The Neoclassical Model and the Welfare Costs of Selection

<p dir="ltr">This paper embeds firm dynamics into the Neoclassical model in a framework with<br>partially reversible capital and investment distortions, allowing for a simple characterization<br>of the transitional dynamics of economies moving towards greater selection. At equilibrium,<br>aggregate technology is Neoclassical, with the quality of capital and the depreciation rate<br>depending on selection. As investment distortions are corrected, selection increases, and both<br>output per capita and welfare rise at the steady state. However, selection destroys existing<br>production capacities, leading to transitional welfare losses. When calibrated to the US, the<br>model shows that developing countries reducing investment distortions to US levels would<br>experience substantial steady-state welfare gains, though transitional costs could absorb 70%<br>to 76% of these gains. While the associated welfare gains from selection at steady-state are<br>significant, between 10% and 23%, transitional costs largely offset these additional welfare<br>gains.</p>