Outlook 2020: Research on Market Size and Patterns of Innovation
January 22, 2020
Much of my recent research aims to understand how market size affects R&D incentives of firms. In 2020, I intend to continue pursuing this research goal along several lines.
The idea that a bigger market size encourages more innovation and leads to faster productivity growth is not new. Indeed, the idea is central to most models of modern economic growth, including the seminal work of Paul Romer, the 2018 winner of the Nobel Prize in Economics. In its simplest form, however, these models predict that larger economies, measured in their GDPs, innovate more and hence grow faster in a cross-section of countries. This simple prediction, often referred to as “the scale effect in economic growth,” has been rejected empirically.
One possible reason for this is that the composition of market size does not matter in these models. In particular, it does not matter whether a large market size is due to a large population size or to a large per capita income. For example, the Netherlands is 10 times richer than Nigeria, but Nigeria is 10 times more populous, so that their aggregate market sizes are of the same magnitude. The standard scale effect would predict that Nigeria would innovate as much as the Netherlands. In my recent paper with Hélène Latzer and Mathieu Parenti, we modify the properties of consumer demand to account for some empirical evidence in an otherwise standard model of innovation and growth. It turns out that this leads to the prediction that, after controlling for the market size, a country with higher per capita income and a smaller population size innovates more and hence grows faster than a country with lower per capita income and a larger population size. Thus, the Netherlands innovates more and grows faster than Nigeria.
This year, I plan to enrich this theoretical framework further to generate more testable predictions.
The composition of the market size is also the key for understanding the patterns of innovation and trade across countries. When the sectoral composition of the market size differs across countries, and if the firms (or entrepreneurs or innovators) respond more to the domestic market than to the export market, the distribution of R&D efforts across sectors becomes different across countries. This creates the patterns of comparative advantage. In other words, countries end up developing their comparative advantage in sectors where there are relatively (to other sectors as well as to other countries) larger domestic demands. Paul Krugman, the 2008 winner of the Nobel Prize in Economics, called it the “Home Market Effect” (HME).
Once stated, this may sound obvious, but it was really a revolutionary idea. In classical trade theory, where the patterns of comparative advantage are determined independently of market size, having a larger market for some products makes the country more likely to import those products. But in the new trade theory with the HME, having a larger market for some products makes the country more likely to export those products. To give an example, the classical trade theory can explain why the Italian love for coffee makes Italy an importer of coffee, while the new trade theory can explain why the Italian love for coffee makes Italy an exporter of expresso machines. However, Krugman’s original formulation of the HME is highly stylized, and there have been some confusion in the existing literature as to how the HME manifests itself in general settings. In my recently published paper, I extend Krugman’s model and develop a more general HME model, which allows for the possibility that the composition of market size across an arbitrary number of sectors may depend on the per capita income of a country. While still restrictive, it generates some interesting, testable implications on the patterns of innovation and trade between rich and poor countries. This year, I am planning to push this line of research even further.
R&D can also be a source of economic fluctuations, as innovation often arrives in waves. Although many models have been developed to understand such fluctuation-generating mechanisms, the role of market size as a cause of economic instability has not received much attention. With Philip Ushchev, I am currently developing a theoretical model, which predicts that a larger market size leads to more instability. I hope to make progress on this project this year.
 Hélène Latzer, Kiminori Matsuyama, and Mathieu Parenti, “Reconsidering the Market Size Effect in Innovation and Growth,” CEPR-DP14250.
 Kiminori Matsuyama, “Engel’s Law in the Global Economy: Demand-Induced Patterns of Structural Change, Innovation, and Trade,” Econometrica, Vol. 87, No.2 (March 2019): 497-528.
 Kiminori Matsuyama and Philip Ushchev, “(De)stabilizing Effects of the Market Size in Innovation Dynamics,” Work in Progress.
Research on Market Size and Patterns of Innovation, Kiminori Matsuyama
Testing the Limits of Abe’s “Political Business Model,” Sota Kato
Repair the Fiscal Roof While the Sun Is Shining, Keiichiro Kobayashi
Teaching AI to Be More Like Us, Shigeki Morinobu
China’s Difficult Choices and Regional Repercussions, Ke Long