David Baqaee, Kunal Sangani, 14 August 2021

There are multiple mechanisms that drive aggregate increasing returns to scale. This column argues that the higher aggregate efficiency in larger markets may principally arise from a ‘Darwinian effect’ that causes high-markup firms to expand relative to low-markup firms as market size increases. This effect, which does not depend on the shape of the demand curve, means that additional firm entry can be valuable because it helps mitigate cross-sectional misallocation. Policymakers can harness this effect by incentivising entry, for example with a subsidy on entry costs. 

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