Industrial Policy with Network Externalities: Race to the Bottom vs. Win-Win Outcome

Abstract

Industrial policy has returned to the centre of economic governance, particularly in the high-tech sectors where positive network externalities in demand make market dominance self-reinforcing. This paper studies the welfare effects of an industrial policy targeting a sector with network externalities in a two-country model with strategic trade and R&D investment. We show how the welfare consequences of this policy are determined by the interaction between the strength of the externality, the type of R&D, and the degree of product differentiation between the home and the imported goods. When externalities are weak or the goods are close substitutes, the business-stealing effect produces a race to the bottom that dissipates more surplus than it creates. Under sufficiently strong externalities and weak substitutability or complementarity of the goods, industrial policy competition can make both countries simultaneously better off compared to the laissez-faire outcome because of the mutual business-enhancement effect. The case is stronger for the product innovation than for the process innovation, as the former directly affects the demand and triggers a stronger network effects than the latter which operates indirectly through the supply. Thus, the network externalities create an opportunity for a win-win industrial policies, but its realisation depends on the market structure and the nature of innovation.

Figures (8)

• Figure 1: Process R&D: welfare differences ($\Delta W_i \equiv W_i^{\text{Nash}} - W_i^{\text{LF}}$) between the industrial policy equilibrium ("Nash") and laissez-faire ("LF") as functions of network externality strength $b$, for $m = 0.05$ (solid) and $m = 0.25$ (dashed). Left: foreign country always loses. Centre: home country always gains. Right: aggregate welfare under policy competition exceeds laissez-faire at high $b$, more strongly at lower substitutability.
• Figure 2: Product R&D: welfare differences ($\Delta W_i \equiv W_i^{\text{Nash}} - W_i^{\text{LF}}$) between the industrial policy equilibrium ("Nash") and laissez-faire ("LF") as functions of network externality strength $b$, for $m = 0.05$ (solid) and $m = 0.25$ (dashed). Left: at $m = 0.05$, the foreign country switches from losing to gaining at high $b$; at $m = 0.25$, the foreign country always loses. Centre: home country gains throughout. Right: aggregate welfare gain is substantially higher at lower and higher $b$.
• Figure S.1: Process R&D: optimal policy instruments as functions of network externality strength $b$, for $m = 0.05$ (solid) and $m = 0.25$ (dashed).
• Figure S.2: Product R&D: optimal policy instruments as functions of network externality strength $b$, for $m = 0.05$ (solid) and $m = 0.25$ (dashed).
• Figure S.3: Process R&D, complements: welfare differences between Nash equilibrium and laissez-faire as functions of network externality strength $b$, for $m = -0.10$ (solid) and $m = -0.25$ (dashed). Left: foreign country switches from losing to gaining at high $b$. Centre: home country gains throughout. Right: aggregate welfare turns positive and rises steeply.

Theorems & Definitions (17)

• Remark 1: Supply-Chain Isomorphism
• Proposition 1: Policy effects on output under process R&D
• proof
• Proposition 2: Network externality effects on output under process R&D
• proof
• Proposition 3: Foreign subsidy best response under process R&D
• proof
• Proposition 4: Home subsidy best response under process R&D and independent goods
• proof
• Proposition 5: Policy effects on output and product R&D