Working Paper: NBER ID: w28969
Authors: Nuno Limão; Yang Xu
Abstract: We model the implications of the classical ideas that larger markets allow for a finer division of labor and this division feeds back into larger market size. Market size affects specialization due to firm-level increasing returns to scale arising from fixed costs of adopting intermediate-intensive technologies. The impacts are magnified in general equilibrium by an endogenous multiplier—due to input-output linkages in a roundabout structure—and a selection effect due to heterogeneous fundamental productivity and entry costs. \nMarket size expansions imply (i) larger real income gains than under fixed specialization; (ii) an increase in the aggregate variable cost share for intermediates and a decrease for labor; (iii) increased concentration; (iv) increased average productivity for survivors; and (v) an increase in the intermediate trade share. We derive similar results for intermediate productivity improvements. The effects in (ii)-(v) are absent in a similar model with exogenous specialization. \nIn a calibration to U.S. manufacturing in 1987-2007 we isolate trade and intermediate productivity shocks, quantify their effects. Trade cost reductions increased effective market size by 7 log points (lp) and generated (i) a real income gain 1.4 times higher than under exogenous specialization; (ii) increases in the intermediate share in production and trade of 2 lp and a reduction in the labor share of value added of similar magnitude. Two counterfactuals highlight the importance of industrial and trade policy. First, a tax that induces firms to specialize increases real income; so the initial equilibrium is inefficient. Second, an increase in trade costs of 16 lp—similar to the recent trade war—reduces market size and real income substantially: almost half way to trade autarky.
Keywords: market size; labor division; specialization; trade; productivity
JEL Codes: F1; F4; L11; O24; O25; O51
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Market Size (L25) | Real Income Gains (D31) |
| Market Size (L25) | Specialization (Z00) |
| Market Size (L25) | Productivity (O49) |
| Larger Firms (L25) | Lower Production Costs (D24) |
| Larger Market Sizes (R12) | Higher Concentration of Firms (L19) |
| Market Expansions (F69) | Increase in Aggregate Variable Cost Share for Intermediates (C43) |
| Market Expansions (F69) | Decrease in Labor Share (E25) |
| Trade Cost Reductions (F14) | Effective Market Size (D40) |
| Effective Market Size (D40) | Substantial Real Income Gains (E25) |