Many policymakers expressed their interest in industrial policy but failed to experience economic growth. As Evenett (2003) noted, industrial policy means different things to different people. In this study, industrial policy refers to any type of selective government intervention or policy that attempts to change the structure of production in favor of sectors that are expected to offer better forecasts for economic growth in a way that would not occur in the absence of such intervention in the market equilibrium. People who believe that an efficient market exists and must be left alone views industrial policy as fiction. Those who believe, on the other hand, that market failures are rampant believe that economic development needs industrial policy.
Although there are cases where government intervention coexists with success, there are many instances where industrial policy has failed to produce positive results. Consider the claim that Japan’s industrial policy was crucial for its success. Because we do not know how Japan would have performed without industrial policies, it is difficult to attribute its success to it. It might have performed better in the absence of industrial policy or maybe much worse. Counterfactual evidences are not available, so only indirect proofs can be obtained regarding the effectiveness of industrial policy.
Why Industrial Policy
When there are market distortions or when markets are incomplete, a competitive market system does not yield the socially efficient outcome. Under such cases, the market gives room for government intervention.
The infant industry argument, the oldest arguments for trade protection, claims that since production costs may be higher for new domestic industries than for foreign ones, domestic industries may never develop if they are not protected. To prevent this from happening, temporary protection of the domestic industry can be in the national interest. As the costs of domestic producers decline over time as they learn by doing, they can be at par with the production efficiency of their foreign rivals. They can even have lower costs if the true comparative advantage lies with the domestic industry. Under this case, temporary protection will be of global interest.
Baldwin (1969) criticised the infant industry argument by saying that “if after the learning period, unit costs in an industry are sufficiently lower than those during its early production stages to yield a discounted surplus of revenues over costs, it would be possible for firms in the industry to raise sufficient funds in the capital market to cover their initial excess of outlays over receipts.” If future returns outweigh initial losses, capital markets would finance the necessary investment needed by the domestic industry. If future returns are significantly lower than initial losses, the industry should not be established in the first place.
Baldwin’s argument is countered by the claim that market imperfections might prevent the infant industry from getting the required financing. However, as a prerequisite of this argument, firms that have not even begun production must know more about their prospects than investors whose main objective is to find profitable uses for their excess capital. Such condition defies credibility.
The assumption of all-knowing financial intermediaries should be taken with caution. Financial actors are also imperfect as evidenced by market bubbles. With the industrial policy of Asian countries, suppressed financial sector and directed loans, the banking sector was observed to be in need of improvement in operating procedures as much as industrial firms. Thus, the belief that if there were opportunities investors would take advantage of them might be a loophole in Baldwin’s argument. On the other hand, it also implies that selective economic policies would have to also address the flaws of the financial sector along with that of goods and other services. In any case, policies should narrowly target problems rather than impose trade protection.
Bardhan (1971) stated that the infant industry argument is dynamic and that “any elaboration of this idea involves dynamic analysis, and it has hardly been integrated into the main corpus of trade theory which is mostly comparative-static in nature.” Bardhan provides the first dynamic model of learning by doing in an open economy and explained the optimum extent and time path of protection to the learning industry. When learning is unbounded, Bardhan shows that it is optimal to subsidize the infant industry. Succar (1987) extends this analysis to allow the learning in one sector to generate spillovers for other sectors, providing an interindustry spillover rationale for the infant industry argument. However, it is not sufficient to justify intervention. As Succar notes, productivity gains generated by learning by doing in the infant industry should outweigh subsidies or else intervention is socially undesirable. With all this, the difference between firm and industry-level learning by doing is important because firms are heterogeneous.
Baldwin notes that there are four more other versions of the infant industry argument. First, the costly acquisition of knowledge may not be appropriable by an individual firm. Second, firms may provide costly training but may be unable to prevent diffusion as workers tend to transfer to other companies. Third, static positive externalities in the production of a good may justify trade protection. Lastly, investment in new industries might result in informational externalities that will make it difficult for investors to earn a rate of return high enough to justify the initial investment. This argument has been formalized by Hausmann and Rodrik (2003) and called it the process of self-discovery – determining what a company can produce profitably at world prices.
Pack and Westphal (1986) remarked that learning is rarely exogenous and that it usually requires effort and investment from firms. If firms cannot prevent the leakage of knowledge, they will have little incentive to impart them. If property rights are not enforceable, this can create a motivation for government intervention.
Entrepreneurs can often stop the leakage of knowledge. However, if this is not the case, neither trade protection nor production subsidy is needed. Subsidies to initial entrants to the industry must be given. This will create knowledge and discover better protection technologies. Moreover, a policy of rewarding early players entails forecasting the social value of their inventions and discoveries—a process that can be weighed down by failure. Also, a delayed pattern of adoption might even be socially optimal given the uncertainty associated with new technologies.
Knowledge Spillovers, Dynamic Scale Economies, and Industrial Targeting
Under free trade, a country can increase its national income by allocating resources according to comparative advantage. However, it can only ensure static efficiency but cannot guarantee dynamic efficiency. Succar (1987) indirectly calls for industrial targeting by claiming that “promotion of industries which generate substantial learning by doing economies should be an integral part of a strategy of human capital formation in [developing countries].” The ideal goal of industrial policy is to generate a general-purpose technology. However, such a goal is rarely attainable and less likely in developing countries than in industrial countries.
Industrial targeting needs to take into account informational limitations that policymakers face. Klimenko (2004) shows a country can specialize in sectors in which it does not have comparative advantage through a well-designed industrial policy and it can end up abandoning the industries in which it has “true” comparative advantage depending on the beliefs of the policymaker. He further stated that policymakers may stop looking for better targets once favoured industries perform well. This can be viewed as a failure of industrial policy since merely doing something well does not imply that one might not be better at something else.
Coordination Failures as a Rationale for Industrial Policy
Many projects require simultaneous investments to be feasible, and if these investments are made by independent agents, there is little guarantee that each agent would choose to invest. As Scitovsky (1954) noted, externalities in the presence of increasing returns can lead to market failure because the pricing system is not capable of transmitting information about present plans and future conditions to coordinate investment decisions. Pack and Westphal (1986) argue that such externalities are persistent during industrialization.
A coordination problem arises because the demand for the intermediate good depends on its price, which in turn determines incentives for entry into the intermediate sector. If producers anticipate low demand for their good, only a few would enter, implying a higher price for the intermediate. This could make the industry unsustainable assuming that the intermediate good is locally supplied. The opposite happens when producers are certain of high demand for the product. Okuno-Fujiwara (1988) shows that there is no unique equilibrium in a small open economy that has the production structure above. He suggests the following to ensure that good equilibrium is attained: the government can provide a production subsidy to one or both competing industries for them to expand; it can provide an export subsidy to one industry; or it can shutoff international trade. He also suggests that the government can coordinate between producers through information exchange. However, he argues coordination failure can only be settled with repeated information exchanges.
Although Rodrik (1996) stated that coordination failures will exist between upstream and downstream industries if there are scale economies in production and if imperfect tradability holds across national borders, he is hesitant to offer policy recommendations based on his analysis and concludes instead that government intervention is a risky strategy. This is somehow backed by the World Bank’s (1993) report on the East Asian miracle, where it showed that East Asian efforts to coordinate investment decisions led to a number of inefficient industries.
The argument for rectifying coordination failure lies on the assumption that the organization of production activity is exogenously given. Long-term contracts between firms have been used to solve problems of relation-specific investments in many industries. However, it is not clear why this cannot be the case for coordination failures. The biggest problem with the coordination failure argument is that it relies heavily on the assumption of nontradable intermediate inputs. Rodriguez-Clare (1996) noted that if the coordination failure is to be solved, it needs to appeal to nontradable services as well. The problem here, however, is that industrial policy on the basis of coordination failures is quite unlikely if inward foreign direct investment (FDI) is feasible.
Informational Externalities
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