PBM, October 2016

Home market as in textbook (Bowen, Hollander and Viaene)

The home market effect is a relative advantage for large countries in trade with smaller
countries. This effect arrives in monopolistic competition increasing returns to scale models
as a consequence of assuming transportation costs.
In this note we will assume that there are two sectors in the economy. The first sector is
assumed to be the type of industry we have already looked, a monopolistic competition
increasing returns to scale industry. The second industry is assumed to be a standard perfect
competition constant returns to scale industry. For the case of interpretation, the
monopolistic competitive industry is denoted manufacturing, while the perfectly competitive
industry is denoted agriculture. The home market effect in this type of model is that the
largest country will have a disproportionally large share of the manufacturing industry while
the smallest country will be relatively specialized in agriculture. In this note, a presentation of
the two sector model in line with the textbook is presented.

A two-sector model of trade and transportation costs.

The second industry in the model will be assumed to be a standard industry with constant
returns to scale production technology producing a homogenous good. We assume that this
industry produces one good with one unit of labour. Thus, there are two industries one with
monopolistic competition, CES preferences and increasing returns to scale and one with
perfect competition and constant returns to scale. We assume that unit labour requirements in
the constant returns to scale industry is one. Therefore it takes one unit of labour to produce
one unit of output. We will now introduce the very unrealistic assumption that trade is
costless in the homogenous good case and that trade costs are relevant only for the
differentiated good industry. Now if there is trade in the homogenous good industry, costs and
prices will be similar in this industry in the two countries. This allows us to use the
homogenous good as numeraire and we set prices equal to one in this industry. It follows that
wages are equal to one as well. We will now assume that there are two countries, (i,j=H,F)
which are similar in all respects except for their size. We will be interested in how
productions of the two goods are located in the two countries.
How is demand modeled in this case?
In the appendix we will formulate this as a two stage optimization problem. The first stage is
to choose between consumption of the homogenous good and an aggregate of the
differentiated good. This first stage therefore determines the expenditures on the homogenous
good and the aggregate of the differentiated good, respectively. In the second stage the
quantities of each variety of the differentiated good, given the expenditures on these goods,
are determined.
Consumers utility function is written

U = C a1 C m

N 1 1
C m = qi
i =1

The first equation is the overall utility function for consumption of Ca and the aggregate of
differentiated good Cm. The utility function is a standard Cobb-Douglas utility function. The
second equation is a CES function of the type we introduced above. This CES function has
the same characteristics as we have already described.
We will use the Ca good as numeraire and set its price level equal to 1. Prices on the
differentiated good are described with the price index above; written P. Consumers income
are their wage income. We therefore have the budget constraint:

Ca + PCm = L
We find expenditure shares for Ca and Cm as:
PCm = L

Ca = (1 )L
The above demonstrates that and (1-) are the expenditures for Cm and Ca respectively. The
expenditure share for Ca is the demand function for this good (given that prices equal 1). The
demand function for each variety of the differentiated good is:

qj =

p j Cm

( p )

1 1
i

It is shown in the appendix that this equals:

qj =

p j L
P1

The above is the same demand function that we arrived at in the one sector case except for the
fact that only a fraction, , of total income is used for the differentiated goods Cm.
When there is trade in the homogenous good, wages are equal to one. For the monopolistic
competition industry therefore, we can model firms behavior as in section 1. From the above

therefore, we can drop subscripts for each good and formulate the profit maximization
problem for firms in country i one of maximizing:

i = pi qi (bqi + f )
The difference between the above and the profit equation in the one sector model is that w=1.
Profit maximization therefore requires setting the derivative of the profit function with respect
to qi equal to zero:
d i
dp
= pi + i qi b = 0
dqi
dqi

dp q
pi 1 + i i = b
dqi pi
1
1
pi 1 = pi
=b


pi =

1
bqi
1

i =

Free entry allows determination of each firms production.

1

bqi f = 0
1

i =

1
bqi = f
1
1
qi =
f
b

The general demand function is demand for domestic goods and for imported goods. We write
them as:
pii Li
qii = 1
Pi

ji

p* ji Li
=
1
Pi

Since there are transportation costs, we have to take these into account.
Note from the above that quantities consumed by the consumers are determined as in the
model without transportation costs. In the demand functions therefore, pii are prices for

domestically produced goods in country i and pji are prices for goods produced in country j in
country i. The price index refers to prices faced by consumers in country i. The demand
functions have the same price elasticity, -. We have used the country identification i also for
wages. We will allow wages to differ between the countries.
The reason for using * is because of transportation costs. We will assume that transport of
goods from one country to the other is costly. There are many ways to introduce trade costs.
Here we will use the iceberg transportation costs approach. This approach assumes that a
fraction of each good is lost, or melts away, during transportation. Therefore only a part of the
good, 1/t, arrive, t>1. Or, formulated differently, for q* units to arrive, q*=q/t has to be sent.
Because of transportation costs, imported goods are more expensive than domestically
produced goods. Therefore the consumer price p*ji is different from the price charged by
producers in country j with the factor t. It follows that, p*ji=pjit.
The advantage of formulating transportation costs in this way is that one can disregard the
transportation sector. We merely assume that transportation is costly and that costs are real
and proportional to the quantity of goods transported.
This is why we introduced * above. It is important that one distinguish between the quantity
shipped and the quantity consumed when the iceberg approach is used.
For consumers in country i to consume a given quantity produced in country j, qji*, the
quantity qjit has to be sent.
Consumer prices for products from country j in country i are different from producer prices in
country i. Generally p*ji=pjit>pji. Also quantities differ since more goods have to be sent than
those that arrive. Therefore we also have q*ji=qji/t<qji. The price effect takes into account that
consumers pay more than the producer receives. The quantity effect takes into account that
larger quantities have to be sent than the quantity that arrives.
The demand functions for a producer in country i can therefore be written:
qii =
q =
*
ij

pi Li
1
Pi
qij
t

( pit ) L j
Pj

qij =

pi t1 L j
Pj

The first equation is the demand from consumers in country i for goods produced in country i.
The last equation is demand from consumers in country j for goods produced in country j as
perceived from the producers. This is therefore export demand for producers in country i.
We have similar demand functions for producers in country j. These are:

p j L j

q jj =

Pj

p j t1 Li

q ji =

Pi

Also note that the price indices, Pi and Pj, must be adjusted for transportation costs. The
resulting price index for country i is:

Pi = N i pi1 + N j ( p j t )

1
1 1

Now the sum of output from firms in country i and in country j is:

N i qi = N i qii + N i qij = N i

pi t1 L j
pi Li
N
+
i
1
1
Pi
Pj

N j q j = N j q ji + N j q jj = N j

p j t1 Li
1

Pi

+ Nj

p j L j
Pj

Above, when there are two subscripts, the first refer to the producing country and the second
refers to the consuming country. When we use one subscript, it refers to the producing
country. We have normalized wages to be equal to one. We also normalize prices to be equal
to one. Finally we denote t1- =T. t>1 is the quantity that has to be sent for one unit to arrive. T
is t raised to the power of 1-<0. Note therefore, that when t increases (reflecting higher
transportation costs), T decreases. Generally T<1. If t=1, then T=1.
Consider the pricing equation:

pi =

We have set w=1. This denotes reflects that it takes one unit of labour to produce one unit of
output in the agricultural sector. We can also normalize quantity in the manufacturing
industry so that pi=1.

Now insert for the above assumptions and notation to achieve:

N i qi = N i

Li

1
i

N jq j = N j

+ Ni

T L j
Pj

L
TLi
+ N j 1j
1
Pi
Pj

Furthermore, note that:

= (N i + N jT )

Pi

Pj

= (N iT + N j )

Therefore:
N i qi = N i

(N

N jq j = N j

Li
i

+ N jT )

+ Ni

T L j

(N T + N )
i

L j
TLi
+ Nj
(Ni + N jT ) (NiT + N j )

This gives:

qi

TL j
Li
+
(Ni + N jT ) (NiT + N j )

qj

Lj
TLi
+
(Ni + N jT ) (NiT + N j )

Therefore:
TL j
Lj
Li
TLi
+
=
+
(Ni + N jT ) (NiT + N j ) (Ni + N jT ) (NiT + N j )
And:

Lj
TL j
Li
TLi

=
(Ni + N jT ) (Ni + N jT ) (NiT + N j ) (NiT + N j )
L (1 T )
Li (1 T )
= j
(Ni + N jT ) (NiT + N j )
Li (N i + N jT )
=
L j (N iT + N j )

Now, write L=Li/Lj and N=Ni/Nj. From the above, we obtain:

L=

N +T
NT + 1

Note that since L=Li/Lj and N=Ni/Nj, the share of total population in country i, , and the
share of the number of firms in country i, , are

Li
Lj

L
Li
=
=
L=
L
1
L +1
Li + L j Li
+ j
Lj Lj

Ni
Nj

Ni
=
=
N=
1
Ni + N j Ni N j N + 1
+
Nj Nj

This gives:

+T

T + 1

+ T (1 )
T + (1 )

We are now interested in calculating the share of the number of firms in country i, , as a
function of the share of the country is population, :

(T + (1 )) = ( + T (1 ))(1 )
T + = + T T T + T
= + T T T
(1 T ) = ((1 + T ) T )
=

1
((1 + T ) T )
1T

This is the same equation as equation 8.25 in the book.

First note that the above equation gives an increasing and linear relationship between and .
Now assume that the two countries are of equal size. In this case, =1/2. Then we obtain

1
1
1 1T 1
=
(1 + T ) T =
1T
2
2 1T 2

In this case, therefore, the two countries manufacturing industries are of equal size.
Assume now that country i is completely deindustrialized so that =0. This will be the case
when

(1 + T ) = T
min =

T
1+ T

This is therefore the minimum share of the population for country i consistent with existence
of manufacturing production there. Similarly, assume that country j is completely
deindustrialized. In this case, =1. This will be the case when:

(1 T ) = (1 + T ) T
max =

1
1+ T

This is the maximum share of population in country i that is consistent with manufacturing
production in country j. Since T<1, obviously max>min.
We also have:
d ( 1)(1 T ) ( + T T )( 1)
=
=
dT
(1 T )2

( 1)(1 T ) + ( + T T ) = ( 1) T ( 1) + + T ( 1) = 2 1
(1 T )2
(1 T )2
(1 T )2
Therefore, this derivative is positive if >1/2 and negative if <1/2. Remember that T
decreases with transportation costs. Therefore, if >1/2, so that country i enjoys the home
market effect, reducing transportation costs means increasing the home market effect. If <1/2,
so that country j enjoys the home market effect, reducing transportation costs, reduces country
is share of the firms and also increases the home market effect.
The relationship between relative population size and the number of firms is sketched in the
figure below:

Appendix

Consumers utility function is written

U = C a1 C m

N 1 1
C m = qi
i =1

The first equation is the overall utility function for consumption of Ca and the aggregate of
differentiated good Cm. The utility function is a standard Cobb-Douglas utility function. The
second equation is a CES function of the type we introduced above. This CES function has
the same characteristics as we have already described.

We will use the Ca good as numeraire and set its price level equal to 1. Prices on the
differentiated good are described with the price index above; written P. Consumers income
are their wage income. We therefore have the budget constraint:

C a + PC m = wL

The above constraint simply expresses that total expenditures on Ca and Cm equal income.
The optimization problem is constrained by the budget constrain and can therefore be solved
with use of the Lagrange method. The Lagrangian is:

L = C a1 C m (C a + PC m wL )

First order conditions are:

dL
= (1 )C a C m = 0
dC a
dL
= C a1 C m 1 P = 0
dCm

C m1C = P
1
C a = (1 )C m P
(1 ) C P
Ca =
m

From the first order conditions we obtained the three last equations above. The last equation
gives consumption of Ca as a function of prices and the aggregate consumption Cm. From the
budget equation we obtain:

(1 ) PC

+ PC m = wL

PC m = wL

C a = (1 )wL

The above demonstrates that and (1-) are the expenditures for Cm and Ca respectively.
This was the first stage budgeting. The second stage involves choosing each qi given
aggregate expenditures on the aggregate good Cm. We have established that aggregate
expenditures on Cm is wL. The corresponding Lagrangian for this constrained maximization
problem is:

L* = qi

( pi qi wL )

The * simply indicates that the above Lagrangian is different from the one above. The first
order conditions for optimisation good i and good j are:

1
1 1

L

1 1

=
p i = 0
qi
qi
qi 1

1 1 1

qi qi pi = 0

1 1 1

qi q j p j = 0

It is obvious that the structure of this problem is similar to that of maximizing U subject to the
budget constraint we described in the one sector case. Also in this case we obtain:

qi

qj

q
= i
q
j

p
q
i = i
q j p j
p
qi = q j i
p
j

pi
pj

The last equation above gives demand for good i as a function of demand for good j and their
relative price. Insert this expression into the sub utility function Cm to obtain:

N 1
C m = qi
i =1

1 1 N 1
q j p j pi

i =1

N p
= q j i
p
i =1
j

N 1

= q j p j 1 pi1

i =1

N
1
1

=
q
p
p

j
j
i

i =1

In the second equation the expression was inserted into the utility function. In the third
equation the expression was simplified somewhat. In the fourth equation we used the fact that

summation runs over i and not over j. The resulting equation can be solved for the demand for
good j:

qj =

p j Cm

( p )

1 1
i

Note that total expenditures on the Cm goods are E:

j =1

j =1

E = p jq j =

p 1j C m

N
1
= C m p 1j pi1
=
j =1
i =1

N 1 1
pi
i =1

N
1
C m pi1
i =1

Above, the last equation is valid since summing over all js and all is involves summing over
all goods and therefore over the same goods. Note that the last equation contain the same
expression as we have defined as the price index before, P:

N
1
P = pi1
i =1

From the first stage budgeting we also have the results that

Cm =

wL
P

The demand function can therefore be written:

qj =

p j Cm

( p )

1 1
i

p j wL

( p )
1
i

p j wL

( p )

1 1
i

p j wL

( p ) ( p )
1 1
i

1
1 1
i

p j wL
P1

The above is the same demand function that we arrived at in the one sector case except for the
fact that only a fraction, , of total income is used for the differentiated goods Cm.