We assess the optimal industrial policy factoring in external economies of scale under changing global market conditions. Existing literature focuses on external economies of scale to evaluate industrial policy in a static (long-run) setting. However, since policy effects are likely to materialize with a time lag, policy assessment should compare the short-run distortion of the intervention to its long-run gain.
In this context, we extend the small open economy model of Bartelme et al. (2021) into a two-period dynamic setting to figure out how important the dynamics of global market conditions are in determining optimal policy. Bartelme et al. (2021) proposes higher optimal subsidy rate to an industry with higher elasticity of productivity with respect to sector size (scale elasticity). Based on the dynamic structure of the model, the optimal industrial policy in our model depends not only on the scale elasticity, but also on a multiplier which is larger when more resources are re-allocated to the industry in the long-run based on export market penetration. This optimal policy implies that an industry with a growing future market should receive stronger support than the suggestion in Bartelme et al. (2021).
We quantitatively evaluate the industrial policy of South Korea that was implemented between 1973 and 1979 to promote heavy and chemical industries. We find this intervention particularly relevant to our framework since the global export demand of targeted industries grew significantly during the intervention. For calibration, we estimate the scale elasticity of 26 manufacturing industries using plant-level data from the South Korean Mining and Manufacturing Survey. We also impute the industrial structure and export demand of South Korea using the South Korean Input-output table in 1975 and 1980, and the bilateral trade data from Feenstra et al. (2005). Our quantitative analysis presents two main results which are consistent with the policy implications from the model. First, even though the scale elasticity of targeted industries was smaller than that of non-targeted industries, the Heavy and Chemical Industry drive increased the welfare of South Korea. Second, the suggested optimal subsidy rate for the targeted industries is even higher than the actual rate.