Category Archives: Economic history

Market-size effects, across places and over time

The dividing line between neoclassical trade models and the now-quite-dated “new trade theory” is economies of scale. Neoclassical models feature constant (or decreasing) returns. Free trade is efficient in such settings. With the introduction of increasing returns, Brander, Spencer, Krugman, Helpman, and others “open[ed] the possibility that government intervention in trade via import restrictions, export subsidies, and so on may under some circumstances be in the national interest after all” (Krugman 1987).

The fact that “size matters” in new trade theory (size can influence the pattern of specialization because there are economies of scale) while it does not in neoclassical models became the basis for empirical investigations trying to distinguish these theories. Davis and Weinstein (2003) describe the idea behind this research strategy:

A fundamental divide may be identified between two classes of models. In the first class, unusually strong demand for a good, ceteris paribus, makes a country an importer of a good. An example would be a conventional two-sector neoclassical model with strictly downward sloping import demands. However, there is an alternative tradition within the trade literature which emphasizes an important interaction between demand conditions and production opportunities in which the production response to local demand conditions is so powerful that strong local demand for a product leads a country to export that product. When such conditions exist, the literature terms it a home market effect.

Stepping away from trade, there’s a very different economic context in which the role of market size is also crucial: the literature on innovation. The idea dates at least to Schmookler (1966) who memorably titled two of his chapters “The amount of invention is governed by the extent of the market.” It’s also key to endogenous growth theory. Acemoglu and Linn (2004) provided empirical evidence that market size influenced innovation in a particular sector:

This paper investigates the effect of (potential) market size on entry of new drugs and pharmaceutical innovation. Focusing on exogenous changes driven by US demographic trends, we find a large effect of potential market size on the entry of nongeneric drugs and new molecular entities… Our results show that there is an economically and statistically significant response of the entry of new drugs to market size. As the baby boom generation aged over the past 30 years… the data show a corresponding decrease in the rate of entry of new drugs in categories mostly demanded by the young and an increase for drugs mostly consumed by the middle-aged.

In “The Determinants of Quality Specialization“, I showed that high-income cities manufacture higher-priced, higher-quality goods in part because they are home to more high-income households who demand such products. Quantitatively, I found that the home-market effect plays at least as large a role as the factor-abundance mechanism in quality specialization across cities of different income levels.

What does this have to do with Acemoglu and Linn (2004)? I didn’t see much of a connection when I was writing my paper. Pharmaceuticals were just one of many industries in my data on US manufacturing plants, and pharmaceutical pills are probably less sensitive to trade costs than most goods. But I now see a closer relationship between looking for home-market effects in the cross section and looking for market-size effects in the time series.

The primary bridge is a recent QJE article by Costinot, Donaldson, Kyle and Williams. They used variation in disease burdens across countries as a source of variation in demand for drugs to look for home-market effects in international pharmaceuticals production. I’ve blogged about that paper before.

The latest connection is a paper by Xavier Jaravel called “The Unequal Gains from Product Innovations: Evidence from the U.S. Retail Sector”. His article investigates the time-series analog of my cross-sectional results on quality specialization. In recent decades, income growth has been concentrated at the top of the income distribution. Did the increase in the relative size of the affluent market benefit the affluent beyond the straightforward income gains? With economies of scale, increases in demand could induce supply-side responses that favor affluent-demanded goods. That’s the home-market-effect story for why high-income cities are net exporters of high-quality products: due to increasing returns, greater demand elicits a more-than-proportionate production response. Jaravel documents the time-series equivalent for national outcomes: “(1) the relative demand for products consumed by high-income households increased because of growth and rising inequality; (2) in response, firms introduced more new products catering to such households; (3) as a result, the prices of continuing products in these market segments fell due to increased competitive pressure.”

As a result, a two-by-two matrix neatly summarizes these contributions to the empirical literature on market-size effects:

Pharmaceuticals Vertically differentiated consumer goods
Time series Acemoglu & Linn (2004) Jaravel (forthcoming)
Cross section Costinot, Donaldson, Kyle, Williams (2019) Dingel (2017)

There’s an obvious relationship between the AL and CDKW papers, as explained by CDKW:

In their original article, Acemoglu and Linn (2004) exploit such demographic variation over time within the United States to estimate the impact of market size on innovation. Here, we employ the spatial analog of this strategy, drawing on cross-sectional variation in the demographic composition of different countries in a given year, to explore how exogenous variation in demand may shape the pattern of trade.

With the benefit of hindsight, some more subtle connections between the four cells of this two-by-two matrix seem pretty clear. For example, Jaravel’s adoption of the Acemoglu (2007) terminology for “weak bias” and “strong bias” in his footnote 3 mirrors the distinction between the weak and strong versions of the home-market effect introduced by Costinot, Donaldson, Kyle, and Williams (2019).

In summary, market-size effects seem to be important for understanding both innovation outcomes and the geographic pattern of specialization. We’ve found market-size effects in the time series and in the cross section, for both the pharmaceutical sector and vertically differentiated manufactured goods.

Harry Johnson on Staffan Linder

I haven’t seen a book review like this in some time. Harry Johnson didn’t hold back while expressing his opinion of Linder (1961). This is the closing paragraph of his rather blunt five-page review:

In summary, this is at once an ambitious, provocative, and provoking book-ambitious in the breadth and depth of the problems in trade theory it propounds and seeks to solve, provocative in the hypotheses it propounds, and provoking on account both of the perverse misinterpretations of existing theory that the author produces to support his claims to novelty and of the careless botch he makes of the exposition of his own alternative theories. The result is a volume that ought to be read by specialists looking for seminal ideas and interesting research problems,but that cannot be recommended for use by students insufficiently trained to be alert to the substitution of emotive debating points for reasoned argument and of irrelevance for logical analysis. [Economica, 1964]

What the Boston Tea Party wasn’t

Judge Vinson of the Northern District of Florida has ruled the federal individual health insurance mandate unconstitutional. His decision contains a bit of commentary about the Boston Tea Party. This isn’t a law blog, but I do cover economic history and protectionism. Vinson wrote:

It is difficult to imagine that a nation which began, at least in part, as the result of opposition to a British mandate giving the East India Company a monopoly and imposing a nominal tax on all tea sold in America would have set out to create a government with the power to force people to buy tea in the first place.

The 1773 Boston Tea Party was not a response to monopolization. The English Parliament had given the East India Company a monopoly on British tea since 1698; the American colonies had been required to import their tea only from Britain since 1721. It also wasn’t a response to a price hike. The nominal tax of three pence per pound was imposed by the Townshend Revenue Act of 1767 and renewed in 1773 (though most of the Townshend Act’s other taxes were repealed, the tea tax continued).

So what did cause the Boston Tea Party? A major source of opposition to the 1773 Tea Act was the fact that it lowered the price of imported tea and therefore hurt smugglers who had been illegally importing Dutch tea:

The Townshend Act forbade the [East India] Company from selling its goods directly to the colonists. Instead, the EIC had to auction merchandise to middlemen, who then shipped the cargoes to American wholesalers, who finally sold to local shop owners. In May 1773, Parliament, at the request of the EIC, passed the Tea Act. It imposed no new taxes, but rather allowed the Company, for the first time, to import tea directly from Asia into America. The act cut the price of tea in half and was therefore a boon to colonial consumers. The middlemen cut out by the act, local smugglers and tea merchants, were not as happy…

In November 1773, the East Indiamen Dartmouth, Beaver, and Eleanor entered Boston Harbor with the first loads of the EIC’s tea. The conspirators, probably led by Samuel Adams, were well prepared and highly disciplined: they cleaned the decks when they were finished and took no tea for personal use or later sale. [William Bernstein, A Splendid Exchange: How Trade Shaped the World, 2008, p.242]

Of course, the British claim to have the authority to tax the colonists also produced opposition, but they had been doing so for years. The most proximate change in 1773 was the threat to the economic self-interest of the middlemen and smugglers.

Addendum: LWS suggests this longer treatment of the topic in the New Yorker.

Irwin on Smoot-Hawley

Via the WSJ, we learn that Doug Irwin is writing a book titled The Smoot-Hawley Tariff and the Great Depression. It’s due next year from Princeton University Press.

While most economists do not hold the Smoot-Hawley tariff responsible for the Great Depression itself, it contributed to a sharp decline in world trade. The tariff slashed U.S. dutiable imports by about 15%, for example. Even worse, it spawned protectionism abroad…

The damage wrought by this tariff had only one silver lining. Ever since, the ghosts of Reed Smoot and Willis Hawley (a Republican congressman from Oregon) have stood in the way of anyone arguing for higher trade barriers. They almost singlehandedly made the term “protectionist” an insult rather than a compliment.

Presumably Professor Irwin’s 1998 REStat paper provides some preview of how he’ll approach the technical portion of the book:

In the two years after the imposition of the Smoot-Hawley tariff in June 1930, the volume of U.S. imports fell over 40%. To what extent can this collapse of trade be attributed to the tariff itself versus other factors such as declining income or foreign retaliation? Partial and general equilibrium assessments indicate that the Smoot-Hawley tariff itself reduced imports by 4-8% (ceteris paribus), although the combination of specific duties and deflation further raised the effective tariff and reduced imports an additional 8-10%. A counterfactual simulation suggests that nearly a quarter of the observed 40% decline in imports can be attributed to the rise in the effective tariff (i.e., Smoot-Hawley plus deflation).