Can the expansion of market size increase firm markup? Evidence from China

Traditional international trade theory suggests that a larger market size leads to more intense competition, thereby reducing firm markup. However, this conclusion does not hold in our research. Based on the theoretical model constructed by Melitz, this paper makes the following extensions: First, introducing the cost-saving effect outside of the competitive effect discussed in traditional international trade theory. Second, introducing a specific marginal cost function, which deepens the analysis of the operating mechanism. What’s more, earlier models focused solely on the market size of the industry itself (the target industry), whereas our analysis also takes into account the impact of the market size of its upstream and downstream industries. Our model indicates that the impact of market size on firm markup depends on the relative magnitude of the competitive effect and the cost-saving effect. With firm cost following a Pareto distribution, the expansion of market size leads to an increase in firm markup. In addition, this paper presents a spatial econometric model using industrial firms’ data from China. The results indicate that the promoting effect of market size on firm markup is more prominent among top-tier firms, state-owned firms, low export intensity firms, and firms in technology intensive industries.