Benjamin Faber, 2012, “Trade Integration, Market Size, And Industrialization: Evidence From China’s National Trunk Highway System,” LSE working paper.
Abstract: Krugman’s (1980) home market effect provided a microfoundation for the idea that market size is a determinant of industrialization. The same channel also has important implications for the consequences of falling trade costs between regions of uneven market sizes. This paper exploits China’s National Trunk Highway System as a natural experiment to test for the home market channel of trade integration. The network was designed to connect provincial capitals and cities with an urban population above 500,000. As a side effect, a large number of small peripheral counties were connected to large metropolitan city regions. To guide estimation, I derive qualitative and quantitative predictions from a tractable general equilibrium trade model. To test these predictions, I construct least cost path spanning tree networks as instruments for route placements on the way between targeted city nodes. In line with predictions, the results suggest that network connections had negative growth effects among peripheral counties due to reduced industrial output growth. The network is found to have increased the concentration of economic activity in China as a whole, and within its periphery. Results from a parameter grid search suggest that Krugman’s microfoundation can both qualitatively and quantitatively account for the observed effects.
