Industrial Policy In Advanced Economies Part 1

Posted by mjmedlock on April 28, 2011 in international economics |

We’ll look at two sets of arguments for industrial trade policy in advanced economies. The first sets of arguments are the popular ones that are often voiced in newspapers, politicians and trade unionists, businesses that want government aid, and the “man in the pub”.

In this first post we will examine the popular arguments.

Popular arguments for industrial policy in advanced economies

Governments should protect and promote industries with a high value added per worker (HVA).

This argument assumes that if an firm invests in capital intensive technology it will earn more profit and therefore be able to pay workers higher wages. This argument fails to take note of the fact that the HVA is needed to compensate for the high capital costs for capital intensive industries. While it is true that some employees with highly specialized skills (engineers for example) will have an opportunity to earn relatively higher salaries, most workers will earn little more than the going market rate for factory work. For instance workers in chip fabrication plants or workers in the nuclear industry work in the most capital intensive environments in the world, yet they don’t tend to have salaries that are significantly higher than the general population. Furthermore, as much of the processes are automated they don’t necessarily require higher degrees of skill.

A useful question to ask is: Can a country raise income by expanding into HVA sectors? The answer is that countries become HVA economies because they have become wealthy and /or they have accumulated the capital required to create HVA industries; not the other way around. The best way for governments to encourage HVA is not direct intervention, but through policies that encourage saving and investment. This will give the market the capital it needs to make investment decisions. It is no accident that countries like Germany and Japan have both high savings rates and are strong in capital intensive industries.

An industrial policy can promote linkage industries

The idea here is that the creation of one industry allows for the creation of industries that will use its products. A typical example is steel leading to the development of a car industry and a shipbuilding industry.  However, there is no reason to expect the free market to devote too few resources to developing these kinds of “intermediate goods”. Nor is there any real evidence that industries such as shipbuilding in Japan were created because the Japanese government gave subsidies to the steel industry. Furthermore, modern transportation technology has done away with the need to have natural resources close at hand.

Why do people feel that their economies need intermediate industries such as steel? We cannot be sure, but one cannot help feel that people believe that industries such as steel are more “proper” and more “serious” that doing things such as advertising or fashion.

Governments should promote industries with future growth potential.

The fallacies that are used to argue for infant industries in developing economies are also used in advanced economies.  Again the arguments against the future growth idea are similar. The most important are:

  • Is it possible for governments to predict the winners? There has been a very poor track record, although many people point to the occasional success to claim the argument is valid.
  • What criteria will you use for choosing? In other words, why are you choosing one sector or firm over others?
  • New technologies can “come from nowhere”.  The rapid pace of new technological development can mean that by the time a new technology has been developed, an even newer technology has rendered it redundant.
  • Resources are limited. Help giving resources to one sector you are by definition denying resources to others. For example the money the government investments in biotechnology might mean you cannot provide enough university places for people to study mechanical engineering.
  • Businesses aren’t as short-sighted as people believe.  Investors are in fact willing to make investments industries and firms that they believe have a profitable future. For example new pharmaceuticals can take 7 to 15 years of R&D and testing before being ready for market.

Governments need to counter the effect of other countries’ industrial policies

This argument leads down the path of governments’ role in trade as being purely reactive. Furthermore, it lets governments “off the hook” for failure to invest in education, better and more accountable legislation, and market reform.  Other important points to consider are:

  • Countering another country’s trade policy can lead to tit-for-tat trade retaliation that could ultimately end up in a full blown trade war. This is in nobody’s interest.
  • If firms in our country no longer have a comparative advantage in producing a good, over time capital will be reallocated to firms and sectors that do have comparative advantage.
  • If we believe that we must retaliate again “unfair” foreign trade policies we are in effect accepting that the foreign government has found a way of predicting which sectors will be future winners. As we have discussed before, governments have a very poor record in the prediction game.
  • If a foreign government interferes in the market by giving their producers a production or export subsidy, there is absolutely no reason to retaliate. Afterall, the foreign government (actually the foreign taxpayers) are subsidizing your country’s consumption. The correct action would be to write them a thank-you note!


In the next posting we will examine some of the more sophisticated arguments for industrial policy in advanced economies.

More posts on trade policy

Industrial policy in advanced economies part 2

Trade policy in developing economies

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