Dynamic Efficiency without Increasing Returns: Intertemporal Externalities in Competitive Economies

This paper develops a theory of dynamic inefficiency in a competitive economy with intertemporal externalities arising from structural accumulation. Current output enhances future productive capacity, but firms fail to internalise this effect, generating a wedge between private and social returns to output. This missing intertemporal component of marginal returns is captured by a positive dynamic efficiency wedge. As a result, the competitive equilibrium is dynamically inefficient, with output systematically below the level consistent with intertemporal optimality. The inefficiency arises under concave technologies and does not rely on increasing returns, non-convexities, or market power. The paper further shows that the optimal allocation can be decentralised through an output-contingent subsidy that internalises the dynamic efficiency wedge. The resulting policy is self-financing in present value while respecting a wage constraint, yielding an implementation that is both efficient and institutionally robust.