Home market effects with endogenous costs of production

In a standard imperfect competition model, we endogenize the costs of production of firms in the increasing returns sector (IRS) via process R&D. We show that firms in the larger region in terms of demand invest more in R&D (i.e.: they are bigger in size and have lower marginal costs) than firms in the smaller region, since the former exploit larger economies of scale in production to pay for the costs of R&D. As a result, when the return on R&D is high, the larger region does not employ disproportionately more labor nor attracts a disproportionately larger share of firms in the IRS in relation to share of demand it hosts, i.e.: negative home market effects (HMEs) in employment and in the number of firms. When this occurs, only partial agglomeration of the IRS in the larger region is sustainable in equilibrium. Even so, the larger region always runs trade surplus in the IRS, i.e.: HME in trade patterns. (C) 2012 Elsevier Inc. All rights reserved.