Abstract
This paper studies industrial policy making in the global economy. By reallocating resources from sectors that have low returns to scale to those featuring high returns to scale, industrial policies can in principle improve allocative efficiency. In an open economy, such interventions alter a country’s terms of trade as well. In the absence of coordination across countries, we show how the optimal subsidy rates depend on each country’s trade patterns, scale elasticity, and trade elasticity, whereas the optimal rate if set in a coordinated way depends only on the scale elasticity. This is the dilemma face by members of a free-trade bloc: there are no restrictions to the flows of trade nor impediments to realizing gains from trade, but each member free rides on others’ industry-promoting policies, eventually reducing each other’s incentive to carry out welfare improving reallocative measures. We calibrate a multicountry-multi-sector model featuring input-output linkages and external economies of scale at the sector levels, and quantify the welfare implications in each of the scenarios.