Market Integration and Industrial Structure: Home Market Effects Revisited

Abstract

Does market size matter for industrial structure? This paper generalises the theory on home market effects to reconcile the recent debate by allowing for an endogenous expenditure share on differentiated goods. It is shown that, in general, market size matters for industrial structure. Even when both sectors face identical transport costs, a "home market effect" can arise, disappear, or reverse in sign, depending on whether the elasticity of substitution between the homogenous good and the composite of differentiated goods is greater than, equal to, or less than one. It is also shown that a commonly used benchmark - the relative market size in a one-factor economy - for discussing trade and industrial structure is, in general, not correct. The results should change common perceptions about how market integration affects a country's industrial structure. In particular, it is not always correct to consider a country that ends up with a less-than-proportionate of manufacturing industry in market integration to be "de-industrialised".