ABSTRACT
Two principal theories have been developed to explain why countries or regions trade. Comparative advantage believes that trade arises to take advantage of differences in resource endowments, while increasing returns maintains that trade arises to take advantage of specialization and scale economy. The recent increasing-returns models, labeled ‘economic geography’ by Krugman, allow researchers to distinguish comparative advantage from increasing returns by testing the impact of home market demand on a country’s production and trade. As Davis and Weinstein (1999) put it, in a world of comparative advantage, a country with strong demand for a good will import that good. In a world with increasing returns, when trade costs exist, a country with strong demand for a good makes that country the site of production and the exporter of the good. In other words, the extra demand in the home market leads to large-scale production and high efficiency, and creates exports. This core concept of new economic geography is labeled by Krugman (1980) as ‘home-market effects’.
