What determines aggregate returns to scale?

Abstract

This paper develops a unified framework that incorporates four features important in existing models with increasing returns: fixed costs, decreasing marginal costs, product variety, and market power. When fixed costs are not allowed to vary and profits are imposed to be zero in every period, only the degree of returns to variety determines the degree of aggregate increasing returns to scale. When fixed costs respond to changes in aggregate activity or the zero-profit condition does not hold in the short run, aggregate returns depend not only on product variety but also on diminishing marginal costs or market power. The degree of market power, however, does not affect input prices, which are critical to determine the uniqueness of equilibrium.