By Fabrice Collard and Omar Licandro
This paper embeds firm dynamics into the Neoclassical model and provides a simple framework to solve for the transitional dynamics of economies moving towards more selection. As in the Neoclassical model, markets are perfectly competitive, there is only one good and two production factors (capital and labor). At equilibrium, aggregate technology is Neoclassical, but the average quality of capital and the depreciation rate are both endogenous and positively related to selection. At steady state, output per capita and welfare both raise with selection. However, the selection process generates transitional welfare losses that may reduce in around 60% long term (consumption equivalent) welfare gains. The same property is shown to be true in a standard general equilibrium model with entry and fixed production costs.
The selection mechanism is important in any economy, and this paper shows this is indeed the case. Selection, however, does not always work that well: sometimes, the most efficient firms do not survive. This is the crux of a lot of the less developed economies. But even for developed ones, selection leads to some degree of market power, which can be welfare decreasing.