Market Failure or Government Failure?
Posted July 28, 2010 at 6:20 am 
Filed in: The notion of having the government intervene to spark growth in new industries has received a lot of attention lately, particularly in Congressional debates around whether or not to support the development and deployment of electric vehicles. In general, the discussion boils down to one question: should the government/Congress be picking winners?
Before addressing this question, let’s take a step back and consider the bigger picture, as summarized by professor Rodrik from Harvard: “The essence of economic development is structural transformation, the rise of new industries to replace traditional ones”. To the extent that we believe this proposition, the question then becomes: how can government best facilitate structural transformation? This is where the disagreement lies.
It is widely accepted that government intervention in the economy is justified to correct market failures. In the context of nascent industries, market failures are certainly present, and are manifest in various forms, including: (1) information problems may prevent individual investors from coordinating the required investments in related industries; (2) demonstration effects and positive spillovers (technological or otherwise) which raise social returns above private ones, are not internalized by the individual investors when deciding whether or not to invest. By giving private economic agents a push in a certain direction, the government can go a long way towards solving these market failures and promoting the growth of successful new industries.
A valid contention aired by skeptics of industrial policy revolves around the competence (or rather, the lack thereof) of the government to select which emerging industries to back, and the way it does so. They point to all the examples where governments have spent millions backing certain industries and have resulted in failure – like the French support of their electronics industry in the 80s – and use this observation to argue against using industrial policy to drive structural transformation. The opposite is also true for supporters of government intervention, remembering only the success stories – such as Silicon Valley.
An immediate reaction is to think that if the failures outnumber the successes, then we would be better off without industrial policy. Well, think again. It is not really about the relatively few number of successes, but about their magnitude and potential to enhance economic development and well being – the internet being an appropriate example. “Public programs played an important role in triggering the explosive growth of every other major venture market around the globe” writes Harvard professor Lerner. Furthermore, this success/failure ratio is not very dissimilar to that observed in the private sector, in that the faith of a majority of the privately developed new ventures end up in failure. That is the nature of entrepreneurship – the backbone of a healthy and dynamic economy.
It is true that the incentives faced by the public and private sector are different, and as a result, the former may be less effective in choosing which industries to support, and less efficient in doing so. However, it is worth remembering that due to the presence of market failures, some very successful transformative industries would never have seen the light were it not for government support at the initial stages.
Therefore, recognizing that fostering structural transformation is paramount, the focus should be on designing an appropriate incentives framework for the government, not on whether the government should intervene. The government is right is supporting electric vehicles; it remains to be seen whether it will do so in an effective and efficient way.
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