Ethos Perspectives
Industrial Policy
Introduction
The theory of comparative advantage and international trade imply that countries will specialise in the production and export of goods and services that they are relatively more productive in. Some countries are not content with specialising in low-value-added goods and slow economic growth, and their governments seek to intervene in the economies to change comparative advantages and accelerate structural transformation. These interventions and policies to alter economic structure in a way that would not occur under free market conditions are known as industrial policy.
The Case for Industrial Policy
There is an ongoing debate between advocates and critics of industrial policy. Advocates see industrial policy as a means to correct market imperfections and help countries accelerate structural transformation. Critics believe that markets have more information and are more efficient, government intervention leads to rent-seeking and corruption, and government failures are worse than market failures.
The infant industry argument is the traditional argument for industrial policy in the 1950s and 1960s. Governments promote new industries to change their industrial structures. The presence of scale economies and learning-by-doing effects mean that other countries with larger and more established industries will have cost advantages over these new industries. In an open economy, it will be difficult for a new industry to survive and grow because of competition from lower cost and higher quality imports. To facilitate the expansion of the domestic infant industry, the government needs to protect it from import competition, or provide subsidies to reduce its costs. Critics are concerned that protected infant industries will become inefficient and uncompetitive both domestically and internationally even after expansion, because of over-reliance on government protection and subsidies.
More recently, the presence of various market failures in the form of different types of externalities or missing/malfunctioning markets have been used to justify industrial policy. First, advocates of industrial policy point to coordination failures of the private sector leading to lack of investment in potentially profitable complementary industries. Advocates recommend government intervention to coordinate the complementary investments either through facilitating information exchange, coordinated public investment in the industries ala "big push development", ex post investment subsidies or ex ante investment guarantees to private investors. Critics argue that the private sector, with its profit incentive and superior information, will be better able to identify profitable opportunities than bureaucrats. The absence of investments may be due to the private sector’s belief that the investments will not be profitable.
There are also knowledge spillovers/externalities which discourage private sector firms from investing in R&D and training of manpower. This is because firms investing in R&D and training have to bear the costs but will be unable to appropriate the benefits from such investments when other firms copy the new technologies or when their employees join competing firms. These externalities lead to suboptimal investment in R&D and training by the private sector, and present a case for government subsidies and public financing. The problem can also be mitigated by instituting and enforcing patent systems for new inventions. Critics believe that the case has been overstated and that the private sector is able to prevent spillovers and internalise benefits, e.g., through self-initiated inter-firm collaboration.
Rodrik and Hausmann refer to another information externality. Both government and private sector may not have all the information required to make successful bets on potentially profitable industries all the time. Countries have to embark on a journey of self-discovery where there is investment in many industries in the hope of finding those that will be successful. Private sector firms will not have the incentive to invest in uncertain ventures because their profits from identifying a successful industry will be wiped out by new entrants. Therefore, government has the responsibility of investing or encouraging investment by the private sector in new industries.
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