How does an increase in market size, say due to globalization, affect welfare? We study this question using a model with monopolistic competition, heterogeneous markups, and fixed costs. We characterize the change in welfare in the decentralized equilibrium, and decompose it into changes in technical efficiency and allocative efficiency. Allocative efficiency changes due to three different types of reallocations: (1) reallocations across firms with heterogeneous price elasticities due to increased entry, (2) reallocations due to the exit of marginally profitable firms, and (3) reallocations due to changes in firms’ markups. Whereas the second and third effects have ambiguous implications for welfare, the first effect, which we call the Darwinian effect, always increases welfare regardless of the shape of demand curves. We non-parametrically calibrate residual demand curves with firm-level data from Belgian manufacturing firms and quantify our theoretical results. We find that mild increasing returns at the micro level can catalyze large increasing returns at the macro level. These aggregate gains are due to the Darwinian effect, which reallocates resources from low- to high-markup firms, and not the death of unproductive firms (2) or changes in markups (3). Our results suggest that a policy-maker can harness Darwinian reallocations in an economy with fixed resources by subsidizing firm entry
