What is the effect of the internal market?
The domestic market effect was initially assumed by Staffan Linder in 1961 and formalized by Paul Krugman in 1980. The central tenet of the assumption is that countries with larger sales of certain products domestically will tend to have sales. most important of these same products abroad.
Key points to remember
- The domestic market effect indicates that goods, which have large economies of scale and high transport costs, will tend to be produced and exported by countries with high domestic demand.
- The internal market effect is part of the new trade theory and was developed to explain evidence from world trade models that seemed to contradict comparative advantage.
- Studies have confirmed the appearance of effects on the domestic market and the type of economic factors that influence them.
- Businesses and investors should consider the possible benefits of the effects of the domestic market on the choice of location.
Understanding the effect of the internal market
The internal market effect is part of the new trade theory, which relies on economies of scale and network effects, rather than more traditional business models based on comparative advantage.
The domestic market effect describes the tendency of large countries to be net exporters of goods with high transport costs and strong economies of scale. He postulates that in the presence of fixed costs, which would allow economies of scale when increasing production, it makes sense to concentrate the production of a good in a single geographic location.
In addition, in the presence of transportation costs, it makes sense to locate this production in a place where the demand for goods is high. Since the richer countries and / or those with large populations would tend to have a higher demand for products, and because these countries will also have higher gross domestic products (GDP), the consequence of the effect of domestic market is that it is the larger countries that tend to be the ones with large production bases.
The domestic market effect thus explains a link between the size of the market and exports that cannot be explained by commercial models of comparative advantages. It also helps explain why manufacturing activity tends to cluster in particular places, even within countries.
- One implication of the model is that countries with high consumption of a particular item will often show a trade surplus in that industry (if economies of scale exist and transport costs are high).
- Another implication is that rich countries with a greater demand for high quality goods will tend to specialize in these goods and therefore tend to trade more with other rich countries.
- A third implication is that goods with low economies of scale and / or low transport costs will tend to be produced by smaller countries (where lower wages tend to compensate for other factors).
Much empirical research has been carried out on the subject and generally finds that there is evidence of an effect on the internal market. By the mid-20th century, earlier models of international trade based on countries’ comparative advantage and capital and labor endowments were challenged, on the basis of evidence that some capital-rich countries, such as US United, exported mainly labor-intensive products. .
The internal market effect was initially developed to explain this observation. After Krugman formalized the domestic market effect theory, later studies were able to test this explanation directly against real-world data. These studies have shown that domestic market effects occur and the direction of returns to scale (i.e. whether returns to scale increase, decrease, or are constant) and how much transport costs are high will increase or moderate the extent to which market effects are observed in a particular country or industry.
Implications for businesses and investments
The domestic market effect predicts that the production of goods with economy of scale / high transport cost can be done more efficiently in geographic locations with high local demand, rather than at high comparative advantage. Companies should take this into account when choosing the location of their production facilities; the benefits of proximity to large local markets may outweigh other costs associated with the location. Investors should also keep this in mind when considering the current and planned location of companies in which they may invest.