Optimal Firm Entry with Returns to Scale

We study the welfare implications of distortions, such as markups and returns to scale, when firm entry is slow to adjust, allowing quasi-rents to persist for longer. First, we present evidence on differences in speed of firm entry adjustment across US industries. In some industries, such as hospitality, firms respond rapidly to profit opportunities, arbitraging quasi-rent quickly. Whereas, in other industries, such as construction, entrants respond slowly, sustaining incumbents’ quasi-rents for longer. We develop a model of sluggish firm adjustment, which shows that the sluggishness of firm adjustment magnifies the welfare costs of distortions. We study a model with a fixed cost and increasing marginal cost such that a perfectly competitive equilibrium exists, and in the absence of distortions market and planner equilibrium coincide with firms operating at minimum efficient scale. We contrast outcomes when there is curvature on the demand-side of the economy from markups and curvature on the supply-side of the economy from returns to scale, adding counter-evidence to the perception that the setups are isomorphic.