Studying the model of Krugman, 1991: the one in which good varieties are country-specific so that there is trade because in presence of increasing returns, each good is produced in only one country, I find its conclusions a bit counter-intuitive.

The model states that a country will specialize in the production of the good for which it has the larger home market, the so-called home market effect. Thus, a country will the larger home market for a given good will be a net exporter of that good.

Now, here is my question: let's analyze two European countries, i.e. Germany and Spain. For a given level of transportation costs, Germany will produce more varieties than Spain because it is larger (larger home market). If the EU Commission would propose the creation of a Single Market, i.e. a reduction of trade barriers, that we can interpret as transportation costs going down, will Spain accept?

  • $\begingroup$ This seems to depend on what Spain is trying to maximize and also on the dynamics of your model, as it is not clear what will happen after the single market is created. There are multiple equilibria towards which the model can converge. $\endgroup$ – Giskard May 15 '17 at 19:32

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