out of the profits generated by the increasing returns sector<sup>4</sup> . This model suggests that a large internal market may provide a path to development, even in the absence of trade. The middle class, which determines the size of this market, is the result of an initial wealth shock _and_ an initial relatively equitable distribution of firm ownership.

# **3 Empirical Strategy**

Bringing a highly stylized model to the data is challenging. As noted earlier, we know that the model is “wrong.” Accordingly, we do not attempt to test it against alternative hypotheses. Instead, our empirics are very much in the spirit of Leamer and Levinsohn (1995) who in their Chapter for the Handbook of International Economics encourage empirical researchers to “‘estimate, not test.” We use an empirical model inspired by the theoretical framework described in the previous section to estimate the threshold market size required to achieve sustained poverty reduction, and answer the questions posed in the Introduction related to the role of domestic and international market size in development. In line with this thinking, the empirical model includes only variables suggested by the theoretical framework.

Before we present the empirical model in detail, a couple of remarks are in order. First, the theoretical model is static in nature, but makes statements about an inherently dynamic process, the process of development. The estimation utilizes cross-country panel data for countries in which extreme poverty still exists at the beginning of the sample period.<sup>5</sup> The specifics of the empirical model will be explained in the next section, but we note here that identification of the parameters relies heavily on cross-country variation, as most of the key variables in the analysis (population, various measures of market size) move only slowly over time. However, they do move (otherwise there would be no development, i.e., poverty reduction), so that the time dimension of the data is essential for identification. Given the slow movement of most variables and the fact that our focus is on _sustained_ poverty reduction, and not on transitory changes, we do not utilize annual data, but employ 5-year windows instead.

Second, we do not measure increasing returns to scale by estimating production functions.<sup>6</sup> Our

> 4In a different context, Keane and Prasad (2002) provide cross-country evidence from the transition economies in the 1990s showing that domestic redistribution that reduced inequality promoted growth.

> 5Given that the focus is on the forces that set off the process of development, and not on the final outcome, we exclude countries that are already “developed” during our sample period. Developed countries may look today very different from when they started to develop, and one would need to go back in history and analyze historical data in order to understand their paths.

> 6Returns to scale have been empirically elusive (some of the reasons why empirical work may fail to find evidence for them even when they exist go back to the Klette and Griliches (1996) critique of revenue-based production function estimation). However, a recent literature has found indirect evidence for scale economies in several settings based on

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