-dpi sets the resolution (in dots per inch). You don't see any difference because most programs ignore the resolution reported by the X11 server (which is most of the time unreliable), or simply do everything in pixels.
You can easily check by running xdpyinfo on the Xephyr display:
$ Xephyr -dpi 20 :1 & $ xdpyinfo -display :1 | grep resolution resolution: 20x20 dots per inch $ Xephyr -dpi 177 :2 & $ xdpyinfo -display :2 | grep resolution resolution: 177x177 dots per inch