Historically, the size of an economy has coincided with its domestic market. However, in a globalized world, a country’s market may or may not coincide with its political borders. Market size is therefore defined as a combination of country size and foreign markets.
Economic research, in line with the current GCI, suggests two ways through which market size affects productivity: economies of scale in production and incentives for innovation.
In general, market size produces efficiency gains by allowing for specialization—an idea that remains as true today as when Adam Smith proposed it in 1776. Furthermore, large markets can take advantage of economies of scale in the production of goods and services. Public goods tend to have high fixed costs and low marginal costs, and consequently the per capita cost of services such as justice, defense, and infrastructure decreases in places where a greater number of taxpayers pay for them.93 Similarly, firms may also attain increasing returns to scale that enable them to produce more output with proportionally less input by using larger and more efficient capital equipment.94 As argued by Balassa (1967) and Kravis (1971) and modeled by Krugman (1979), economies of scale play a crucial role in explaining the postwar growth in trade, since extending the market through trade allows exploitation of economies of scale in production.95
The second driver of productivity is perhaps even more important: larger markets create substantially bigger incentives for generating new ideas. Larger stocks of resources increase the likelihood of finding new ways to use those resources, and a single idea can make more profit when it is sold in larger markets.96 On the same note, larger markets create positive externalities in the accumulation of human capital and transmission of knowledge because of increasing returns to scale embedded in technology or knowledge creation.97