Firm Heterogeneity, Home Market Effect, and Gravity Equation in an Oligopoly

Developing a two-country oligopoly model with firm heterogeneity, this paper examines the relationship among market size, the Home Market Effect, and the gravity equation. We show that in the long-run with free entry, the Home Market Effect holds, namely, more firms locate in the large-sized country. This leads the large-sized country to be a net exporter of the oligopoly good. In the short-run with restricted entry, the Home Market Effect no longer holds and the large-sized country becomes a net importer of the oligopoly good. These results suggest that the theoretical predictions of Feenstra et al. (Can J Econ 34(2):430–447, 2001) survive firm heterogeneity.