Firm Dynamics in the Neoclassical Growth Model

This paper integrates firm dynamics theory into the Neoclassical growth framework. It embeds selection into an otherwise standard dynamic general equilibrium model of one good, two production factors (capital and labor) and competitive markets. Selection relies on firm specific investment: i) capital is a fixed production factor --playing the role of an entry cost, ii) the productivity of capital is firm specific, but observed after investment, iii) firm specific capital is partially reversible --its opportunity cost plays the same role as fixed production costs. At equilibrium, aggregate technology is Neoclassical, but the average quality of capital is endogenous and positively related to selection; due to capital irreversibility, the marginal product of capital is larger than the user cost and capital depreciation positively depends on selection. At steady state, output per capita and welfare both raise with selection; rendering capital more reversible or increasing the variance of the idiosyncratic shock both raise selection, productivity, output per capita and welfare.