The Darwinian Returns to Scale

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Abstract: How does an increase in the size of a market, say due to fertility, immigration, or trade, affect welfare and real GDP? We study this question in the context of a model with heterogeneous firms, monopolistic competition, and increasing returns. An increase in the size of the market improves technical efficiency by inducing entry since fixed costs can be spread over more customers. More interestingly, an increase in market size also toughens competition and triggers Darwinian reallocations across firms: large firms expand, and small firms shrink or exit. Our analysis shows that changes in allocative efficiency, due to reallocations across heterogenous firms, are quantitatively much more important than the aforementioned change in technical efficiency. Using firm-level information, we non-parametrically identify residual demand curves, and using these estimates, quantify our theoretical results. We find that somewhere be-

tween 70 to 90% of the welfare effects of a change in population are due to changes in allocative efficiency. Furthermore, these reallocation effects are not driven by the oft-emphasized pro-competitive (markup-reducing) effects of market size.