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Journal of Economic Integration 2011 March;26(1) :81-109.
Technology Advantage and Home-market Effect: An Empirical Investigation
Yo-Yi Huang and 
Deng-Shing Huang 
Institue of Economics, Academia Sinica
Academia Sinica
Copyright ©2011 Journal of Economic Integration

According to the conventional home-market effect, free trade tends to shrink the market share for a small economy in differentiated manufacturing goods, and in the extreme leads to a complete hollowing-out of the industry in a small economy. This paper considers the technology difference between countries using the standard Helpman-Krugman model. We will show that the home-market effect can be offset and even reversed if the smaller economy is characterized by better technology. The effect of a technology advantage is composed of two parts: a direct effect from lower unit costs that leads to a higher output level of each firm, and an indirect effect through a change of survival firms after trade. Based on theoretical results we derive the gravity equation to undertake empirical tests on the hypothesis of home-market effect, and direct and indirect technology effects using the stock of each country's patent registered in US in 2002 for six industries ranging from the most technology-intensive semiconductor industry to the most labor-intensive apparel and clothing industry. Empirical results show that the degree of home-market effect varies from industry to industry. The reversal of the home-market effect due to counteracting direct and indirect technology effects is more likely to occur in technology-intensive industries. In this regards, any technology improving policy like R&D subsidies is always justifiable especially for a small open economy and for high-tech industries to prevent from being marginalized by a large economy.

JEL Classification: F12, F14, F15

Keywords: Home-market Effect | Technology Advantage | Gravity Equation
1. Behrens, K. (2005), Market Size and Industry Location: Traded vs non-Traded Goods, Journal of Urban Economics, 58, 24-44.
2. Branstetter, L. (2006), Is Foreign Direct Investment a Channel of Knowledge Spillovers? Evidence from Japan's FDI in the United States, Journal of International Economic, 68, 325-344.
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