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Abstract

Most product industries are local. In the U.S., firms selling goods and services to local consumers account for half of the economy's sales and create over sixty percent of jobs. Competition in these industries occurs in local product markets. I propose a theory of such competition in which firms have output market power and choose where to operate. Spatial differences in local competition arise endogenously due to the spatial sorting of heterogeneous firms. The ability of more productive firms to charge higher markups induces them to overvalue locating in larger markets, leading to firm misallocation across space. The optimal policy is a location-specific output subsidy that eliminates markups, providing a rationale for place-based policies. Moreover, the optimal policy incentivizes productive firms to relocate to smaller markets by eliminating markup dispersion. I use U.S. Census micro-data to estimate the model's parameters and find significant heterogeneity in markups across U.S. markets. Producers in markets in the top decile of the market-size distribution have a fifty percent lower markup than those in the bottom decile. Using the estimated model, I quantify the general equilibrium effects of implementing the optimal policy and find that welfare losses due to output market power are 2.4%. Additionally, this policy increases local productivity in smaller markets by 14%, but decreases local productivity in larger markets by 5%.

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