A Test of Trade Theories when Expenditure is Home Biased

Abstract

We develop and apply a criterion to distinguish two paradigms of international trade theory: constant-returns perfectly competitive models, and increasing-returns monopolistically competitive models. Our analysis makes use of the pervasive presence of home-biased expenditure. It predicts that countries' relative output and their relative home biases are positively correlated in increasing-returns sectors, while no such relationship exists in constant-returns sectors. We estimate country-level sectoral home biases through a gravity equation for international and intranational trade, and we use those estimates to implement our test on input-output data for six European Union economies.international specialisation; new trade theory; home-market effects; border effects