The home-market effect and bilateral trade patterns: A reexamination of the evidence Cong S. Pham a, ⁎, Mary E. Lovely b , Devashish Mitra c a School of Accounting, Economics and Finance, Deakin University, 221 Burwood Highway, Burwood, 3125 Victoria, Australia b Department of Economics, Syracuse University, Eggers Hall, Syracuse, NY 13244, United States c Department of Economics, Syracuse University, 133, Eggers Hall, Syracuse, NY 13244, United States article info abstract Article history: Received 20 June 2013 Received in revised form 22 October 2013 Accepted 22 October 2013 Available online 9 November 2013 This paper finds that the evidence for the home market effect (HME) found by Hanson and Xiang (AER, 2004) is sensitive to the way the dependent and the independent variables are constructed. Second, we also find that the HME evidence goes away when we estimate their difference-in-difference gravity model on a truncated sample of positive trade flows. With Eaton–Tamura–Tobit, Heckman, and Helpman–Melitz–Rubinstein estimation of the gravity equation using Hanson and Xiang's data, we are unable to find any evidence for the HME. Finally, the HME evidence is also absent for a sample of Canadian provinces' exports to U.S. states. All of our results, taken together, do not reject the existence of the HME in general but rather suggest that the HME results found by Hanson and Xiang may not be robust. © 2013 Elsevier Inc. All rights reserved. JEL classification: F12 F14 Keywords: Gravity equation Home-market effect Zero trade flows 1. Introduction Hanson and Xiang (2004) develop a multi-sector, monopolistic competition model and use it to reveal a systematic relationship between the strength of the home-market effect and industry characteristics. 1,2 The multisectoral nature of their model, by suggesting “treatment” and “control” sectors, allows them to devise a difference-in-difference gravity approach to empirically test the home-market effect. The home-market prediction is that industries with high transport costs and low substitution elasticities (more highly differentiated products) will tend to be more concentrated in large countries than industries with low transport costs and high substitution elasticities. Hanson and Xiang treat the former industries as “treatment” industries and the latter as “control” industries. Using this innovative approach, they are able to address major econometric concerns about earlier tests of the home-market effect, including possible correlation between industry demand and supply shocks and a failure to control for “remoteness” of exporting and importing countries, both of which can lead to biased coefficient estimates. Because Hanson and Xiang's approach provides a novel and potentially quite useful methodological breakthrough, we examine the robustness of their findings to changes in data handling, changes in sample, and changes in estimation procedure. Overall, the International Review of Economics and Finance 30 (2014) 120–137 ⁎ Corresponding author. Tel.: +61 3 924 46611. E-mail addresses: cpham@deakin.edu.au (C.S. Pham), melovely@maxwell.syr.edu (M.E. Lovely), dmitra@maxwell.syr.edu (D. Mitra). 1 HME: the home-market effect; OLS: ordinary least squares; ET-Tobit: Eaton–Tamura Tobit. 2 Note that the HME hypothesis is an important prediction of new trade theory and new economic geography. Empirical studies on the HME include for example Head and Ries (1998), Behrens et al. (2009) and Kamal, Lovely, and Ouyang (2012). It is important here not to view the HME hypothesis in international trade as analogous or similar to the equity home bias puzzle in international finance. The latter refers to the fact that individuals and institutions in most countries hold modest amounts of foreign equity in their portfolios. See, for instance, French and Poterba (1991), Jinlan (2009) and Fugazza, Giofre, and Nicodano (2011). 1059-0560/$ – see front matter © 2013 Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.iref.2013.10.005 Contents lists available at ScienceDirect International Review of Economics and Finance journal homepage: www.elsevier.com/locate/iref