Home market effects and increasing returns with non-constant marginal costs

Abstract We reexamine the role of increasing returns in production, central to trade and economic geography theories, focusing on the home market effect. We extend the conventional multi-industry new trade model to introduce (1) nonconstant marginal costs and (2) nonhomothetic production in factors. If factors that are more (less) intensively used in fixed costs than variable costs also have higher relative prices in large countries compared to small countries, then large countries exhibit larger (smaller) firm sizes and specialize in industries with decreasing (increasing) marginal costs. Notably, different levels of fixed costs have a limited impact on these patterns.