• We gratefully acknowledge helpful comments from Henry Y. Wan, Jr at the Asia-Pacific Economic Association Third Annual Conference (APEA 2007). The authors also thank the participants of seminars at National Sun Yat-Sen University and National Chung Cheng University. We are grateful to the editor and two anonymous referees for useful comments on the earlier version of this paper. Financial support from the National Science Council (Yo-Yi Huang: NSC 95- 2415-H-019-001 andDeng-ShingHuang: NSC 96-2415-H-001-015-MY2) is acknowledged. Any remaining errors are our responsibility.


According to conventional home market effects, free trade tends to shrink the market share for a smaller economy in differentiated manufacturing goods, and in the extreme, leads to a complete hollowing out of the industry. Departing from the original Helpman–Krugman modelling assumptions behind the home market effects, we introduce a technology advantage in terms of the difference in fixed cost and/or marginal cost between trading partners and prove that home market effects will be offset and even reverse if a small economy has better technology than another country. With a higher elasticity of substitution, the marginal cost advantage becomes more important if it is to dominate the home market effect. We also show that even with an identical country size, the intra-industry trade addressed in the existing literature may not occur; it will occur only if the technology differential lies within a certain range that is positively affected by the level of transport cost.