The home market effect in a home-biased geography

Abstract

A demand-side mechanism for international trade, the Home Market Effect (HME), predicts a more-than-proportional relationship between domestic expenditure and domestic production. Yet, since its inception in the 1980s by Paul Krugman, this theoretical result has only been shown to be generally valid in two-location models. I prove that the HME is maintained in an arbitrary number of locations provided the geography of trade is home-biased: the majority of domestic sales go to domestic consumers. Intuitively, without home bias, increasing domestic expenditure can actually benefit foreign production more, thus causing domestic production to rise by less, violating the more-than-proportional relationship. This result has been overlooked until now because in standard two location models all geographies are necessarily home-biased.