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Industrial Policy In Advanced Economies 2

Posted by mjmedlock on June 1, 2011 in international economics |

Sophisticated Arguments For Industrial Policy in Advanced Economies

In this second section about industrial policy in advanced economies we will examine some sophisticated arguments for industrial policy. These arguments often do hold water. However, as usual we will see that governments’ good intentions do not always turn into desirable results.

Technology and externalities

The idea is that hi-tech industries produce externalities that are:

  1. Not all of the benefits of reseach and development are collected by the company. In other words other companies copy or mimic the technology without having had to do the clever or painful initial research.
  2. Good for society.

These two points may indeed be true, but we should be careful before using these points as a justification for the state helping industry.

When a government subsidizes a firm or an industry it is not just subsidizing “new-tech” workers it is also subsidizing office workers, cleaners and other non-hi-tech staff. A better solution would be to invest in research at universities and improve the whole country’s stock of intellectual property.

Suppose a government goes ahead and subsidizes a firm or industry. What are the appropriate levels of subsidy? For how long should the subsidy be in place? How do you measure the value of the externalities that are created? Even though it is generally accepted that there are externalities from hi-tech industrial investment, nobody really knows how to measure them and therefore we cannot be sure if a subsidy will have a positive or negative net economic effect for society. Again we come across the same old “unreliable crystal ball problem” of governments having a poor record in picking winners.

Imperfect competition and strategic trade policy

When firms are monopolies or oligopolies they can earn excess returns. (Often markets are oligopolies or monopolies because the market will not support a situation with many firms. This is usually the result of very high cost of entry. ) If the firms that are earning excess profits are foreign firms then governments may be able to alter the rules of the game to shift the excess returns from foreign to domestic firms.

If a government can deter an investment by foreign firms in an industry then it might be possible for them to raise the profits of domestic firms by more that the subsidy. In other words, national income can be raised at another country’s expense!

Look at the following example of how a country might promote the fortune one its own firms at the expense of a foreign firm.  We’ll call the country Megaland.

Both firms have the opportunity to design and develop a new kind of very large, very fast ship. We will assume that there is a limited market for these ships. We’ll call the firms Agoship and Bigcraft. The follow is a payoff schedule for both firms. Values are billions.

payoff schedule industrial policy in advanced economies

Scenario 1

Suppose Megaland gives a $25 billion subsidy to Agoship. The payoff schedule now looks like this.

industrial policy in advanced economies payoff if supported

In this scenario the subsidy means that Agoship will always make a profit, whether Bigcraft enters the market or not. However, it is unlikely that Bigcraft would enter the market knowing that they would lose $5 billion. The most likely outcome then would be that Agoship makes a profit of $125 billion, a return of 500%. This will make both Agoship and Megaland happy.

The problem with this scenario however is that in real life it is improbable that we have access to all the information we need to be confident that our cost estimate are correct. For example, Bigcraft may have developed a better technology that was unknown to both Agoship and Megaland before the subsidy. This technology might significantly reduce costs for Bigcraft.

Scenario 2

The following represents the same situation as before but this time with different cost.

industrial policy in advanced economies payoff schedule 3

As you can see Bigcraft makes a profit even if Agoship does enter the market. Suppose Megaland gives Agoship the same $25 billion subsidy as it did in our first scenario. The situation would look like this:

industrial policy in advanced economies payoff schedule 4

The subsidy now takes away the risk for Agoship to enter the market. Agoship will make a profit even if Bigcraft remains in the market. However, it is important to note what will NOT happen. Bigcraft will not be driven out of the market, instead we will have a situation where both firms operate but with reduced profits. In fact this is the likely outcome. The MOST IMPORTANT point to note is the return on investment Megaland gets from its $25 billion subsidy. In this situation they only get back $5 billion dollars for the Megaland economy, a loss of $20 billion for the Megaland taxpayers.

Keywords: industrial policy in advanced economies, international economics

Further reading on industrial policy

Industrial policy on advanced economies part 1

Trade policy in developing economies

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