DP15712 Darwinian Returns to Scale

Author(s): David Rezza Baqaee, Emmanuel Farhi
Publication Date: January 2021
Keyword(s): Allocative Efficiency, Incomplete pass-through, increasing returns, Market Size Effect, monopolistic competition
JEL(s): E0, L1, O4
Programme Areas: Industrial Organization, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15712

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.