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«© 2013 The International Institute for Sustainable Development © 2013 The International Institute for Sustainable Development ...»

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While in principle market forces should guide the process of determining the optimal productive structures of an economy, there are a number of sound theoretical reasons why this might not in fact be the case.

In economics, the general case for government intervention comes into play when markets are either distorted or incomplete. A market distortion can occur due to the presence of an externality, a situation in which the price fails to signal the true cost or benefit of a good or a service. But markets can also be distorted in cases of excessive market power, which arises, for example, in the presence of a monopoly when there are increasing returns to production scale.

An incomplete market typically arises in situations of uncertainty, such as, notably, in the financial and insurance sector, and refers to a situation in which the set of possible outcomes is higher than the set of contingent claims. In the presence of such market failures, a competitive market equilibrium fails to deliver a socially optimal outcome, and the state then has a role in helping achieve this optimum.

While all economic justifications for industrial policy fall under this broad categorization of market failure in one way or another, we will review a few more specific arguments in greater detail.

Marshallian and Inter-Industry Externalities A classic case for government intervention occurs in the presence of Marshallian externalities (Krugman, 1991;

Marshall, 1920). These localized, industry-level externalities result in formation of industry clusters, which benefit from synergies such as knowledge spillovers among firms, labor pooling, or input-output linkages where upstream IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy firms provide inputs for downstream firms, taking advantage of low transportation costs (Harrison & Rodríguez-Clare, 2009). Empirical work has found great support for the existence of such externalities (Rosenthal & Strange, 2004). A classic example of such agglomeration economics is Silicon Valley, but such clusters are also found elsewhere: Qiaotou, Wenzhou and Yanbu are all relatively small regions in China that, respectively, account for 60 per cent of world button production, produce 95 per cent of the world’s cigarette lighters, and dominate global underwear production (Lyn & Rodriquez-Clare, 2011).

The associated spillovers automatically increase with the size of the sector, which in turn necessarily becomes more productive. This idea aligns well with the aforementioned notion of dynamic comparative advantage, in the sense that the development of a country’s comparative advantage in a given sector is conditional on the successful formation of such an industry cluster. A developing country might have such a dynamic comparative advantage in a certain industry, but be denied its development due to the prior existence of well-established clusters elsewhere (the so-called infant-industry argument for industrial policy). Until the industry cluster reaches a critical size, it will be unprofitable, producing at inefficiently low rates and unable to compete on international markets. Temporary government support to the industry may help it take off and eventually become competitive.

Spillovers need not be localized within industries only. Instead, there may be aggregate externalities that benefit a whole range of industries, when realized in a certain sector or industry (Stiglitz & Greenwald, 2006). Certain sectors may provide key inputs for others; one could think of the energy sector or infrastructure more generally. Underdevelopment of this key sector would have detrimental effects on a whole range of related sectors. Private firms underinvest, as they do not account for the greater social benefit of their actions, and again government intervention could theoretically rectify the ensuing market failure.

Of course, both cases necessitate careful examination of the underlying causes of the underperformance in order to choose the right instrument for government support. For example, subsidizing an ailing key industry will not make it profitable if the reason for its underperformance is a coordination failure between industries.

Coordination Failures Coordination failures come about when a project requires simultaneous investments in order to be viable; if these investments are made by independent agents there is little guarantee that, acting in their own self-interest, each agent would choose to invest, leading to a suboptimal equilibrium (Pack & Saggi, 2006). Murphy, Shleifer and Vishny (1988, p. 28) argue that “a program that encourages industrialization in many sectors simultaneously can substantially boost income and welfare even when investment in any one sector appears unprofitable.” As this type of pecuniary externality makes different firms’ and industries’ profits interdependent, it calls for a coordinated investment strategy that goes beyond piecemeal targeting of certain firms or sectors. Moreover, it requires careful examination of a country’s inputoutput linkages in order to decide on an appropriate and effective aid scheme, ensuring that implicit subsidies flow across sectors crucial to simultaneous industrialization.

Self-Discovery and Diversification Market failures are endemic to economic development, as structural transformation of the economy requires producing new goods with new technology (Rodrik, 2008a). Countries might not know their comparative advantage, in that it is impossible to know the counterfactual cost structures of industries that do not yet exist (Hausmann & Rodrik, 2003).

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy Effectively exploring those cost structures, an entrepreneur attempting to produce and market a new product will necessarily face a lot of uncertainty as to the success of her endeavour. Even production processes that have extensively and successfully been tested elsewhere will require local adaptation (Evenson & Westphal, 1995). There may be strong economy-wide demonstration effects, in that the successful implementation of an entrepreneur’s business signals the profitability of the new business and encourages other entrepreneurs to emulate the incumbent. But while a successful pioneer entrepreneur’s success has such positive externalities on others, she would have to privately bear the costs in case of failure. And in case of a successful market entry, she would not be able to fully appropriate the benefits of her investment, as her competitors would enter the market as well. She might thus decide against the investment, as she won’t be able to share the costs if her project fails. Taken together, the result is that a suboptimal number of pioneer entrepreneurs would be willing to take on such risks and the country would be unable to exploit its full potential for diversifying its economy.

This line of reasoning draws heavily from the literature on firm strategy and departs substantially from the neoclassical assumption of passive price-taking firms. It recognizes that successful firms create and maintain barriers to entry and rents associated with them, effectively exploiting their competitive advantage (Porter, 1990).

Credit Market Imperfection Baldwin (1969) provided an incisive criticism of the infant-industry argument, pointing out that if future returns outweighed initial losses, capital markets would provide the necessary financing for domestic industry projects, enabling the creation of successful industry clusters without the need for government intervention. His assumption was that financial markets would possess sufficient information to accurately assess the risks involved in financing new industry projects, and financial intermediaries would grasp profitable opportunities, making government intervention unnecessary. However, deficiencies in the financial sector have been all too frequent in recent history and have cast doubts on the validity of the assumption of omniscient financial intermediaries (Pack & Saggi, 2006). Indeed, Banerjee and Duflo (2005) summarize a wide range of studies that show huge variation in interest rates paid by different borrowers in developing countries and conclude that these can be explained only by credit-market imperfections (Rodrik, 2009). While the pervasiveness of credit-market imperfection does provide a rationale for industrial policy, it also means that any selective economic policies would have to simultaneously address the weakness of the financial sector along with that of manufacturing or other services (Pack & Saggi, 2006).

Learning by Doing The idea that firms or industries learn by doing relates to the aforementioned notion of dynamic comparative advantage, but does not restrict the latter to the formation of industry clusters. The earliest theoretical formulation of the learningby-doing hypothesis goes back to Arrow (1962), who hypothesized “that technical change in general can be ascribed to experience, that it is the very activity of production which gives rise to problems for which favorable responses are selected over time” (p. 156). The acquisition of knowledge is hence central to the development of a firm’s or an industry’s dynamic comparative advantage. More recently, the concept has been extended to “learning by exporting” as a justification for export promotion, aided by the advent of new intra-industry models of international trade, as pioneered by Melitz (2003) (Fernandes & Isgut, 2007).

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy Environmental Externalities Environmental externalities present the textbook case of a market failure and are likely to become a major driver of industrial policy worldwide (Altenburg, 2009). According to the United Nations Glossary of Environment Statistics, environmental externalities “refer to the economic concept of uncompensated environmental effects of production and consumption that affect consumer utility and enterprise cost outside the market mechanism” (United Nations Statistics Division, 1997). Markets fail to adequately price environmental effects, and this failure can lead to economically viable but socially undesirable economic activity. Investors will tend to overinvest in sectors where the social cost of an investment is greater than the cost accruing to the investor alone (for example, an investment in a coal-fired power plant). Likewise, investors will underinvest where the social return is higher than the private return (such as clean energy investments). In both cases, the government has an important role in levelling the playing field for green industries, aligning private returns more closely with social returns by using a set of policy tools discussed in greater detail in chapter 4.

The distinctive feature of environmental externalities is their scope: they can be localized and occur within a limited geographic area, but may as well be global in nature, depending on which market failure one looks at. Sir Nicholas Stern (2008), author of the influential Stern Review on the Economics of Climate Change, famously described climate change as the result of “the biggest market failure the world has ever seen” (p. 1). The failure of markets to put a price on greenhouse gas emissions has led to an unsustainable mode of industry that is fuelling global warming.

Climate change proves to be particularly challenging for industrial policy. On the one hand, industrial policy is of great importance for climate change adaptation: a vibrant industrial sector is vital in absorbing excess labour that rapid urbanization is causing in many developing countries. This role of industry is expected to become more pronounced in the near future, as adverse effects of climate change are predicted to produce many “climate refugees” unable to sustain their livelihoods in agriculture. In this sense, climate change calls for an acceleration of traditional industrial policy, in order to speed up industrialization and structural change in developing countries. On the other hand, industrial policy is vital for climate change mitigation, i.e. actively promoting reduction of economy-wide anthropogenic greenhouse gas emissions. It is this particular function that calls for a novel green industrial policy that balances traditional considerations of industrial development and efforts to reduce its environmental impact.

Hence, green industrial policy is to a large extent motivated by the same considerations that apply to traditional industrial policy. However, its usefulness as a government tool is warranted by a few additional considerations that are

otherwise absent or less compelling (Karp & Stevenson, 2012):

First, governments face a commitment problem, as the size of future markets facing green industries is largely determined by future government policy. For example, the less stringent future emissions ceilings are, the less profitable current investments will be. Industries that are reluctant to undertake green research and development (R&D) or adopt green technologies can therefore be nudged into undertaking such investments through green industrial policies.

Second, future government policy is endogenous in that it is a function of current investments. As Karp and Stevenson (2012) point out, the practicality of future carbon taxes, for example, depends on the future availability of alternative fuels, which in turn depends on current investments.

Third, when externalities are transnational or even global in scope (such as climate change), global welfare considerations of green industrial policy will outweigh purely national ones. The inability of national governments to appropriate such international benefits calls for greater coordination of international policy.

IISD REPORT JUNE 2013 2013 The International Institute for Sustainable Development © Industrial Policy for a Green Economy

3.0 Traditional Industrial Policy While establishing a theoretical case for industrial policy is not very difficult, the question of what instruments best serve different purposes is more involved.

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