The Neoclassical Model and the Welfare Costs of Selection

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