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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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or (c) shut off international trade. However, he notes that trade protection can be effective only if the autarkic equilibrium production of good x is sufficiently large – something that is less likely to be true of small developing countries. In addition to traditional industrial policies (a) and (b), Okuno-Fujiwara (1988) also suggests that the government can play a coordinating role between x and y producers by facilitating information exchange between them.7 However, he argues that only repeated information exchanges can resolve the coordination failure. It is difficult to believe that policy-makers can effectively execute such information exchange between disjoint industries about whose day-to-day business they may know very little. Furthermore, the above policy prescription suggests a massive role for government intervention in the process of industrialization. It is noteworthy that Okuno-Fujiwara himself is skeptical whether the mechanisms captured by his model and the policy prescriptions that emerge from his analysis had any practical analog in the Japanese experience.

In a paper along the lines of Okuno-Fujiwara (1988), Rodrik (1996) argues that for coordination failures between upstream and downstream industries to exist, it is necessary that there be some type of scale economies in production and that imperfect tradability holds across national borders of some of the goods, services, or technologies As will be discussed below, good x could be produced by multinationals that establish local production, thus obviating the coordination problem.

Much of the effort of MITI and the Ministry of Finance in Japan can be described as the interchange of information among firms and the interaction with the government to reduce any obstacles to the realization of consistent plans. The same is true of French indicative planning of the 1950s and 1960s. As noted associated with manufacturing. In his model the intermediate good sector is characterized by monopolistic competition rather than oligopoly. Second, he suggests that the nontradable intermediate goods sector should be viewed as representing different categories of specialized skill labor. The idea is that a worker’s decision to acquire any skill depends upon demand for that skill and it is indeed quite costly or simply infeasible to import labor services should certain skills be in short supply locally. Like OkunoFujiwara (1988), Rodrik (1996) is quite hesitant to offer strong policy recommendations based on his analysis and he concludes that government intervention designed to resolve such coordination failures “must be judged a risky strategy”. Thus the World Bank’s (1993) well-known report on the East Asian miracle argues that East Asian efforts to coordinate investment decisions led to a number of inefficient industries.

While the theoretical rationale for redressing coordination failure appears to be sound, the argument rests on certain key assumptions, particularly that the organization of production activity is exogenously given. Why would industries whose profitability is so intimately intertwined not find ways to help coordinate decisions as is the case of the many international supply networks (Gereffi and Memedovic, 2003, Sturgeon and Lester, 2002, 2003). For example, vertical integration between intermediate and final goods producers can help resolve some coordination problems although there are clearly limits to the extent to which organizations can adjust their scale and scope in order to solve coordination problems. At some point, all firms have to interact with others via the market. But long-term contracts between firms have been used to solve problems of relation specific investments in many industries. It is not clear why contracts cannot play the same role in the context of coordination failures.

Perhaps the biggest problem with the coordination failure argument is that it relies heavily on the assumption of non-tradable intermediate inputs, partly reflecting the fact that much of the early literature was based on the example of steel and autos circa 1960 rather than the products in which transportation costs for the intermediate are likely to be low. Virtually all of the models make this assumption despite the fact that the majority of international trade is in intermediate goods. Thus, the coordination failure argument runs earlier, it is difficult to assess whether such sector specific targeting was successful. For an extensive review of the empirical evidence on Japan, see Noland and Pack (2003).

up against the central fact around which much of the ‘new’ trade theory has been built (see, for example, Ethier, 1982). This is no small contradiction and if the coordination failure story has to be rescued it needs to appeal to nontradable services as in RodriguezClare (1996a). But the problem then is that the case for industrial policy on the basis of coordination failures is quite thin if inward foreign direct investment (FDI) is feasible and/or permitted. If local firms do not produce sufficient number of intermediates due to coordination failures, why can’t they be produced by foreign multinationals that are surely not dependent upon the production structure of any one economy? In small developing countries, a large-scale investment by a multinational can create sufficient demand for intermediates and easily resolve the coordination problem. In fact, this is partly what the literature on backward linkage effects of FDI argues (see Markusen and Venables, 1999 and Rodriguez-Clare, 1996a). It is quite unlikely that multinational firms would be hostage to the type of coordination problems that confront small producers in developing countries. Indeed, the huge growth in the importance of international supply chains established by MNCs has become one of the most visible features of industrial growth in the last decade (Sturgeon and Lester, 2002). In section 2E we further discuss the role multinational firms can play in determining the overall case for industrial policy.

C. Informational externalities In a recent paper, Rodrik (2004) argues that the traditional view of industrial policy (based on technological and pecuniary externalities) is out-dated and does not capture the complexities that characterize the process of industrialization. His view is that industrial policy is more about eliciting information from the private sector than it is about addressing distortions by first-best instruments. He envisions industrial policy as a strategic collaboration between the private and public sectors the primary goal of which is to determine areas in which a country has comparative advantage. The fundamental departure of this viewpoint from classical trade theory is that entrepreneurs may lack information about where the comparative advantage of a country lies. Or more to the point, at the micro level, entrepreneurs may simply not know what is profitable and what is not.

In the presence of informational externalities, a free rider problem arises between initial investors and subsequent ones. Suppose no one knows whether activity x is profitable or not and the uncertainty can only be resolved by making a sunk investment that cannot be recovered in case the outcome turns out to be unfavorable. If there is free entry ex post, no entrepreneur may be willing to make the investment required to discover the profitability of activity x: if someone does make the investment and the activity turns out to be profitable, other entrepreneurs will be attracted to the same activity thereby eliminating all rents. It is worth noting that Baldwin’s (1969) classic paper anticipates Rodrik’s argument almost exactly. He wrote “…suppose, for example, that a potential entrant into a new industry, if he could provide potential investors with a detailed market analysis of the industry, could borrow funds from investors at a rate that would make the project socially profitable. However, should this information become freely available to other investors and potential competitors, the initial firm might not be able to recoup the cost of making the market study….under these circumstances the firm will not finance the cost of the study, and a socially beneficial industry will not be established.” Similarly, in the context of adoption of high yielding varieties of crops by farmers in developing countries, Besley and Case (1993) note that late adopters may learn from early adopters when “a technology is of uncertain profitability, some potential adopters may wait until they observe whether others have fared well by using it” and that such “externalities are potentially important in agricultural technology adoption.” Given the importance of this argument for the debate on industrial policy, it is useful to consider the framework presented in Hausmann and Rodrik (2003) in some detail. They consider a small open economy comprised of two sectors: traditional and modern. The production technology in the traditional sector is constant returns to scale and the presence of a fixed factor generates diminishing returns. In the modern sector (that consists of many goods), there are constant returns to scale in production but the cost of production of a good depends upon an unobserved productivity parameter (θi) that becomes known only when the production of a good is attempted (something that requires a time period in which resources must be utilized but no production takes place – this is what Baldwin called a ‘market study’). Entrepreneurs lack information about the profitability of production of various goods in the modern sector and this information can be obtained only by undertaking a sunk investment.

After uncertainty regarding θi is resolved, entrepreneurs compare their production costs with world prices and produce those goods for which they make monopoly profits (which accrue for length of time T -- call this the monopolization period). Of course, once information becomes public (which it does in period three when the monopolization period has elapsed) there is further entry (into goods that yield positive profits) until all profits are competed away to zero.

Hausmann and Rodrik (2003) analyze the laissez-faire equilibrium of the above model and compare it to the social planner’s problem in order to derive the market failures that result from the presence of informational externalities. They argue that the market equilibrium is deficient in two respects. First, the level of investment and entrepreneurship delivered by the market does not coincide with the social optimum because the entrepreneurs care only about profits and not about economy-wide benefits of their investment. If the monopolization period is very long, the market economy can actually deliver too much investment in the modern sector as opposed to too little. This suggests that in economies where firms face substantial entry barriers, the underinvestment problem noted by Hausmann and Rodrik (2003) is not likely to be serious. For example, the industrial licensing regime pursued by India during the first forty or so years after independence made it quite difficult for firms to enter new markets.

And the recent literature on the business climate that emphasizes other factors that discourage investment such as the time it takes to obtain business permits, telephone lines, and other utility hookups further discourages excessive investment in the modern sector (World Bank, 2006).8 Such barriers should have helped protect rents for those that did manage to enter profitable markets.

The second market failure identified by Hausmann and Rodrik (2003) is that the market equilibrium yields too little specialization – all activities that turn out to be profitable are sustained whereas optimality requires that only the one with the highest return be pursued. In other words, in their model, while it is optimal for the small open economy to only produce the good for which the profit margin is the highest, the market solution allows all those that make positive profits to stay in business during the period of monopolization.

If there is concern about excessive investment, some aspects of the adverse business environment may unwittingly be a second best policy.

This result reflects the general equilibrium nature of their model and the fact that they consider a small open economy. To see this, first note that the modern sector draws resources out of the traditional sector and optimality requires that these resources be utilized where they generate the largest profits (which happens in the modern good for which the productivity parameter (θi is the highest). Second, since the country’s output of a good does not affect world price, one can never have a situation where the mark-ups across different goods are equalized. Clearly, if world prices changed with a country’s exports/output, complete concentration in the modern sector need not obtain. A more likely scenario would be that a country should produce higher quantities of modern goods for which it has a more favorable productivity draw and lower quantities of other goods.

Hoff (1997) argues that if initial producers benefit subsequent producers, the case for subsidizing initial producers hinges very much on the assumption that the externalities operate in a deterministic fashion (i.e. do not involve any uncertainty). She constructs a model where initial entrants provide information that is socially valuable by reducing uncertainty for potential followers regarding production conditions. In her model, factors that increase the informational barrier to entry can actually imply a lower optimal subsidy for the infant industry. By contrast, in most existing models, the externalities are assumed to remove all uncertainty as opposed to reducing it. Since Hoff’s model is clearly more realistic, it is notable that her results weaken the case for subsidizing an infant industry.

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