Quality heterogeneity and misallocation: The welfare benefits of raising your standards

Using data from Chile, we find that more restrictive standards are associated with a reallocation of domestic sales from small to large firms, which has allocative efficiency implications. Guided by this evidence, we study the welfare effects of the reallocation brought about by stricter standards in a model with monopolistically competitive, heterogeneous firms, and a general demand system. Restrictive standards have an ambiguous effect on welfare. On the one hand, they improve allocative efficiency because low-quality firms over-produce in the market allocation. This market distortion is driven entirely by the presence of variable markups and exists to varying degrees in both homothetic and non-homothetic frameworks. On the other hand, the imposition of stricter standards forces firms to pay a fixed cost that is welfare reducing. We estimate our model for Chile and find significant heterogeneity in the welfare gains from moving to the optimal standards policy across industries.