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Marshallian Externality, Industrial Upgrading, and Industrial Policies

Jiandong Juy Justin Yifu Linz Yong Wangx , , January, 2013

Abstract A growth model with multiple industries is developed to study how industries evolve as capital accumulates endogenously when each industry exhibits Marshallian externality (increasing returns to scale) and to explain why industrial policies sometimes succeed but sometimes fail. The authors show that, in the long run, the laissez-faire market equilibrium is Pareto optimal when the time discount rate is su¢ ciently small or suf…ciently large. When the time discount rate is moderate, there exist multiple dynamic market equilibria with diverse patterns of industrial development. To achieve Pareto e¢ ciency, it would require the government to identify the industry target consistent with the comparative advantage and to coordinate in a timely manner, possibly for multiple times. However, industrial policies may make people worse o¤ than in the market equilibrium if the government picks an industry that deviates from the comparative advantage of the economy. Key Words: Marshallian Externality, Industrial Policies, Structural Transformation, Industrial Upgrading, Economic Growth JEL Codes: L50, O14, O25, O41

This paper bene…ts from the discussions with Gene Grossman, Norman Loayza, Aart Kraay as well as from the seminar and conference participants at Nanyang Technological University, Fudan University, Lingnan University, Shanghai Foreign Trade Institute, TsinghuaFudan-CUHK Conference on Chinese Economy (2011), Midwest Macro Meeting (2012). Roula Yazigi provides excellent editorial support. Wang gratefully acknowledges the hospitality and …nancial support from the World Bank during his stay in the 2010-2011 academic year. y University of Oklahoma and Tsinghua University. Email Address: jdju@ou.edu z World Bank. Email address: justinlin@worldbank.org x Hong Kong University of Science and Technology. Email address: yongwang@ust.hk...