I just took my final today for my Economic Development: Theory and Evidence course, taught by Dani Rodrik and Rohini Pande.  So if there’s ever a day to post on what I’ve learned about industrial policy from Dani, today is definitely the day.

The first fundamental welfare theorem of economics tells us that a competitive equilibrium is efficient, provided markets work perfectly.  This is to say the marginal product of labor and capital are equalized across the economy, otherwise resources could be shifted to higher productivity activities, increasing output.  This is not what we observe in most countries today, especially developing ones.

These inefficiencies in resources allocation are a big part of why some countries are richer than others.  Industrial policy can promote structural shifts in economies towards higher productive activities, increasing total factor productivity (TFP) and creating growth.  But when is government intervention justified and how should we go about determining the appropriate policy for a given situation?

The first question we have to ask ourselves is: why aren’t entrepreneurs shifting resources already?  It might be that they aren’t in fact profitable in the economy in question.  For this reason, policies should never target specific sectors.  We should be suspicious anytime we hear promoting “value added” activities, sectors with declining terms of trade, or activities with “linkages.”

Then when are policies appropriate?  The answer lies in the presence of market and government failures. Dani teaches us to look for several market failures in particular: learning externalities associated with learning by doing and learning about costs, credit constraints, and coordination failures.  In the interest of your time I won’t get into each of them in detail.  What’s key is to identify the market failure and formulate policies that target that specific failure as much as possible: subsidize credit or training, coordinate investment, or socialize investment risks.

We are also taught to look for government failures.  Insecure property rights, corruption, red tape, barriers to entry, and overly rigid labor laws are just a few examples of potential government created impediments to investment in productive activities.

Of course it may be the case that we are able to identify multiple market and government failures with respect to specific activities.  In this case we should determine which of the failures bind, that is, which is the greatest constraint to growth.  How to do so still remains a mystery, I’ll have to wait for Ricardo Hausmann’s Development Strategy course next semester.

The most important thing to remember is that only market and government failures justify policy intervention, and that policies should target the binding constraint as closely as possible.