Home Market Effect Hypothesis in a Multi-Country World

The home market effect (HME) is commonly defined as a more than proportional positive causation from demand to supply. Recent theoretical literature, however, shows that the traditional definition highlighted within two-country framework does not always survive in higher dimensional settings. This is because ‘third’ country effects (i.e. adjustments in foreign expenditures) may reverse the positive impact that an increase in domestic demand has on its production. As such, empirical implementations of the HME hypothesis are problematic. In this paper, we try to fill this gap by proposing a revised version of the HME test, robust to an arbitrary number of countries. Using Behrens et al. (2004), which extends Krugman (1980) model to a multi-country setting, we derive a theory-founded empirical specification that accounts for a complete geographical structure of demand and proximity incentives offered to firms when choosing location sites to set up production facilities. We estimate the evolution of production structure in the EU countries for 24 manufacturing sectors over 1979-1999. We find support for the presence of the HME in a number of industries. The results also emphasize the importance of countries access to foreign markets.