Elasticity of Substitution, Small Enterprises and Economic Growth

This paper extends the Lucas (1978) model of firm formation by taking into account a normalised CES function in the production process. In a general equilibrium framework it is proved that there is an inverse relation between the value of the elasticity of substitution and average firm size. This relation is also valid, under fairly general assumptions, in steady state. If interpreted together with the fact richer countries are characterised by a higher elasticity of substitution this result can explain why the recent literature finds a positive association between the importance of SMEs in an economy and its stage of development but seems to fail in finding causality between the two. They have a common origin: a high value of the elasticity of substitution. The paper also provides a first empirical test of the theory proposed using econometric techniques