# **7.1 Counterfactual 1: Targeting the selection pattern**

We first run an experiment that encourages the participation of smaller firms in procurement. This counterfactual aims to reproduce the type of “set-aside” policies for small businesses implemented, for example, by the U.S. Small Business Administration. Policies of this type could be those that facilitate access to the competition for procurement contracts —like better publicity or direct assistance to prepare the application— or measures to provide more transparency of the whole process.

To evaluate this type of policies, we reduce the parameter _η_ 1 so that the model generates a procurement size premium of 50%, as opposed to the 72% in the baseline calibration. That is, we solve for a new economy in which the procurement system gives relatively lower weight to firms’ investment in _b_ , making it easier for small firms to participate. We also change _η_ 0 and _Yg_ so that the fraction of procurement firms _mg_ and total government expenditure _PgYg_ remain unchanged.

We present the main results from this exercise in column (2) of Table 3, which shows the relative change of some relevant variables compared to their counterparts in the benchmark economy.<sup>25</sup> As mentioned before, we report the two measures of GDP: “nominal” GDP, which uses the relative price of procurement _Pg_ in the reformed economy, and “real” GDP, which keeps the price _Pg_ of the benchmark economy. We also report changes in the levels of capital in the two sectors and the aggregate, together with changes in variables related to misallocation and aggregate TFP.

**Aggregate output.** We find that the reform increases nominal GDP by around 1.07%.<sup>26</sup> Since we keep _PgYg_ constant in our experiment, this increase comes entirely from a 1.21% increase in _Yp_ . Importantly, we find only a tiny increase in “real” GDP of 0.05%. The reason is that, due to the policy experiment, the relative price of procurement _Pg_ increases (making the provision of public goods more costly), and hence the total amount of public sector goods _Yg_ falls. The fall in _Yg_ is apparent in the real measure of GDP growth but not in the nominal (as nominal expenditure remains constant). We will come back to the increase in _Pg_ below.

**TFP vs. K.** We can decompose the increase in “nominal” GDP into that coming from capital accumulation vs. TFP. We find that most of the increase in GDP (around 75%) is accounted for by an increase in the aggregate stock of capital _K_ , which increases by 0.78%. In Section 7.3 below, we will provide more details that will help understand the evolution of the stock of capital. The rest is explained by an increase of 0.28% in aggregate “nominal” TFP, which is the result of a slight increase in TFP _p_ (0.09%), a large reduction in TFP _g_ (6.85%), and the above-mentioned increase in _Pg_ . When keeping constant _Pg_ to its value in the benchmark economy, our model predicts a

> 25We report the difference, not the relative change, for variables that are already in shares, i.e., the percentage of procurement firms and the share of procurement in GDP, as well as for the interest rate _r_ , the tax _τ_ , and the parameters _η_ 0 and _η_ 1.

> 26 This compares to a 12% increase in GDP of eliminating financial frictions in our economy (setting _φa_ →∞).

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