Highlights :

• Because it affects the toughness of competition, market size is important in explaining variation in industry performance across markets.
• This paper shows that high quality firms perform disproportionately better in larger markets, thereby raising aggregate quality.
• The paper exploits a unique dataset which contains quality ratings at the firm level, allowing for the most direct test to date of this key mechanism for pro-competitive effects.

 Abstract :
This paper presents the most direct test to date of the key welfare mechanism put forward by Melitz and Ottaviano (2008): the best firms increase sales disproportionately when competing in larger markets. I test this prediction in a quality context where the best firms produce the highest quality. The empirical analysis is guided by a quality-augmentation of Melitz and Ottaviano (2008). I capture product quality empirically using a unique dataset containing firm-level quality ratings. The results are in line with the key prediction of the model. I also find a strong positive relationship between a proxy for consumer quality preference and demand for quality which is consistent with the theory.

 Keywords : Heterogenous firms | Flexible mark-ups | Market size | Quality | Complementarities

 JEL : F12, F14, F15, F61, L11