The Home Market Effect in International Arms Trade

I. INTRODUCTION A. International Trade Perspective Traditional models predict that international trade is driven by differences in factor endowments or production technologies, with each country exporting goods in which it has a comparative advantage. If we allow for variation in demand in this setting, we find that countries with higher demand for a good are net importers of that good. (1) In the monopolistic competition model, on the other hand, Krugman (1980) introduces scale economies and draws predictions about the direction of trade from variations in demand: differentiated, increasing returns to scale goods will be produced in, and exported from, the market that has higher demand for them. (2) This is the home market effect (HME)--a prediction that runs counter to the intuition drawn from comparative advantage models, and which can therefore be used to tease out the importance of economies of scale and transportation costs in determining international trade patterns. In practice, testing this effect poses significant endogeneity challenges. For most goods we have no measure of demand aside from revealed spending patterns, and these often respond to the same factors that impact the supply side. Therefore the typical approach has been to assume that individual citizens of different countries have identical preferences, and simply use country size to measure demand: in a pair of countries, the larger one is said to have higher demand for all goods; the HME is then the prediction that the large country exports more differentiated goods, whereas the small country exports more constant returns to scale, homogeneous goods. (3) In this article, I use government military spending to measure the demand for arms and ammunition, which allows me to account for variation in the patterns of demand across countries, while limiting potential sources of endogeneity. Results are no longer dependent on the absolute size of nations; instead, the model's empirical prediction is that countries with higher military spending as a share of gross domestic product (GDP) export more arms relative to homogeneous civilian goods. This represents a closer interpretation of the original HME formulation, and a more direct empirical verification of it. To elaborate further, standard treatments of the HME (as in Feenstra 2004; Helpman and Krugman 1985) are based on a monopolistic competition model of trade that has one homogeneous, constant returns to scale industry with zero transport costs, and one differentiated, increasing returns to scale industry with positive transport costs. Hanson and Xiang (2004) extend this model to allow for a continuum of differentiated-product industries. (4) They show that industries with high transport costs and low substitution elasticities (i.e., more product differentiation) tend to concentrate in the larger country, whereas industries with low transport costs and high substitution elasticities (i.e., less product differentiation) tend to concentrate in the smaller country. As in the standard treatment, they exploit differences in goods' characteristics and GDP to demonstrate the HME. However, this approach has its drawbacks; GDP is only a loose approximation of demand for most goods, because preferences are of course not identical across countries. This does not become an issue in Hanson and Xiang (2004), because a varied bundle of goods is considered on both the treatment and control sides, and in aggregation GDP does become a suitable proxy measure for demand. If we want to analyze a single good or a narrow set of goods, however, variation in demand patterns becomes a potentially confounding factor. The military sector in particular is an example where different countries exhibit vastly different spending preferences: consider for instance that Mexico is over six times the size of Israel in terms of GDP, but its military expenditure is less than I present a monopolistic competition model that builds upon that of Hanson and Xiang (2004), but includes a differentiated military sector in addition to the continuum of civilian industries. …