Externalities, Endogenous Productivity, and Poverty Traps

We present a version of the neoclassical model with an endogenous industry structure. We construct a distribution of firms’ productivity that implies multiple steady-state equilibria even with an arbitrarily small degree of increasing returns to scale. While the most productive firms operate across all the steady states, in a poverty trap less productive firms operate as well. This results in lower average firm productivity and total factor productivity. The distributions of employment by firm size across steady states are consistent with the empirical observation that poor countries have a higher fraction of employment in small firms than rich countries. Differences in output and total factor productivity across steady states are increasing in the degree of returns to scale, the capital share, and the Frisch elasticity of labor supply.