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Rodrik and externalities

Posted By Russ Roberts On April 13, 2011 @ 3:07 pm In Podcast,Subsidies | Comments Disabled

In this week’s EconTalk, Dani Rodrik discusses [1] how labor markets in some countries work better than others. It’s an interesting conversation about the next best alternative. When workers in America lost their jobs the next best alternative can be fairly close to the lost job and may pay nearly as well. And of course some workers who lose their jobs are fortunate to find a job that even pays more. But in poorer countries, if the agriculture sector is destroyed by cheaper imports, for example, the next best alternative may not even be there or if it is, it may pay very poorly. One way to think of this is that creative destruction may not be equally creative everywhere.

Along the way, Rodrik argued, to my surprise, that starting a new venture in a poor country has a positive externality that leads to market failure. He gave the example of a call center–suppose a country has a work force that would be good at working in call centers. An entrepreneur who starts a call center will thereby provide information to other entrepreneurs about the quality of the work force. The original entrepreneur can’t capture this gain so the government should correct this market failure by subsidizing it. Rodrik and I discussed the issue for a while and he raised what he considered other examples of market failure including the possibility that any rents generated from starting the call center might quickly be eroded by other entrants who start their own centers and bid up the price of your labor.

After the podcast was over, I realized I had neglected to raise an important objection to Rodrik’s claim. We ended up emailing back and forth and he kindly gave me permission to print our exchange. I offered him the last word but he didn’t respond. I’m sure he was had simply had enough or had other things to do. I mention it only because I don’t want you to think that I didn’t give him the chance or that he conceded my point. Again, I’m sure he has something more to say.

ROBERTS: If entrepreneurs are uncertain about whether a countries labor force is productive or not, how would a government policy maker assess that more accurately?

RODRIK: It’s actually very simple.  The first-best intervention here is an entry subsidy to any entrepreneur who invests in a product or technology that is new to the country.  And there is a host of second-best policies that could also do the trick.

You don’t need to assume the government knows more than the private sector, any more than in the case of externalities from R&D in the advanced economies.  Even though the government has no idea which research projects will produce genuine advances, there is an argument for subsidizing R&D across the board.

Or think of patents, which are aimed to achieve in a second-best fashion, the same kind of knowledge spillovers that new products and processes generate in rich countries.

In fact, when entrepreneurs in developing countries engage in cost discovery, they are the source of exactly the same kind of positive externalities that entrepreneurs in Silicon Valley produce.  Except that the latter get patent protection, while the first normally don’t get any subsidies at all (unless we implement the kind of policies I am advocating).

ROBERTS: Let’s say creating a cardboard box factory, a new venture for the country, has a negative rate of return so no one is willing to start one. The government offers a subsidy to all new products. Now, when the subsidy is included, the factory has a positive return so it gets built. How is that a good idea?

RODRIK: It’s a good idea in the same sense that financing a R&D project with a potential externality is a good idea EX ANTE, even if the project ends up failing.  Other R&D projects that are successful (and are similarly subsidized) will more than pay for the failures.

This is all worked out in the following paper: http://www.hks.harvard.edu/fs/drodrik/Research%20papers/selfdisc.pdf

But here is the gist.  If there is an externality in investing in new activities, there will be underinvestment by the private sector.  A (small enough) subsidy to investors is efficiency-enhancing, because it brings investment closer to the first-best level, even if not all of the new projects succeed.

ROBERTS: I guess I’m skeptical about subsidizing R& D as well. If the subsidy is set too high (and there will be a political incentive to so) the subsidy will make the nation poorer. The same seems true of a blanket subsidy to new ventures.

If you’re interested in the idea, check out his paper and the podcast. The only other point I would add is that political pressure will make it very hard to define “new” as in subsidies to “new” ventures.

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