In 2008, Paul Krugman won the Nobel Memorial Prize in Economics for his contributions to the ‘‘new’’ trade theory and to the ‘‘new’’ economic geography (Krugman, 1980, 1991). Central to both of these theories are the so-called ‘‘home market effects’’ (HMEs). In a two-region economy, the HMEs predict that the larger region in terms of demand, in comparison to the smaller region: (i) attracts a disproportionately higher share of firms in the increasing returns sector (IRS) in relation to the share of demand it hosts (HME in the number of firms); (ii) uses disproportionately more factors of production in the IRS in relation to the share of demand it hosts (HME in employment); and (iii) runs trade surplus in the IRS (HME in trade patterns).

A central assumption in Krugman (1980) is that the costs of production are exogenous.1 We check the robustness of Krugman (1980) HMEs when the costs of production are endogenous. Costs of production are endogenized via process R&D investment that reduces marginal costs but increases fixed costs. In this set-up, we show that when the return on R&D is high, the larger region, relatively to the smaller region, does not disproportionately employs more labor nor attracts a disproportionately larger share of firms in the IRS in relation to share of demand it hosts (negative HMEs in the number of firms and in employment), but even so it always runs a trade surplus in the IRS (HME in trade patterns). In other words, while we continue to have a HME in trade patterns, we find negative HMEs in the number of firms and in employment, given that an increase in the market size of the larger region triggers a less than proportional increase in the number of local firms and factor employment.

Our paper then contributes to the theoretical and the empirical literature on HMEs. We contribute to the theoretical literature on HMEs, since we check the robustness of one of the assumptions in Krugman (1980): exogenous costs of production. Standard imperfect competition models (Krugman, 1980; Brander, 1981 and Ottaviano et al., 2002) assume exogenous costs of production for analytical convenience. However, as we all know, the empirical evidence demonstrates that the costs of production are endogenous (Gustavsson et al., 1999; Aw et al., 2008; Glaeser et al., 2010). But further than just adding more realism totrade-geography models, our results point out that the assumption of exogenous costs of production is not innocuous.