Home Market Effects on Innovation

We model and estimate the home-market effect and study its implications for inequality within and across countries. The home-market effect occurs when exogenous differences in demand across countries generate endogenous differences in comparative advantages through technical change that is specific to a country and sector. Estimating it has proved difficult because econometricians do not directly observe exogenous differences in demand but only observe equilibrium expenditures, which also depend on supply-side characteristics. Our solution is to exploit non-homotheticity in preferences to construct instruments for the location of production, which determines comparative advantage through a home-market effect on innovation. Motivated by data, the model features factor-biased technologies and imperfect technology diffusion, which generate both Ricardian (endogenous relative productivity) and Heckscher-Ohlin-type comparative advantage (endogenous factor intensity). Because the production of income-elastic goods concentrates in rich, skill-endowed countries, technology diffusion implies that income-elastic goods in the model are endogenously more skill intensive in all countries. Home-market effects thus generate within-country inequalities through skill-biased technical change while they generate across-country inequalities because countries differ in their access to larger, richer markets. We explore counterfactual simulations using the estimated model to evaluate the effects of trade and technology diffusion on inequalities.