, or (b) estimating the cross-country correlation between the supply of industry output
and the demand for industry output. The distinctive feature of our approach is that we compare
the correlation between relative exports and relative country size in explicitly chosen industry
pairs, as is consistent with our theoretical results on home-market effects in a many-industry
world. To see how these empirical approaches differ, we compare our results with representative
results from previous literature.
Our approach is similar in spirit to Feenstra, Markusen, and Rose (1998), which falls
under approach (a). They find that for the subset of manufacturing identified by Rauch (1999) as
differentiated-product industries, the elasticity of bilateral exports with respect to exporter GDP
is 1.07 (in 1990 for a sample of OECD countries). For homogeneous goods, which primarily
include non-manufacturing industries, this elasticity is 0.38. To compare their results to ours,
25take the difference of these two coefficient estimates, which approximates a single-difference
gravity regression in which the dependent variable is relative bilateral exports (for a single
exporter) of differentiated and homogenous products. This single-difference coefficient estimate
is 0.69, which is about two-thirds larger than our double-difference estimate of 0.42 for thepooled sample of industries (column (3), Table 5). The Feenstra-Markusen-Rose results are
qualitatively similar to ours, though their coefficient estimates on exporter GDP are somewhat
larger. In contrast to our approach, their approach does not control for importing-country
remoteness or tariffs and cannot detect variation in the strength of home-market effects acrossdifferentiated-product industries.
In one example of approach (b), Davis and Weinstein (2002) find evidence consistent
with home-market effects for many industries, including food products, textiles, leather, andwood products. These are industries with high-transport costs and large estimated substitution
elasticities. Our theoretical model suggests that they are poor candidates for either treatment orcontrol industries. Based on our approach, we would interpret evidence of home-market effects
for these industries as at best neutral support for the proposition that increasing returns influence
trade patterns. Davis and Weinstein (2003) find evidence inconsistent with home-market effects
for other industries, including paper and pulp, chemicals, non-metallic minerals, machinery, andtransportation equipment. Of this group, our selection criterion identifies pulp and paper andnon-metallic minerals as good candidates for treatment industries and we find evidence of homemarket effects in both cases. While a full evaluation of competing approaches to test for homemarket effects is beyond the scope of this paper, it is clear that the strategy one takes to identify
home-market effects matters for what one finds.

IV. Conclusion
26

In this paper, we develop a monopolistic competition model of trade with many industries
and show the conditions under which home-market effects obtain. We then test the predictionsof this model using a difference-in-difference gravity specification.
In our theoretical model, we show that the nature of home-market effects depends on thenumber of differentiated-product industries. In a world with many such industries, home-market
effects take the form of industries with higher transport costs and more differentiated products(lower substitution elasticities) being more concentrated in large countries than industries withlower transport costs and less differentiated products (higher substitution elasticities). In a world
with just two industries, the former type of industry concentrates in the larger country in absoluteand not just relative terms.
On the basis of our theoretical results, we develop a difference-in-difference gravity
specification. We test whether, across country pairs, the larger country tends to have higher
exports of goods in “treatment” industries (high-transport costs, low substitution elasticities) thanof goods in “control” industries (low-transport costs, high substitution elasticities).

The

difference-in-difference gravity specification sweeps out of the regression the effects of importtariffs, home bias in demand, importing-country remoteness, and the tendency for larger
countries to export more of all goods. Across all treatment and control industry matches, we findstrong evidence of home-market effects: the log ratio of relative treatment to control industry
exports is increasing in relative exporter GDP. Across individual matches of treatment andcontrol industries we find some variation in the strength of these effects. When we match
industries randomly (rather than on the basis of our theoretical selection criterion) the correlation
between relative exports and relative exporter GDP shrinks to zero.
Consistent with new trade theory, our results suggest that imperfect competition and27

increasing returns to scale affect patterns of trade between countries. Country size matters forindustrial specialization. Our results identify a set of industry characteristics that predict which
industries will be relatively concentrated in which countries. Of additional value, the approach
we develop in this paper is widely applicable as a test for home-market effects. It is grounded ingeneral-equilibrium trade theory and, within the confines of the monopolistic competition model,
imposes few restrictions on the number of industries or on parameter values. Also, our approach
has modest data requirements and can be applied to data sets that are publicly available.

28

Appendix

A. Derivation of equation (4).
By (1), p(z)/p*(z) = w/w* = w (w* is normalized to 1) and q(z) = q*(z). Since n% (z) ≡ n(z)w andn% *(z) ≡ n*(z)w* = n*(z), (2) can be simplified as:(A1)

n% ( z )c( z )σ ( z ) = α ( z )Y

n% ( z )n% ( z )+ α ( z)σ (z)−1*n% ( z ) + n% ( z ) w x( z )n% ( z ) + n% ( z ) ⋅ wσ ( z ) x( z )*( n% ( z ) + n% ( z ) ) c( z )σ ( z ) = α ( z )(Y + 1)
*

Thus,
(A2)

n% ( z ) =Yx( z )2 − wσ ( z ) (1 + Y ) x( z ) + 1 α ( z )x( z ) 2 − ( wσ ( z ) + w−σ ( z ) ) x( z ) + 1 c( z )σ ( z )Plugging (A2) into (3):Yx( z )2 − wσ ( z ) (1 + Y ) x( z ) + 1
α ( z )dz
0 x ( z ) 2 − ( wσ ( z ) + w−σ ( z ) ) x ( z ) + 1

Y= ∫

1

1

⇔ ∫ α ( z )(0Yx( z ) 2 − wσ ( z ) (1 + Y ) x( z ) + 1− Y )dz =0x( z )2 − ( wσ ( z ) + w−σ ( z ) ) x( z ) + 1

Y ( x( z ) − wσ ( z ) ) − wσ ( z ) ( wσ ( z ) x( z ) − 1)
α ( z )dz =00( x( z ) − wσ ( z ) )( x( z ) − w−σ ( z ) )

⇔ ∫

1

1

⇔ 0 = ∫ α ( z ) g ( z )dz , g ( z ) = [0Ywσ ( z )−]x( z ) wσ ( z ) − 1 x( z ) − wσ ( z )B. Derivation of g(z) = (1+Y)[h(z)/(h(z)+1) – Y/(Y+1)].
Since, h(z)/(h(z)+1) = n% (z)/( n% (z)+ n% *(z)), by (A1) and (A2),(1+Y)[h( z )Y−]h( z ) + 1 Y + 1
29=Yx( z )2 − wσ ( z ) (1 + Y ) x( z ) + 1–Yx( z )2 − ( wσ ( z ) + w−σ ( z ) ) x( z ) + 1=

Y ( x( z ) − wσ ( z ) ) − wσ ( z ) ( wσ ( z ) x( z ) − 1)
= g(z).
( x( z ) − wσ ( z ) )( x( z ) − w−σ ( z ) )C. Proof of Lemma 1.
Denote the right-hand side of (4) by R(w). It is easy to verify that if R′(w) exists, R′(w) < 0 for
all values of w and Y.
(C1) It is easy to verify that R(1) > 0. If w > 1 and w rises towards min [ x( z )]1/ σ ( z ) , R(w)approaches −∞ . (Notice that x( z ) wσ ( z ) − 1 > x( z ) − wσ ( z ) since w > 1.) This establishes that (4)always has a solution such that 1 < w < min [ x( z )]1/ σ ( z ) .
(C2) It is easy to verify that R() > 0 if w > max [ x( z )]1/ σ ( z ) .

If min [ x( z )]1/ σ ( z ) < w <max [ x( z )]1/ σ ( z ) , R(w) is ill defined since ∃ z such that x(z) – wσ(z) = 0. Thus, the solution in (C1)is the unique solution for w > 1.
(C3) It is easy to verify that R(0) = 0. As w rises from 0 towards min [ x ( z )]−1/ σ ( z ) , R(w) falls
towards −∞ . When w falls from 1 towards max [ x( z )]−1/ σ ( z ) , R(w) rises towards +∞ . If
min [ x ( z )]−1/ σ ( z ) < w < max [ x ( z )]−1/ σ ( z ) , R(w) is ill defined since ∃ z such that x(z)wσ(z) – 1= 0.
Thus no w < 1 can solve (4).

D. Proof of Proposition 2.
(D1) Since Y/[x(z)wσ(z) – 1] decreases with σ(z) and wσ(z)/[x(z) – wσ(z)] increases with σ(z), g(z)decreases with σ(z). This establishes part (1).

30

(D2) The statement is true if holding σ(z) constant, g(z) increases with x(z). Drop the index z.
Let g1 ≡ Y /( q1w − 1), q1 ≡ xwσ −1 , g 2 ≡ 1/( q2 / w − 1), q2 ≡ xw1−σ . Then dq1 = q1dx, dq2 = q2dx, and
wq1 – 1 > q2/w – 1 > 0. Normalize dx to 1. Then:(A3)

dg = dg1 – dg2 =[dq2 ] / w
w[dq1 ]
−Y2
(q2 / w − 1)
( wq1 − 1) 2

∝ (wq1 – 1)2[dq2] – Y(q2 – w)2[dq1] = (wq1 – 1)2q2 – Y(q2 – w)2q1

It is easy to verify that Y = g1(wq1 – 1), 1/g2 = (q2 – w)/w and w2σ – wq1 = wq1(w/q2 – 1).
(A4)∴ –(q2 – w)2Yq1 = q2(wq1 – 1)( w2σ – wq1)

g1
g2

Plug (A4) into (A3), we have:(A5)

dg ∝ (wq1 – 1)2q2 – Y(q2 – w)2q1= q2[wq1 – 1][(wq1 – 1) + ( w2σ – wq1)

∝

g1
]
g2

Y [ x( z ) / wσ ( z ) − 1] 2 w2σ ( z )
g w2σ
Y
)
[1 − ( 1 ) 2] ∝ 1– (x( z ) wσ ( z ) − 1
Y
g1
g2
Y

By Proposition 1, g() increases with x(z) around z* such that g(z*) = 0, and so dg > 0 when g1 =g2, and (A5) is positive. Then if g(z0) < 0 so that g1(z0) < g2(z0), (A5) remains positive, and dg >0 for z0. If g(z1) > 0, then clearly g(z1) > g(z0); if g(z1) < 0, then g() also increases with x(z) at z1,and so g(z1) > g(z0). On the other hand, if g(z0) > 0 and (A5) is positive for both z0 and z1, thendg > 0 for both industries, and g(z1) > g(z0).

E. Approximation of h(z) as linear in polynomials of lnY and Y-1.
Combining equation (4) and the definition of g(z), we obtain

31

(A6)

h( z )
Y1wσ ( z )wσ ( z )
=
+
−
(1 +
)
h( z ) + 1 Y + 1
x( z ) wσ ( z ) − 1 x( z ) − wσ ( z )x( z ) − wσ ( z )=Yx( z )2 − 1wσ ( z )−Y + 1 ( x( z ) − wσ ( z ) )( x( z ) − w−σ ( z ) ) x − wσ ( z )If Y = 1, then h(z) = 1 for all z (i.e., if the 2 countries are of equal size, then they produce thesame numbers of varieties for each good). Around h0 = 1, a first-order Taylor approximation ofh(z)/(1+h(z)) yields h(z)/(1+h(z)) ≈ h0/(h0+1) + [h(z) – h0]/(1 + h0)2 = (h(z)+1)/4. Likewise,around Y = 1, Y/(Y+1) ≈ (Y+1)/4. Plugging these into (A6):(A7)h(z) ≈ aY + ba=x( z ) 2 − 1x( z ) 2 − 1
4wσ ( z )
−
−1
,
b
=
( x( z ) − wσ ( z ) )( x( z ) − w−σ ( z ) )( x( z ) − wσ ( z ) )( x( z ) − w−σ ( z ) ) x − wσ ( z )Take the log of (A7) and then approximate ln(Y+b/a) using a first-order Taylor approximation
around Y =1 so that ln(Y+b/a) ≈ ln(a+b)-lna+a(Y-1)/(a+b). Thus:(A8)lnh(z) ≈ ln(a+b) +

a
(Y-1)
a+b

Let ln(a+b) = H(Y, z) (the dependence of a and b on Y is through w). Then around Y = 1, ln(a+b)≈ H(1, z) + H ′ (1,z)(Y-1). Since both H(1, z) and H ′ (1, z) are independent of Y, denote them asconstants c1 and c2. Thus, ln(a+b) ≈ c1 + c2(Y – 1). Likewise, a/(a+b) ≈ c3 + c4(Y – 1). Plugging
these two expressions into (A8), we have:(A9)lnh(z) ≈ c1 + c5(Y – 1) + c4(Y – 1)2, c5 = c2 + c3

Since the c’s depend on z but not Y, equation (A9) is an approximation of lnh(z) by thepolynomials of Y – 1. To use the polynomials of lnY instead, note that around Y = 1, lnY = ln(Y –1 + 1) ≈ Y – 1. Thus (A9) becomes:(A10) lnh(z) ≈ c1 + c5lnY + c4(lnY)2, c5 = c2 + c3

32

Higher-order approximations can be obtained analogously.

33

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of Economic Research (Cambridge, MA) Working Paper No. 6804, November 1998.

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Fujita, Masahisa; Krugman, Paul and Venables, Anthony J. The Spatial Economy: Cities,
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Holmes, Thomas J. and Stevens, John J. “The Home Market and the Pattern of Trade: RoundThree.” Federal Reserve Bank of Minneapolis Staff Report No. 304, 2002.
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38

*

Hanson: IR/PS 0519, University of California San Diego, 9500 Gilman Drive, La Jolla, CA 92093-0519 (e-mail:gohanson@ucsd.edu, phone: 858-822-5087, fax: 858-534-3939). Xiang: Purdue University, Economics, KRAN, 403
West State Street, West Lafayette, IN 47907-2056 (e-mail: cxiang@mgmt.purdue.edu, phone: 765-494-4499, fax: 765496-1778). The authors thank two anonymous referees, Richard Baldwin, John Bound, Alan Deardorff, Robert Feenstra,David Hummels, and seminar participants at the CEPR, the Fall 2002 Midwest International Meetings, the University ofMichigan, Purdue University, UCSD, and the University of Florida for valuable suggestions.
1

On the observational equivalence of scale economies and comparative advantage, see also Glen Ellison and

Edward L. Glaeser (1997) and Hanson (2001). On trade and scale economies, see also Simon J. Evenett andWolfgang Keller (2002).
2

There is debate about the robustness of the home-market effect in Krugman (1980). Davis (1998) finds that with

one differentiated-product industry (with positive fixed costs), one homogeneous-product industry (with zero fixed
costs), and identical industry transport costs the home-market effect disappears. Krugman and Venables (1999)
counter this result by showing that the home-market effect exists as long as some homogenous goods have lowtransport costs or some differentiated goods have zero fixed costs.
3

To be precise, they find that for an aggregate of differentiated-product industries the elasticity of bilateral exports

with respect to the exporting country’s GDP exceeds the elasticity of bilateral exports with respect to the importing
country’s GDP, but for homogeneous-product industries the reverse is true.
4

For regressions on individual industries, they find that about half exhibit a home-market effect.

5

Mary Amiti (1998) and Krugman and Venables (1999) examine the case of two monopolistically competitive,

differentiated-product industries. Thomas J. Holmes and John J. Stevens (2002) depart from the monopolisticcompetition framework and allow for a continuum of industries that have common transport costs and varying
returns to scale. They find that goods with strong scale economies are subject to a home-market effect and that
goods with weak scale economies are non-traded. See Feenstra, Markusen, and Rose (1998) for results on homemarket effects in a two-sector, reciprocal dumping model of trade.
6

An additional advantage of our approach is that by using national income, distance, and other gravity variables asregressors we lessen concerns about simultaneity in the estimation.

39

7This assumption is not as onerous as it may seem. Consider two examples. First, suppose Y is large. It might seemthat sectoral specialization would occur as in Helpman and Krugman (1985). However, in their model, nonspecialization implies that the relative wage equals one, so that relative goods prices cannot adjust as Y changes. In
our model, w is free to adjust as Y changes, so that relative goods prices are also free to adjust and specialization at
the sectoral level doesn’t occur. Second, suppose industry z0 has a high effective trade cost. It might seem thatexporting z0 from the large country to the small country is unprofitable, so that z0 is not traded. However, ice-berg
transport costs tend to keep export sales unchanged, so that quantities remain positive even when prices are high.
Thus, z0 will be traded.
8This is also the intuition for Lemma 1. Suppose w ≤ 1. Then relocating to the large country offers not onlysavings in trade costs but lower production costs, in which case every firm has an incentive to relocate. Clearly, thiscannot be an equilibrium.
9Previous studies have focused on the roles of σ and τ and found the effects of σ on industry concentration in thelarge country to be non-monotonic: holding τ constant, both very high and very low values of σ work against homemarket effects (Krugman and Venables, 1999). This is because σ affects both production and trade costs. The
savings in trade costs are too small for sectors with very low σ, and the extra production costs too large for thosewith very high σ. However, if we hold x constant (i.e., if we vary τ with σ such that x is unchanged) lowering σ
always raises industry concentration in the large country.
10

To see the logic behind (b), suppose σ is the same for all industries, and x(z0) is very high (so that x(z1) is evenhigher). Then the left-hand side of the inequality in Proposition 2 approaches 1 – Y/ w

2σ ( z0 )< 0 and Proposition 2

fails to hold. The intuition for this is that, although industries with very high effective trade costs (such as z1) arelikely to show home-market effects (by Proposition 1), goods in these industries are not much traded, making themlikely to be less concentrated in the large country than industries with intermediate values of effective trade costs(such as z0). See note 11.
11

By Proposition 1, industries with very high trade costs are likely to show home-market effects, but since goods inthese industries are not much traded, they might be less concentrated in the large country than industries withintermediate values of trade costs. In our empirical work, we restrict our control industries to the bottom 20 percentof the industry distribution of freight costs.

40

12

For analytical ease, we assume that the markup of price over marginal cost is a multiplicative function of

production costs, tariffs, and transport costs.
13

To be rigorous, Propositions 1 and 2 show that the ratio of relative exports exceeds 1 when country j is larger thancountry h. Consider a sequence of experiments, each involving the continuum-good model of Section I.A and arandomly drawn value for relative country size. Record the logs of the relative exports ratios of industry m and o in
all these experiments. These ratios are positive for cases with ln(Yj/Yh) > 0 (i.e. Yj > Yh) and negative for cases withln(Yj/Yh) < 0. A plot of the log of the relative exports ratios against ln(Yj/Yh) would reveal an upward-sloping
relationship. Thus, for a regression that is across country pairs for fixed industry pairs such as ours, Propositions 1
and 2 suggest that the relative exports ratio is increasing in relative market size.
14

Debaere (2002) finds that the gravity model fits better for OECD countries than for non-OECD countries. Thissuggests that drawing our sample of exporters from rich countries may aid in finding support for home-market
effects. Results may be weaker for a sample of poor-country exporters.
15

The European exporter countries are Austria, Belgium-Luxembourg, Denmark, Finland, France, Germany, GreatBritain, Greece, Italy, Ireland, the Netherlands, Norway, Portugal, Spain, and Sweden.
16

For this sample, 85 percent of the observations have non-zero values for all four components of the dependent

variable. To preserve information on zero trade values, we follow Jonathan Eaton and Akiko Tamura (1994) andassume countries with zero bilateral imports of a good actually import minute quantities, which we set to one. The
results are unaffected by dropping observations that contain zero trade values from the sample.
17

Theory would suggest using effective trade costs, x=τσ-1, to select industries. Actual transport costs depend on

both unit shipping costs and distance shipped. It is difficult to translate these two dimensions into a scalar measureof τ, as would be necessary to calculate x. Proposition 2 states that when comparing low σ to high σ industries, x
should be at least as large in the former as in the latter. To achieve this, we limit low σ industries to those with highfreight rates and high σ industries to those with low freight rates.
18

We allow intercepts to vary across three-digit SITC industries and slopes on distance to vary across two-digit

SITC industries. We estimate this regression on four samples of U.S. imports: with U.S. border countries andwithout U.S. border countries (with two different cutoffs on minimum exporter size).

We use the mean ofcoefficient estimates across these four samples to estimate the freight rate for an industry.

41

19

Median distance for the country pairs in our sample is 8008 km. Our results are robust to using instead a distancevalue of 4004 km to construct estimates of freight rates.
20

Hummels’ (1999) estimate of σ for all manufacturing is similar to other results. We use Hummels’ OLS

estimates. He also reports IV estimates, which yield higher values of σ for the industries in our sample.
21

For other applications of market potential see Hanson (2001) and Stephen Redding and Venables (2002).

22

Using coefficient estimates on the distance variable from the gravity model in Hummels (1999), we set λ equal to0.92. These estimates of the gravity distance coefficient are similar to results in many other empirical studies. We
obtain similar results when using other values of λ. In the specifications in which we control for market potential,
we include both log relative exporter GDP and log relative exporter market potential as regressors (where we define
exporter market potential excluding own-country GDP).
23

Since the data include observations on relative income, distance, and other variables for given exporter pairs

across many importing countries, we correct the standard errors to allow for correlation in the errors acrossobservations that share the same exporter pair.
24

Since the regressors do not vary across industries, there is no gain to estimating equation (9) jointly across pairs oftreatment and control industries (OLS is just as efficient as GLS).

42

Table 1: Summary Statistics

Variable
Exports

Mean-0.005

Standard
Deviation
3.978

GDP

0.271

1.562

Market Potential-0.1240.400

Distance

0.067

0.500

Common Language

0.029

0.279

Common Border-0.013

0.192

Capital per Worker-0.172

0.501

Wage in Low-Skill Industries-0.046

0.504

Land Area/Population

0.120

1.525

Average Education-0.065

0.311

Notes: Data are for 1990. Trade data are by country and three-digit SITC industry. Allvariables are differences in log values for pairs of exporting countries (except for common
language and common border, which are level differences in dummy variables). The exporter
pairs are Australia-New Zealand, Canada-United States, and all pair wise combinations of theset, Austria, Belgium-Luxembourg, Denmark, Finland, France, Germany, Great Britain, Greece,
Italy, Ireland, the Netherlands, Norway, Portugal, Spain, and Sweden. The importing countries
are the 58 largest importers.

43

Table 2: Industry Freight Costs and Substitution Elasticities (σ)
Control Industries: Low Transport Costs, High σ
SITC Industry
Freight Rateσ
541 Pharmaceuticals
0.03159.53
752 Computers
0.0333
11.02
761 Televisions
0.0364
9.44
884 Optical Lenses
0.0405
8.13
764 Audio Speakers
0.0407
9.44
762 Radios
0.04089.44
759 Computer Parts
0.042011.02
514 Nitrogen Compounds
0.04757.50
881 Cameras
0.04778.13
751 Office Machines
0.0481
11.02
882 Camera Supplies
0.04888.13
885 Watches and Clocks
0.04908.13
726 Printing Machinery
0.0495
8.52
Treatment Industries: High Transport Costs, Low σ
SITC Industry
Freight Rateσ
671 Pig Iron
0.10103.53
621 Rubber and Plastics
0.1037
3.57
674 Iron Sheets
0.10993.53
679 Iron Castings
0.1118
3.53
665 Glassware
0.11192.65
663 Mineral Mfg.
0.1135
2.65
666 Pottery
0.12292.65
678 Iron Tubes
0.13103.53
642 Paper Products
0.1313
4.25
812 Sanitary and Plumbing
0.1317
4.40
625 Tires
0.1321
3.57
676 Steel Rails
0.13683.53
641 Paper and Paperboard
0.13684.25
677 Iron Wire
0.13803.53
672 Iron Ingots
0.1404
3.53
635 Wood Manufacturing0.14203.99
673 Iron Bars
0.1557
3.53
821 Furniture
0.1573
3.64
634 Wood Panels
0.1594
3.99
661 Cement
0.21172.65
662 Clay
0.2721
2.65
44

Table 3: Quantiles for Industry Freight Costs
Percentile
10
20
30
40
50
60
70
80
90

Freight Rate
0.04050.05120.06240.07290.08290.09220.10370.11440.1318Notes: See text for details on how freight rates are constructed.

45

Table 4: Single-Difference Gravity Estimation Results

Low-Transport
Cost Industries
541
Pharmaceuticals
752
Computers
761
Televisions
884
Optical Lenses
764
Audio Speakers
762Radios759
Computer Parts
514
Nitrogen881
Cameras751
Office Machines
882
Camera Supplies
885
Watches, Clocks
726
Printing Machin.

Relative
High-Transport
GDP
Cost Industries
0.835
671
(5.32)
Pig Iron
1.097
621(6.42)
Rubber, Plastics
1.155
674
(12.68)Iron Sheets
1.217
679
(6.49)
Iron Castings
1.188
665
(9.47)
Glassware
0.997
663(10.46)
Mineral Mfg.
0.914
666
(6.33)
Pottery
1.053
678(6.60)
Iron Tubes
1.132
642
(6.51)
Paper Products
0.849
812
(3.82) Plumbing Fixtures
1.709
625
(12.24)
Tires
1.637
676
(15.47)
Steel Rails
0.032
641
(12.89) Paper, Paperboard

RelativeGDP
1.505(7.73)
1.411(12.55)
2.390(11.75)1.432(15.68)1.521(12.02)
1.259(11.77)1.471(20.00)1.842(15.73)
1.555(12.78)1.226(20.05)1.355(14.07)1.214(8.10)
1.654(7.16)

High-Transport
Cost Industries
677
Iron Wire
672
Iron Ingots
635
Wood Mfg.
673
Iron Bars
821
Furniture634
Wood Panels
661
Cement662
Clay

RelativeGDP
1.455(8.31)
1.360(21.26)
1.174(22.14)1.841(10.92)
1.380(25.50)1.202(8.02)
1.195(10.61)
1.692(12.84)

Notes: This table shows coefficient estimates on log relative exporter GDP from regressions inwhich the dependent variable is log relative industry exports for a pair of countries. T-statistics(calculated from standard errors that have been adjusted for correlation of the errors acrossobservations that share the same pair of exporting countries) are shown in parentheses. Coefficient46

estimates on other regressors (see text) are suppressed. For each industry, the sample is relative
bilateral exports by 107 country pairs to 58 large importing countries (5115 observations).

47

Table 5: Difference-in-Difference Gravity Equation, Pooled Sample of Industries

Independent Variablesln(GDP)ln(GDP)2(1)
0.420(3.46)
0.026(0.72)

GDP – 1

Common Language
Common Border
Capital/Worker
Wage in Low-Skill Industries
Area/Population
Average Education
Constant

R Squared

(3)
0.420
(3.45)

0.105(1.71)
0.000(-0.03)(GDP - 1)2

Distance

(2)

(4)

0.104
(4.40)-0.273(-5.01)-0.420(-3.39)0.888(10.33)
1.697(4.62)-1.897(-8.37)0.253(2.43)-3.090(-7.03)-0.260(-1.80)-0.264(-4.95)-0.346(-2.65)0.811(8.91)
1.819(4.53)-1.730(-7.33)0.160(1.97)-3.492(-7.95)-0.308(-2.13)-0.275(-5.07)-0.422(-3.34)0.893(10.13)
1.699(4.69)-1.901(-8.35)0.243(2.32)-3.139(-7.22)-0.191(-1.51)-0.264(-4.99)-0.345(-2.81)
0.811(9.13)
1.819(4.49)-1.729(-8.00)0.159(2.12)-3.496(-8.88)-0.306(-2.44)

0.077

0.074

0.077

0.074

Notes: This table shows estimation results for the specification in equation (11), in which thedependent variable is, for a pair of countries, log relative exports in a treatment industry minus log
relative exports in a control industry. GDP is the GDP ratio for a country pair. Other variables are
expressed as differences (Common Language, Common Border) or log differences (all othervariables) for a country pair. T-statistics (calculated from standard errors that have been adjusted

48

for correlation of the errors across observations that share the same pair of exporting countries) arein parentheses. The sample is exports by 107 country pairs to 58 importing countries pooled
across the 273 treatment-control industry matches in the data (N=1,396,395).

49

Table 6: Difference-in-Difference Gravity Equation, Additional Results
Regressors
GDP
MarketPotential
Distance
CommonLanguage
CommonBorderCapital/Worker
Low-Skill
Wage
Area/
Population
Average
Education
ConstantN
R Squared

(1)
0.333
(2.98)-1.019(-2.53)(2)
0.420(2.96)(3)
0.493(3.45)(4)
0.461(4.08)(5)
0.429(3.80)(6)
0.452(3.77)-0.308(-6.18)-0.324(-2.74)
0.818(10.33)2.009(5.21)-1.833(-9.06)0.006(0.04)-3.080(-7.70)-0.206(-1.90)0.195(2.08)-0.618(-4.09)1.250(8.52)
2.70(6.70)-2.260(-7.99)0.189(1.50)-2.697(-5.60)-0.156(-1.06)0.519(4.75)-1.334(-6.85)1.357(9.10)
2.076(5.17)-2.422(-9.66)0.258(1.99)-2.446(-5.37)-0.186(-1.30)-0.249-0.363(-4.06) (-7.25)-0.433-0.471(-3.60) (-3.50)
0.896
0.919
(8.02)(9.25)
1.398
1.493(4.34)(4.37)-2.654-2.360(-12.09) (-10.85)
0.037
0.085
(0.37)(0.89)-4.914-3.950(-12.01) (-9.95)-0.190-0.160(-1.62) (-1.37)-0.161(-2.59)-0.384(-3.33)0.870(8.56)
1.604(4.86)-2.195(-9.98)0.195(1.84)-4.103(-9.71)-0.220(-1.78)1396395
0.082

3445260.112

1629810.1322762100.1416444900.1085984550.1(7)0.00003(0.00007)(8)
0.00002(0.00010)----

Notes: This table shows results in which the sample or specification is modified relative to theregression in column (3) of Table 5, which we refer to as the preferred regression. See notes toTable 5 for other details on the estimation. Column (1) adds log relative market potential to thepreferred regression. Columns (2) and (3) change the sample in the preferred regression by
restricting importers to be the 15 (column 2) or 7 (column 3) largest importing countries.
Columns (4), (5), and (6) change the sample in the preferred regression by restricting treatmentcontrol industry matches to be more restrictive treatment to more restrictive control industries(4), more restrictive treatment to all control industries (5), or all treatment to more restrictive
50

control industries (6). Columns (7) and (8) change the sample and specification in the preferred
regression by randomly matching industries (where industry pairs are either the full set of
possible industry matches (7) or the initial treatment-control industry matches (8)), rerunning thedifference-in-difference gravity regression, and then repeating the exercise 1,000 times.

51

Table 7: Summary of Industry-by-Industry Regression Results

All Industry Matches

No. ofCases
273

Share of Regressions withp-value<0.1
β>0
0.857
0.582

More-restrictive TreatmentMore-restrictive Control

54

1.000

0.741

Less-restrictive TreatmentMore-restrictive Control

72

0.986

0.750

More-restrictive TreatmentLess-restrictive Control

63

0.762

0.460

Less-restrictive TreatmentLess-restrictive Control

84

0.726

0.429

Notes: This table summarizes the coefficient estimates on log relative exporter GDP for the
specification in column (3) of Table 5, in which we re-estimate the regression separately for eachof the 273 treatment-control industry matches in the data (N=5115 for each industry pair). It
shows, for all industry matches or subsets of industry matches, shares of regressions with apositive coefficient estimate and with a positive coefficient estimate that is statisticallysignificant at the 10 percent level. The more restrictive treatment industries are 666, 678, 625,
676, 677, 672, 673, 661 and 662. The less restrictive treatment industries are 671, 621, 674, 679,
665, 663, 642, 812, 641, 635, 821 and 634. The more restrictive control industries are 541, 752,
761, 764, 762 and 759. The less restrictive control industries are 884, 514, 881, 751, 882, 885
and 726.

52

Table 8: Summary of Regressions without Industries 882 and 885

All industries

No. ofCases
231

Share of Regressions withp-value<0.1
β>0
0.978
0.680

More-restrictive TreatmentMore-restrictive Control

54

1.000

0.741

Less-restrictive TreatmentMore-restrictive Control

72

0.986

0.750

More-restrictive TreatmentLess-restrictive Control

45

0.956

0.644

Less-restrictive TreatmentLess-restrictive Control

60

0.967

0.567

Notes: This table summarizes regression results in a way that is similar to Table 7, except that all
the matches involving industries 882 and 885 have been dropped from the sample. See notes toTable 7 for other details.

53

1

Cumulative Distribution

.75

.5

.25

0
.5

1
1.5
2
2.5
Relative Log GDP, Exporter Pairs

3

3.5

Figure 1: Distribution of Relative Exporter GDP

54

.3
662

Industry Freight Rate

661

.2

0

821 634673
672 635641
677
625
812
642
678
676

666
664
663
665

679
674
621
671
0

.1
0

0

0

0
0
0 0
00
0
00
00
0
00
0
0
0
0

0
0

0
0
0
0

00
0
0
000
0
0
0

0
0
0
0
0
0

0
0

0
0
00

0

0 0
0 0
0
0
0
00
00
0 0
0 0
0
0 0
0 0 00 0
00 0
00
0
0

0
0
0
00
0

0

0
0
00 0
0
0
0
0
0
0 0
885
882
881 726
884

762
764
763
761
542
541

751
759
752

0

0
1

3

5
7
Industry Substitution Elasticity

911

Figure 2: Distribution of Industry Freight Rates and Substitution Elasticities

55