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Industrial Policy for Overall Economic Development in Economics

By HWA | Publish On: May 11, 2011 | Posted In:

Industrial Policy:

Beyond support for basic science and technology, an aggressive approach has been proposed for encouraging technological development is industrial policy. Generally, industrial policy is a growth strategy in which the government – using taxes, subsidies, or regulation – attempts to influence the nation’s pattern of industrial development. More specifically, some advocates of industrial policy argue that the government should subsidize and promote “high-tech” industries, so as to try to achieve or maintain national leadership in technologically dynamic areas.

The idea that the government should try to determine the nation’s mix of industries is controversial. Economic theory and practice suggest that under normal circumstances the free market can allocate resources well without government assistance. Thus advocates of industrial policy must explain why the free market fails in the case of high technology. Two possible sources of market failure have been suggested and borrowing constraints and spillovers.

Borrowing Constraints: Borrowing constraints are limits imposed by lenders on the amounts that individuals or small firms can borrow. Because of borrowing constraints, private companies, especially start up firms, may have difficulty obtaining enough financing for some projects. Development of a new supercomputer, for example, is likely to require heavy investment in research and development and involves a long period during which expenses are high and no revenues are coming in.

Spillovers: Spillovers occur when one company’s innovation stimulates a flood of innovations and technical improvements by other companies and industries. The innovative company thus may enjoy only some of the total benefits of its breakthrough while bearing the full development cost. Without a government subsidy (argue advocates of industrial policy), such companies may not have a sufficiently strong incentive to innovate.

A third argument for industrial policy has less to do with market failure and more to do with nationalism. In some industries (such as aerospace) the efficient scale of operation is so large that the world market has room for only a few firms. For the world, the most desirable outcome is that those few firms be the most efficient, lowest – cost producers. However, in terms of a single country, like the United States, at least some of the firms in the market should be US firms so that profits from the industry will accrue to the United States. Moreover, having US firms in the market may enhance US prestige and yield military advantages. These perceived benefits might lead the US to subsidize its firms in that industry, helping them to compete with the firms of other nations in the race to capture the world market.

These theoretical arguments for government intervention all assume that the government is skilled at picking winning technologies and that its decisions about which industries to subsidize would be free from purely political considerations. However, both assumptions are questionable. A danger of industrial policy is that the favored industries would be those with the most economic promise.

The available evidence on the arguments for industrial policy has been surveyed by Gene Grossmann. Grossmann concluded that, in general, industrial policy is not desirable because, in choosing industries to target governments have frequently “backed the wrong horse”, the costly attempt of European governments to develop Supersonic Transport (SST) and other new types of commercial airplanes is a case in point. Grossman also points out that alternative policies – such as tax break for all research and development spending – promote technology without requiring the government to target specific industries.

However, Grossman also concedes that government intervention may be desirable in some cases, notably in the early development stages of technologically innovative products, such as computers and CAT scanners. Empirically, the potential for beneficial spillovers in these cases appears so large that the government may choose to support ultimately will not prove worthwhile.

This article is in continuation with our previous article on Government Policies to Raise Living Standards

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