Export Conditions in Small Countries and Their Effects on Domestic Markets

Summary: This paper studies the impact of better export access on the domestic economy of small countries, where firms of all sizes commonly export due to the limited size of the home market. We propose and estimate a model where small firms, characterized as in monopolistic competition, coexist with large granular firms making quality investments. In our framework, better export access benefits large firms by expanding their sales volume and, hence, reducing their average quality costs. Simultaneously, they are adversely affected by increased domestic competition following entry by small firms. Estimating the model for several Danish industries shows that, while some large firms benefit from better export access, others are severely hurt by the tougher competition at home. In some cases, the latter effect is so pronounced that domestic market share is reallocated towards small firms and total industry profits decrease.