Working Paper: CEPR ID: DP15712
Authors: David Rezza Baqaee; Emmanuel Farhi
Abstract: How does an increase in the size of the market, say due to fertility, immigration, or globalization, affect welfare? We study this question using a model with heterogeneous firms, Kimball preferences, fixed costs, and monopolistic competition. We decompose changes in welfare from increased scale into changes in technical efficiency and changes in allocative efficiency due to reallocation. We non-parametrically identify residual demand curves with firm-level data from Belgian manufacturing firms and, using these estimates, quantify our theoretical results. We find that around 80% of the aggregate returns to scale are due to changes in allocative efficiency. As markets get bigger, competition intensifies and triggers Darwinian reallocations: socially-valuable firms expand, small firms shrink and exit, and new firms enter. However, important as they are, improvements in allocative efficiency are not driven by reductions in markups or deaths of unproductive firms. Instead, they are caused by a composition effect that reallocates resources from low- to high-markup firms.
Keywords: increasing returns; allocative efficiency; incomplete passthrough; monopolistic competition; market size effect
JEL Codes: E0; L1; O4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| market size increases (D40) | welfare increases (I38) |
| intensified competition (L13) | allocative efficiency increases (D61) |
| allocative efficiency increases (D61) | welfare increases (I38) |
| reallocation of resources from low-margin firms to high-margin firms (D21) | allocative efficiency increases (D61) |
| entry of new firms into the market (M13) | allocative efficiency increases (D61) |
| market structure and frictions (D49) | aggregate returns to scale (E23) |