Why and How to Enact Consumer-Responsive Industrial Policy

Updated: Oct 3



Introduction

Industrial policy is one of the most important aspects of Post-Monetarist Political Economy; this article will describe why it is necessary and how it can work. Industrial policy consists of government programs and regulations which support strategically important industries. Examples of industrial policy include subsidies, tariffs, financing of targeted industries, state-owned enterprises, and buffer stocks. I begin by explaining how markets fail to produce ideal outcomes. Next, I explain how government intervention can be beneficial. Finally, I respond to arguments against industrial policy.


Examples of Inefficient Markets

For the purpose of this article, markets are inefficient if they do not sufficiently allow consumers to express their all of their preferences, which includes not only their preference for low prices but also other preferences, such as environmental sustainability and social equity. Inefficient markets whose conditions lead to adverse outcomes - even when economic agents are reasonably well-informed - include electricity, health care, transportation infrastructure, and housing. For example, in competitive electricity markets, where demand is uncertain and fluctuates throughout the year, “it is more profitable for electricity producers to shave spikes in electricity demand over the year than to build expensive capacity which will be idle during most of the year.” (Milstein and Tishler 2010) This leads to underinvestment and undercapacity.

There are several market conditions that lead to adverse conditions in the healthcare industry. (Mwachofi and Al-assaf 2011) For example, the supply of health services is interdependent with the market for education, making it difficult for the supply of providers to match the demand for care. Because a shortage of doctors leads to higher prices, doctors can earn the same amount of money by seeing fewer patients, which in turn raises prices, ensuring that the supply of doctors will always be lower than demand. Because the initial costs of many healthcare facilities are high, larger, established firms have high market power, which makes the introduction of competing providers difficult and allows established firms to set prices which reduce consumer purchasing power and welfare.

The difference in power concentration between actors in different products in the transportation industry prevents adequate investment and consumer satisfaction. Uninhibited markets only lead to efficient markets when transaction and negotiation costs are low and unevenly distributed. Consider a subway system, for example. Once it is built, the cost of operating a subway system for a city of one million people might be lower than the cost of each of those one million people driving their own cars, but the cost of an individual negotiating and transacting to purchase a car is much lower than the cost of one million individuals planning and building a subway system. This cost differential is exacerbated when powerful market actors intentionally sabotage public transportation projects, and once cities are designed to accommodate cars, economic inertia and network effects make building a subway system even more difficult. Many of the beneficiaries of public transportation projects are low-income individuals who do not have the option of waiting to use these projects even if they are willing to pay the cost of building and using them. Combined, these conditions can lead to chronic underinvestment in transportation infrastructure despite public support for expanding public transit.

The market for affordable housing has many inefficiencies that prevent adequate supply even though market participants are reasonably well-informed and act in their best interest. The housing market is unlike the market for consumer goods, in which buyers can choose incrementally less luxurious, more affordable products to meet their needs all the way down to the point of paying orders of magnitude less. For example, a consumer who wants to buy a new, top of the line mobile device can (as of this writing) purchase Samsung Galaxy Z Fold for $1900, but a consumer someone who wants to save money while still gaining much of the utility from a mobile device can purchase the Samsung Galaxy A01 for $60, over 30 times less. No such flexibility exists with respect to housing; in San Francisco, the rent for a luxury apartment is $5000 per month, but there is no $200 per month option.

The reason the price of homes are inflexible is that much of the cost of renting housing is either fixed or interdependent on other markets. Regardless of whether a developer is building luxury or affordable housing, they must (among many other things) take several very expensive steps for which there is no inexpensive alternative. For example, a developer must (1) test the soil to determine the depth of the foundation, excavate for the foundation, and pour the concrete for the foundation; (2) install plumbing, electrical wiring, and ventilation; (3) weather proof the building to ensure it is not damaged by rain, snow, fire, or earthquakes. The things that make luxury apartments expensive - appliances, age of the building, hardware, finishings, size of windows, amenities, etc. - make up a relatively small amount of the cost of construction. Even luxury apartments do not have gold plated electrical wiring and copper pipes, and their floors are not real wood but wood laminate. Similarly, the costs of building and operating housing is interdependent on many other markets. The price of land, the price of labor for construction, the price of labor for staffing the completed complex, the cost of energy and water to supply common areas, property taxes, permitting costs, etc. are not costs that developers can freely reduce in order to create a product more affordable to low-income renters. It will almost always be more profitable to spend an extra $10,000 on fancier appliances, finishes, etc. so the apartment can rent for an extra $1,000 per month. The result is that intelligent, reasonably well-informed developers acting in their best interest have neither the incentive nor the ability to provide affordable housing in adequate supply.


Consumer-Responsive Industrial Policy

As described in the previous section, inertia and uneven distributions of wealth and power can create inefficiencies which lead to prices which do not reflect consumers’ true preferences, even when each actor is reasonably well-informed and acting in their best interest. Industrial policy can amplify consumers’ true preferences without enacting a coercive tax or attempting to change their preferences. The simplest way to do that without fostering a corrupt bureaucracy is to create incentives that are firm-neutral, technology-neutral, and - most importantly - purchase-dependent.

Firm-neutral incentives are given out to each actor in that industry based on objective qualifying criteria. There should be no mechanism through which the government can choose which company gets a specific grant. Technology-neutral incentives are given to firms without placing conditions on which line of R&D they pursue, as long as the end product meets the consumer needs as objectively defined by the policy. Lastly, purchase-dependent incentives are given in conjunction with sales to final end users, rather than merely upon creation of the product. I refer to policies that meet these three criteria as Consumer-Responsive Industrial Policy.

The most effective example of Consumer-Responsive Industrial Policy in the United States is the federal tax credit for residential solar installation. It is purchase-dependent, since the credit is given to the consumer and only after they have purchased and installed the panels, instead of to the firm when the panels are produced. It is technology-neutral because it does not discriminate between types of solar panel; monocrystalline, polycrystalline, and thin-film panels are all eligible. It is firm-neutral because panels purchased from any firm qualify; there is no process by which participating manufacturers are selectively enrolled in the program. Finally, it has been successful; the share of the US’s energy derived from solar energy tripled between when the tax credit was first enacted in 2007 and 2019, when the linked article was written. This program is not perfect, however. It would be more effective and more responsive to consumers if it were an immediate transfer of funds rather than a credit used for paying taxes.

Other hypothetical examples of Consumer-Responsive Industrial Policy can be found in the proposed applications for the (not passed as of this writing) Industrial Finance Corporation Act of 2021. The IFC Act proposes the creation of a government-owned corporation which will strengthen semiconductor manufacturing infrastructure by providing (among other things) low-interest loans for construction of facilities and purchase guarantees to ensure a stable demand for chips. Here is how I would make these policies Consumer-Responsive. Both the loans and the purchase guarantees should be firm-neutral and technology-neutral; any firm that meets objective requirements such as solvency, capital, and liquidity should automatically qualify, and firms should qualify if they make any type of semiconductor chips. Both programs should also be purchase-dependent. The loan should either be forgivable or benefit from a reduction in interest if the firm that took the loan sells some predetermined amount of chips to the public, and the purchase guarantee should be based on the price and amount of chips sold to the public. For example, the interest on a $10 million loan might go from 2% to 0% if the firm sold 100,000 chips. The guarantee might be to purchase a number of chips equal to 10% of chips sold to purchasers other than the federal government at the average price of chips sold to purchasers other than the federal government. These slight tweaks would ensure that the programs would only benefit firms that were directly responsive to the preferences of consumers.


Responses to Arguments against Industrial Policy

There are two primary arguments against industrial policy that I would like to respond to: that it is inefficient and that it is immoral. The efficiency argument is that industrial policy is unnecessary because free markets can provide whatever goods and services consumers need and desire and because government intervention can only ever decrease the quantity, quality, or affordability of targeted goods or services because governments misallocate resources when not guided by price signals. The moral argument is that individual consumers can and should be allowed to make their own decisions unimpeded by the coercive meddling of government bureaucrats. The issue with both of these arguments is that they assume market conditions and policy structure that is not always present. The efficiency argument assumes that the market for the targeted product is efficient in the first place. A market for a product is efficient if, among other things, it is not dominated by a monopolist, demand is certain, supply is certain and not dependent on outside markets, demand is not induced by the supplier, risks are certain, the customer can test the product before consuming, information symmetry exists between buyers and sellers, and consumers can predict the results of their consumption decisions. In many markets which do not meet these conditions, rational behavior by reasonably well-informed actors can lead to adverse outcomes, and government interventions can improve efficiency to increase overall consumer satisfaction. The moral argument assumes that the industrial policy is intended, designed, and implemented to alter consumer choices. An example of such a policy is a direct tax on retail purchases of junk food or cigarettes. However, industrial policy need not be structured this way and can actually work with consumer choices rather than against them.

Summary

There are several markets which suffer from inefficiencies that are in no way reflective of the lack of information or ill intent of producers or consumers and which cause underproduction or a dampening of consumer preference signals. Government policies can help to overcome these inefficiencies by enacting Consumer-Responsive Industrial Policy, which requires that incentives be firm-neutral, technology-neutral, and purchase-dependent. Examples include (1) direct subsidy of purchases by end-users through immediate transfers, (2) low-interest or forgivable loans which are dependent on selling a certain amount of the targeted product, and (3) purchase guarantees whose price and amount are dependent on sales to the public.