Firm Entry, Trade, and Welfare in Zipf's World

Firm size follows Zipf's Law, a very fat-tailed distribution that implies a few large firms account for a disproportionate share of overall economic activity. This distribution of firm size is crucial for evaluating the welfare impact of macroeconomic policies such as barriers to entry or trade liberalization. Using a multi-country model of production and trade in which the parameters are calibrated to match the observed distribution of firm size, we show that the welfare impact of high entry costs is small. In the sample of the largest 50 economies in the world, a reduction in entry costs all the way to the U.S. level leads to an average increase in welfare of only 3.25%. In addition, when the firm size distribution follows Zipf's Law, the welfare impact of the extensive margin of trade -- newly imported goods -- vanishes. The extensive margin of imports accounts for only about 3.5% of the total gains from a 10% reduction in trade barriers in our model. This is because under Zipf's Law, the large, inframarginal firms have a far greater welfare impact than the much smaller firms that comprise the extensive margin in these policy experiments. The distribution of firm size matters for these results: in a counterfactual model economy that does not exhibit Zipf's Law the gains from a reduction in entry barriers are an order of magnitude larger, while the gains from trade liberalization are an order of magnitude smaller.