Home Market Effect

A trade theory which argues that countries that exhibit higher demand for some products locally tend to record higher sales of the same products in foreign markets

Written by CFI Team

Published September 20, 2020

Read Time 4 minutes

What is the Home Market Effect?

The home market effect is a trade theory that argues that countries that exhibit higher demand for some products locally tend to record higher sales of the same products in foreign markets.

Home Market Effect

The home market effect hypothesis was first hypothesized by Stephan Linda (1961) and later formalized by Paul Krugman (1980). From a policy standpoint, the home market effect implies that the protection of imports may promote exports, an analogy often more popular among communities than among economists.

The home market effect shows a relationship between a country’s market size and industrial specialization and is considered a central tenet of the New Trade Theory.

Key Highlights

The home market effect is an international trade hypothesis that examines the causal effect of cross-country differences in demand.
It overcomes the challenge of explaining the relationship between a country’s exports and market size, as seen in comparative advantage models.
The majority of empirical studies that used real-world data to test the home market effect confirm the hypothesis that higher demand for a product at home tends to increase its sales abroad and that this effect can make that country a net seller of the product.

Understanding the Home Market Effect

The home market effect describes the tendency of large countries to specialize in sectors with high economies of scale and shows a proportional relationship between a country’s share of world output and its share of world demand for those products. It describes the tendency for large countries to focus on exporting products that incur high trade costs due to economies of scale and transport costs.

The hypothesis further suggests that it is economically prudent to concentrate the production of a single product line in a single geographic zone when fixed costs are present. The logic behind such an approach is that increasing production would yield economies of scale.

At the same time, it is economically viable to establish production in an area with high product sales, even in the presence of transport costs.

The home market effect considers larger or richer countries as the monopolies of large production bases because of (1) higher demand for the product; and (2) higher gross domestic product. The pattern is based on the market effect of high-population or rich countries.

Implications of the Home Market Effect Model

The home market effect describes the relationship between exports and market size. Typical comparative advantage trade models can hardly explain such a relationship. The home-market theory also elucidates the concept of the accumulation of manufacturing activity in specific zones, even within countries.

Under the assumptions of the presence of economies of scale and transport costs, the model implies that trade surplus abounds for countries with a large demand for a particular product.

It also means that larger countries with a high demand for quality products tend to specialize in such product lines and eventually trade more with rich countries.

Another implication of the models is that smaller countries will end up producing products with low economies of scale and low transport costs since other trade factors are offset by low wages.

Validity of the Home Market Effect

An overwhelming number of empirical studies on the theoretical framework demonstrate the causal effect of cross-country differences in demand. Previous international trade theories were criticized because most products exported by capital-rich countries were labor-intensive.

Such aspersions on the comparative advantage of labor and capital led to the home market effect model. Subsequent studies that followed Krugman’s idea used real-world data to test the model’s validity. Against such a backdrop, the home market effect is known to be a phenomenon whose market effects depend on transport costs and the direction of returns to scale.

For example, the pharmaceutical sector can be shown to experience a robust home-market effect. A rich country whose population is likely to be affected by a particular illness is also expected to demand pharmaceutical products targeting the disease.

The elasticity of a country’s foreign sales of pharmaceuticals can be significant enough to convert countries with greater demand for the same medications into net sellers.

It shows that sector-level economies of scale substantially drive demand elasticity, rather than a low elasticity of demand. Other industries with high transport costs and high substitution elasticities include leather, textiles, and food products.

Impacts of the Home Market Effect on Business

The home market effect states that areas with strong local demand for certain products can produce products with high economies of scale. Managers should keep abreast of the observation and consider it when locating production facilities.

The benefits of being close to broader domestic markets with high demand may outweigh other benefits associated with a location. The home market effect may also help investors effectively make future and current plans for a business’s location.

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