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«January 16, 2006 Howard Pack Kamal Saggi The Wharton School Department of Economics University of Pennsylvania Southern Methodist University 1400 ...»

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The case for industrial policy: a critical survey*

January 16, 2006

Howard Pack Kamal Saggi

The Wharton School Department of Economics

University of Pennsylvania Southern Methodist University

1400 Steinberg Hall-Dietrich Hall PO Box 750496

3620 Locust Walk Dallas, TX 75275-0496

Philadelphia, PA 19104-6372 E-mail: ksaggi@smu.edu

E-mail: packh@wharton.upenn.edu Abstract: What are the underlying rationales for industrial policy? Does empirical evidence support the use of industrial policy for correcting market failures that plague the process of industrialization? To address these questions, we provide a critical survey of the analytical literature on industrial policy. We also review some recent industry successes and argue that only a limited role was played by public interventions.

Moreover, the recent ascendance of international industrial networks that dominate the sectors in which LDCs have in the past had considerable success, implies a further limitation on the potential role of industrial policies as traditionally understood. Overall, there appears to be little empirical support for an activist government policy even though market failures exist that can, in principle, justify the use of industrial policy.

*This paper has been partly funded by the Development Research Group of the World Bank.

1. Introduction Many nations in recent years have encountered great disappointment with the results of pursuing conventional economic policies that Williamson crystallized and named the Washington Consensus. Although few countries ever followed the pristine form of this consensus, some countries in East Asia adhered to many (but hardly all) of its components and experienced extraordinarily rapid growth for a period of three decades or more. Though there was a brief and sharp recession in some of these countries during the crisis of 1997 to 1999, most have rebounded with the exception of Indonesia.

Yet other nations that have gotten their macroeconomic and trade regimes much closer to the idealized consensus than the Asian countries did have failed to experience comparable growth. In many Latin American nations and in some African ones as well, there is an understandable search for the magic bullet and many policy makers have expressed interest in some form or other of industrial policy.

Few phrases elicit such strong reactions from economists and policy-makers as industrial policy. As Evenett (2003) notes, industrial policy means different things to different people. According to us, industrial policy is basically any type of selective intervention or government policy that attempts to alter the structure of production toward sectors that are expected to offer better prospects for economic growth than would occur in the absence of such intervention, i.e., in the market equilibrium. Given this definition, it is not surprising that those who believe strongly in the efficient working of markets view any argument in favor of industrial policy as fiction or, worse, an invitation for all types of rent seeking activities. On the other side, people who believe market failures are pervasive think that any path to economic development requires a liberal dose of industrial policy.

In this paper, we address arguments for and against industrial policy and then ask whether empirical evidence helps settle the debate in favor of one group or another.

While there certainly exist cases where government intervention co-exists with successes, in many instances industrial policy has failed to yield any gains. The most difficult issue is that the relevant counterfactuals are not available. Consider the argument that Japan’s industrial policy was crucial for its success. Since we do not know how Japan would have fared under laissez-faire, it is difficult to attribute its success to its industrial policy.

Maybe it would have done still better in the absence of industrial policy or maybe it would have done much worse. Given this basic difficulty, we can only hope to obtain indirect clues regarding the efficacy of industrial policy. Direct evidence that can `hold constant’ all of the required variables (as would be done in a well specified econometric exercise) simply does not exist and it is unlikely that it will ever exist – perhaps that is why the debate over industrial policy has remained unsettled and may remain so in the future.

The paper is organized as follows. In section 2 we critically analyze the major conceptual arguments in favor of industrial policy. Since the infant industry argument for trade protection anticipates most of the rationales for industrial policy, we begin with an extensive discussion of this argument. Then, in section 3, we examine how the case of India’s successful software industry fits into the arguments for industrial policy. In section 4, we ask how the expansion of international production networks has altered the case for industrial policy. In section 5, we provide some concluding remarks where we also comment on the issue of ‘policy space.’

2. Why industrial policy?

At a general level, there is room for government intervention either when markets are characterized by some distortions (such as externalities or market power) or because they are incomplete (for example futures markets for many goods simply do not exist).

As is known from one of the basic theorems of welfare economics, under such market failures, a competitive market system does not yield the socially efficient outcome. In the end, any argument for industrial policy is a special case of this general argument.

Three specific arguments in favor of industrial policy have received the most attention. The first is derived from the presence of knowledge spillovers and dynamic scale economies; the second from the presence of coordination failures; and the third from informational externalities. Before discussing these arguments in detail, it is useful to begin with the rather well known infant industry argument for trade protection since in many ways it is a precursor of modern arguments for industrial policy.

A. The infant industry argument: a precursor of modern industrial policy The infant industry argument is one of the oldest arguments for trade protection and is perhaps the only such argument that is not dismissed out of hand by trade economists. The most popular (and the simplest) version of the argument runs as follows.

Production costs for newly established domestic industries in a country may be initially higher than those of well-established foreign competitors due to their greater experience.

However, over time, domestic producers can experience cost reductions due to learning by doing (i.e. they enjoy dynamic scale economies) and can end up attaining the production efficiency of their foreign rivals. However, if the fledgling domestic industry is not initially protected from foreign competition, it may never take off. Furthermore, if dynamic scale economies are strong enough, temporary protection of the domestic industry can be in the national interest.

A stronger version of the argument states that the domestic industry might even be capable of attaining production costs below its foreign rivals if it is given sufficient protection. In this version of the argument, true comparative advantage lies with the domestic industry and temporary protection can actually be in the global interest since consumers in the rest of the world also benefit from the eventual lower production cost of the domestic industry. In an influential paper, Baldwin (1969) provided an incisive criticism of the infant industry argument. He argued 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 (and therefore indicate a comparative advantage for the country in the particular line), 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.” As Baldwin (1969) points out, if future returns indeed outweigh initial losses, capital markets would finance the necessary investment needed by the domestic industry. It is obvious, but worth stressing, that if future returns fall short of initial losses, the industry should not be established in the first place. A frequently cited counter to Baldwin (and one that he acknowledged) is that capital market imperfections might prevent the infant industry from being able to obtain the required financing. For example, a proponent might appeal to the presence of informational asymmetries: unlike producers, investors may not know that the industry is profitable in the long run and therefore fail to provide the capital needed to cover the initial costs. However, such an argument defies credibility since it requires one to believe that firms that have not even begun to produce the good in question know more about their prospects than those whose main objective is to find profitable uses for their excess capital and have previously analyzed and financed similar projects. Even if one grants the presence of asymmetric information, why cannot potential producers convey such information to likely investors?

While the infant industry argument assumes that it is known with certainty that the industry in question will eventually be profitable, it seems more likely that the prospects for most new industries are uncertain and no one really knows whether or not a particular infant industry will in fact be profitable in the future. Under such circumstances, capital markets would require compensation for the risks involved and the interest rates required might make the investment unprofitable. But efficiency requires that those bearing risks should be compensated and there is no market failure if the underlying problem is that investors do not provide the necessary capital because they perceive the rewards to be not commensurate with the risks they are asked to bear.

Nevertheless, the assumption of omniscient financial intermediaries should be viewed with some degree of skepticism. From early bubbles such as the tulip mania to the internet bubble of the late 1990s it is clear that financial actors are often deficient. In the case of Asian countries that suppressed the financial sector and directed loans to specific industries and firms as a part of industrial policy, the banking sector was itself in need of significant improvement in operating procedures much as industrial firms were. Thus, the argument that if there were opportunities they would be exploited by investors might be a weak link in Baldwin’s argument. On the other hand, it also implies that any selective economic policies would have to simultaneously address the weakness of the financial sector along with that of manufacturing or other services. Indeed there might be an argument for initially strengthening the banking sector, perhaps by allowing foreign financial intermediaries into the country, before pursuing targeted sectoral policies. In any case, as Baldwin notes, if there indeed is a problem with capital markets, policy ought to target that specific problem as opposed to resorting to trade protection. In today’s world of global capital markets, the simple version of the infant industry argument runs into another difficulty: investors ought to be able to determine the prospects for the domestic infant industry from the experience of foreign producers. If domestic investors lack such information, surely foreign investors ought to have it. Why cannot the borrowing be international rather than local? A potential answer to this question is that investors may believe that just because an industry has succeeded abroad does not necessarily imply that it will also succeed at home. But this explanation can be consistent with the very hypotheses underlying the infant industry argument only if investors are not fully rational.

What light has formal analysis shed on the infant industry argument? A seminal paper by Bardhan (1971) noted that the infant industry argument is dynamic in nature and that “any elaboration of this idea involves explicitly dynamic analysis, and it has hardly been integrated into the main corpus of trade theory which is mostly comparative-static in nature.” Bardhan (1971) provides the first dynamic model of learning by doing (LBD) in an open economy and derived the optimum extent and time path of protection to the learning industry. In his model, there are two goods c and m and two factors of production capital and labor with constant returns to scale in production of both goods.

The learning effect is assumed to depend upon the cumulated volume of industry output in good m and it shifts out the production function for the good in a Hicks neutral fashion.1 Bardhan models LBD as a classic Marshallean externality: the higher the cumulative output of the industry, the more productive the technology of each individual firm. When learning is unbounded, Bardhan shows that it is socially optimal to subsidize the infant industry and that the time profile of the optimal subsidy depends upon initial conditions, However, his framework does not capture the idea that international spillovers may partially substitute for domestic learning since the learning effect function contains the stock of domestic and foreign outputs as separate arguments and the relationship between the two is not really considered.2 Succar (1987) extends Bardhan’s (1971) analysis to allow the learning in one Bardhan’s model is in the spirit of the original learning-by-doing model of Arrow which posited learning that occurred in the machine producing sector. Some of the endogenous growth literature also posits such effects. However, much of the literature on technological innovation summarized in Evenson and Westphal (1995) and Ruttan (2002) shows that learning can occur in all sectors, a fact that makes would enormously complicate the results of much of the literature.

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