The free market cannot optimize everything that generates economic value. Industrial policy is an extended series of responses to this fact.1
The shortcomings of free markets are a vast topic, with many of them having little relevance to industrial policy. Those important for our purposes here are:2
1. Externalities
2. Time horizons
4. Fundamental innovations
Because each of the above creates at least the possibility of the free market producing a suboptimal outcome, it creates, in principle, the possibility that government intervention could produce something better.3
Let us examine these shortcomings in turn, and the policies used in attempts to overcome them. This discussion is simplified and abstract, but we will spend the rest of this book filling in the concrete details.
Externalities
An externality occurs whenever an economic activity “leaks” costs or benefits elsewhere, without the entity performing the activity incurring the cost or benefit itself. Some externalities are negative, such as pollution, which harms the environment without this cost being borne by the firm doing the harm. The classic governmental responses are emissions regulations and fines for polluters.
Other externalities are positive, such as when a firm develops a new technology that will create value all over the economy, beyond the reach of its own profits.4 When its innovation cannot be protected by patents or trade secrets, a firm may not be able to capture all of its value and thus may choose to underinvest in developing the technology.5 Governmental responses include tax credits for, and direct investments in, R&D (see Chapters 19–23).
Another example is training personnel who may then go to work for other companies – a disincentive to invest in training. Governmental responses include free public schools and subsidies for worker training.
The concept of inappropriability embraces everything firms do that generates economic value they cannot fully capture. Inappropriability also occurs, for example, when a firm invests in upgrading its supplier companies, which will then be able to sell to anyone, not just the company paying for the upgrades. Governments have responded by funding technology extension services to help small and medium enterprises upgrade themselves (see Chapter 22).
Time Horizons
Short-term investing can accomplish many important economic tasks, but some of the most crucial investments must be long term. And there is nothing in capitalism guaranteeing that capitalists will have sufficiently long time horizons.6 But without long-term investments, whose payoff may not come for years or even decades, businesses often won’t develop the next generation of technology, instead sticking with variations on what already exists. Companies with short time horizons will cede market after market to rivals with longer time horizons. Entire industries can be outcompeted by foreign rivals with time horizons artificially lengthened by their home country’s industrial policies.
Short-term thinking may be economically rational for the firms engaging in it, and even more so for managers compensated for short-term results. But society, as opposed to any one firm, goes on forever, so it has good reason to prefer long time horizons. Thus, governments try to lengthen firms’ time horizons with tools such as low-cost, “patient” capital (see Chapter 3). This capital is often generated by the many, often hidden, policies used to force or incentivize people and firms to save more. Governments also offer tax credits for, and incentivize banks to lend preferentially to, projects expected to have long-term payoffs for the economy as a whole, and directly fund high-risk technological research whose potential payoff is too far in the future to interest private firms.
Systemic Effects
Systemic effects are aspects of the economy that are not optimizable at the level of individual actors like people and firms. Most things are optimizable at this level, which is why market economies work in the first place. But a market economy, by definition, is not centrally planned, so it will have a hard time achieving outcomes that don’t emerge naturally from the actions of its individual profit-seeking players. Even if every player does what’s best for itself, the result will not always be optimal for the economy as a whole.
For example, “quality of demand” refers to the fact that companies selling anything from jewelry to jet engines to exceptionally sophisticated customers will be driven by their demands to excel.7 Competitive pressure to respond to these demands will drive them to upgrade their capabilities, since they can no longer maximize profits by standing pat. But no individual customer will see a financial reward commensurate with the benefits that the quality of their demand confers on the whole economy. As a result, markets alone will not always induce an optimal quality of demand. Therefore, governments have deliberately pushed their nation’s industries to upgrade more aggressively than immediate profitability would have caused (see Chapter 6). Quality of supply has an analogous logic.
Another systemic issue concerns the benefits of geographical clusters of related firms such as Silicon Valley, which are often extraordinarily successful. Once a cluster exists, the market will automatically prompt firms to locate in it. However, it is very hard for an individual firm, unless it is extremely large, to create a cluster on its own. The coordination problem is usually not solvable by a single firm. Therefore, governments try to create and nurture clusters (see Chapters 29 and 30).
Market Shortcomings: Fundamental Innovations
Per capita economic growth requires that an economy produce more goods and services on Tuesday than it did on Monday because something changed that made its workers more productive.8 Adding capital investment is the obvious candidate, but how should the money be invested? Simply buying every mechanic in a factory a second wrench won’t make that factory more productive.9 The mechanics need something they don’t already have, something that will enable them to produce more output with the same amount of labor: a better wrench, or perhaps some automation. In other words, technology.
Technological advance in developing nations can mean adoption of technologies already existing elsewhere. But in developed nations that already use existing technologies to their full potential, new technologies must be created.10 In these economies, innovation is required for productivity growth.11
Unfortunately, free-market economics, despite its enthusiastic rhetoric about innovation, has a very incomplete explanation for why and how technology advances. It is on reasonably solid ground explaining incremental advances by the private sector. The market will pay to develop technologies that are readily monetizable. But many technologies must pass through long stages of risky and expensive development before they earn a profit. Because the market can’t optimize their creation, it has not, in recent decades, produced many of the most economically important technologies. Since World War II, the great majority have originated elsewhere: in government labs, especially military ones, in publicly supported nonprofits such as universities, and in government-sanctioned monopolies such as AT&T. The internet, for example, was created to enable government scientists to share data, not to make money. Jet engines were first developed for the Air Force (see Chapters 19 and 26).
Market Shortcoming: Static versus Dynamic Efficiency
With respect to economic growth, each nation faces not one question but two:
1. What is the most productive thing to do today, given the current state of its productive resources?
2. How can it transition to better productive resources tomorrow?
Markets are generally good at achieving the former, so-called static efficiency. But they are less good at the latter, “dynamic” efficiency. This is clearest in developing nations: Growth is about turning Burkina Faso into South Korea, not about being the most efficient possible Burkina Faso forever. But it is also true for developed nations.
Why? Because static and dynamic efficiency are not only different, but can conflict. It can sometimes be rational to do things that are inefficient in the short run because there is a long-run payoff. For example, a nation can protect infant industries – forcing its consumers to buy more expensive domestically produced goods for a time – to get lucrative new industries started. This difficult but fruitful trade-off between static and dynamic efficiency is central to many aspects of industrial policy.
Market Shortcoming: Increasing Returns
Increasing returns mean that when a firm spends more money on inputs, the value of its outputs goes up even faster. For example, if baking a loaf of bread requires a $1,000 oven and $1 worth of dough, then baking one loaf will cost $1,001 per loaf. But if one bakes two loaves, the cost will be $501 per loaf – and if one bakes enough loaves, it will eventually get close to $1. Because the cost per loaf continually falls, the value of additional bread obtained for each additional dollar continually rises.
In industries where increasing returns are present, the market will not be completely free. This is clearest in the extreme case, increasing returns that go on forever, costs dropping ad infinitum with each additional unit. (A search engine like Google is probably the closest thing to this in the real world.)12 The most efficient outcome is one producer for the entire world, because two producers would each produce half as much and therefore have higher costs. An initially free market will tend to deliver this one-producer outcome because whichever producer has slightly higher volume will have slightly lower costs per unit, be more competitive, gain volume at the expense of its rivals, lower its costs more, and inexorably drive them out of business. But then the free market will come to an end, because there will be a monopoly. Any new firm entering the industry, unless it can do so with the same production volume as the incumbent, will not be competitive, so the monopoly will persist.
Most increasing returns are not this extreme, but the more they are present in an industry, the less free the market will be. There will be “imperfect” competition: not one single producer but only a few, so that each firm will be big enough for its actions to affect the entire market. In other words, an oligopoly. Increasing returns tend to make the industries in which they occur oligopolistic – a fact with great significance for industrial policy, as we will see in the next section.
Advantageous Economic Activities
Increasing returns are the first of a set of characteristics of what this book will refer to as “advantageous” economic activities.13 These characteristics tend to coincide, reinforce each other, and build up cumulative causation (when something happens because multiple causes build up over time). To wit:
Economic activities with these characteristics tend to produce dynamic efficiency, causing an economy to repeatedly gain in productivity and thus grow. The more a nation’s economy consists of such activities, the more prosperous it will be today and the better its growth prospects will be for tomorrow. Industrial policy, at root, is about increasing the quantity of such activities in an economy.
Pricing power occurs whenever a firm can choose to charge more and sell less, or charge less and sell more – as opposed to just having to accept the market price. The latter happens when there are many small competitors: Each will be able to sell at will at the market price, but not at all if it charges a penny more. Pricing power requires that some factor be present that reduces competition, so pricing power tends to accompany increasing returns.
Pricing power means that sellers get a higher price. It can come from being the only coffee shop on the block, but the kind relevant to industrial policy comes from producing things that are hard to produce, such as jet engines or smartphones. When only a small number of highly skilled firms can produce a product, an oligopoly will develop – whose members will have pricing power. In fact, whenever know-how is the major production cost, there will necessarily be increasing returns, because once that know-how has been paid for, each additional unit of product amortizes its cost over more output.
Technological dynamism:
“Hard to produce” usually means sophisticated technology. But what was once cutting-edge usually becomes commonplace and easy to produce over time. So, what producers want is ongoing technological change, so that they can stay forever near the leading edge, employing the difficult, relatively new technology that confers pricing power.
One way to accomplish this is to produce the technological change oneself. Enter R&D. Pursuing profits in this way is called “dynamic rent-seeking.” (The term “rent,” in the peculiar usage of economics, means profits exceeding what a free market would grant.) Dynamic rent-seeking is based on continually innovating and upgrading to keep earning the rent. Its opposite is static rent-seeking, which means seeking some privilege, such as a legal monopoly, that enables charging a premium without doing anything productive to earn it. Static rent-seeking does an economy no good, but dynamic rent-seeking increases productivity and thus produces growth.
Synergies:
Some economic activities, when they first emerge or later improve their productivity, enable other activities to emerge or improve their productivity. For example, cheap mass-produced steel, whose first major market was railroad rails, made skyscrapers possible. Vacuum tube production originally flowered to build radios, then enabled televisions. Computer chips were invented when computers were room-sized, but eventually became sufficiently small, powerful, and cheap to enable smartphones. Smartphones, in turn, enabled ride-hailing services. Jet engines developed for military aircraft enabled passenger jets, mass tourism, and ultimately Disney World.
When synergies are present, advances in one part of the economy tend to push forward other parts. This is important for long-term growth because there is a limit to how much any one industry can grow, simply because there is a limit to how much of any one product consumers want. When are synergies absent? Consider single-export economies, producing, say, bananas or petroleum. A nation may be poor if it produces only bananas, or rich if it produces only petroleum, but either way, market forces alone are unlikely to set it on a path to producing anything else.
Advantageous Industries Produce Growth
Advantageous economic activities are activities, not industries, but all economic activities take place in industries. Some industries are “tightly packaged” – that is, one must perform all their activities to perform any. Others are loosely packaged: Some activities can be delegated to other firms, or geographically scattered so a country can host some but not others.
Advantageous industries tend to have six key characteristics:
2. Susceptibility to repeated improvement
4. Capacity to absorb investment
5. Path dependence
6. Human capital accumulation
Advantageous industries generally produce products for which income elasticity of demand is high. For example, people spend significantly more money on cars as their incomes go up, but only a little more on milk. Therefore demand for products like cars can rise with the overall income growth of an economy. As a result, productivity gains in making such products do not just drive down their price, as output can rise along with those gains. Productivity gains are thus shared between producers, in the form of higher profits and wages, and consumers, in the form of lower prices. Contrarily, with products of relatively inelastic demand, such as commodity foodstuffs, productivity gains usually go mostly to consumers, not producers.14
Advantageous industries tend to produce goods susceptible to repeated improvement, like computers or airplanes, while disadvantageous industries produce goods whose character is basically fixed, like fruit or T-shirts. When a product exhibits meaningful variety, producers can establish mini-oligopolies in specific niches, enabling dynamic rent-seeking. Product variety also increases opportunities for innovation, both because inventing new varieties is itself an innovation, and because innovation can now advance on multiple fronts.
Advantageous industries tend not to compete on pure price. (Price is obviously a factor with anything sold for money, but it is relatively less important here.) They compete instead on quality, technology, reliability, reputation, marketing, service, variety, style, rapid innovation, understanding of buyer needs, vendor financing, managerial sophistication, and customer relationships.15 Importantly, these forms of competition make cheap foreign labor much less relevant, allowing advantageous traded industries to maintain their workers’ incomes despite foreign competition.
Advantageous industries tend to have a high capacity to absorb investment. Buying another $1,000,000 worth of tractors for a coffee plantation that already has them won’t increase its productivity very much. But a television factory will likely be able to repay investment in better machinery with higher productivity. Even better, advantageous industries tend to activate a virtuous cycle in which innovation absorbs capital and repays it by raising profitability, generating more capital and repeating the cycle. Economy-wide growth often involves a multi-industry virtuous cycle, in which the upgrading of one industry causes others to upgrade and so on.
Advantageous industries tend to exhibit path dependence. That is, having advantageous industries makes it easier for a nation to acquire other advantageous industries.16 For example, nations that produced radios were better equipped to produce televisions. As a result, economic growth is path dependent: What nations can produce tomorrow largely depends on what they produce today. This is why much industrial policy, historically, has centered on policies, from infant-industry protection to cash subsidies, designed to break into industries expected to lead somewhere. Historically, this usually meant getting out of agriculture and raw materials and into manufacturing (especially of products sophisticated at the time), although a small segment of advanced service industries has been entering the advantageous category since the late 1970s.
Advantageous industries tend to experience human capital accumulation, because they use technology their workers must have training to operate. This creates a premium on a skilled, not just cheap, workforce. Human capital embodied in the workers themselves encourages better treatment of labor, for the same reason factory owners do not let valuable machinery rust away. Advantageous industries thus make at least possible the “countervailing powers,” such as the bargaining power of unions, that spread the profits of industry beyond its owners. (Such leverage is not guaranteed, but workers can’t bargain for a share of profits that aren’t there.) Rising worker incomes also provide the purchasing power to sustain growth, and as incomes rise, consumers generally demand better products, driving the industries of the nation – which will depend at least in part upon domestic demand – to upgrade.
Advantageous versus disadvantageous is not binary, but a sliding scale from very advantageous to very disadvantageous, with most industries falling somewhere in between. It is also not guaranteed that any given advantageous industry will have all six listed qualities. But these qualities are interlinked, mutually dependent, and tend to appear as a package. For example, technological advance is linked to expanding production because it is much easier to invest in new technology when one is adding new machinery to expand production. And expanding production is linked to elastic demand, or else nobody would buy the output.
Note, finally, that our treatment here is highly abstract and elides many industry-specific details. Exceptions will not be hard to find. But it is certainly true enough of the time to be a useful guide to policy.
The ideas of increasing returns and oligopoly industries have been around for a long time. But mainstream economics does not generally follow the train of thought just discussed, largely because its logic interferes with the idea of general equilibrium, the keystone of the notion that free markets are best.17 This is because in the presence of increasing returns, there is not one possible equilibrium but many, depending on contingent events.
The main academic home of these concepts is thus not economics departments but business schools. For example, here is Michael Porter of Harvard Business School, who refers to our “advantageous” industries as “structurally attractive”:
[I]ndustries important to a high standard of living are often those that are structurally attractive. Structurally attractive industries, with sustainable entry barriers in such areas as technology, specialized skills, channel access, and brand reputation, often involve high labor productivity and will earn more attractive returns to capital. Standard of living will depend importantly on the capacity of a nation’s firms to successfully penetrate structurally attractive industries.18
Disadvantageous Industries
In disadvantageous industries, some or all of the positive dynamics just explained are absent – or worse, run in reverse. Such industries not only tend to have low wages and profits today, but also tend not to lead to better industries tomorrow. For centuries, “disadvantageous” has meant commodity agriculture, natural-resource extraction, and services such as domestic servants and retail. And since the late 1960s, low-skilled manufacturing has been inexorably joining this category.
Agriculture and natural resources generally exhibit diminishing, not increasing, returns, as once the best land and most accessible resource deposits have been exploited, increasing production means turning to inferior land and deposits.19 Such industries rarely have pricing power, as they generally produce undifferentiated commodities. (Commodity booms come but they also go.) Because price and income elasticity of demand for their products are low, productivity growth tends to flow to consumers as lower prices, rather than to producers as profits and wages. American farmers, for example, use advanced technologies ranging from genetically engineered seeds to satellite positioning systems for their tractors, but struggle to stay solvent.20
Industries such as retail and restaurants have less scope for productivity improvement than manufacturing. A 1950s diner is not that different from one today, while a 1950s auto assembly line would be totally uncompetitive. Technological innovations in disadvantageous industries tend to come from other industries: Farmers themselves don’t invent satellite-navigating tractors or genetically engineered corn. As a result, innovations tend to increase the productivity of all producers at once, driving down the price of the product: The producer of the innovation, not its end user, earns the premium. Agricultural prices also tend to be volatile: Soybean or banana prices can vary by 50 percent from year to year, but not car prices.
Disadvantageous industries generally lack synergies. When the Santa Clara Valley in California (better known today as Silicon Valley) specialized in plum production before World War II, this brought about a prune industry and fruit canning, but little more. When it became a center for aerospace and defense electronics, this led to transistors, then integrated circuits, then computer hardware, computer software, and, contemporaneously, a venture capital industry feeding on and nurturing these industries and others. Their output is worth many, many times what the region’s fruit production once was.
The presence of advantageous industries in an economy generally improves wages in even that economy’s disadvantageous industries. For example, growth of manufacturing in a developing nation raises the incomes of farm workers by tightening the labor supply. Rising manufacturing wages generate higher prices for farm goods that must be consumed locally because of transport costs and perishability. Advantageous industries can also set a “wage floor,” preventing the unemployed from crowding into disadvantageous industries and dragging down productivity due to these industries’ diminishing returns.21
Underdeveloped nations are poor because their economies are predominantly composed of disadvantageous industries and they can’t find a way out of them. Developed nations are not wealthier because they engage in the same economic activities as developing nations, only with greater productivity. They engage in fundamentally different activities because they host fundamentally different industries. Commodity agriculture, for example, exists in developed nations, but is a small percentage of GDP and employment.
Nations that used to be poor and agricultural, such as South Korea in 1960, didn’t become rich by finding ways to produce rice and fish (South Korea’s main industries then) with 20 times the productivity. They used proactive industrial policies to break into industries, like steel and cars, where 20 times the per-worker productivity of a small-scale fisherman or peasant farmer is the norm.
Note, finally, that having a lot of advantageous industries is not the same thing as merely being rich, as small-population states with large natural resources, such as Argentina in 1900 (beef; see Chapter 12) or Kuwait in 1980 (oil), can have high per capita incomes. But the resource-based model doesn’t scale. There has never been a large nation that was rich purely on the strength of natural resources because no nation has ever had enough resources. As Chinese economist Justin Yifu Lin, the World Bank’s former chief economist, puts it, “except for a few oil-exporting countries, no countries have ever gotten rich without industrialization first.”22 But advantageous industries, on the other hand, can scale. And when their ability to scale is exhausted and their products commoditized, they lead to new industries and scaling can begin anew.
