Europe's Economic Challenge: Analyses of Industrial Strategy and Agenda for the 1990s (Industrial Economic Strategies for Europe)

EUROPE’S ECONOMIC CHALLENGE

INDUSTRIAL ECONOMIC STRATEGIES FOR EUROPE

EUROPE’S ECONOMIC CHALLENGE Analyses of Industrial Strategy and Agenda for the 1990s

Edited by Patrizio Bianchi, Keith Cowling and Roger Sugden

London and New York

First published 1994 by Routledge 11 New Fetter Lane, London EC4P 4EE This edition published in the Taylor & Francis e-Library, 2005. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 © 1994 Patrizio Bianchi, Keith Cowling and Roger Sugden All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Europe’s economic challenge: analyses of industrial strategy and agenda for the 1990s/edited by Patrizio Bianchi, Keith Cowling and Roger Sugden p. cm.—(Industrial economic strategies for Europe) Includes bibliographical references and index. ISBN 0-415-11428-4 1. Europe—Economic policy. 2. Europe—Commercial policy. 3. Industry and state—Europe. 4. Industrial promotion—Europe. I. Bianchi, Patrizio, 1952– . II. Cowling, Keith. III. Sugden, Roger, 1958– . IV. Series. HC240.E858 1995 338.94–dc20 94–14950 CIP ISBN 0-203-40212-X Master e-book ISBN

ISBN 0-203-40846-2 (Adobe eReader Format) ISBN 0-415-11428-4 (Print Edition)

CONTENTS

List of figures

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List of tables

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Introduction

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Chapter abstracts

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Chapter 1

Policy Mix and Industrial Strategies Jacques De Bandt

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Chapter 2

Industrial Strategy in an Open Economy Patrizio Bianchi

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Chapter 3

Industrial Strategy: Guiding principles and European context Keith Cowling and Roger Sugden

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Chapter 4

Industrial Policy in Europe and Industrial Development in the Third World Ajit Singh

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Chapter 5

Industrial Strategy: Process or content? Insights from the Austrians Pat Devine

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Chapter 6

Innovation, Entrepreneurship and Industrial Districts Peter Dorman

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Chapter 7

European Community R&D Support: Effects on the cooperative behaviour of firms Y.Katsoulacos and E.Nowell

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Chapter 8

Does a Reduced Public Sector Increase Welfare in an Open Economy? Johan Willner

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Chapter 9

Continuity and Change in Portuguese Industrial Policy: Mobility regulation in the textile and clothing markets (1946–1992) João Confraria

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Chapter 10

British Industrial Policy in the Light of Traditional Theory and More Recent Developments in Economics and Management Christos Pitelis

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Chapter 11

Taming the Balance of Payments Constraint with a Sectoral Policy for Auto Candace Howes

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Index

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FIGURES

2.1 2.2 8.1 8.2

A closed economy Customs union The reaction functions of country 1 and country 2 The optimal public sector when productivity differs

15 19 95 101

TABLES

2.1 2.2 6.1 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12 7.13 7.14 9.1 9.2 9.3 9.4 9.5 9.6 9.7 11.1 11.2 11.3

Coalitions formed under the Smithian scheme and the Ricardian scheme Effects on social classes of opening a closed economy A typology of production forms Number and percentage of firms involved in SCAs Impact of CEC decision on non-selected applicants’ research effort Non-selected applicants’ market position and SCAs Nature of SCAs among successful participants Nature of SCAs among non-selected applicants Research-related outcomes from SCAs Objectives of forming RJVs (successful participants) Objectives of forming RJVs (non-selected applicants) Market relationship of partners in collaborative activities OCA partnership success and SCAs (successful participants) Reasons for not engaging in SCA (successful participants) Reasons for not engaging in SCA (non-selected applicants) Motives for SCAs for commercial development, production and marketing Demand growth and substitutability of SCA products The legal minimum dimension in the textile markets Number and size distribution of incumbents Size distribution of incumbents—spinning, weaving and finishing Size distribution of incumbents—clothing Linear correlation between firm and investment sizes Projects supported according to type of investments —spinning, weaving and finishing Projects supported according to type of investments —clothing Balance of payments and competitiveness Percentage shares of fourteen-country OECD manufacturing output by industry, for 1985 Merchandise imports, exports and balance of trade by sector

13 16 66 77 78 79 80 80 80 81 81 82 84 84 85 86 86 105 107 109 110 110 111 111 126 129 130

INTRODUCTION Industrial economic strategies for Europe: Preparing for the turn of the century

Europe is currently at a crucial stage in its economic, social and political development. Many questions are being asked about the appropriate way forward, partly in the light of the Maastricht Treaty but also more generally. Most of these questions are unanswered. For example, although the importance of the European level initiatives in economic policy has increased over recent years, numerous questions about the contribution that European policy can make to thriving industries and regions remain unexplored. In Britain, for instance, many have replaced their traditional blindness to Europe’s existence with a very narrow and unimaginative perspective; membership of the European Union is merely seen to impose constraints which need to be avoided. The possibility of membership offering positive opportunities for future development poses many issues that seem to be ignored by many people and that need detailed exploration. In Germany, questions over future European policy arise in the context of restructuring in the East. This raises queries about long-term strategy, and about the relationship between industrial and environmental policies. In addition, for various reasons completion of the European internal market is likely to give new momentum to the issue of efficiency. For example, the decisions of the European Court of Justice, by enforcing European Anti-Trust Law, may pressurize the Federal Government into questioning vested interests. Moreover, the Single European Act’s principle of mutual recognition may open up a ‘competition of systems’ and act as a threat to more regulated sectors of the economy. Meanwhile in The Netherlands, for example, there is concern that future policy will be dominated by larger economies, especially Germany, and thus be inappropriately designed. Similar worries can be seen in such countries as Greece and Portugal. More generally, there are fundamental queries about the proper allocation of responsibilities for various policies at the national and the Union levels, e.g. in the light of a potential conflict between structural and competition policies. Indeed this potential conflict is itself a basic issue; the traditionally broad approach of, say, France raises interesting questions in comparison with the emphasis on competition policies that has been seen in the Union. All of this suggests that further discussion and analysis of Europe’s future is needed. Moreover the time is especially ripe, given the massive job losses predicted to result from the European Union’s 1992 initiatives for instance. This programme is in many ways the Union’s most ambitious industrial economic initiative to date, but its potential welfare implications have already been questioned. Likewise the questioning implied by the Maastricht Treaty and the consequent break for thought that this precipitated makes further discussion and analysis of Europe’s future an urgent priority. In addition, the Community has become so preoccupied with monetary union that other concerns, focusing directly on the ‘real’ economy’s development, have been neglected; it is high time this balance was redressed. Furthermore the recent changes in Eastern Europe reveal that the continent is currently in a period of massive change and thus exciting opportunity. Removal of the ‘Iron Curtain’, transition from centrally administered systems and

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other changes have altered Europe’s geography and economy. The consequent challenge to European economic policy demands to be answered in a coherent and fundamental way. Thus at many levels and amongst many people, queries are being raised about the set of economic policies to take Europe into the next century. Moreover there seems to be a real and widespread desire to pursue coherent initiatives which address difficulties associated with growth, employment, environmental protection and international competitiveness whilst promoting European cohesion, convergence and stability. A problem is that, from the current state of the art in economic analysis, it is not at all clear which policies would achieve these objectives. It is against this background that a research workshop was held at the Research Centre for Industrial Strategy, University of Birmingham, in September 1993 as the launch pad for an evolving project on ‘Industrial economic strategies for Europe: Preparing for the turn of the century’. The contributions to this volume are revised versions of selected papers presented at the Birmingham workshop. The aim of the project as a whole is to focus on whether European industrial economic strategies can enable industries and regions to flourish as we begin the next century and, if so, on the precise nature and role of such strategies. Amongst other things, the project will include a series of workshops over the coming few years and publication of the Routledge Industrial Economic Strategies for Europe series, launched by this volume. The following chapters cover wide-ranging problems, as can be seen from the chapter abstracts. This reflects the broad set of issues that require analysis if successful industrial strategies are to be designed. Our concern in the project is not merely structural, competition or regional policies. Nor is it merely innovation strategy, environmental initiatives, problems of economies in transition from centrally administered systems or economic cohesion. Rather it is a coordinated approach to all of these issues. The strategic approach to European industrial economic development links together structural, competition and regional policies in a systematic way, such that problems associated with innovation, the environment, transition from centrally administered systems and economic cohesion are simultaneously addressed and the possibility of designing an appropriate set of coordinated initiatives is given careful consideration. The basic idea is to analyse and understand the nature of our industrial economic systems and thus the determinants of successful economic progress, and hence to examine the design of strategies for future development and contribute to the search for a new way forward. In part this entails an evaluation and assessment of previous ideas and past experience. This is an important root for our analysis. More importantly, however, it requires the development of new ideas via detailed theoretical and empirical research which, using both mainstream and less orthodox approaches, coherently ranges from the basic theory of firms and industries to improved understanding of the implications of particular activities to the consequent design of specific strategies. Moreover in doing this it is important to take into account the impact of European initiatives elsewhere, not least the Third World, and to learn from ideas being discussed in relation to other areas, e.g. the USA and Japan. Clearly it is beyond the current volume to cover all of these complex issues in detail. Nevertheless many aspects of the problems requiring analysis are discussed in some depth. Furthermore the volume identifies numerous, more specific areas where future research is needed. In this sense, it lays some foundations as a springboard for a more systematic and more detailed analysis in the future. PARTICIPANTS AT THE BIRMINGHAM WORKSHOP Ken Alexander David Bailey

Advisory Panel, Research Centre for Industrial Strategy, University of Birmingham University of Birmingham

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Patrizio Bianchi Ivo Bicanic João Contraria Keith Cowling Jacques De Bandt Pat Devine Peter Dorman Candace Howes Yannis Katsoulacos Hiroyuki Okamuro Christos Pitelis Michel Renirie H ans Schenk Sudi Sharifi Ajit Singh Geoff Stewart Roger Sugden Sandy Taylor Johan Willner

Universita di Bologna University of Zagreb Universidade CatÓlica Portuguesa University of Warwick CNRS-Université de Nice Antipolis University of Manchester Michigan State University University of Notre Dame Athens University of Economics and Business Hitotsubashi University University of Cambridge Erasmus University Erasmus University University of Birmingham University of Cambridge University of Southampton University of Birmingham Birmingham City Council Abo Akademi University

CHAPTER ABSTRACTS

1 Policy Mix and Industrial Strategies Jacques De Bandt To convince people that industrial policies are necessary, emphasis should be placed both on the necessity to adapt changing policy mixes to changing circumstances and on the strategic—goal oriented—dimension of such policies. The starting point for our analysis is the observation that the policies actually implemented in many countries have been inappropriate. Policies have been strongly biased, a point seen firstly in terms of the pre-eminence of macro policies and secondly in terms of the systematic priority given to market mechanisms and competition. Furthermore, account has also to be taken of the weaknesses of past industrial policies. While too much emphasis has been put on financial transfers, huge bureaucratic inefficiencies have constantly weakened these policies. A typology of industrial policies is then proposed. The emphasis which the chapter puts on the policy mix allows us to consider a variety of socioeconomic objectives, with changing weights attached to them, and obliges us to face consistency requirements. More important still is the fact that, within the policy mix, the industrial policy component—and particularly the ‘supplétive’ industrial policy component—should be made more specific and for that reason defined as elements of a strategy at the level of subsystems, i.e. based on concertation and cooperation among existing actors. A strategy is here defined as consisting of specific targets, means or resources and an organizational set-up. Such a bottom-up approach would be feasible only on the basis of the required accompanying industrial policy measures and technical assistance. 2 Industrial Strategy in an Open Economy Patricia Bianchi In the 1980s the term ‘industrial policy’ was erased from the economic debate, essentially because industrial policy recalled a pervasive role of the State in a closed economy. In the French-style tradition the role of industrial policy was to create national champions to compete in international conflicts among nations, and to subsidize weaker competitors: in both cases, government action distorts market dynamics because it is oriented to reducing market multiplicity.

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In contrast to this, the new approach to industrial policy is oriented to developing the institutional conditions for an increased market dynamic. This means defining at the macro level (national or supranational) an institutional context which is conducive to effective competition between a variety of players, and at the micro level (local) the environmental conditions for creating networks of innovators. Together, policies on both levels must be integrated to create the positive externalities needed for growth in order to avoid the formation of regressive coalitions to resist change. This approach was pioneered by several European Community (EC) programmes and finally embodied in Article 130 of the Maastricht Treaty. This new approach is especially relevant in the case of opening the market through regional economic agreement, such as with the EC, NAFTA and MERCOSUR. 3 Industrial Strategy: Guiding Principles and European Context Keith Cowling and Roger Sugden Faced with a lack of dynamism throughout Europe, the design of industrial economic strategies is an urgent priority. This chapter advocates a new approach to policy making in this area. Whereas previous approaches start with markets and market failure, we start with the modern corporation and its strategic decision making. Without purposive government policy, the long-term evolution of free market economies is seen to be dictated by the strategic decisions of the major corporations. This yields socially inefficient outcomes. The fundamental problem is identified as a concentrated structure of decision making. Accordingly the essence of industrial strategy making is seen as the process whereby a concentrated structure of decision making within the industrial economy is progressively replaced by a democratic structure. The implications of this general analysis are applied in the context of topical issues. Severe deficiencies in existing privatization and inward investment policies are identified. A broader approach is suggested, e.g. with privatization embedded in sectoral strategies and coupled to an opening of strategy making in major corporations. Emphasizing the importance of a flourishing network of small and indigenous enterprises, it is recognized that inward investment may be desirable, perhaps to gain technological expertise. However, the importance of linking this into the domestic technology complex is stressed. For technology policy more generally, new structures to support systems of small-scale production are advocated. Our analysis of the relationship between regions and the European Union suggests real opportunities for endogenous regional development. The Union is seen as a constraint on traditional industrial policy but as congruent, to some degree, with the approach we advocate. 4 Industrial Policy in Europe and Industrial Development in the Third World Ajit Singh This paper analyses the implications of an industrial policy in Europe for industrial development in the developing countries. A central analytical question addressed here is to what extent, if any, does industrialization and competition from the South harm the North’s industry and workers. At the policy level, the paper examines the policy configuration, including global economic policies and institutional arrangements as well as the more narrow industrial policies in the North, which would make industrial development in both the North and the South a positive rather than a zero or a negative sum game.

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An essential argument of the paper is that the kind of industrial policy which is actually adopted by the European economies is an endogenous variable. In a slow growing European economy with high levels of unemployment, the European Union countries are likely to adopt protectionist industrial policies. These will harm industrial development in the South and are also unlikely to be in the long-term interests of European industry itself. However, a ‘positive’ European industrial policy which encourages structural change will help industrial development both in the North and in the South. Such a policy will only become feasible if the European economies resume fast economic growth and restore full or high levels of employment. The paper examines the economic policy and institutional requirements for the recreation of the Golden Age of high employment and faster economic growth in Europe on a sustainable basis. 5 Industrial Strategy: Process or Content? Insights from the Austrians Pat Devine The modern Austrian school emphasizes the role of market processes in promoting discovery—market processes enable the social mobilization of tacit, inarticulated knowledge through decentralized entrepreneurial activity. The paper first examines the significance of this insight for industrial strategy at the level of the firm and the region. It is argued that participatory decision making at these levels enables the discovery of tacit knowledge to be generalized, thus maximizing the potential for efficiency in meeting social welfare. Participatory decision making at the level of the firm and the region, however, does not dispose of the issues that arise from interdependence among firms and regions. These issues require cooperation. The second part of the paper argues that industrial strategy needs to address the appropriate balance between infrastructural development facilitating the competitiveness of individual firms and regions and institutional development facilitating cooperation among firms and regions. This raises the question of whether industrial strategy should be focused on process or content. Both participation in decision making and cooperation involve process. Yet the outcome of participatory process is substantive content. The paper ends by arguing that to be effective industrial strategy must ultimately be based on a view of the sorts of economic activity and the geographical distribution of that activity which maximize the social welfare of those involved in the participatory decision-making processes. 6 Innovation, Entrepreneurship and Industrial Districts Peter Dorman After reviewing (in discursive fashion) the analytics of interactive non-convexity, this chapter proposes a formalization of the role of entrepreneurship in innovation based on such non-convexities (as against those due to increasing returns) in production. The central concept is that of an entrepreneurial entity with the access to information, finance and institutional resources to put in place a plan that incorporates a discontinuous change in the organization of production. This entity can exist below, at or above the level of the firm. The technical conditions conducive to the collective entrepreneurship of industrial districts are considered, and the characteristic features of these districts, drawn from the descriptive literature, are placed in the context of this theory of innovation. The chapter concludes with a few observations on the opportunities for public intervention in economic development illuminated by this model of entrepreneurship.

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7 European Community Research and Development Support: Effects on the Cooperative Behaviour of Firms Y.Katsoulacos and E.Nowell Cooperation in research and development is recognized as a means of dealing with various market failures that characterize the innovation process (especially those related to appropriability and duplication). This is reflected in the Commission of the European Communities’ (CEC’s) policy to require in all of its research and development (R&D) programmes international cooperation as a precondition for R&D funding. Further, cooperation may lead to a speed up in the diffusion of new technologies. CEC support is supposed to expand firms’ incentives to engage in cooperative R&D beyond what would otherwise be the case—the direct investment effect. In this chapter we identify and try to obtain empirical support for the existence of some other potential effects of CEC support. The ‘dynamic effect’ is a ‘learning-to-cooperate’ effect on successful participants of CEC-funded programmes. The ‘indirect investment effect’ is an effect on unsuccessful applicants who, having sunk the cost of preparing the proposal, may decide to go ahead with cooperation. And the ‘strategic effect’ is the effect on unsuccessful applicants due to the support of some of their market rivals. We use a sample of 353 unsuccessful applicants and 208 successful participants of two industrial programmes from across Europe to search for the existence and potential strength of these effects. Results indicate that there may be a strong dynamic and indirect investment effect from CEC support on firms’ cooperative behaviour. 8 Does a Reduced Public Sector Increase Welfare in an Open Economy? Johan Willner In most Western countries, policy makers perceive the need to maintain international competitiveness as restricting the scope for transfer payments, environmental regulation and the amount of public consumption. We focus on public consumption and ask how its welfare maximizing level depends on foreign competition. It turns out that it may become larger if trade is liberalized and countries compete, although firms move from the high tax countries until profits are equal. If on the other hand one country chooses a smaller or larger than optimal public sector size, the other country should do the same if it maximizes welfare. However, a policy harmonization increases both welfare and public sector size. The non-cooperative solution can be compared with a game in which the competing countries give subsidies to their exporting firms. The optimal public sector becomes even larger if it is assumed to represent education so that it improves private sector productivity. 9 Continuity and Change in Portuguese Industrial Policy: Mobility Regulation in the Textile and Clothing Markets (1946–92) João Confraria The purpose of this chapter is to analyse the evolution of objectives and instruments of different types of regulation of entry and internal growth that have been pursued in the Portuguese textile markets since the mid-1940s up to 1992. From 1946 to 1973, regulatory restrictions were imposed, at the plant level, on

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market mobility of textile firms, clothing remaining generally absent from the regulatory framework. After a period where policy trends have been somewhat ambiguous, from 1986 to the early 1990s, EC membership has decreased the protection from external competition given to Portuguese producers and at the same time the Portuguese government was able to allocate funds to improve restructuring at the firm and industry levels. It is shown that, based on different concepts of efficiency at the plant level, the government has been trying to influence market mobility, promoting the growth of the plants considered more efficient and with higher growth potential. In recent years this approach has, at the conceptual level, improved substantially, given the previous patterns. It is also likely that stated policy objectives, namely those relating to promoting the survival and growth chances of some reasonably well endowed firms, have been reasonably accomplished on technological and managerial grounds. 10 British Industrial Policy in the Light of Traditional Theory and More Recent Developments in Economics and Management Christos Pitelis The aims of this chapter are to assess critically the main tenets of British industrial policy in the postSecond World War period, to examine the economic theory which underlay and informed the policy and to outline some new approaches in economics and management which can throw some light on the arguably unsatisfactory record of British industrial policy. It is claimed that, throughout the period under examination, British industrial policy was, on balance, interventionist, an intervention intended to enhance large size and pick winners (national champions policy). Moreover, it was discontinuous (as evidenced by the nationalizations of the 1970s and the privatization/liberalization policies of the 1980s) and adopted a neutral stance towards the issue of manufacturing versus services-led growth. In terms of economic theory, the policy was characterized by market failure type intervention, a consumer-surplus focus and free trade, based on the principle of static comparative advantage. We claim that overall it failed to constitute an industrial strategy, in the sense of a consistent set of industrial policies intended to serve a well-defined purpose concerning industry, and overall its performance was not satisfactory. A number of recent developments in economics and management, most notably the ‘new international trade theory’, the ‘new competition’, the ‘competitive advantage of nations’ approach and the debates on transnational corporations and competitive bidding and on democracy and industrial strategy, are surveyed in the chapter. It is suggested that they provide a theoretical justification for the performance of British industrial policy and some hints as to how this policy should be modified. 11 Taming the Balance of Payments Constraint with a Sectoral Policy for Auto Candace Homes This chapter argues that an auto sectoral policy which combines both macroeconomic and microeconomic tools is necessary to restore competitiveness in the auto sector. Its focus is the USA but it has implications for policy design in other areas, including Europe. The chapter suggests that US firms must adopt a series of Japanese practices that have been associated with higher productivity and quality. Because it has proven very difficult to transform the internal structure and decision-making process of the firm in the face of unstable markets, the chapter argues that growth and stability are central to relaxing constraints on the

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transformation of firms. The chapter shows that the USA faces a balance of payments constraint which precludes the use of traditional Keynesian policies to stimulate growth, and that the balance of payments constraint is due to decades long neglect of the manufacturing sector which has rendered it uncompetitive vis-à-vis foreign competitors, most notably Japan. It shows that auto plays a central role in generating the balance of payments constraint and as such is central to its resolution. It outlines an appropriate policy for auto which combines both microeconomic and macroeconomic elements.

1 POLICY MIX AND INDUSTRIAL STRATEGIES Jacques De Bandt

Opposition against any kind of industrial policy—which is essentially ideologically based—remains very strong. The strong drive towards the market, embodied in generalized liberalization and privatization programmes throughout the world, has increased the a priori preference for the market and the a priori opposition against any industrial policy. Industrial policies have anyway been accepted in the past only as exceptions: in order to solve particular problems in exceptional circumstances. In the Western countries, industrial policies have only been admitted first, in the 1960s as ‘adjustment’ policies, in order to restructure ‘trade injured’ sectors (OECD 1975), and then, on a rather huge scale, in the 1970s, mainly in the form of financial transfer policies. Because of the importance of competitive pressures, governments felt obliged to solve severe immediate problems and to use defensive measures: industrial policies were admitted only as a ‘necessary evil’. For that reason, OECD (1979) was insisting at the same time on the necessity to develop more ‘positive’ policies. These adjustment and industrial policies have, as a matter of fact, reinforced the arguments against industrial policies: many of these policies have been only poorly efficient or even, in many cases, clearly inefficient (see also Chapter 10, Christos Pitelis’ contribution to this volume). That this may have been due not to industrial policies per se, but to the ways industrial policies have been conceived and the conditions under which they have been implemented, has not been considered to be relevant. And when industrial policies—or the more visible part of those policies—were nearly eliminated from the scene in the 1980s, the — mainly intellectual—debate was reopened, due to the knowledge which had been accumulating concerning the role ‘industrial’ policies have been playing in the outstanding industrial performances of Japan and some of the newly industrialized countries (NICs). But this debate was without much effect, until now at least. The question is thus how to convince of the necessity of an industrial policy. This is certainly not possible if one remains within the framework of the strong (ideological) opposition between ‘market’ and ‘industrial policy’. The only possibility would seem to consist of trying to adapt combinations of policies to combinations of objectives and circumstances. POLICY BIASES The starting point is the observation that, let us say since the early 1970s, the policies adopted and implemented by the advanced industrial countries have been rather poorly adapted both to the objectives as stated (renewed long-term industrial dynamism) and to the economic circumstances of the 1970s and 1980s (transition crisis) (De Bandt 1993). Two types of biases have been more or less systematic. The emphasis

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EUROPE’S ECONOMIC CHALLENGE

has been too much on the market (competition, liberalization, flexibility, deregulation, etc.) and not enough on production (competencies and capacity building, human resources, new products and processes, specific assets, etc.). As far as production is concerned, the emphasis has been too much on existing capacities and models (conservation, rationalization, etc.) and not enough on new production models and capacities (production and work organization, norms, regulation, etc.). The only clear exception would seem to be technological policies, aiming at accelerating innovations and technical progress. But even in this case, the emphasis has been more on both the promotion of product innovations of rather limited scope and the production of technological information, rather than on the development of new production models and capacities. These biases can be seen as the result of basic misunderstandings concerning the economic circumstances of the 1970s and 1980s. One clear example of this has been the idea that because of the crisis or because of low growth, since the beginning of the 1970s, structural change would necessarily slow down,1 and so would competition, structural change being the main source of competitive pressures. But the link between growth and structural change that existed during the high growth period and the Verdoorn law was essentially circumstantial. As a matter of fact, the pace of structural change became faster and the intensity of competition became stronger during the 1970s and 1980s. There was thus probably no need for intensifying anti-trust policies. The same could be said of the idea according to which one major requirement (since the 1970s), from the standpoint of industrial performance, consisted of increasing the flexibility of labour. Both external and internal flexibilities have been constantly increased. But the expected results, in terms of industrial dynamics, have not shown up, and one can defend the idea that in fact flexibility has been much too strong: layoffs have been again and again used as easy immediate solutions, instead of looking for longer-term developments.2 I would like to dwell briefly on three illustrations of such biases. The pre-eminence of macro policies In most cases (‘stop and go’ policies, ‘orthodox’ policies, adjustment programmes in less developed countries (LDCs) and now in Eastern countries) macro policies aiming at eliminating macroeconomic disequilibria (with reference to some a priori norms) have been given a high or even absolute priority, whatever the negative effects and costs may be at the level of enterprises and thus from the standpoint of industrial dynamics. This is of course not to deny that macroeconomic disequilibria have to be managed. But the idea that the restoration of macroeconomic equilibria is a prerequisite of growth or development processes is certainly not justified. The same can be said of the idea that in order to restore macroeconomic equilibria, one needs to go through restrictive or deflationary processes. To the extent that industrial growth or development processes and the resulting structural changes are anyway implying some forms of disequilibria, the real problem is that of combining objectives and policies. Proposition 1 In order to demonstrate the possibility and feasibility of industrial strategies, one major issue is the possibility of showing that indeed degrees of freedom exist at more decentralized levels, such that behaviours and evolutions are not strictly determined by the situation or expected evolution of the global system.

POLICY MIX AND INDUSTRIAL STRATEGIES

3

Deregulation The deregulation debate has clearly shown that priority is systematically given to the market as such: this means that the problem of the rules or the organization of the relations between actors has been raised only from the standpoint of the market or of competition and not from the standpoint of production or the building up of competencies and capacities. These standpoints were only supposed to converge on the basis of a particular hypothesis: the reduction of rules would reduce rigidities and thus increase degrees of freedom, which would thus increase initiatives, which would thus increase innovation and developments. We observe a variety of cases, and deregulation has shown to have, in many cases, both huge costs and unexpected or undesirable effects. This all means that regulation per se is not a relevant category: the system has to be organized and while, from that standpoint, the market is ‘organizing’ the system, at least to a certain extent, it appears that the market is not able to satisfy all organizational requirements, under all circumstances. Proposition 2 Deregulation cannot and should not be discussed per se, purely from the standpoint of market mechanisms; it should be discussed directly in terms of the rules and organization which are necessary from the standpoint of economic performances. Competition The priority given to the market of course means that the emphasis has systematically been on competition and thus on competition (anti-trust) rules. The importance attached to those rules has to be questioned. We all know of course how important competition is and that the use and abuse of dominant positions must be systematically eliminated. But there are at least four major reasons for which traditional anti-trust should have received less weight: 1 Due to the crisis and structural change and to the internationalization process, competition has been increasing steadily: there was apparently no need for additional pressures. 2 Due to technological progress, the definitions and boundaries of the different industries and of ‘relevant markets’ are likely to be outdated. 3 The configuration and boundaries of firms have also been undergoing big changes, such that in most cases complex sets or networks of actors are involved. 4 Traditional anti-trust policies are referring to traditional organizational models, and have thus become a source of rigidity and conservatism. Proposition 3 The building up of competitive strength is as important as—and in actual circumstances of structural change more important than — keeping or increasing competitive pressures. These illustrations show that priority is systematically given to the market, without specifically taking account of the requirements for industrial performances at both the firm and the industry level. On the basis of such kinds of observations, the question is of course whether it is possible to correct those biases and to move towards other priorities, in accordance with actual circumstances, and thus to more productionoriented strategic approaches?

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WEAKNESSES OF PAST INDUSTRIAL POLICIES Industrial policies have been characterized in the past by strong deficiencies, which will now be stressed and analysed. I shall then indicate a possible typology of industrial policies. Transfer policies: degenerate forms of industrial policies Transfer policies have been developed on a huge scale, particularly in the 1970s: huge transfers have been made aimed at giving firms the necessary additional resources they were supposed to need. Immediate social pressures convince again and again of the possibility/necessity to restore competitiveness through some form of aid or transfer, while experiences show that, while such transfers can occasionally be useful, they usually appear to be only very poorly efficient. They have largely contributed to creating the rather negative image of industrial policies. Such transfer policies are based on the traditional misconception of what the firm is: a ‘black box’ into which resources and inputs are injected, the more inputs are allocated, the more outputs are likely to be obtained. Empirical studies show that most enterprises tend to receive these financial resources passively and are unable to use them correctly. A parallel can be drawn here with protective measures—they are both included in ‘effective protection’— which have also usually proven to be rather inefficient. While (transitory) protective measures may be useful, and even necessary, protective measures lead, in most cases, to vicious circles: because they are protected, firms do not feel, with the same intensity, the necessity to restructure, and because the firms are not really becoming more efficient, additional protective measures appear to be necessary. Proposition 4 Care should be taken not to define industrial policies in terms of ‘effective protection’ measures: such measures should only be accepted as elements of a broader and comprehensive industrial policy or strategy package. Inefficiencies at the centralized level One of the major difficulties with industrial policies is linked with the fact that, at the centralized level, inefficiencies seem to be such as to eliminate the feasibility of such policies. Without being able to go into the details here, it may be useful to indicate that such inefficiencies have several dimensions: 1 2 3 4

information problems, the administration is at a big disadvantage for decisive information; lack of competencies and expertise, dependence on lobbies and public opinion; lack of incentives and sanctions, absence of risks and responsibility; ‘lagging behind’ decision processes, in most cases decisions which could have been useful are not taken, because the civil servants feel they do not have enough information, when they do take their decisions these are too late to be useful; 5 bureaucracy: rigidities, delays, power struggles, etc. This all means that ‘top—down’ approaches are not likely to be very efficient. They have nevertheless proven to be efficient in specific cases (Japan and the NICs have been mentioned), depending on the circumstances and on the conditions. We have a few ideas about these circumstances (strong

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industrialization or catching-up processes) and conditions (strong State—enterprise links and cooperation, development of competencies and expertise within the administration, future studies, plan rationality, operational procedures and bodies, definition of long-term strategies, etc.). It must be stressed that even if these approaches were mainly ‘top—down’, the decentralized actors, mainly of course the firms, were in any case playing a very large and active role. Proposition 5 We should know much more precisely what the various elements or the complex set of elements are which have made for the operationality and success of such approaches in specific cases. A typology of industrial policies In order to eliminate possible misunderstandings, I would propose, as a working hypothesis, the following typology of interventions in industrial affairs (see also Chapter 10 of this volume, by Christos Pitelis). 1 Policies affecting the ‘environment’ of enterprises: macroeconomic policies, exchange rate, resources and factor prices, infrastructure, rules and institutions, economic climate, etc. These policies are not considered to be industrial policies, even though they affect or are likely to affect substantially the functioning and performances of enterprises. 2 Policies affecting the ways enterprises in general are functioning: status, fiscal rules (taxes, depreciation, etc.), labour regulations (contracts, security, flexibility, etc.), competition rules, energy conservation, environment, information, norms, industrial property. These types of policies can be regarded as industrial policies in the large sense (sensu largo) of the word: they aim at or are affecting the functioning and the performances of all (as many as possible) enterprises as such, but in a general or indiscriminate way. 3 Selective policies, affecting particular enterprises or groups of enterprises, or industries (or subsystems), on a discriminatory basis: in the field of training, investment, research, information, etc., i.e. in all those activities leading to the development of human resources, competencies, capacities, etc. These are industrial policies in the usual or narrow sense of the word, aiming at increasing performances on a more selective and voluntary basis. 4 Within industrial policies—both in the large and in the narrow sense—distinctions must be made between the following. (a) Regulatory policies Technical rules defining specifications of products, processes, procedures, etc., aimed at various objectives: security, energy conservation, quality standards, environment, etc. Such technical rules can be general or specific. (b) Rules of the game That is, rules concerning the relations between the enterprise and various other actors: labour, commercial law, financial rules, competition. Some of these rules can be more or less sector specific. (c) Supplétive policies The State (or another public body) takes charge (with a distinction between financing and execution) of some activities or operations which have to be performed within the productive system, but which the enterprises are not taking charge of or not taking charge of enough. These supplétive interventions are concerned more particularly with activities like

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professional training, information, research, marketing (promotion of exports), etc., most of which are contributing to the ‘non-material’ investments of the enterprises. (d) Transfer policies These consist in transferring resources, mainly financial resources, to particular firms or groups of firms. Besides those transfers which are only aiming at compensating for actual losses—this does not solve any other than insolvency problems—transfers are made in order to strengthen the firm with additional resources, and thus to improve its functioning and performance. 5 Industrial policies proper or in the strict sense (sensu stricto) of the word. To this list of interventions affecting the functioning of the firm must be added the most important, although the less used, forms of industrial policy, at least in the Western countries. These would (with reference to the developmental State of Johnson (1982) be labelled ‘developmental’ industrial policies or strategies. These consist, on the basis of some kind of ‘plan rationality’, of defining and implementing an industrial strategy at the level of specific productive subsystems. This type of strategy implies, besides of course that the required are actors willing to take initiatives and risks, the clear definition of three types of elements: targets, means or resources and an organizational model. Proposition 6 We have to be very clear about the different types of interventions and make explicit that when we are speaking of industrial policies or strategies, we are referring to developmental industrial strategies. This would allow us to benefit from two positive images: enterprise strategies and Japan’s success story. POLICY MIX The idea of an industrial policy mix is to be understood not only in the sense that various types of interventions (of the State or any other collective body, at the local or regional level) can be combined— they usually are—but that their combination should be adapted both to the objectives or goals assigned or pursued and to actual circumstances (time and place). Economic performances as objectives The first problem, when speaking of an industrial policy or some kind of policy mix, is of course related to the objective(s) to which one is referring. The overall objective does concern industrial economic performances. But, unless we accept that all types of economic performances are converging (but for some marginal exceptions), we are of course obliged to specify what type of economic performance we use as a reference. Three basic lines of distinction, and of possible conflicts of interests, exist: 1 real and financial performances the difference between real production or supply performances (efficiency, productivity, etc.) and market (power) or distributional (factor prices) performances; 2 static versus dynamic performances the difference between performances in terms of current income and expenditure flows and long-term growth and competitiveness performances; 3 decentralized versus collective performances the difference between private financial interests and collective interests (employment, income, environment, balance of trade, etc.).

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Along these three lines, convergences can of course exist (e.g. market power as a result of efficiency, or financial profitability leading to development of resources and competencies) but divergences are likely to appear (e.g. market power compensating for inefficiency, or static performances at the cost of longer-term investments and developments). While we are looking obviously for real collective dynamic performances, the market may, especially so in particular circumstances (when windfall gains are attractive and longer-term solutions are uncertain or too risky), be biased towards the opposite: decentralized, financial, static performances. But we are obviously also looking for other types of socioeconomic objectives, e.g. in terms of employment, environment, sociocultural values, etc., which market mechanisms are not taking care of. Proposition 7 Contrary to what national accounting is doing, economic and social accounting should measure economic performances alternatively from these different points of view or according to these different performance criteria. Consistency requirements While the ‘market’ is supposed to contribute to the global performance objectives directly, the partial objectives of particular policies are only, explicitly or implicitly, supposed to be in line with the global objectives. In any case, the variety of actions and policies raises questions of consistency. Besides clear problems of knowledge (what are the likely mediate and immediate effects of any policy or action), the problem of consistency usually stems from the fact that decisions are taken and actions implemented by a variety of bodies or administrations, depending on the existing structure of decision powers and competencies. Coordination procedures are lacking or are, most often, insufficient for meeting basic consistency requirements. I would tend to suggest that per se the problem of consistency cannot be really solved, or only quite approximately: due to the various dimensions (scope, variables, time hori2ons) involved, consistency requires some basic (consistency) principle. Such a consistency principle can only exist operationally within the framework of a comprehensive strategy (De Bandt 1987). A distinction should probably be made between weak and strong consistency requirements. In the case of weak consistency, coordination would only eliminate opposed or contradictory actions or measures. In the case of strong consistency, related actions should be made to converge on the same objective. Proposition 8 A systemic approach (of the industry or productive ‘system’) is needed in order to be able to locate the objectives as pursued and to identify the actions, interactions and retroactions of industrial policy measures, and in order to allow the ‘in-process’ analysis of consistency problems. FROM INDUSTRIAL POLICIES TO INDUSTRIAL STRATEGIES In order for the policy mix to be consistent, the industrial policy component should be made more specific.

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The importance of supplétive policies As indicated, supplétive policies mean that the State (or other public bodies) take charge of some activities or operations which are required for the functioning of the productive system. In the typical ‘market failure’ situation, the enterprises are not induced to engage sufficient resources in those activities or operations, while, from the standpoint of socioeconomic objectives, social returns may be (substantially) higher than private returns. The State is thus introducing additional incentives or taking charge directly of such activities. The ‘division of labour’ between the State and the enterprises clearly varies according to time and place. It is not quite easy to find out how this division was concretely decided and/or has been evolving over time. It is difficult to decide whether it is the administration which partially takes charge, because the firms are not doing enough, or the firms which are doing less because the administration is doing part of the job. As a matter of fact, the ‘division of labour’ is decided with reference to various kinds of problems: efficiency requirements (decentralization versus centralization and bureaucracy), profitability (difference between private and social return) and power relations (enterprises being more or less able to impose part of the costs on the collectivity). But the general observation is that when they are performed by the administration or some public body, these activities are only poorly (cost-)efficient and effective. The explanation would seem to be, besides those factors related with size, complexity and bureaucracy of (public) organizations, that these activities are too generic and indiscriminate. Being obliged to satisfy equally all possible needs, they are unable to satisfy efficiently specific needs. Proposition 9 Suppletive actions can and should be made more efficient; by being more specific (goal oriented), more customized, more decentralized in the execution. Are selection procedures feasible? If industrial policies consist of selecting firms or industries to which resources are transferred in order to improve performances, decision makers have to face what appears to be an impossible task. And the a priori definition of ‘eligibility criteria’ does not solve this problem of evaluation of the real potential of firms. Between the ‘picking the winners’ case, in which the public agents are both sure to be right (the results are mostly positive as expected) and useless (these positive results would have been obtained anyway), and the ‘lame-ducks’ case, in which aid is unable to transform the firm into something near to a competitive unit, the problem of selection is really difficult. The problem is that, for industrial policies to be useful and successful, the firm must be both weak enough to need some aid or complementary resources and strong enough to be able, with some additional resources, to be competitive and performant. To decide this is an impossible task. Pragmatism can be of some help. But even while the intermediate category (no winner, no lame duck) is in principle quantitatively the most important, it appears in most cases difficult, or even impossible, to decide to which category particular firms belong. The only solution would appear to consist of abandoning this kind of impossible choice and building concerted strategies taking account of existing actors.

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Proposition 10 Selections should be made with reference to the strategies as defined, more than to the intrinsic strengths and weaknesses of the enterprises involved. Strategies at the level of subsystems While ‘top-down’ approaches are not likely to be efficient or may not be feasible to actual circumstances in European countries, at the same time industrial systems clearly need some kind of explicit voluntary intervention of the State. The problem is how to combine the necessary intervention of the State with the necessity to eliminate ‘top-down’ approaches. This is clearly a question of ‘division of labour’ between the State and enterprises: on the one hand, decentralized actors have to take the responsibility for launching and succeeding with the strategy, to allocate the resources and organize the operations and to assume the risks which are inherent; on the other hand, while the firms may be hesitant because they are too weak to launch an ambitious strategy, the State should initiate (when necessary), make possible, facilitate and endorse the conception, definition and implementation of a target-oriented development strategy. The limit may not be that clear between the State doing too much (in which case we fall into the ‘top-down’ category) and the state doing too little (in which case there is no ‘industrial policy’ and the strategy of firms may not come through or remain too modest). One point would seem to be decisive: this is the real willingness on the side of firms to make the strategy their own and to do whatever is necessary for the success of the strategy, and this willingness will, in many cases, be dependent on the necessary backing by the State. This combination would seem to be possible only on the basis of the following elements. 1 A long-term development strategy is needed. As indicated this implies expected performance targets, the necessary means (resources to be allocated and to be developed, technical assistance) and an organizational model (actors, relations, cooperation). If one refers to the permanent debate around the notion of a strategy itself, the opposition is between those who see a strategy as an a priori well-defined and comprehensive plan and those who consider that once the targets have been decided, the best one can do is to work as best as possible in that direction, while the ways and the means will continuously have to be adapted in due course. The opposition is clearly between substantive and procedural rationality. This would appear to be also the dividing line between a ‘top-down’ and a ‘bottom-up’ approach. 2 A strategy is needed at the level of a productive subsystem, i.e. the group of interdependent actors working in the same field who are willing, on a more or less cooperative basis, to work out the strategy. The problem here is that, speaking of strategies of actors (not of the State), we have to transpose what we know to be a strategy from the level of the firm (a ‘hierarchy’) to the level of a group of heterogeneous actors. This supposes that those actors are willing to give priority to their convergent interests and to cooperate effectively, i.e. that effective conflict-cooperation relationships can be developed and organized among the actors involved. Such subsystem level strategies have proven to be successful in various contexts. 3 Besides the endorsement of the strategy, which becomes thus of ‘public interest’, the State is supposed to define the industrial policy measures and to provide the technical assistance which is considered to be necessary—on the basis of a rigorous diagnosis —for the success of the strategy.

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Proposition 12 We need urgently to study how, under what conditions and on the basis of which procedures and institutions it is possible to define and implement strategies at the level of particular industries or subsystems. NOTES 1 During 1975, OECD predictions were revised downwards twice: with the second revision a zero growth scenario was proposed, the implication being that because of stagnation structural change would also come to a halt. 2 One strong confirmation of this is given by the latest survey of the American Management Association (1992). This survey shows that firms tend to downsize mainly because they have already done so in the past, and that less than half of the downsized firms obtain better profits (one-quarter of them having lower profits).

BIBLIOGRAPHY American Management Association (1992) ‘1992 AMA survey on downsizing and assistance to displaced workers’. De Bandt, J. (1987) ‘French industrial policy: successes and failures’, in P.R.Beije, J.Groenewegen, I.Kostoulas, C.W.A.M.van Paridon and J.H.P.Paelinck (eds) A Competitive Future for Europe? Towards a New European Industrial Policy, London: Groom Helm. —— (1993) ‘Politiques industrielles et de la concurrence: quelles priorités, quelles combinaisons?’ Revue d’Economie Industrielle 63 (1):207–21. Johnson, Ch. (1982) MFTI and the Japanese Miracle: The Growth of Industrial Policy, 1925–1975, Stanford, CA: Stanford University Press. OECD (1975) Adjustment for Trade: Studies on Industrial Adjustment Problems and Policies, Paris. —— (1979) The Case for Positive Adjustment Policies, Paris, June.

2 INDUSTRIAL STRATEGY IN AN OPEN ECONOMY Patrizio Bianchi

WHY TALK ABOUT ‘INDUSTRIAL POLICY IN AN OPEN ECONOMY’? In the 1980s the concept of ‘industrial policy’ was eliminated from economic debates. There was a return to a mythical vision of the market as a single institution sufficient to manage the economy and it was held that the role of the State must be minimal, implicitly accepting a vision of society based on a social evolutionism rooted in biology, in which economic dominance was an expression of efficiency and ability to adapt to external events. This perspective was largely motivated by a long period in which the economy was strongly regulated by nation states. In the USA this pervasive presence of the state translated into heavy regulation of economic activity, especially public services and control over concentrations within the internal market. In the USA none the less the internal market was sufficiently large to permit the development of a sufficiently large number of efficient firms, so that the presence of the State was expressed above all through anti-trust activity, aimed at preventing the creation of collusive and anticompetitive behaviour by the strongest players. In Europe the presence of the State was even more pervasive. Since the dimensions of the market were larger than the area of sovereignty of the individual national governments, each government developed policies explicitly sustaining their own firms in the competition which was transformed into conflicts among nations. Until the end of the eighteenth century all European countries developed public policies to strengthen their champions and to protect their most fragile firms (Landes 1969; Supple 1973). Therefore, various forms of protectionism were developed in which the State either restricted trade among countries or intervened in favour of its own firms altering the functioning of the market. For example, in the French tradition of industrial policy, the State itself directed the process of industrial concentration to have firms of adequate dimensions and to be dominant on the international level. The process of international market opening can generate internal social dynamics within the various countries which can cause the aggregation of various coalitions for and against the opening. For example, all the potential losers, i.e. the least efficient firms which would be forced out of the open market, could resist the opening and the international integration. In this sense regional integration agreements, like the European Community (EC), NAFTA and MERCOSUR, can be either instruments for protectionism to resist competition from stronger competitors or instruments to favour the rapid structural adjustment of the most fragile firms to be able to open the internal market up to international competition. This rapid adjustment nevertheless requires a presence of

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the State to push the firms to reorganize themselves and to grow in an opening market setting (de Mélo and Panagariya 1993). This chapter is dedicated to redefining this vision of industrial policy as an essential part of a process of the development of market forces. THE STATE AND THE MARKET IN THE EMERGING CAPITALISM With the birth of capitalism the nation state affirmed itself because the new productive classes emerged as the forces of social change that wanted to see political recognition of the rights of citizenship (entitlements) which their economic abilities (capabilities) had affirmed in the economy. Smith asserted that the wealth of nations consists in the organization of production, and that this should only be limited by the extension of the market. Smith explains that there cannot be feudal laws hindering the individual initiatives and that a nation prospers if, and only if, the competition is free of feudal constraints (Smith 1776 (1976:31)). In Smith it is evident that the market is a social institution in contrast to the feudal mechanism rigidly based on hierarchical exchanges, determined by the social position of the social actors. The market according to Smith is a nexus of horizontal relations in which the relative power is not given but is contestable on the basis of the ability to organize productive activity. The organization of production and the industrial competition are therefore the instruments for affirming the rights of individuals in society. The economic dynamic is therefore connected to institutional change, and these are linked to the existence of a multiplicity of subjects, free of feudal constraints and independent, able to compete to affirm their power and their social position. Smith is therefore against any form of monopoly not only because it distorts the allocation of resources and alters the distribution of wealth, but above all because it reintroduces constraints on decision making that limit market dynamics (Smith 1776 (1976:163)). The market is the result of the interaction of a ‘multiplicity’ of individuals, i.e. the number and diversity of individuals. Social interaction in the Smithian scheme was not only competitive, but also cooperative so that the division of labour was based on the complementary specializations of various individuals and various firms. Efficient production comes from just this possibility of permitting individuals to accumulate specific knowledge, and therefore to develop specializations which, when aggregated, define the different productive organizations. In this sense institutional stability, guaranteed by the State, permits individuals to specialize themselves, knowing that there is the possibility to work with others, without the risk of free riders. Thus Smith holds that the origins of monopoly are institutional, i.e. they result from regulations that limit the activity of members of a given professional corporation, or are the result of privileges attributed to Royal (or Regulated) Companies, like the East India Company (Smith 1776 (1976:733)), or are linked to a social order, linked to feudal origins. At the same time it is evident that the social dynamic is increasingly supported when there is more multiplicity, i.e. when there is a large number and variety of subjects interacting in the economy. Smith himself recalls therefore that an economy based on the development of market forces requires a strong state to guarantee property rights and to legitimate private contracts, but also to guarantee those positive externalities that no one individual citizen could activate by himself, like defense, justice and public works necessary for collective growth such as communications, educational and health systems (Smith 1776 (1976:689)).

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For these reasons Smith was against any type of protectionism, such as the agreement between England and Portugal signed by Lord Metheun, and was an advocate of free trade, which for him meant a widening of the extension of the market and therefore an increase in the multiplicity of competing subjects (Smith 1776 (1976:661)). This vision of the social dynamic based on the free interaction of individuals requires that the State guarantee individual liberties through the creation of a context of normative stability and that it create positive externalities. When the class of businessmen became the dominant class and the demand arose for a State that represented not the castes but the nation, countries became nationalistic, and became as closed as the feudal states. In this nation state the instruments of state intervention served to protect national producers and to support national champions. The German reaction to the English expansion, for example, pushed the German states to unite in a customs union to create a large internal market protected from external competition from stronger competitors (Landes 1969). A theory was then developed to argue the necessity of protectionism to permit the consolidation of a strong national industry. List illustrates how protectionism has political aims, to prevent the strong English firms from eliminating the young German firms, imposing English domination on the new Germany. On the other hand in England, Mill theorized the return to protectionism to permit infant industries to grow and to prevent competition with already consolidated competitors that would destroy newborn industries (Mill 1844). The opening and closing of the economy, however, has also had important consequences on the internal equilibria of countries involved in trade. For example, the relationships among different social classes change if markets are opened, and this can result in coalitions of interests which differ according to the type of opening that is realized. In a Smithian scheme the principle of absolute advantage holds and, therefore, referring to the case of the agreement between England and Portugal, the English producers of cloth and the landowners/wine producers were interested in selling to Portugal because both were more efficient than their Portuguese competitors, who were interested in resisting the opening of the Table 2.1 Coalitions formed under the Smithian scheme and the Ricardian scheme I. Smitbian scheme: absolute advantage England Portugal Manufacturers ++ → – Landlords + → − II. Ripcardian scheme: relative advantage Manufacturers → Landlords ← Coalitions according to Theory I and Theory II In favour of opening the economy In favour of closing the economy I. M(E)+L(E) versus M(P)+L(P) II. M(E)+L(P) versus M(P)+L(E) Notes: +, efficiency advantage; −, efficiency disadvantage; , capital flows; →, trade flows.

market. In this case the English producers formed a coalition in favour of the opening and the Portuguese created one calling for closure.

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Different coalitions form if we look at a Ricardian scheme, based on relative advantages, i.e. on the relative advantage of specializing oneself in a relatively more efficient production area (Ricardo 1986: 128). If the English manufacturers are much more efficient than the Portuguese, the advantage of trade occurs if English capital moves to the production of cloth and Portuguese capital specializes in the production of wine, less efficient than the English competitors but relatively more advantageous than concentrating on the production of cloth. In this case there would be a transnational coalition of English manufacturers and Portuguese landowners who have a common interest in market opening, and English a coalition of landowners and Portuguese manufacturers who are against the opening (Table 2.1). The decision to open the market, therefore, results from the conflict between these coalitions of interests, in the first scheme this shows that all the national producers ask for either the opening or the closure of their

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Figure 2.1 A closed economy

country’s market to international trade. In Ricardo’s scheme we see coalitions of interests that ask for both opening and closure from within each country. Let us now look at the groups which may fight the opening or closing of the economy from within a country’s borders. EFFECTS OF OPENING A CLOSED ECONOMY We shall begin with several considerations related to a closed economy. We represent a closed economy with the traditional Marshallian curves of demand (D) and supply (S). Let us assume that in closed conditions, i.e. of an explicit prohibition on importing goods from outside country I, the equilibrium between D(I) and S(I) is fixed at point A, with the relative price PA and the relative quantity QA.

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Suppose that the international price of the good being considered (PW) is much lower and that the possible demand of the country in question is relatively low with respect to the world supply, so that an eventual opening of this country to foreign trade will not change the international price. In this case we can represent the curve of world supply with a line that corresponds to a price PW, which crosses the local supply line at point B and the local demand at point C. A unilateral and instantaneous opening to international trade would have a significant positive effect for consumers because prices would fall and therefore the demand would expand to point QC, since a larger number of people would be able to purchase the good imported at price PW. However, there would also be an obvious negative effect: the internal production (QA) would be substituted by the imports (QBQA+QAQC) and, in microeconomic terms, the national production could only offer QB and thus the internal producers would have to close their factories and in macroeconomic terms the country’s balance of payments would show a deficit. In political terms this could have very important effects on the conflicting internal social forces and interest groups, inducing the formation of regressive coalitions, united by the intention of blocking the change but incapable of proposing alternative paths for growth. Consumers would favour the opening, as long as their incomes were not directly connected to internal production; thus, conflict between those consumers whose incomes come from the production of the good in question and those consumers whose incomes are independent from the internal production of the good could develop. The national producers are clearly opposed to opening; until now their survival has been at the base of a very clear political exchange: the government guarantees protection and the producers support the protectionistic government. The opening to international trade, that could be the ruin of these operators, implies the rupture of this pact and thus the weakening of the government’s authority. Paradoxically, government authority must be relatively strong in order to open a country to international trade. Table 2.2 Effects on social classes of opening a closed economy National producers Closed economy + Open economy − Notes: +, stand to gain; −, stand to lose.

Merchants—importers − +

From the point of view of the social classes, we would have a weakening of the class of national producers, who have until now supported the government, in favour of an emerging class, the merchantsimporters, who will benefit from policies differing from those implemented in the past (Table 2.2). Therefore, supposing we have four groups of actors: a class of producers, a class of merchant-importers, consumers whose incomes are derived from national production and consumers whose incomes come from other sources. In a closed economy the citizens linked to the national production (the class of producers plus the consumers whose income is linked to production) are at the centre of both the economic system and the political system, while the merchant-importers and the citizens who earn their incomes from other sources are at the margins of the power structure. This situation is illustrated by the workers and leaders of the Staterun firms in the ex-Soviet Union. Opening the system turns it upside down and the national producers, managers, workers and their families find themselves in difficulty, while the new class of merchant—importers emerges and those who

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do not have incomes connected to the national producers benefit; again, the case of post-Soviet Russia is a good example of this turnaround and the political problems linked to such institutional change. Furthermore, from a political point of view, a trade deficit also implies political dependence on the countries able to produce the good at price PW. Paradoxically, the process of opening should be realized by a governmental authority supported by social classes which have everything to lose in opening the economy. On the other hand, those groups which stand to gain from the opening have until now played only a marginal role in the power structure. Thus, demand for protection becomes increasingly relevant, since the economy depends on the production of the good under consideration and thus the good is strategic for the country, and because supply is increasingly concentrated and thus the action of political pressure by the producers is evident, while that of the possible independent supporters of opening is divided. The more the economic confrontation between countries tends to be transformed into political dependence, the more the governments will be willing to consider protectionist and autarkist solutions. On the other hand, this solution is obviously inefficient because it is monopolistic; rather than lowering prices and expanding supply it is seen as preferable to maintain a limited supply at high prices, with the goal of defending the national industry, which is not capable of competing in the open market against more efficient competitors. Thus, the cost is transferred to the consumers, particularly those who do not benefit from the national industry, who must endure long lines, and then severe rationing, only to buy goods at extraordinarily high prices. An autarkist situation is always difficult, as there is the danger of growing internal dissatisfaction and the development of regressive coalitions, which block the change but are not able to propose institutional solutions able to develop complementary relative specializations to reorganize the internal production to withstand the international conflict. In this context a protectionist movement can be a regressive result, or an intermediary solution to permit internal reorganization which could transform the potential regressive coalitions into coalitions capable of identifying paths for collective development through the redefinition of the division of labour. An agreement of economic integration on a regional level can therefore be an instrument to guide the opening process and the process of structural adjustment which regulates internal adjustments, to sustain the processes of opening without generating the harmful effects of an opening process which is too rapid, and without falling into a situation of indefinite protectionism. CUSTOMS UNIONS AND STRUCTURAL ADJUSTMENT A customs union is a political agreement among national governments to regulate the economic and social effects of opening trade on the respective economies, through the creation of a common trade area and a common policy of exclusion of external operators held to be more efficient. The economic theory of customs union was developed after the Second World War by Viner (1950) and Bye (1950) and challenged by many authors in the 1960s (Cooper and Massell 1965). In recent years, however, there has been a return to analyses of strategic protectionism and thus also of forms of regional integration as instruments to regulate the opening of the economy (Krugman 1986, 1987; de la Torre and Kelly 1992; de Mélo and Panagariya 1993). This discussion is based on the assumption that there are at least three actors: country I and country II, both closed to international trade, and both less efficient in the production of a given good A in comparison to a third country W, the rest of the world. Let us start by assuming that both country I and country II are sufficiently small so as not to influence the world supply of the considered good with their opening.

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Then suppose that country I’s internal situation can be represented by the traditional curves of demand and supply of the good being considered (point A in Figure 2.1); international prices are lower and therefore there is an internal structural problem linked to the relative inefficiency of the national production compared with the international production, which offers the same good at lower prices. The opening of the economy to international trade would imply the consequences mentioned above; consumption would expand to reach the point at which the demand curve of country I (D(I)), meets the international supply curve S(W), none the less this would happen with imports substituting the internal production (QBQC; leaving the internal producers only at point QB). As we outlined in the previous section this solution will be opposed not only by the national producers but also by those consumers whose incomes are derived from the internal production of the good, and by the government which would have difficulties sustaining a situation in which internal production decreased and imports increased; the unilateral opening would instead be supported by the consumers who do not earn a living from the internal production of the good, by a new social category, the merchant-importers, that live off the profits from the importation of goods from abroad, and obviously by producers in the more efficient country. The solution results in a very complex conflict of interests in which the authority of the government facing a unilateral opening would be put in the position of taking action that would initially weaken the national producers—its principal supporters. On the other hand we have seen how difficult it is to sustain complete closure over time against those who would group together in opposition to the monopolization of the internal economy. The customs union represents an intermediary solution, which allows the regulation of the opening process, controlling the structural effects; this implies an agreement with another country, in a similar situation of relative inefficiency in comparison with the rest of the world, to create limited trade to preserve at least a portion of the national production, and therefore limit the negative effects opening would have on the existing productive structure. Obviously this also implies limiting the positive effects because the demand will not expand to the extent that it would with complete openness. This last consideration pushes the neoclassical commentators to judge the customs union solution negatively against the option of unilateral opening. At this point it is helpful to further examine what a customs union is, and what it does. Let us assume, for example, that the effect of closure occurs through an explicit prohibition on imports from the rest of the world, or that imports are regulated by import taxes. In this case the agreement could then be that the goods that come from country II, with which there is an agreement, are not subject to taxes above their market price (which, however, is higher than the international price because the production is less efficient) while the countries not participating in the agreement pay a tax on the international price. The final price would then be equal to the price of autarky so that these countries are excluded from the trade, or the final price is sufficiently high to discourage the import of goods produced outside of the customs union area. The production of country II, more efficient than country I but less efficient than the international level (see the slope of the supply curve), is added to the production of country I, so that the demand levels off at point E and not at point C, as in an open market, but does not remain at A as in a closed market (Figure 2.2). The internal supply is divided between the internal production QD and imports QE−QD from the partner country. In the creation of a customs union there is thus an aspect of opening, creating more trade than that present in a situation of autarky (from QA to QE), but also an aspect of further protectionism from the rest of the world, with related trade diversion, directing the trade not toward the international market but only toward

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Figure 2.2 Customs union

another country that itself suffers from problems of relative inefficiency in comparison with the more efficient operators on the international level. Cooper and Massell (1965) clearly demonstrated that a solution of unilateral lowering of tariffs is preferable to the creation of a customs union. From the neoclassical point of view in fact there is no explanation that justifies the creation of a customs union when compared with the option of a unilateral opening to international trade. In fact, if the point of reference is the single consumer, and one analyzes personal losses in welfare, a customs union is inefficient. However, as we have already outlined above, a customs union is justified by the principle that integration does not only involve single individuals, but also effects social groups, whose behaviour limits single

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individuals and whose collective action is strongly limited by the institutional conditions in which it takes place. In particular we are dealing with collective subjects in which the institutional structure has been central in the social development of the last 200 years, i.e. the national state. For example, maintaining a situation of closure to trade implies a strong emphasis on the internal and external power relations that also alter the individual behavioural rationalities. On the other hand the England of Smith’s time could sustain an international liberalization of commercial trade because this implied its economic and political expansion. At the same time Prussia justified protectionism to give itself time to respond in active terms to the English offense, proposing a customs union with the other German states to create a sufficiently large market to develop efficient productive structures to compete with the English (List 1841). A customs union is therefore justified because it allows regulation of trade among weak countries, establishing common protection from competitors who are too strong to be faced individually. It is a coalition of potential losers that are united to create conditions of reciprocal interest. This interest can be seen in static terms, as indicated above, or in dynamic terms, i.e. it can be used to buy time while adjusting the internal structures to make them become efficient enough to be able to compete in the customs union market, and eventually to compete in an open market. A customs union, and in general every regional integration agreement, can be a regressive coalition, sustained by those who believe that they are incapable of maintaining a small closed market, but are not able to withstand the social costs of opening. Dynamic effects can be generated if the passage toward a customs union is regulated over time, in order to permit an adjustment of the national production structures during the transition, so that a progressive coalition is formed that pushes for complete opening, increasing the number of those capable of sustaining opening through a process of rapid structural adjustment. In this case an agreement is established that foresees the progressive removal of internal tariffs among countries taking part in the customs union, maintaining a common external tariff to create an internal market sufficiently large to allow economies of scale both static and dynamic. This process, however, is worthwhile and credible as a path to reduce the external barriers over time, making the internal firms competitive on a global level. The risk of generating resistance to opening is very high. The only response to this tendency is further integration, passing to a form of integration that foresees a reorganization of production to fit the extension of the single market—an economic union. This passage occurred between the treaties of Rome and Maastricht. The economic union therefore is necessary to productive reorganization on a vast scale so as to permit further international opening. However, economic union implies strong institutional integration and, thus, public policies for industrial development must be aimed not only at favouring a change in the institutional context in which the firms do their business, but also in specific actions aimed at favouring the development of industrial cooperation among firms to permit individual specialization in a context of complementarity. This passage is very complex because it means going beyond nation states and going beyond national identification of social groups. MACRO AND MICRO INDUSTRIAL POLICIES In our view the market is a social construction that does not emerge by itself from a natural human impulse to trade. Rather we begin with the assumption that in a society based on the existence of individual rights to

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trade, the market, as the place where trade relations among individuals (legally equal and equally able to trade) are created, is an institution that should be created through the definition of collective rules that foster positive dynamics among these individual actors. In this sense the industrial policy is comprised of a variety of actions including macro actions aimed at defining and guaranteeing individual rights to trade and micro actions aimed at guaranteeing the individual and collective capabilities for trade. In other words, industrial policies, in our collective action perspective, are instruments activated by a variety of subjects to favour institutional stabilization, to guide structural change, to stabilize reciprocal specializations and thus to consolidate groups of production; this means instruments to guide the process of consolidation of progressive coalitions and at the same time of actions to make rights of access more effective, sustaining the conditions of development of capabilities (Sen 1984, 1985). Thus the process of international opening is a way to extend the market and increase the division of labour beyond the national borders and to thereby create networks of firms, whose unifying elements are not only geographic proximity and the dependence on a single government, but also the possibility of outlining new mechanisms of common institutional definition. The process of international integration is therefore not only an economic fact, it is necessarily a political one. It is therefore necessary to specify the historic conditions in which social aggregation processes have been realized and, based on these specifics, to design macro and micro actions that function not so much as substitutes for a public authority, but to develop a collective mechanism, in which various public or private subjects interact to form progressive coalitions that can develop complementary and efficient specializations, that are also fair and participatory and, therefore, stable. Since we hold that capitalism cannot be imposed by decree, as we see in the current Russian situation, that it is not possible to pass from a centralized economic and institutional regime to a decentralized system simply by eliminating the previous structures, we also argue that in a situation in which economic underdevelopment is linked to institutional decline it is not necessary to ‘return to the market’ but to ‘construct the market’. This means acting on the institutions of collective life and providing the capabilities to allow the majority of subjects to effectively take part in the collective. In any case the central theme of Smithian thought must be reexamined: the market is a social construction that is founded on the legitimation of individual rights; this leads to a definition of collective dynamics that are not hierarchically predetermined, but a public authority is needed to guarantee the functioning of a decentralized system of collective decision making. The role of the State is central to the development of market forces. MACRO INDUSTRIAL POLICIES In this context macro industrial policies are those actions capable of acting on the institutional design of the system in which intervention is to occur. This means acting not only on the organization of the public administration but also on the accumulation regime of the country, i.e. on the relationship between property and control of the firms. For example, in a country moving from a centralized, closed economy toward a market economy, like Russia and Argentina, this means above all facing an extraordinary process of institutional change. In addition to an intense manoeuver to achieve macroeconomic stabilization there must be widespread action of denationalizing the economy, through an extensive privatization policy of public utilities, manufacturing activities and services formerly managed by the State.

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This radically modifies the relationship between State and economy and requires a public administration with minimal managerial involvement and more functions of directing and guaranteeing the choices made by the economy itself. An omnipresent State is thus substituted by a ‘lean State’, lean but with more authority, capable of favouring development by guaranteeing access to public goods, even if they are managed in a decentralized way. This new State must not only favour international competition of the large national groups, but also internal competition; it must promote the growth of a variety of small and medium firms helping them to specialize and become integrated. The State no longer limits itself to disposing of a huge centralized administrative body, it also must organize itself in a small but efficient central administration, in a variety of independent authorities, that guarantee the course and control of public utilities in a variety of autonomous administrations, charged with promoting local development through a process of aggregation of all the entrepreneurial and intellectual forces around specific projects. In this case the first series of interventions regards the definition of the formal rights of citizens, and the definition of the procedures which define collective actions. The following step deals with the definition of public goods, i.e. those goods to which a citizen is entitled simply because he is a member of the collective and the ways in which these goods should be managed. Here we must define the role of the public authorities which oversee the functioning of the market, preventing monopolization but establishing exceptions to favour activity that is particularly risky if not collectively supported. In this definitional phase of industrial macro policies the regulatory regimes of public utilities must be redefined, as well as the functions of the financial markets and the activities of research and development, i.e. the activities that come before and after the production processes. In our approach it is clear that it is production that forms the centre of the argument, because only by stabilizing the relations of reciprocal specialization can we develop individual and collective efficiencies which can activate endogenous growth processes. The origin of efficiency is the ability to accumulate knowledge, so that macro action must be aimed at protecting and promoting the capacity to accumulate and utilize knowledge. This calls for the redefinition of rights of access and the general rules of use of the collective structures that reduce the individual costs of accumulation of knowledge, this includes schools and all activities that help in the diffusion of knowledge. All of these considerations would not be important if we did not emphasize the possibility of reestablishing a structure of property rights to allow access to the market and if social rules are not implemented so that disparities within the collective do not arise to induce members to form regressive coalitions. As Dahrendorf writes, a system in which formal rights (entitlements) are not supported by an adequate distribution of resources (provisions) will be unstable, as will a system in which there is an accumulation of resources which does not translate into increased rights of access to its citizens (Dahrendorf 1988). In this sense industrial macro policies are linked to the definition of rules shaping collective life and the norms governing the functioning of those public activities that make the common rules manageable. Rules and public institutions have historically been identified with the nation. In many cases a process of international opening can be the way to force change, identifying limits and opportunities for an institutional redefinition, otherwise blocked by regressive coalitions which have consolidated over time. The way to manage the opening can be important for the reactivation of internal mechanisms that lead to progressive coalitions able to redefine not only institutional assets but also the processes of industrial reorganization. In any case, efficiency, equity and stability are macro level problems which must be faced in this new approach.

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MICRO INDUSTRIAL POLICIES Micro policies imply the possibility of identifying catalysts for growth and thus mechanisms of convergence of a variety of subjects, public and private, aimed at guiding the process of relative specialization and therefore an increase in individual sunkness, and the creation of groups of closely linked subjects, which remain open to successive cooptations. In an already consolidated context—in which the collective capacity for the accumulation of knowledge, the autonomous development of complementary specializations and the negative selection of those who are not able to accumulate complementary knowledge already exist, and entry is guaranteed—it is probably not necessary to implement micro policies because the multiplicity of the system is such that it can generate mechanisms of aggregation. A situation in which this multiplicity does not exist is quite different and micro policies are called for. Initiatives that start from specific local realities are of political value if they can be seen as the first node in a network to be constructed, if the procedures used there can be extended and used by other local experiences and if learning from these pilot projects can be generalized to contribute to the positive evolution of the collective. SOCIAL RULES AND COMMON OBJECTIVES In conclusion we must remember that customs unions and economic unions are political agreements to favour processes of economic integration in an international arena circumscribed and limited by a common action of control of external trade. None the less, because internal trade activates processes of sectoral specialization and remodels the intraindustrial division of labour, the process of economic integration influences the rules that define collective action and thus assumes a function of institutional definition. A process of opening to international trade, however, generates changes in both countries, favouring coalitions that support or oppose the opening. A regulated opening to international trade, like a customs union, is an ambiguous solution that can translate into a last attempt at protectionism, or into a collective mechanism to guide the process of global opening; in either case there are structural changes connected with the type of institutional modifications generated by the formation of these coalitions. The process of economic integration pursued through common forms of regulation means an evolution of productive and institutional relations that modifies the structural characteristics of the individual economies and of the resulting social groups. The EC has initiated a process to become an economic union, but it has seriously underestimated the significance of this move, too often leaving the resolution of possible internal conflicts to a mythical market and indulging too often in the maintenance of levels of protection of their own producers as in the case of producers of agricultural goods. In this sense the crisis after the Treaty of Maastricht fully demonstrates why an intervention after a period of institutional decline causes despecialization and therefore the déstructuration of the system. The industrial micro policies are thus essentially networking actions, or policies aimed at reconstructing a network of relationships, that consolidate mechanisms of integration among individuals, permitting the evolution of a productive system based on reciprocal recognition, the sense of adherence to a group, the identification of public goods, and thus of externalities, and of therefore the suitability of collective action, with the capacity to sanction free riders. The industrial micro policies therefore have a strong territorial and sectorial foundation because it is easier to induce these processes of aggregation where a common cultural and technical base already exists.

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In a context of international integration it is therefore possible to delineate actions which favour the process of economic and institutional integration: these actions can be macro actions to delineate a path of convergence of the general rules and micro actions to induce individuals to aggregate. The first process, that we shall call top-down, implies a constitutional phase to establish the general principles establishing the existence of a path toward convergence, and at the same time establishing the nature of the decision-making model to be adopted for collective decisions, unanimously or by a majority vote. The evolutionary mechanisms follow in a second phase, that nevertheless can generate negative coalitions if the mechanisms are not accompanied by the ability to act from the bottom up to favour the aggregation of individuals through policies which permit entry and participation to all individuals in the new integration phase. If the top-down process can be based on integrated convergence mechanisms, the bottom—up actions are founded on complementary mechanisms, generating a process which favours the convergence of the general rules, but pushing toward specialization and thus toward the differentiation of the productive capacity of individuals. The micro actions in a context of international integration do not only have the function of accelerating the process of increasing the efficiency of the national systems, favouring the multiplicity of subjects in interaction, but also have the function of aggregating transnational networks allowing subjects, developed in the national systems, to operate together and thus to develop new procedures, that may eventually sustain the process of change of the general rules, if the process of top-down institutional change seems to encounter resistance. Bottom-up action based on local experiments is valuable for industrial policy, although it is difficult to guide the process of institutional and structural adjustment of an aggregation of interests that now has a dominant role in the world economy. The design of an industrial strategy, like that drafted in the Bangemann Report, becomes fundamental to the re-launching of the EC (Bangemann 1992). A crucial point in this industrial strategy is the concept that the market is a social construction based on the multiplicity of actors and on the decentralization of the decision-making process. This multiplicity, however, is constructed with actions that allow new entry, that permit access to research and development and that encourage industrial cooperation beyond that of anti-trust regulation. Such actions are possible today if we consider that the state is no longer a unitary subject, but rather a variety of institutional levels interconnected in a complex web of cooperative and conflictual interactions. BIBLIOGRAPHY Bangemann, M. (1992) Meeting the Global Challenge, Establishing a Successful European Industrial Policy, London: Kogan Page. Byé, M. (1950) ‘Unions douanières et données nationales’, Economie Appliquée 3:1–17. Cooper, C.A. and Massel, B.F. (1965) ‘A new look at customs union theory’, Economic Journal 75:762–7. Dahrendorf, R. (1988) The Modern Social Conflict. An Essay on the Politics of Liberty, New York: Weidenfeld & Nicholson. Krugman, P. (1986) Strategic Trade Policy and the New International Economics, Cambridge, MA: MIT Press. ——(1987) Is free trade passé?’, Journal of Economic Perspective 1:131–44. Landes, D. (1969) The Unbound Prometheus, Cambridge: Cambridge University Press. List, F. (1841) System der Politischen Oekonomic, 1904 reprint, New York: Longmans Green; 1972 Italian edition, ed. G.Mori, Milan: Isedi.

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de Melo, J. and Panagariya, A. (eds) (1993) New Dimensions in Regional Integration, Cambridge: Cambridge University Press. Mill, J.S. (1844) Essays on Some Unsettled Questions of Political Economy, First Essay, London 1976; Italian edition, ed. S.Parrinello, Milan: Isedi. Ricardo, D. (1817) On the Principles of Political Economy and Taxation, republished as vol. I of the Works and Correspondence of D.Ricardo, ed. P.Sraffa, Cambridge: Cambridge University Press, 1951 (1986). Sen, A. (1984) Resources, Values and Development, Oxford: Blackwell. —— (1985) Commodities and Capabilities, Amsterdam: North Holland. Smith, A. (1776) An Inquiry into the Nature and Causes of the Wealth of Nations, republished as vol. II of the Glasgow edition of the Works and Correspondence of A.Smith, ed. R.H.Campbell and A.S.Skinner, Oxford: Oxford University Press, 1976. Supple, B. (1973) ‘State and Industrial Revolution (1700–1914)’, in C.M. Cipolla (ed.), The Fontana Economic History of Europe, The Industrial Revolution, Glasgow: Collins. de la Torre, A. and Kelly, M.R. (1992) ‘Regional trade agreements’, IFM Occasional Paper, No. 93, March. Viner, J. (1950) The Customs Union Issue, New York: Carnegie Endowment for International Peace.

3 INDUSTRIAL STRATEGY Guiding principles and European context Keith Cowling and Roger Sugden

INTRODUCTION The absolute and relative failures of European economies over recent years imply a general need to rethink the overall form and direction of industrial economic policies throughout the continent. Although there have been notable successes at certain points in time and for certain economies, in general Europe is in an economic crisis requiring new responses at regional and panEuropean levels. There are various symptoms of this crisis. One is the recent very high unemployment levels in industrialized countries; the average unemployment rate amongst members of the Organization for Economic Cooperation and Development (OECD) in Western Europe rose from 3 per cent in 1973, the end of the period of relatively full employment stretching back at least to the early 1960s, to 11 per cent in 1986, subsequently falling through 1989 before returning to the 1986 level in the early 1990s. Another symptom is the economic disintegration and collapse of the formerly centrally administered economies of Central and Eastern Europe, following their opening to the processes and structures of free market capitalism; by the end of 1992 output in these economies had already fallen by at least 16 per cent, a decline that was generally set to continue. Our aim in this chapter is to consider the appropriate response to this crisis (see also Cowling and Sugden (1993a, 1994) for further detail). More specifically, we advocate an approach which addresses industrial issues in a coherent and consistent manner. We do not presume omniscient policy makers, rather a willingness to become involved in the strategy making of the major actors in economies and a willingness to construct a framework within which these actors make their decisions. The basis for our suggestions is not an analysis which starts with markets and a consideration of market failure, unlike most work in industrial economic policy and indeed in economics generally. A foundation for traditional analysis is essentially a theory of the firm which begins with market systems and which is concerned with incorporating the firm into the market (see, for example, Alchian and Demsetz 1972; Jensen and Meckling 1976; Williamson 1981; and Klein 1983). With such a foundation, it is hardly surprising that policy discussions have focused on the failure of market systems to yield desirable outcomes. For us, however, industrial policy is not essentially about markets. We join with Coase (1991) in his recent criticism of excessive concern with markets and exchanges in the theory of the firm and thus start our analysis with deeper and more fundamental concerns. It is suggested in Cowling and Sugden (1993b) that a theory of the firm rooted in markets is one rooted in superficialities, ignoring what actually happens when production takes place and, more specifically, ignoring the crucial importance of strategic decision making in production. Building on this, we therefore suggest a policy perspective recognizing that markets have a role as an important instrument of economic development, but that they are only an instrument. We root analysis

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in the socially incomplete nature of strategic decision making in modern corporations. We identify strategic planning of industrial activity as the key issue for industrial development and thus advocate strategic planning by communities as the core issue for industrial policy. In contrast, these two issues do not feature in the market failure approach. We do not deny that traditional policy areas such as monopoly abuse remain important. However, these areas need to be set alongside a wider set of concerns, simultaneously addressed as part of a coherent approach to policy design and, most importantly, addressed from a strategy-making perspective. The plan of the chapter is as follows. After this introduction we shall look at some guiding principles. If industrial policies are to be successful not by luck but by judgement, their design needs to be grounded in theoretical and empirical analysis explaining industrial activity; the theory and empirics should lead to the policies. Thus the following section outlines the basis for an industrial strategy. It focuses on socially incomplete decision structures as the fundamental problem and hence advocates the introduction of democratic decision processes as a fundamental response. We shall then clarify what we are saying, and what we are not saying, about industrial strategy by addressing four specific issues which have a current resonance within Europe, namely privatization, inward investment, technology policy and the relationship between regions and the European Union. Having drawn some threads together, we shall round off the chapter in the last section with comments on a future research agenda. GUIDING PRINCIPLES The argument in this section is that so-called free market systems fail the communities they purport to serve and that they will inevitably continue to do so, unless fundamental changes are introduced. This is the crisis Europe is currently facing, as well as its economic, political and social challenge. First we shall characterize free market economies and thus highlight inherent failures, and then we shall outline our general response. Socially incomplete decision structures In a so-called free market economy, the distribution and allocation of resources is essentially determined by the interplay of various actors—e.g. individuals, households and firms—operating within a set of ground rules implemented and policed by the state. A popular perception is that such a system yields optimal results, a well-recognized albeit now qualified theoretical conclusion being that a complete set of perfectly competitive markets yields a Pareto efficient outcome. The reality of the free market economy, in contrast, is that the markets and institutions acting within it are manipulated by a powerful subset of the population. These élite influence situations and events for their own benefit and hence observed outcomes will be optimal for some but not for society as a whole. As a consequence a free market economy is a socially inefficient economy. This is not a problem of markets per se, rather a problem with the way markets are used. To explore and illustrate these points, consider for instance the structure and activities of a typical large Anglo-American corporation. Decisions within such a firm can be classified into various types. The most important, in terms of influence on the firm’s activities, are strategic decisions, see Pitelis and Sugden (1986). Following Zeitlin (1974), these decisions are concerned with broad corporate objectives and are made by an élite, despite resistance from others. There are arguments about the composition of the controlling élite, but it is clear that strategic decisions are effectively made by a subset of those involved with the firm. These strategic decision makers take the firm in directions which they prefer rather than in directions others would wish to follow. For example, when decisions are being made about a firm’s

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geographical orientation, we should expect those decisions to be made in the interests of the élite. Assuming the latter desire profit, when conditions for accumulation weaken in any particular country, we should be unsurprised to see deindustrialization and hence unemployment. The élite decision makers will ensure that a firm locates production wherever the conditions for accumulation are optimal. Shop-floor workers may object, as may deserted communities, but neither are making these crucial decisions. For evidence on deindustrialization in practice, see Cowling (1986) on Britain and Sweeney (1992) on Ireland. More systematically, the consequences of opting for a free market economy have been explored in the monopoly capitalism literature, see especially Kalecki (1971), Steindl (1952), Baran and Sweezy (1966), Braverman (1974), Friedman (1977), Cowling (1982) and Cowling and Sugden (1987). Focusing in particular on the USA and Britain—the nearest to mature free market economies that can be observed in practice—this literature has identified and explained failures and problems at both macroeconomic and microeconomic levels. It is interesting to observe, for instance, the relatively poor economic performance of the USA and Britain since 1945; in our view this reflects the price that communities pay for free markets. Within this monopoly capitalism tradition, we suggest that it is particularly important to focus on the role of transnational corporations and thus on problems of transnationalism. The basic idea concerning transnationalism is that transnational corporations have come to dominate economies, whose development is therefore threatened. The global perspective and ambitions of transnationals tends to cut across the interests of any particular nation state, or any particular community. Moreover, there is an asymmetry of power between corporation and community deriving from the corporation’s transnationality, which can be exploited by strategic decision makers playing on the inherent locational rigidity of every specific community. This is seen, for instance, when transnational use divide and rule strategies to obtain lower labour costs; there is widespread evidence that transnational play off both workers and governments in different countries to increase profits, see for example, Fröbel et al. (1980), Greer and Shearer (1981), Sugden (1991) and Marginson (1992). We see transnationalism as an inherent deficiency of a free market economy. The very nature of the system implies its presence; a free market economy cannot avoid problems associated with transnationalism simply because such problems are essential features of the system. The crucial, strategic planning role within a firm is deliberately assigned to an élite who are not only given powers to pursue their own interests, they are actually encouraged and expected to do so. Thus we are not surprised to see deindustrialization etc; the surprise would be if this was absent! Democratic decision making Faced by such deficiencies, an obvious response is to address the most fundamental cause for concern. The basic argument is very simple. The firm in which strategic decisions are taken by a subset of the population will serve the interests of that subset. Accordingly, if a firm is to serve the interests of the community more widely—defined in terms of ‘connectedness’ with that centre of strategic decision making, see for example Frank (1992)—more of the members of that community must be involved in strategic decisions. In short, there must be greater democracy (see also Pat Devine’s contribution to this volume, Chapter 5). A prime task for economists is then to design policies by which this can be achieved. Precisely how economies might move in the direction of greater democracy given their current positions needs detailed attention and imagination. The next section examines practical ways of proceeding in the context of specific issues: privatization, inward investment, technology policy, the European Union and Europe’s regions. Before getting into this, however, we shall make some more general comments on the policy framework and on the problem of agency.

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As regards the overall framework, lessons can be learnt from success with industrial strategy in various countries and regions: Japan, some Pacific Rim economies, the third Italy, Baden Württemberg—for discussion of such experience see for example Brusco (1982), Johnson (1982), Best (1990), Cowling (1990), Wade (1990) and Dei Ottati (1991). However, it should be appreciated that none of these economies fully conform to the guiding principles that we have been outlining. This is one reason why we would not wish to advocate that any of their examples be slavishly followed. Another point we wish to emphasize on the policy framework is the need for a dual track approach, involving both changing the environment within which enterprises make strategic decisions and changing the nature of firms themselves. The remedy for socially incomplete decision structures requires two things: both the entry of new actors, representing the community as a whole, into market processes; and the structural, and therefore behavioural, changes in the individual strategic decision-making units. Policy will therefore have two basic dimensions: the first viewing corporate structures as parametric with policy instruments seeking changes in strategic decisions via a public strategy on industry and sectors (see also Jacques De Bandt’s contribution to this volume, Chapter 1); the second viewing corporate structures as variables to be influenced in appropriate ways, e.g. by changes in company law and corporate tax policies. To many our remedies will appear as a replacement of an economic concentration of power with an even more overweening concentration of political power over the economy, e.g. with Brussels establishing an even greater grip over the affairs of Europe. If this were the outcome, then our whole purpose would have been undermined. If the state is to usurp the wishes of the people, then there can be no presumption that replacing the power of corporate élites with political élites will increase welfare, indeed the experience of the Soviet Union and Eastern Europe would suggest that, in the economy at least, the change could well be for the worse. This is a serious matter. The advocacy of industrial strategy has to recognize inevitable problems of agency that would be raised and has to design institutions capable of making economic democracy a reality. In calling for community control, we are not simply calling for control over the corporate economy but also for control over the institutions of the state. Thus we are explicitly attempting not to repeat the lack of logical reciprocity that appears to characterize mainstream arguments against the involvement of government in the market; just as the relevance of the role of the market is not denied by the mainstream, despite the incidence of market failure, so the relevance of the role of government should not be denied as an actor within the market economy, despite the existence of government failure. SPECIFIC AND TOPICAL ISSUES We shall now address a variety of specific issues within the context of our suggested principles. These illustrate inadequacies in existing policies and give some indication of what we would regard as appropriate ways forward. Privatization Privatization1 may have started within Thatcherism in Britain but it has become the current vogue across much of the world economy. Throughout much of Europe and the Third World it is taken as a panacea for a multitude of ills—it has a clear political resonance in a world plagued by large and mounting public sector deficits. But it is within the former centrally administered economies of Central and Eastern Europe and the Soviet Union, with their essentially state-owned production sector, where the issue of privatization looms largest.

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Whilst many people appear to see privatization in a largely unproblematic light, it has recently been suggested that there is no formal theoretical case within mainstream economics for privatization, see for example Grosfeld (1990). For some this is an argument against blanket solutions, but others, e.g. Grosfeld, seem undeterred and argue that efficiency will be stimulated because shareholders have stronger incentives to pressure managers. But it is not clear why this should be so. There will always be a problem of asymmetric information between principal and agent. It would seem that the form or nature of the relationship between principal and agent is the essence of the problem, rather than whether the principal is public or private. Notice how performance within the public sector varies from polity to polity; within nations, witness the Third Italy (e.g. Emilia Romagna) versus the Second (Mezzogiorno); between nations, witness the evidence on the dynamism of public enterprise in China, given recent reforms (Nolan 1991), compared with the failure of similar reforms within the Soviet Empire; and indeed over time, witness the significant improvements observed in Britain prior to privatization, revealing how the pressure on management by public principals to improve performance was effective. However, the argument for privatization can be extended: if control of managers by owners fails, and adequate incentives cannot be designed, then takeover can reassert the interests of shareholders: the market for corporate control will reestablish efficiency. But this argument is also of dubious validity: all the evidence points to the inefficiency promoting activities of the market for corporate control (see for example Scherer and Ross 1990), and, too, its existence is likely to impose a short-termist perspective on decision making. Nevertheless the advocates of privatization persist: ‘All imperfections of capital market and market for corporate control notwithstanding, they still seem the key elements of the market environment which East Europeans are looking for’ (Grosfeld 1990). Let us consider this, step by step. The raison d’être for privatization requires the creation of an ‘owning group’ with sufficient power to challenge the prerogatives of management, otherwise efficiency could be achieved by the decentralization of decision making within the state sector without too much concern with questions of ownership. (Clearly there would be real political issues to be resolved, but so there are in entrusting the state with the process of privatization.) Thus two breaks are seen to be required: the break from central administration and control, but also the break from managerial control. Note that the argument for privatization cannot be a matter of managerial incentives because decentralization/marketization should establish the incentives (see Nolan (1991) for the China case), and privatization does not ensure managerial incentives are established—for example the tax system could discourage enterprise. There appear to be two routes for achieving a concentration of ‘ownership’ sufficient to effectively challenge the prerogatives of management. The first route could be termed the big capital solution, which can be achieved directly by selling off to big capital, which in many cases will mean foreign capital, or, indirectly, via a wide scale distribution of shares to inexpert owners, followed by the almost inevitable concentration of ownership in that group with relative wealth and power. The second route would be a democratic solution and three examples are offered. First the broadening of the membership of the joint stock company to include employees, suppliers and the community more widely. One consequence of this would be that the principalagent problems arising from an information asymmetry would be reduced, because of greater internal, or connected, representation within the firm, in contrast to the external, or disconnected, representation of most shareholders with the joint stock company. The concentration of ownership, or, strictly speaking, membership, can then be achieved via institutions such as trusts, with collective power invested in trustees, see Knight and Sugden (1990). Our second example, selfmanagement, implying the transfer of ownership to a collective of workers/producers (including management), who would then be able to elect, control and remove managers, obviously offers a more democratic solution than the capitalist firm, but it stops short of community control. Finally, a third example

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would be a new transparent and accountable public ownership, one requiring election to boards and democratic supervision of management. This would imply the transformation of the notion of public ownership from the model embedded in present and former nationalized industries to something that might be more accurately called common ownership. Our preference for the democratic solution over the big capital solution is clear. One way of expressing this would be to say that we seek a concentration of power as a countervailing power, rather than as a successive power. If we were to control managerial prerogatives by substituting the prerogatives of another élite group, it is not clear that progress is being made. A first best solution requires control over management without the concentration of private power, that is a democratic solution. Thus the objective would be to establish, within or without the privatization process, democratic control over private accretions of power. Policy would be directed at creating diffuse and deconcentrated structures where accretions of power will inevitably be kept to a minimum. It is clear that the present conjuncture in Central and Eastern Europe and the former Soviet Union presents both a significant opportunity and serious dangers. Our analysis points to the requirement for an opening-up of existing structures in order to establish community control. Privatization may be consistent with this in that it can provide an opportunity for fracturing the link with an élitist system of control. This becomes the central reason for privatization, the reason why it can be seen as progressive by a wide range of political opinion. But the basic need is for economic democracy, and privatization provides one potential instrument for achieving this; but one among many, and one whose effectiveness towards this end is by no means unconditional and unambiguous. To avoid a transformation from ‘state socialism’ to monopoly capitalism great care needs to be exercised with privatization and more generally with the structure of control—it needs incorporating into a more broadly based industrial strategy which seeks to begin the process of transformation of centrally administered economies into democratic market economies rather than free market economies. This means a planned process; one in which the big monopolies are, wherever possible, broken down into meaningful smaller enterprises; where experimentation is allowed with the type of organization; and finally where meaningful regional economies and communities are created. Structures appropriate to the evolution of a more democratic economy can be created most readily in the ex ante planning of the privatization process, rather than within the ex post regulation of its unplanned outcomes. Without this, Lombardini’s (1992) prediction that ‘privatisation may provide the historical opportunity for a class of a few, very rich people to emerge in the USSR’ may turn out to be an accurate one. Inward investment The question of inward investment has become a central issue within Europe over recent years. Whatever the underlying impetus, the international pursuit of inward investment has intensified markedly and remains firmly at or near the top of the policy agenda for the foreseeable future. The first thing we might say about inward investment is that it has certain affinities with privatization as an element of policy making and it is therefore not surprising that governmental preference for the one will tend to be associated with preference for the other. In both cases, rather than seeking to resolve the perceived inadequacies of the sector in question within that sector, whether public or private, the problems are simply hived-off. It reflects a particular way of viewing the organization of production and the working of the market economy: it denies the ability of production units to reform themselves, given appropriate incentives to do so, instead relying either on the spontaneous creation of allegedly superior organizations, as a result of a change in ownership, or on existing, outside (foreign) organizations, which are in some unspecified way allegedly efficient. The attention is on the market rather than the organization: policy is

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directed at opening up more of the economy to the full thrust of market forces, rather than aimed at improving the functioning of indigenous organizations, whether public or private. When judging the appropriateness of inward investment to the objective of raising the level of economic performance of a particular country, we have first to recognize the simple fact that the strategic decisions resulting in that investment are being taken in the corporate interest, consonant with the objectives of an élite which may have little commitment to the country or locality in question. There is no reason why this should be congruent with the democratic interest in that country. This does not rule out inward investment; what it means is that inward investment has to be positioned within a broader strategy within which it does contribute to that democratic interest, a socially complete decision structure has to be imposed; but this should be seen as a positive rather than a negative policy, seeking ways in which the strategy of the inward investor can be adapted to the needs of the community. It would seem clear that the benefits of unregulated inward investment, in terms of balance of payments, employment and technology base, are not built on particularly secure foundations. Whilst temporary gains in these areas may be observed, a longterm commitment to specific locations cannot be assured, and even where an investment of longer-term duration is made, it cannot be assumed that such activity is congruent with the national interest. Research and development would be a case in point. Whilst the establishment of such facilities in Europe by nonEuropean transnationals is often seen to be particularly beneficial, it is not clear that embedding European scientific and engineering expertise in the corporate structures of such firms represents the best use of indigenous talent. There is an alternative: indigenous talent can be harnessed to indigenous enterprise to create a locally based and more durable dynamism within the community. But that will require a strategy which shapes the market in the interest of the community, rather than the present policies which shape communities in the interest of the market. Ireland, following a policy of unqualified enthusiasm for inward investment, has recorded a wealth of experience relating to the impact of inward investment in the absence of an overall industrial strategy. It appears that the three phases of inward investment in Ireland ‘led to increased output and employment for a time, but none as yet has created the basis for lasting expansion’ (Kennedy et al. 1992). The same authors conclude that ‘the Irish branches were often little more than production platforms which had few linkages with the rest of the economy. They did not therefore go far towards building an indigenous innovative capacity that would be more likely to endure.’ Scottish experience reveals a similar lack of connection with the local economy by foreign transnationals (Turok 1993). A survey of the electronics industry reveals that the plants set up as a result of inward investment bought only 12 per cent of their components and material inputs from Scottishbased companies. (See also the discussion of US experience by Candace Howes in Chapter 11 of this volume.) In contrast to the previous Irish position of unqualified enthusiasm, it is instructive to observe how the Japanese approach to inward investment has evolved over time (see for example Bailey et al. 1994). In the earlier post-war period both inward and outward investment was tightly controlled. Over the past thirty years there has been a graded liberalization in response to international pressures, but, throughout, there has been an explicit awareness of the potential problems involved, and barriers have been lowered only when it was felt the industry in question was strong enough to compete with foreign investment. More recently policy on inward investment has taken on a more positive dimension: in certain key industries policy has been aimed at bringing in foreign transnationals with certain technological expertise and linking them into domestic technology complexes. This would seem a particularly important lesson to learn from Japan. Rather than laissez-faire, inward investment needs positioning within the matrix of intrasectoral relationships so that the potential wider benefits of entry into the domestic economy can be realized. At the best of times the market finds it difficult to handle the innovation and diffusion of new technology, and

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where the source of that technology is a new foreign entrant there is an even more compelling case for government being an active partner in facilitating this process. Technology policy As alluded to earlier, there is wide acceptance of the case for government involvement in the development of technology, given the many and obvious reasons for market failure in this area of economic activity, with appropriability being a central one (see for example Stoneman and Vickers 1988; see also Chapter 7 by Katsoulacos and Nowell). However, in contrast to the conventional view that, essentially, the market should remain as the final arbiter of the direction of investment in new technology, with government simply raising the overall momentum by favouring research and development with a variety of stimulatory policies, we would put the policy emphasis much more on the qualitative dimension. Whether the total magnitude of research and development should be raised or not within a particular area of economic activity would be derivative of our overall industrial strategy: the socially incomplete nature of the decision structure within the free market economy means that the pattern of research and development cannot be expected to be socially optimal. Since the development of new technology is so fundamental to the pace, direction and form of industrial development it is necessary to consider the question of government involvement within a much broader perspective, otherwise it is all too easy for the technology policy of government to get transmuted into simply subsidising corporate decisions concerning research and development expenditures rather than aiming to raise the basic dynamism of the industrial economy. We would argue that it is necessary to design future government initiatives as part of a wider concern to develop a diffuse, deconcentrated economy consistent with a move away from a concentrated structure of decision making. Thus in the area of technological change we need to be circumspect about a policy favouring scale. This would suggest that automatic grants and tax incentives are inappropriate, because as Geroski (1990) argues, such subsidies tend disproportionately to benefit large firms because they formally account for most measured research and development expenditure, whereas much activity which could be accurately termed research and development goes unrecorded in smaller organizations. Our analysis suggests that it is inappropriate to favour national champions, which has typified procurement policies throughout Europe (see again Geroski 1990). This focus away from large organizations may well have a positive impact on innovation, and crucially on the output of the research and development process. Pavitt et al.’s (1987) research on British firms found that the biggest firms (with at least 10,000 employees), whilst accounting for 80 per cent of recorded research and development in 1975, only managed to generate 47 per cent of significant innovations over the period 1970–9, a result which finds substantial resonance in recent surveys of innovation research—see for example Scherer and Ross (1990), who conclude that Very high concentration has a positive effect only in rare cases, and more often is apt to retard progress by restricting the number of independent sources of initiative and by dampening firms’ incentive to gain market position through accelerated R&D’. This concurs with the view that the hierarchical large firm is, by its very nature, an essentially stifling organization where individual talent is all too often constrained by institutional straight jackets. IBM’s current dramatic difficulties, despite its former enormous economic power, may be illustrative of the general problem. More generally, it seems likely that promoting an economy of small firms will free more and more individuals to pursue their own and their firm’s development, and thus encourage innovative activity. Smaller firms can operate in ways that encourage individuals to contribute ideas about development. They can also operate in ways that better facilitate human development, again feeding the innovative process.

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Thus a successful system for encouraging technological progress requires far more than the mere absence of large hierarchical firms; especially important is the design of mutually supportive organizations and arrangements to meet collective needs of smaller firms, i.e. public investment in a wider infrastructure rather than state aids in the traditional sense. These needs may focus on, for instance, the availability of sophisticated techniques for designing new products and access to long-run finance and hands-on managerial advice, identified by Geroski (1990) as important for supporting risky research and development projects (see also Minns and Rogers 1990). To meet these needs the design work need not start from scratch. The Third Italy offers relevant experience of the successful design of supportive structures: consider the case of CITER (Centro Informazione Tessile dell’Emilia Romagna), a textile and clothing industry support centre for the region (see Best 1990). For our purposes the significant aspect of this initiative is that it appears to be a successful example of a non-hierarchical, cooperative institution supporting small producers by efficiently providing services that they collectively require. There are economies of scale associated with the development and use of new techniques and CITER appears to have obtained such scale economies without the need for large, hierarchical organizations. When advocating a diffuse and deconcentrated economy it is natural to look at the Third Italy where the small firms sector has received so much attention by policy makers and has been so successful, but lessons can also be drawn from other countries. For instance, there are interesting cases of industrial districts within the USA where high technology industries have developed in close association with local universities (see Piore and Sabel 1984). The USA also provides a fascinating history of yeomen democracy in which the Federal Government has provided what Piore and Sable describe as an indispensable infrastructure of innovation within agriculture. Likewise the Baden-Württemburg model of technology transfer (Löhn and Stadelmeier 1990), the collective procurement arrangements of small firms represented within the Japanese Electronic Computer company (Anchordoghy 1988) and the provision of forty-five technical training centres in West Jutland, Denmark, which appears to have stimulated the dramatic development of a highly diffused engineering industry within an essentially rural community (Kristensen 1990), are successful, variegated examples of the non-hierarchical provision of technology to systems of small and medium-sized enterprises. Furthermore, where current technologies necessitate large-scale production, policy should include efforts to find ways of changing these technologies, having in mind the initial bias in the process by which these technologies are selected, on the basis of control as well as efficiency. There can be no assumption that existing technological structures are either optimal or invariant. Regions and the European Union This is an appropriate point to consider the specific institutional structures within Europe in order to evaluate how much progress might be made towards the European economy we seek within such existing structures. Many people appear to believe that industrial policy making in member states of the European Union, which may in the not too distant future incorporate most European states, is now a thing of the past: nation states’ room for manoeuvre is very much circumscribed by Brussels. At one level this is increasingly true: the Commission has been seriously concerned with the levels of state aid to industry, witness the numerous disputes with the Italian government where state aid to manufacturing was being provided at three or four times the level reached in the rest of the Union (see Commission of the European Communities 1989; Bianchi 1992b). Union policy actively seeks ‘to avoid…monopolisation, excessive concentration and unfair public aids to national companies’ (Commission of the European Communities 1990). The Commission argues that firms are being compensated for inefficiency rather than helped to remove its causes. Bianchi (1992b) agrees with this assessment, but nevertheless offers Italy as an instructive example

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of both the best and the worst in industrial policy making. National government in Italy constructed a policy for the Mezzogiorno (the South) that ignored regional government and proceeded to pump in enormous subsidies to the giant industrial enterprises of the North in order to encourage them to set up large capitalintensive plants in the South. This was a complete failure and Italy was the only country in Europe to have increased internal regional disparities in recent history. At the same time, however, a regional and local industrial strategy was dramatically succeeding in the Third Italy where dependence on handouts from national government had been avoided. Here a much more subtle process of endogenous economic development involving networks of innovators was being supported by the provision of ‘information, training, research facilities and entry opportunities to final markets’ (Bianchi 1992b). This sort of policy clearly does not constitute an interregional zero-sum game with the more successful regions absorbing resources from outside, rather it is a process by which a regionally indigenous, latent economic dynamism can be released. However, this experience, seen in its extreme form in Italy, with its extremely large state aids to industry, has been, and is being, observed throughout Europe, and whilst European Union policy is containing largesse in the support of large enterprises, it is at the same time supporting the development of the more effective industrial strategy which appears in the regions. For example, the new industrial policy based on the ‘balanced development’ of the single market identifies as one set of policies public support for the development of small companies through the promotion of a network of innovators (see Commission of the European Communities 1990), and the Reform of Structural Funds (Commission of the European Communities 1989) sought to bring ‘the regions into play as primary actors in the policy-making process’ (Bianchi 1992a). There remains the critical question of the significance attached to this aspect of policy making by both those at the Commission and those operating policy making within the member states, but the structure is certainly there for a regionally based industrial strategy focused on creating a local industrial dynamism based on the development of networks of indigenous entrepreneurs. This focus receives support from research on regional development: for instance, Sweeney (1985) concludes that ‘entrepreneurial vitality is very much a local phenomenon. Prosperity and economic growth of regions and localities are strongly associated with the strength and vitality of the small firm sector in the region or locality.’ Thus, whilst the development of European Union policy could be seen as an increasingly constraining force in terms of the traditional industrial policy making of nation states, as has been observed in Italy and indeed Britain in recent years (e.g. over the sale of British Leyland, see more generally Chapter 10, by Christos Pitelis), in terms of the approach to industrial strategy advocated here it is, to some degree, congruent. For member states in general our approach to industrial strategy warrants some shift in power from national governments to Brussels and from national governments to the regions. A shift to Brussels would seem appropriate as a change necessary to facilitate the containment of the power of transnationals which are already operating at least at a European level. A shift to the regions is a necessary condition for achieving more diffuse, deconcentrated and therefore dynamic economies: national economies made up of meaningful regional economies; regions populated with closely interrelated enterprises with an indigenous base, rather than dominated by branch plants of far distant parent companies with few linkages with other enterprises within the region (Sabel 1988). The direct, political connection of the regions with Brussels, and with other regions, is also a desirable objective in its own right, serving as it will to establish the significance of a wider democracy, a wider community; an outward looking rather than introverted approach, a matter of equity, in that complete regional autonomy within Europe could lead to an increasing divergence between rich and poor, but also a matter of efficiency, given that introverted societies can lose impetus and momentum without the stimuli of outside influences. Thus in Europe, and of course elsewhere, industrial policy must be regional policy,

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inspired and created within the regions, but regional policy must be coherent as a whole, at the interregional level, and common desires across regions should be pursued collectively, e.g. via international networks between European regions. Such developments provide further justification for the existence of a supranational policy aimed at containing the ability of transnational corporations to play off regions against each other. DRAWING THE THREADS TOGETHER In the light of the lack of dynamism and the associated persistent unemployment throughout Europe, we would suggest urgent attention be given to the significant gap in policy making which is generally evident, the construction of an industrial strategy. We have sought to identify a new approach to industrial strategy based on an examination of some fundamental deficiencies of free market economies as they have developed in the twentieth century. Our approach diverges from previous approaches for a quite fundamental reason: previous approaches to policy making in this area start with markets and the consideration of market failure whereas we choose to start with the modern corporation and a consideration of the socially incomplete nature of strategic decision making within it. In the absence of purposive government policy aimed at changing matters, we see the long-term evolution of free market economies as dictated by the strategic decisions of large and dominating organizations; the transnationally based major corporations. It is the concentration of decision-making power within the upper reaches of these organizations that shapes the character of the market. To remedy defects in the free market economy we must seek to change the nature of strategic decision making within the modern corporation, and in the longer term seek to displace its dominance within the market system. It is this process whereby a concentrated structure of decision making within the industrial economy is progressively replaced by a democratic structure that constitutes the essence of industrial strategy making, given our identification of the defects of the free market system. Such a strategy will inevitably require the development of appropriate agency structures, various forms of government, both reflecting and informing the democratic policy, at local, regional, national and supranational level. We have applied our general principles in the context of a variety of central and topical issues. In the case of both privatization and inward investment we have identified severe deficiencies in past and present policies, but this is not meant to deny their potential relevance to industrial strategy. Rather what we argue for is the necessity of their incorporation within a broader strategy in which a broader array of interests are represented. Thus the process of privatization needs to be embedded within appropriate sectoral strategies and needs to be coupled with an effort to open up strategy making within each major corporation involved, both by restructuring and by changing the nature of decision making within what remains. Similarly with the case of inward investment. Whilst we would wish to emphasize the importance of endogenous development created by a flourishing network of small, indigenous enterprises, we recognize that inward investment can be an important stimulus to dynamism. However, if the aim at certain stages of development is to bring in foreign transnational corporations with certain, e.g. technological or organizational, expertise, then it is important, if the potential benefits are to be fully realized, that attention is given to linking-in the new entrant to the domestic technology complex, as is done in Japan. In the case of technology policy more generally, we have advocated the creation of new structures designed to support systems of small-scale production, part of an extended infrastructure dedicated to achieving a gradual, but persistent and fundamental change in industrial structures over an extended time period. Finally, our consideration of the European, and particularly Italian, experience suggests both the real opportunities offered by endogenous development at the regional level and the failure of traditional state aids operated at the national level,

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observations that fit quite securely within our framework of analysis, supporting as they do our contention that industrial strategy should be founded on strong regional roots and that simply doling out state aid to the dominant organizations of the existing industrial structure is not only wasteful but holds back necessary change. FUTURE RESEARCH We suggest that the analysis we have outlined provides a clear and firm foundation for the design of policies to take Europe out of its current crisis and on to a dynamic, successful development path. Nevertheless we would be the first to recognize that the analysis requires further exploration in future research. In particular we suggest: 1 there is a need to clarify and explore the relationship between the theoretical analysis of socially incomplete decision making and mainstream welfare theory; 2 there is also a need to extend the analysis of democratic decision making in the direction of political and sociological theory, given the dramatic changes in social roles that is implied; 3 the theoretical issues raised in building diffuse, deconcentrated economies have to be addressed, issues such as scale and scope economies or diseconomies; 4 empirical evidence relating to the impact of socially incomplete decision making on the development of specific industries and regions has to be collected and analysed; 5 finally, relating back to point (2), we have to explore the central issue of democracy and agency within the context of the transformation to decentralized, cooperative economies in order to avoid a bureaucratic/authoritarian takeover of the process. NOTES 1 Cowling (1994) offers a fuller treatment of the issue. 2 Clearly, Austrian economics presumes to offer a theoretical case, but see how Pat Devine has turned this on its head in Chapter 5; it would seem implausible that entrepreneurialism is uniquely a characteristic of capitalist enterprise. 3 The recent assessment of industrial policy making in Ireland, following similar principles except that the investment came from outside Ireland, comes to similar conclusions (Kennedy et al. 1992).

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Kristensen, P. (1990) ‘Education, technical culture and regional prosperity in Denmark’, in G.Sweeney, T.Casey, P.Kristensen and N.R.Prujai (eds) Education, Technical Culture and Regional Prosperity, Dublin: SICA. Löhn, J. and Stadelmeier, M. (1990) ‘The Baden-Württemberg model of technology transfer’, in K.Cowling and H.Tomann (eds) Industrial Policy after 1992: An Anglo-German Perspective, London: Anglo-German Foundation. Lombardini, S. (1992) ‘Privatization in market economies and for building a market economy’, in F.Targetti (ed.) Privatisation in Europe: West and East Experiences, Aldershot: Dartmouth. Marginson, P. (1992) ‘Multinational Britain: employment and work in an international economy’, paper presented at the VET Forum Conference, ‘Multinational companies and human resources: a move able feast’. Minns, R. and Rogers, M. (1990) ‘The state as public entrepreneur’, in K. Cowling and R.Sugden (eds) A New Economic Policy for Britain. Essays on the Development of Industry, Manchester: Manchester University Press. Nolan, P. (1991) ‘State and market in the transition from Stalinism: Chinese economic reforms in comparative perspective’, Conference of The European Association for Research in Industrial Economics, Ferrara. Pavitt, K., Robson, M. and Townsend, J. (1987) ‘Size distribution of innovating firms in the UK: 1945–1983’, Journal of Industrial Economics XXXV: 297–316. Piore, M. and Sabel, C. (1984) The Second Industrial Divide. Possibility for Prosperity, New York: Basic Books. Pitelis, C. and Sugden, R. (1986) ‘The separation of ownership and control in the theory of the firm: a reappraisal’, International Journal of Industrial Organisation 4:69–86. Sabel, C. (1988) ‘The re-emergence of regional economies’, Papers de Seminiari 29–30:71–140. Scherer, F.M. and Ross, D. (1990) Industrial Market Structure and Economic Performance, Boston, IL: Houghton Mifflin. Steindl, J. (1952) Maturity and Stagnation in American Capitalism, Oxford: Oxford University Press. Stoneman, P. and Vickers, J. (1988) The assessment: the economics of technology policy’, Oxford Review of Economic Policy 4: i—xvi. Sugden, R. (1991) ‘The importance of distributional considerations’, in C. Pitelis and R.Sugden (eds) The Nature of the Transnational Firm, London: Routledge. Sweeney, G. (1985) ‘Innovation is entrepreneur-led’, in G.Sweeney (ed.) Innovation Policies: An International Perspective, London: Pinter. ——(1992) The role of vocational training in endogenous economic growth’, in J.Davis (ed.) Education, Training and Local Economic Development, Dublin: Regional Studies Association (Irish Branch). Turok, I. (1993) ‘Loose connections? Foreign investment and local linkage in Silicon Glen’, Strathclyde Papers on Planning, University of Strathclyde. Wade, R. (1990) Governing the Market: Economic Theory and the Role of Government in East Asian Industrialisation, Princeton, NJ: Princeton University Press. Williamson, O.E. (1981) The modern corporation: origins, evolution, attributes’, Journal of Economic Literature 19: 1537–68. Zeitlin, M. (1974) ‘Corporate ownership and control: the large corporations and the capitalist class’, American Journal of Sociology 79:1073–119

4 INDUSTRIAL POLICY IN EUROPE AND INDUSTRIAL DEVELOPMENT IN THE THIRD WORLD Ajit Singh

INTRODUCTION This chapter1 is concerned with analysing the implications of an industrial policy in Europe for industrialization and economic development in the Third World. Over the last decade or more, by postSecond World War standards, the industrial countries of the North have been experiencing extremely high rates of unemployment. The workers and trade unionists in these countries increasingly blame competition from cheap labour products from the developing economies for these job losses. Hence the growing populist demands for protection in one form or another in many of these countries. In this context a central analytical question is to what extent, if any, does the industrialization of the South harm the North’s industry and workers. If the consequences are indeed harmful—and that proposition, as we shall see below, is far from being obvious, and needs to be carefully established—the challenging policy question is what kind of industrial policy in Europe will minimize these harmful consequences, and at the same time be not inimical to industrial development in the South. Put more simply, a main issue examined in this chapter is the policy configuration, including both global economic policies and institutional arrangements as well as the more narrow industrial policies in the North, which would make industrial development in both the North and the South a positive rather than a zero or a negative sum game. NORTH-SOUTH INDUSTRIAL COMPETITION AND SIGNIFICANCE OF THE WORLD CONJUCTURE In considering the analytical and policy questions outlined above, the first important point to note is the significance of the world conjucture for the nature and consequences of North—South competition in industrial products. The post-war history of the world economy suggests that the competitive game, not only between the North and the South but among nation states in general, is played in a cooperative, non-zerosum manner only when the world economy is growing fast and there is more or less full employment in the leading countries. However, when there is widespread unemployment in these economies and the world economy is expanding slowly, instead of international cooperation the outcome is likely to be conflict and a retreat into non-zero-sum ad hoc protectionism. Between 1950 and 1973, the period which has been rightly called the Golden Age2, there was a historically unprecedented expansion of production and consumption (at a rate of nearly 5 per cent per annum) in advanced industrial nations. Moreover, this was a long sustained period of virtual full employment in most of these economies. A number of countries not only enjoyed full employment but in

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fact had over-full employment—nearly 10 per cent of the employed labour force in countries like France and West Germany came from abroad. During this period, there was an enormous expansion of world trade, and that in manufactures grew in volume terms at a very fast rate of nearly 10 per cent per annum. Most developing countries also participated in and benefitted from this world-wide prosperity. Many Asian and Latin American countries embarked on a veritable industrial revolution in these post-war decades. The Golden Age of simultaneous prosperity for the North and the South evidently came to an end with the first oil shock in 1973. Since then, the rate of growth of the Organization for Economic Cooperation and Development (OECD) and the world gross domestic product (GDP) has nearly halved. Significantly, the recorded rate during the last twenty years is much more in line with the long-term trend rate of growth of industrial countries in the hundred years before the Golden Age (Reynolds 1983; World Bank 1987). Consequently, many industrial countries, particularly in Western Europe, are witnessing large-scale unemployment, a situation which was unthinkable in the Golden Age. Similarly, for a large number of countries in the South, in contrast to the industrial revolution and significant rises in the average standard of living of the Golden Age, the last fifteen years have been marked by deindustrialization and sizeable falls in per capita incomes. The end of the Golden Age has also coincided with a sharp deceleration in the expansion of world trade in manufactures. What principal policy lessons can be learnt from this post-war rise and fall of the Golden Age for North— South cooperation and the harmonious development of the world economy? More significantly, can the Golden Age be recreated? What should be the role of industrial policy in the North in such an endeavour? THE GOLDEN AGE AND ITS EROSION Considered purely in statistical terms, in the long history of economic development in industrial countries the post-war quarter century of the Golden Age appears to be a historical aberration. Measured in terms of the rates of growth of output, productivity and capital stock, the period 1950–73 in advanced economies as a whole unquestionably represents a highly distinct deviation from the long-term trend values of these variables over the last two centuries (see Glyn et al. 1990; Maddison 1982). Turning to economic analysis, detailed examination of the data shows that the length, steadiness, speed and spread of the Golden Age economic boom was such that they could not be accounted for by an accidental combination of favourable economic circumstances. Rather, the extraordinary economic performance of the industrial countries was brought about and sustained by a unique historical conjuncture which created a specific economic regime.3 The most important macroeconomic characteristics of the Golden Age pattern of economic development were 1 rapid and parallel growth of productivity and capital stock per worker, 2 parallel growth of real wages and productivity. The significance of these two relations is that they guarantee both a roughly constant profit rate and a roughly equal growth of consumption and production, thus ratifying and maintaining the initial rate of accumulation. However, such a macroeconomic growth path could only be perpetuated if it were compatible with the behaviour of individual economic agents—firms, workers and consumers. This compatibility in the Golden Age was insured by a social consensus around institutional arrangements in respect of setting up wages and prices, the distribution between wages and profits and the state fiscal, credit and welfare policies which guaranteed minimum living standards and maintained aggregate demand. In the

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sphere of wage setting, for example, productivity wage bargaining which flourished during this period played a key role both in keeping a rough constancy of the share of wages and profits in the national product and also in helping to provide an adequate rate of growth in consumer demand. Similarly, at the international level, under the leadership of a single hegemonic power for much of this period, the USA, the global economic system functioned under stable monetary and trading arrangements. The process of the erosion of the Golden Age began well before the oil price shock of 1973. Serious difficulties arose at the levels of both the national and the international regulatory regimes; these began to interact with each other in a cumulatively adverse way to the detriment of the system as a whole. The Bretton Woods monetary system broke down in the late 1960s, partly as a consequence of the success of the Golden Age itself—the rise of the Japanese, the West German and other European countries in the international market place led to serious balance of payments problems for the USA, hitherto the lynch pin of the international system. There is also evidence of a productivity slow-down by the late 1960s in several leading industrial countries, which was not matched by a deceleration in the rate of growth of real wages, thus leading to a profit squeeze. By the early 1970s, the Golden Age system was so fragile that it disintegrated under the impact of the two oil shocks, thus pushing the world economy into a period of prolonged slow growth which began in 1973. The social consensus of the Golden years which was crucial to the functioning of the economic system as a whole broke down. For a while, after the first oil shock, the governments of the OECD countries tried to restore the Golden Age institutional consensus by following expansionary economic policies, but this attempt was finally abandoned in 1979 (symbolized by the ‘Volcker shock’—the implementation of deeply contractionary monetary policies in the USA which were subsequently widely imitated elsewhere, particularly in the UK). In the 1980s and into the 1990s, the leading OECD governments have been attempting to create a new economic system based much more on free market principles, but this does not yet command a broad social consensus in these countries. In pursuit of this objective, there has been a widespread movement towards ‘privatization’, ‘de-regulation’ and the erosion of Golden Age arrangements with respect, for example, to wage bargaining and to the provisions of the welfare state (with the professed aim of increasing labour market flexibility). At one level this post-1980 development model has had some success—the most conspicuous being the sharp decline in the OECD rate of inflation. Instead of ‘stagflation’ of the 1970s—i.e. low growth and high inflation—the 1980s and the 1990s so far have been characterized by low growth and low inflation. However, against this, as noted earlier, most OECD countries, especially in Western Europe, are suffering from very high rates of unemployment. There are also large payments imbalances among the leading countries as well as fragile financial markets. On present projections of leading international organizations, the prospects for an appreciable increase in rates of economic growth and for a substantial reduction in unemployment in the OECD economies, in the foreseeable future, are rather gloomy (IMF 1993; UNCTAD 1993). However, notwithstanding the fall of the Golden Age and the consequent slow-down in the growth of world production and trade, it is important to appreciate that the world economy is far more integrated than ever before. If greater economic integration is supposed to lead to more efficient resource utilization and hence faster economic growth, as the Bretton Woods institutions contend, this clearly has not happened. Be that as it may, close international financial integration has been a particularly significant feature of the post-1973 world economy. Such integration has been brought about by the more or less complete abolition of exchange controls in leading industrial economies and the globalization of the stock markets (Cosh et al. 1992).

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DOES SOUTHERN INDUSTRIALIZATION CAUSE DEINDUSTRIALIZATION AND UNEMPLOYMENT IN THE NORTH?4 Industrialization of the South and deindustrialization of the North: the facts The three decades from 1950 to 1980 were also in an important sense the Golden Age of development for the poor countries of the world. During this period, developing countries made on average historically unprecedented economic and industrial progress. In the propitious circumstances following the end of the Second World War, many of these countries, particularly in Asia and Latin America, began to carry out an industrial revolution—a revolution that they had been prevented from implementing fifty or a hundred years earlier on account or the rather different world economic and political conditions which prevailed then. Even developing countries in Sub-Saharan Africa, which started with extremely unfavourable initial conditions when colonial rule ended, managed to increase their share of world manufacturing production during the 1960s and 1970s. More significantly, a group of Asian and Latin American nations—the socalled newly industrialized countries (NICs)—were especially successful in the post-Second World War period in establishing technical, scientific and industrial infrastructures, in training their labour forces, in creating managerial and organizational capacities and in developing broad-based industrial structures. By the 1970s these countries were providing formidable competition to the rich industrial economies in a range of consumer and producer goods industries (Singh 1984, 1989). Patel (1992) argues that the Third World’s economic achievements of the three decades 1950–80 are a story without parallel in world development history. During this period, the South surpassed the eighty-year record of the North’s nineteenth-century (1820–1900) advance. The South did this in half the time, at twice the growth rates and with five times the North’s population in the nineteenth century. Turning to trade, and specifically North—South competition in manufacturing products, broad facts may be summarized as follows. Between 1965 and 1985, the South’s share of world manufacturing production, though still quite small, increased from about 14 per cent to 18 per cent. More significantly, during this period the South’s share of the world exports of manufactures increased at a much faster rate than its share in world industrial production; the exports share more or less doubled over this period (from about 9 per cent to 18 per cent). Further, the record indicates that, whereas there was a sharp trend decrease in the rate of growth of manufactured exports from the industrial market economies during 1973–85 compared with 1965–73, the developing countries registered a trend increase in their growth of manufacturing exports over the corresponding periods. This is a very important point which can be put in a more striking way as follows: during 1965–73, the rate of growth of manufacturing exports of the developed countries was much the same as that of the developing countries—about 10 per cent per annum at constant prices. Between 1973 and 1985, the former’s exports grew at only 4.4 per cent per annum, whilst the latter’s increased at an incredible 12.3 per cent per annum. The same pattern continued in the later period, 1980–90. UNCTAD (1993) indicates that during this decade, the volume of Third World manufactured exports expanded at a rate of 12 per cent per annum; this was two to three times as fast as the corresponding expansion in the rate of growth of manufactured exports of industrial countries. Much the larger part of the Third World’s manufactured exports continues to go to the North. Further, there is evidence that the developing countries are not only exporting the traditional labour-intensive and resource-based products, but are also recording a very fast growth in the exports of a variety of products of capital goods industries (World Bank 1987; UNCTAD 1993). This period of rapid increase in the South’s industrial exports has coincided with ‘deindustrialization’ in most of the older industrial countries of the North. The latter group of countries have been experiencing,

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particularly since the end of the Golden Age, falling shares of manufacturing output and employment in their economies. The basic facts concerning their ‘deindustrialization’ can be stated in a highly abbreviated way as follows.5 In the Golden Age, i.e. before 1973, there was a small decline in the proportion of the labour force employed in manufacturing in some of the advanced countries (notably the UK, Sweden and Belgium). However, no country showed a trend decline in the share of manufacturing in output at constant prices. Since the slow-down in world economic growth in 1973, the share of manufacturing in both output and employment has fallen to a greater or smaller degree in most industrial countries. In terms of the absolute numbers employed in the manufacturing sector, during the decade 1973–83 manufacturing employment fell in almost all industrial countries, the rate of decline ranging from 0.04 per cent per annum in Japan and the USA to a massive 3.1 per cent per annum in the UK and 3.4 per cent per annum in Belgium. Thus, in the UK, the numbers employed in manufacturing industry fell from their historical peak of 8.4 million workers in 1966 to 5.4 million at the end of 1984, a drop of 35 per cent, half of which occurred in the five-year period 1979–84. Data for the subsequent period show that between 1985 and 1992, UK manufacturing employment fell further by about another million workers. Manufacturing employment as a percentage of total civilian employment fell in the UK from 30.2 per cent in 1980 to 22.5 per cent in 1990; in the USA the decline in the corresponding period was from 22.1 per cent to 18.0 per cent and in Japan from 24.7 per cent to 24.1 per cent (Nolan 1993). Conceptual issues and empirical analysis However, as far as economic analysis is concerned, the question of the impact of Third World competition on manufacturing job losses or overall unemployment in the advanced countries is rather complex. This is in part because for these countries, deindustrialization, in the specific sense of a reduction either in the share of manufacturing employment or an absolute contraction in manufacturing employment, is a longterm phenomenon of economic development.6 At an empirical level, therefore, it becomes necessary to distinguish between reduced manufacturing employment arising from this source and that from other sources (e.g. new technology) as well as manufacturing trade. In view of this complexity of the subject, there is no agreement in the literature on the appropriate theoretical or empirical models for analysing it. There exist instead alternative paradigms, which lead to very different policy conclusions. According to the dominant neoclassical paradigm, trade does not cause unemployment (see, for example, Malinvaud). The observed deindustrialization in advanced countries is ascribed in this doctrine to the following two causes: (a) the long-run factors mentioned above which lead to a shift from manufacturing to service employment; (b) it is argued that the comparative advantage in a range of manufactured products has shifted from the North to the South. This leads to a temporary problem of structural adjustment for which the proper remedy is to reduce the rigidities in the North’s labour markets rather than to call for protection or subsidies.7 Building on the work of Sayers and of Kaldor, Singh (1987, 1989, 1990) put forward an alternative nonneoclassical conceptual framework, for examining this issue. In this framework, although the long-term factors of economic development do cause deindustrialization in advanced countries, trade can also significantly contribute to it and to overall unemployment. Singh advanced twin concepts of an ‘efficient manufacturing sector’ and that of ‘longterm structural disequilibrium’ for examining this issue for an advanced economy like the UK. His analysis suggests that industrial countries with ‘inefficient manufacturing sectors’ or those in ‘long-term structural disequilibrium’ can be seriously disadvantaged by trade—leading to speedier deindustrialization (i.e. decline in the numbers or the proportion of the labour force employed in manufacturing) as well as to rising overall unemployment. In summary, in Singh’s

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framework, the answer to the question whether, and to what extent, deindustrialization in an advanced economy is due to Third World competition in manufactures, requires the following chain of causation to be established. 1 Taking into account its interactions with the rest of the world, is the economy in ‘long-term structural disequilibrium’?8 2 If so, is this disequilibrium due to trade in manufactures rather than, for example, trade in services? 3 If the structural disequilibrium is, indeed, because of the trade in manufactures, is this due to competition with the Third World or with other advanced countries (e.g. Japan)? At a more general level, it should be emphasized that the expansion of industry in one part of the world need not necessarily be at the expense of industrial development in another part of the world. Long ago, Sayers (1965) made a useful distinction between ‘complementary’ and ‘competitive’ aspects of world economic expansion for any particular country or region. Economic growth elsewhere is ‘complementary’ to the extent that it raises demand for the country’s exports, but it becomes ‘competitive’ insofar as it leads to the development of alternative sources of supply. So, from the point of view of a country or a region, the development of the world economy may be characterized by a changing balance between ‘complementary’ and ‘competitiveness’. For example, during the period 1960–80, not just the South but the former socialist countries of Eastern Europe also industrialized very fast; the latter’s share of world industrial production increased from 17 per cent to 27 per cent over these two decades (UNCTAD 1981). Nevertheless, it would be difficult to maintain that East European industrialization was achieved at the expense of the older industrial countries of Western Europe. On the contrary, most observers would agree that, if anything, West European industrial development was most probably positively helped by industrial demand from Eastern Europe. Put in these terms, the question remains whether industrialization of the South, and, in particular, of the NICs, has been more ‘competitive’ rather than ‘complementary’ to the North and, hence, responsible for the loss of manufacturing or other jobs in the advanced countries. Singh’s (1989) empirical analysis for the 1970s, carried out within the non-neoclassical framework outlined earlier, showed that for an advanced industrial economy with an ‘inefficient’ manufacturing sector like the UK, trade in manufactures did lead to a net loss of jobs.9 But importantly, the study also showed that it was not manufactured trade with the Third World but rather with the other advanced countries which was the main cause of the disequilibrium. On the contrary, Singh estimated that at least in the 1970s, UK manufacturing trade with the newly industrializing countries led to a small net rise in employment rather than a fall. However, the econometric analysis also showed that there was evidence that in the longer term Britain’s trade with the NICs is likely to become as disequilibriating as that with the advanced countries. In analysing the impact of Third World competition on advanced industrial economies as a whole, the important conceptual point in Singh’s analysis was to distinguish between countries like the USA and the UK with ‘inefficient’ manufacturing sectors (which led to these economies being chronically balance-ofpaymentsconstrained at desired levels of output and employment) and those like Japan and West Germany with ‘efficient’ manufacturing industry (i.e. industry generating enough net exports to ensure the required current account balance at desired levels of employment or overall economic growth). With respect to empirical evidence for the industrial countries in general, the OECD (1979) study for a group of advanced countries and a sub-set of NICs found that OECD’s trade balance in manufacturing with NICs was positive and it increased over the period 1970–7. This suggested that even if in some balanceofpayments-constrained advanced countries, manufacturing trade with NICs had become disequilibriating in the 1970s, it was likely in general to have been a far smaller source of disequilibrium than the trade among

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the industrial countries themselves. However, as in the case of the UK, there was no reason to believe that this would necessarily continue to be the case over time. Indeed for the 1980s, there is evidence of significant job losses in the USA as a result of its manufacturing trade with developing countries. But, barring a few East Asian countries, as Marshall (1989) rightly pointed out, this fall in employment was much more due to a loss of US exports rather than to a huge increase in imports. As a result of the fast expansion of the US economy after the trough of the recession in 1982, the US share of world imports increased from 13.3 per cent in 1980 to 19.2 per cent in 1985, but remained about the same relative to gross national product (GNP). Marshall noted that the US deficit grew as a result of a decline in exports relative to GNP—merchandise exports fell from 8.4 per cent of GNP in 1980 to 5.3 per cent in 1985. The US merchandise exports to the developing countries declined by 24.4 per cent in real terms during these years compared with 11.7 per cent reduction in total exports. This was, however, mainly due to ‘import strangulation’ in developing countries as a consequence of the debt crises (Singh 1986; Khan and Knight 1988). The US exports to heavily indebted Latin America countries fell for example by 30.9 per cent during this period. On the other hand, job losses arising from the US trade with South Korea and Taiwan, both of which were running sizeable trade surpluses in the 1980s, was more likely due to their greater penetration of the US market. These two countries were not subject to import compression arising from the debt crises in the way the Latin American countries were in the last decade. CONCLUSION: INDUSTRIAL POLICY IN THE NORTH AND THE DEVELOPMENT OF INDUSTRY IN THE NORTH AND THE SOUTH Endogeneity of the European industrial policy Rapid industrialization in the Third World during the last three decades as well as the continuing extremely fast expansion of the Third World manufacturing exports to the advanced countries has raised the question whether these have, or will in future, lead to ‘deindustrialization’ in advanced countries. Will Third World industrialization become ‘competitive’ with industry in the North, as Japanese post-war growth appears to have been, or will it be ‘complementary’ as in the case of East European industrial development vis-à-vis Western Europe during the 1960s and 1970s. The empirical evidence summarized above suggested that although in the past (e.g. the UK economy in the 1970s) the industrial countries manufacturing trade with the NICs may not have been disequilibriating, it is likely to become so for many of them over time (particularly those with ‘inefficient’ manufacturing sectors). What will be the impact of an industrial policy in Europe on these underlying processes? The answer obviously depends on the nature of industrial policies which the European Union (EU) countries choose to follow. If the threat of Third World competition leads to a protectionist EU industrial policy and discourages Third World manufacturing exports, it would certainly not help Third World industrial development. Developing countries need to import technology and capital from industrial economies and their ability to do so depends essentially on their export earnings. A protectionist European industrial policy, which keeps out Third World exports, would therefore be inimical to the South’s industrial development. Whatever its short-term advantages for the affected European industries, in the long term such a policy may not be in the interest of the European economies either. This is because it would slow down structural change and hence reduce long-term economic growth. On the other hand a ‘positive’ European industrial policy which encourages structural change will help industrial development both in the North and in the South. Such a policy would involve, instead of

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protection for industries like textiles and steel, positive help for upgrading workers’ skills and for the redeployment of resources to up-stream, technologically more advanced activities. However, experience over the last two decades indicates that the kind of industrial policy that is actually adopted by advanced economies is an endogenous variable. In a slow growing OECD economy with high levels of unemployment in many countries, it has become increasingly more difficult for these countries to accept the loss of their markets to a growing list of NICs, as well as the new democracies of Eastern Europe. This has resulted in ad hoc calls for protection against the Third World (as well as the Japanese and other countries) products. Often the arguments for protection, particularly against the developing countries’ exports, are put in more subtle forms. It is suggested that Third World competition is unfair because it involves cheap labour, working in sweat shop conditions. To ensure ‘level playing fields’ developing countries are asked to implement International Labour Office (ILO) labour standards and trade union rights. ‘Worker right provisions’ have, for example, been written into various pieces of recent US legislation, specifically those relating to the Generalised System of Preferences (the GSP), the Caribbean Basin Initiative, the Overseas Private Investment Corporation and the US participation in the multilateral Investment Guarantee Agency affiliated with the World Bank (see further US Department of Labor, Annual Report, Fiscal Year 1990 and Singh (1990)). Developing countries regard such measures to be motivated by protectionist considerations, rather than by altruism or a genuine concern for worker rights. If the world economy were again to expand at the rates that were achieved during the Golden Age (1950– 73) and there was near full employment in the European and other advanced countries, the fast growth of the manufactured exports from the South could clearly be much more easily accommodated. In those circumstances there is a much greater likelihood that the European countries would adopt a ‘positive’ rather than a ‘negative’ or protectionist industrial policy. What then are the prospects and the conditions necessary for the return of the Golden Age? Recreating the Golden Age It was noted in the section on ‘The Golden Age and its erosion’ that the second oil shock saw the final abandonment of what may be called the Golden Age pattern of development (encompassing both the internal and external rules of coordination of the economic system). It is beyond the scope of this chapter to provide a full discussion of the emerging post-1979 pattern. However, it may be briefly recalled that at the international level, instead of attempting to compensate for the deflationary effects of the 1979 oil price rise, restrictive monetary and fiscal policies were strongly reinforced in the USA and adopted by other main industrial countries. In an international economy, ever more closely linked by ‘free’ and gigantic capital movements, this resulted in the early 1980s in a ‘beggar-my-neighbour’ competitive deflation and a prolonged recession. At the national level, the challenge to the Golden Age institutional framework within the individual industrial countries inevitably occurred at an uneven pace in different countries. Nevertheless a number of common features can be discerned. 1 The Golden Age presumption that workers should bargain collectively to protect wages against inflation and to collect a share of the fruits of productivity growth was challenged. Norms of indexation were repudiated (Italy) and attempts were made to weaken trade unions by legislation (UK, secondary picketing; Germany, social security payments for strikers).

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2 Demands for wage flexibility have been paralleled by demands for employment flexibility—the right to hire and fire through rolling back employment protection legislation (UK, France). 3 Attempts to reduce the coverage and value of welfare state benefits have been general. 4 There has been an explicit abandonment of full employment policies embodied in the adoption of rules about monetary growth and public sector deficits. 5 There has been a general trend towards extending market pressures—privatization of nationalized industries (UK, France, Japan) and cuts in government subsidies to loss making firms and industries. Viewed from the standpoint of the governing economic circles in the leading OECD countries, this emerging new pattern of development has already been ‘successful’ in some important directions. First, there has been a major change in the balance of power both internationally and internally. Internationally, the collapse of commodity prices, the extremely high real interest rates and the reduction of capital flows have greatly weakened the economic and political power of Third World countries. In the mid-1970s these countries were vociferously demanding a new international economic order; today most of them (particularly in Africa and Latin America) are severely balance of payments constrained, heavily in debt and in the position of being supplicants before the International Monetary Fund (IMF) and the World Bank. The latter two institutions are only willing to provide the much needed foreign exchange if these countries carry out the so-called ‘structural reforms’, which usually follow the same pattern of de-nationalization, deregulation and internal and external liberalization of markets, which are the hallmark of changes in the advanced countries (Singh 1992). Similarly in the latter group the bargaining positions of the trade unions and of the working class in general have been weakened at both the work place and at the macroeconomic level. The second main success of the emerging new system, as noted earlier in the section on ‘North—South industrial competition and significance of the world conjucture’, has been an improvement at least in terms of inflationary performance of the industrial countries compared with the mid-1970s. This is of course directly related to the weakened bargaining power of the unions and the fall in commodity prices that accompanied the changing internal and international balance of power, referred to earlier (see further Beckerman and Jenkinson 1986). There are, however, important weaknesses in the post-1980 record. First, although unemployment rates in the industrial economies can be expectd to come down to some degree in the mid1990s as the rate of growth of their labour forces declines due to demographic factors, they look set to remain exceptionally high in most European countries. Only a trend increase in the rate of growth of the world and European economic activity can offer the prospect of an improvement before then. However, under the present institutional arrangements, the realization of such faster economic growth poses serious problems. For if expansionary policies were followed and the world rate of economic growth rose on a sustained basis to anywhere near its Golden Age level, it will again lead to an increase in the power of unions as well as a sharp rise in commodity prices, including oil. This in turn will rekindle inflation. Therefore, as long as high unemployment rates in EU countries are politically acceptable, the balance of advantage (from the standpoint of conservative governments in the leading countries) lies in continuing with the current macroeconomic pattern of low growth and low inflation. For those who do not regard large-scale unemployment in Europe as politically acceptable, it is essential to work towards changing the current institutional arrangements which thwart faster and sustainable economic growth. It is certainly true that the recreation of the Golden Age today is a much more difficult problem than it was at the end of the Second World War. This is in part because at that time the USA was the single hegemonic economic and political power in the world and could therefore enforce its economic design

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(which for various reasons happened to be a far-sighted one) on the rest of the world. Today, at a time when the national economies are much more interdependent and subject to far greater market fluctuations, there is no single hegemonic power but rather a multipolar world. Thus, even if it wanted to, given its balance of payments position the USA could not institute a ‘Marshall plan’ on its own. Nevertheless, if there is political imagination and political will in the leading countries (the USA, West Germany and Japan), a new Golden Age is certainly not impossible. This would, however, require an explicit abandonment of the pattern of development of the 1980s and a commitment to a very different economic and social order. In particular, growth rates approaching the Golden Age levels in the OECD countries will only be feasible and sustainable with low inflation on the basis of a new institutional and behavioural framework internally (e.g. a more cooperative relationship between the labour force, management and government) and a rather different system of international regulation (which for example will involve among other things some scheme for orderly commodity price movements, hitherto rejected by the leading OECD governments). Paradoxically, in order to raise the rate of growth of world aggregate demand, such a regime may also require certain protectionist measures. However, instead of ad hoc protection against various Third World exports, this would involve multilaterally agreed trade and exchange rate discrimination against a country like Japan which is in structural trade surplus but does not wish for internal reasons to expand its domestic economy adequately (as considered from an overall global perspective).10 Only if such a mutually cooperative pattern of development is instituted, would Europe and the world be able to move towards ‘positive’ industrial policies and harmonious industrial development of the North as well as the South. NOTES 1 In writing this chapter, I have drawn materials from my earlier papers (Singh 1989, 1990). 2 See Kindleberger (1992) and Glyn et al (1990). 3 For reasons of space, this is necessarily a highly schematic and condensed account of the analysis of an extremely complex question: why did the Golden Age arise and why did it come to an end? This summary is based on Glyn et al (1990) to which the reader is referred for a full discussion of these issues. For some alternative interpretations see Maddison (1982), Bruno and Sachs (1985) and Matthews and Bowen (1987). 4 Unless specified otherwise, for the sources of data reported in this section see Singh (1989, 1990). 5 See further OECD (1979), Blackaby (1979), Rowthorn and Wells (1987) and Singh (1987). 6 See Rowthorn and Wells (1987), Singh (1987) and Baumol et al. (1989). 7 This view is best expressed in Beenstock (1984) and in the recent American Express Gold Medal winning essay by Brown and Julius (1993). 8 An advanced country like the UK is regarded as being in long-term structural disequilibrium if its manufacturing import and export propensities are such that the country is unable to achieve current account balance at a desired level of employment and a desired rate of growth of real wages. In this conceptualization, for an industrial country, manufacturing performance in the world economy is regarded as the key to the achievement of the desired current account balance (and hence the country’s ability to reach its longterm growth potential). The emphasis here is on the long-term or the structural factors which may prevent an economy from achieving its full potential, rather than on temporary disturbances which may easily be self-correcting. The disequilibrium becomes structural in the sense that it cannot correct itself through the normal market mechanisms. This is either because, for institutional reasons, there is not adequate wage-price flexibility in the economy (e.g. because of the workings of the labour market it is not possible to achieve a large enough real devaluation without risking inflation); or because even if there is wage-price flexibility, it cannot restore competitiveness because the latter has important non-price dimensions (the quality of the products, technical progress, delivery dates, etc.). See further Singh (1977, 1989), Cairncross (1979) and Ball (1989).

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9 ‘Gross job’ losses, however, can and often do cause enormous social distress even if there is equivalent employment created elsewhere. New service sector jobs often pay less and are less protected by union rights and other benefits than the manufacturing jobs that disappear. Blues tone and Harrison (1982) called particular attention to this phenomenon. 10 For a fuller elaboration of this argument, see CEPG (1979).

BIBLIOGRAPHY Ball, Sir James (1989) ‘Manufacturing industry, economic growth and the balance of payments’, in D.Cobham, R.Harrington and G.Zis (eds) Money Trade and Payments, essays in honour of Sir D.J.Coppock, Manchester: Manchester University Press. Baumol, J., Batey Blackman, S.A. and Wolff, E.D. (1989) Productivity and American Leadership: The Long View, Cambridge, MA: MIT Press. Beckerman, W. and Jenkinson, T. (1986) ‘What stopped the inflation? Unemployment or commodity prices?’, Economic Journal 96, March, pp. 39–54. Beenstock, M. (1984) The World Economy in Transition, London and Boston: Allen and Unwin. Blackaby, F. (ed.) (1979) Deindustrialisation, London: Heinemann Educational. Bluestone, B. and Harrison, B. (1982) The De-industrialisation of America, New York: Basic Books. Brown, R. and Julius, D. (1993) ‘Is manufacturing still special in the new world order?’, The Amex Bank Review, Finance and the International Economy 7, Oxford University Press. Bruno, M. and Sachs, J. (1985) Economies of Worldwide Stagflation, Oxford: Blackwell. Cairncross, Sir Alec (1979) ‘What is de-industrialization?’, in F.Blackaby Deindustrialisation, London: Heinemann Educational. CEPG (1979) Economic Policy Review, Department of Applied Economics, Cambridge. Cosh, A.D., Hughes, A. and Singh, A. (1992) ‘Openness, financial innovation, changing patterns of ownership, and the structure of the financial markets’, in T.Banuri and J.B.Schor (eds) Financial Openness and National Autonomy, Oxford: Clarendon, pp. 19–42. Glyn, A., Hughes, A., Lipietz, A. and Singh, A. (1990) The rise and fall of the Golden Age’, in S.A.Marglin and J.Schor (eds) The End of the Golden Age, Oxford: Clarendon. IMF (1993) World Economic Outlook, Washington DC, October. Kaldor, N. (1978) Further Essays on Applied Economics, London: Duckworth. Khan, M.S. and Knight, M.D. (1988) ‘Import compression and export performance in developing countries’, Review of Economics and Statistics, May. Kindleberger, C. (1992) ‘Why did the Golden Age last so long?’, in A. Cairncross and F.Cairncross (eds) The Legacy of the Golden Age: The 1960’s and their Economic Consequences, London: Routledge. Maddison, A. (1982) Phases of Capitalist Development, Oxford: Oxford University Press. Marshall, R. ‘Linking Workers’ Rights and Trade’, paper presented to the International Metal Worker’s Federation Central Committee Meeting, Madrid, June 1988. Matthews, R.C.O. and Bowen, A. (1987) ‘Keynsian and other explanations of post-war macro-economic trends’, paper prepared for Keynes General Theory After Fifty Years, conference held at the National Economic Development Office, London, September. Nolan, P. (1993) ‘UK manufacturing industry in decline?’, in Centre for Industrial Policy and Performance, University of Leeds, Bulletin no. 2. OECD (1979) The Impact of Newly Industrialising Countries on Production and Trade of Manufactures, Paris: OECD. Patel, S.J. (1992) ‘In tribute to the Golden Age of the South’s development’, World Development 20 (5), pp. 767–77. Reynolds, L.G. (1983) The spread of economic growth to the third world: 1850–1980’, Journal of Economic Literature, September, pp. 941–80.

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Rowthorn, R.E. and Wells, J.R. (1987) De-industrialisation and Foreign Trade, Cambridge: Cambridge University Press. Sayers, R.S. (1965) The Vicissitudes of an Export Economy: Britain since 1880, Sydney: University of Sydney Press. Singh, A. (1977) ‘UK industry and the world economy: a case of deindustrialization?’, Cambridge Journal of Economics, June, pp. 113–36. —— (1984) ‘The interrupted industrial revolution of the third world: prospects and policies for resumption’, Industry and Development no. 12, pp. 43–68. —— (1986) ‘The world economic crisis, stabilisation and structural adjustment: an overview’, Labour and Society, September, pp. 277–93. —— (1987) ‘Manufacturing and de-industrialisation’, in J.Eatwell, M. Milgate and P.Newman (eds) The New Palgrave, Dictionary of Economic Thought, London: Macmillan, pp. 301–8. —— (1989) ‘Third world competition and de-industrialization in advanced countries’, Cambridge Journal of Economics, 13 (1), pp. 103–20. —— (1990) ‘Southern competition, labor standards and industrial development in the North and South’, in S.Hergenberg and J.F.Perez-Lopez (eds) Labour Standards, Development and the Global Economy, Washington DC: US Department of Labor, pp. 239–69. —— (1992) ‘The actual crisis of economic development in the 1980s: an alternative policy perspective for the future’, in A.K.Dutt and K.P. Jameson (eds) New Directions in Development Economics, Aldershot: Edward Elgar, pp. 81–116. UNCTAD (1981) Trade and Development Report, Geneva: UNCTAD. UNCTAD (1993) Trade and Development Report, Geneva: UNCTAD. World Bank (1987) World Development Report, Washington, DC: World Bank.

5 INDUSTRIAL STRATEGY Process or content? Insights from the Austrians Pat Devine

INTRODUCTION The modern Austrian school emphasizes the role of market processes in promoting discovery—market processes enable the social mobilization of tacit, inarticulated knowledge through decentralized entrepreneurial activity. The strength of this insight, combined with the historical failure of Soviet-style central planning, has for the last decade and a half placed advocates of strategic intervention in the economy very much on the defensive. Although the manifest failures of the turn to the free market during the 1980s have resulted in a revival of interest in industrial strategy, this is unlikely to be sustained unless the theoretical challenge of the Austrian school is addressed and its central insight is taken into account. This chapter first outlines the essential features of the modern Austrian school, tracing its origin back to the economic calculation debate of the 1920s and 1930s. It then examines the significance for industrial strategy of the modern Austrians’ central insight – recognition of the importance of tacit knowledge and of institutions that promote the discovery and social mobilization of such knowledge. The chapter argues that this insight must be taken seriously, but that it is participatory decision making and not entrepreneurial activity in the market process that enables the discovery of tacit knowledge to be generalized and thus the potential for efficiency in meeting social welfare to be maximized. For that potential to be realized, however, interdependent decisions, particularly those relating to major investment, need to be consciously coordinated. Participatory decision making at the level of the firm or the community, although necessary for the discovery of tacit knowledge at those levels, does not dispose of the issues that arise from interdependence among firms and communities. The chapter argues, therefore, that industrial strategy needs to be developed through a process of cooperation and negotiation that enables interdependent firms and communities to reach agreement. Such agreement must ultimately be based on a view of the sorts of economic activity, and the geographical distribution of that activity, which would maximize the social welfare of those involved in the decision-making processes. Thus, an effective industrial strategy must involve both participatory process and substantive content. THE MODERN AUSTRIAN SCHOOL The modern Austrian school is based on the centrality of tacit knowledge and discovery. By contrast with the Neoclassical school, the focus of Austrian analysis is not the allocation of limited resources with alternative uses among unlimited wants, but the market process itself, the way in which dispersed and fragmented (tacit) knowledge about an economic world that is continuously changing is socially mobilized

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through rival entrepreneurial activities. Thus, the means-end nexus of economic life in the Austrian setting turns out to be not given, but subject to creative human action—‘a voyage of exploration into the unknown’ (Hayek 1945: 101). The origin of the modern Austrian school may be traced to the economic calculation debate of the 1920s and 1930s. The debate was about whether it was possible to have rational economic calculation in a socialist economic system, defined as state ownership of the means of production. The two principal sides in the debate were economists from the Austrian school, who denied that it was possible, and economists working within a Neoclassical framework, who argued that it was. The standard account of the debate has been that the (Neoclassical) socialists won, although for thirty years or so after the summing up article of Bergson (1948) it was regarded mainly as part of the history of economic thought, with little or no relevance to contemporary discussion. In the 1980s, however, the debate revived. The modern Austrian school contested the standard account, arguing that it was based on a misunderstanding of the original Austrian challenge. Lavoie (1985) argues strongly that the discovery and learning aspects of the market mechanism that are central to the modern Austrian school had already been discussed in the early contributions of Hayek and Mises in the 1920s and 1930s, with the implication that there was no retreat in the Austrian camp during the debate. On this reading, the Neoclassical socialist school of the 1930s misinterpreted the basic concepts used by the Austrians, casting them within a Walrasian paradigm, and ipso facto missed the point. Kirzner (1988), on the other hand, insists that the Austrian approach should be seen as having been developed through the calculation debate, with its crystallization only becoming apparent after the 1940s. His reading is that Mises and, in his early writing, Hayek had not clearly conceptualized their position and differentiated it vis-à-vis that of the Neoclassical, and hence invited their opponents to interpret the Austrian challenge as being based on computational and, to a lesser degree, motivational grounds. The Neoclassical answers based on this interpretation (i.e. Lange-type decentralized solutions), according to Kirzner, then led the Austrian economists to clarify their analysis of the dynamic aspects of markets as processes of discovery and learning. In the modern Austrian vision, the crux of the matter of economic calculation is the fact that dispersed knowledge exists only in a tacit form, waiting to be discovered by entrepreneurs vying to outstrip one another in the process of searching out attractive buying and selling opportunities and creating new products and production processes. It is this that leads Kirzner to argue that Instead of judging policies or institutional arrangements in terms of the resource-allocation pattern they are expected to produce (in comparison with the hypothetically optimum pattern), we can now understand the possibility of judging them in terms of their ability to promote discovery. (Kirzner 1988:13) Within these discovery and learning processes, the Austrian view underlines the vital role, or roles, assumed by the entrepreneur. The Misesian—Kirznerian entrepreneur plays an equilibrating role by detecting and exploiting what others fail to notice, while the Schumpeterian entrepreneur plays a disequilibrating role by innovating new production systems (Schumpeter 1942; Mises 1949/63; and Kirzner 1973). As many commentators have noted (see, for example, Barry 1984), in the Austrian vision the concepts of entrepreneurship and rivalry replace the Neoclassical concept of the Walrasian auctioneer adjusting the prices to which economic agents respond in an automated way. Underlying this change is a fundamental difference in understanding of the nature of information, with the Austrians insisting that knowledge cannot be objectified, codified or transferred, but must rather be discovered in the course of entrepreneurial activity. Only through knowledge which is revealed during this market process, they argue, is the participant able to

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surpass the limits of her/his ignorance. As Lavoie puts it, Like ‘verbal conversation, the dialogue of the market depends on the specific give-and-take of interaction, a creative process of interplay in which the knowledge that emerges exceeds that of any participants’ (Lavoie 1990:78, emphasis added). This emphasis on the process of discovery is the major strength of the Austrian school. However, there is a striking paradox in the Austrians’ position. While insisting on the universal importance of tacit knowledge, they also insist that such knowledge can only be discovered by entrepreneurs competing in a market process based on private ownership. This necessarily excludes the tacit knowledge of non-entrepreneurs from the social process of discovery and mobilization. It follows that if Kirzner’s criterion for judging institutional arrangements is adopted (‘their ability to promote discovery’), there is a prima-facie case that market processes based on private ownership are socially inefficient. A set of institutional arrangements that generalizes access to the social process of discovery would not only be more democratic and more just, but also more efficient. The implications of this for industrial strategy are evident. Strategic decision making, to be efficient, needs to be based on the participation of those who are affected by the decisions that are made. At the level of the firm this means that corporate governance needs to be democratized by the inclusion of workers and communities as well as shareholders. At the level of communities it means that representative government needs to be supplemented by representatives of organized interests—not just managers and workers but also any other interests which choose to organize themselves in civil society. The general conclusion to be drawn from the Austrian insight is that, in whatever context, participatory decision making is necessary in order to maximize the potential for the discovery of tacit knowledge. CONSCIOUS COORDINATION Strategic decisions taken at the level of the firm or the community differ from non-strategic decisions because they are designed to alter the existing set of constraints facing the decision-making unit. Where there is significant interdependence among firms or communities, the outcome of one decision-making unit’s strategic decision will depend in part on the simultaneously undertaken decisions of other units. While participatory decision making within a single firm or community will maximize the potential for the discovery of tacit knowledge, that potential will only be realized to the maximum if interdependent decisions are consciously related to each other and coordinated to the greatest extent possible. Thus, meaningful industrial strategy is necessarily a form of strategic planning. The importance of conscious coordination for efficient strategic decision making was a minor theme in the economic calculation debate referred to in the previous section. Although the principal protagonists were the Neoclassicals and the Austrians, the case for strategic planning was made by Dobb. He suggested three advantages of planning. First, where there are close interconnections among different sectors and industries it is much easier to coordinate decisions before they are implemented rather than after. Similarly, planning has the ability to embrace the wider social effects of production that fall outside the private calculations of atomized decision-making units. Second, through planning it is possible to overcome the uncertainties that are ‘inherent in production for a market when each autonomous decision is necessarily “blind” in part with respect to related decisions’ (Dobb 1935:535). This is particularly important in relation to investment decisions, ‘since current investment by changing both productive capacity and employment can exercise an important influence upon market prices’ (Dobb 1960:6). Third, things which figure as ‘data’ in a static context can be converted through planning into ‘Variables’ in a dynamic framework. Among these Dobb includes the rate of investment, the distribution of investment among different industries and

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regions, the choice of techniques, the rate of introduction of new products and their character, and the degree of standardization or variety of production. If interdependence is to be taken into account, a participatory industrial strategy would require decision making at all levels of generality to take place through a process involving all those affected by the decision. This, of course, contrasts sharply with the Austrian position, in which participation is confined to the micro level. For Austrians, this is not a matter of choice but a necessary fact of life. As Hayek put it, The main point of emphasis is that the conflict between, on the one hand, advocates of the spontaneous extended human order created by a competitive market, and on the other hand those who demand a deliberate arrangement of human interaction by central authority based on collective command over available resources, is due to a factual error by the latter about how knowledge of these resources is and can be generated. (Hayek 1988:7) However, it is mere assertion to state that social processes of discovery can only take the form of rivalrous behaviour in markets based on private ownership. A participatory industrial strategy at each level of decision making would enable knowledge of previously unarticulated interests, possibilities and interdependencies to be discovered and rendered transparent, through a process of social interaction among those affected. Thus, a participatory industrial strategy would enable a more general social mobilization of tacit knowledge than that envisaged by the Austrians to be combined with the advantages of conscious coordination advocated by Dobb. At the same time, participatory strategic planning would not be vulnerable to the Austrian critique that all attempts at conscious intervention are premised on a misunderstanding of the tacit nature of knowledge. CONCLUSION: INDUSTRIAL STRATEGIES FOR EUROPE Strategic decision making arises at the level of the firm, the region, the nation state and various supranational entities. Historically, industrial strategies have been adopted primarily to promote national economic development and/or international competitiveness. Embryonic institutional forms for conscious coordination have evolved or been created in many countries in order to mitigate the uncertainty associated with atomistic decision making. They have included the sectoral bureaux within Japan’s Ministry of International Trade and Industry (MITI), the industrial banking system in Germany, the sectoral commissions associated with French indicative planning and even the Economic Development Committees and Sector Working Parties established in the UK under the auspices of the National Economic Development Council, now abolished. More recent examples frequently cited include Singapore, South Korea and Taiwan, and the Third Italy. Such institutional arrangements have differed from one another in the extent to which they have been effective in achieving conscious coordination and in the degree to which they have incorporated the full range of interests affected by their activities. In the new round of industrial strategy development for the 1990s that is gathering momentum, the modern Austrian school’s insistence on the importance of tacit knowledge and the process of discovery needs to be taken seriously. Two conclusions may be drawn. First, the principle of subsidiarity is reinforced —strategic decision making should take place at the lowest level at which all those whose tacit knowledge is relevant to the decision are able to be involved. The obverse of this, of course, is that those without relevant knowledge should not be involved in the decision making. Second, all those with relevant

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knowledge, not just entrepreneurs or bureaucrats, need to be represented in the decision-making process. Thus, the Austrian insight points in the direction of participatory strategic planning based on the principle of subsidiarity. Recognition that strategic planning/industrial strategy needs to be developed at different levels raises the question of how the competence of each level should be defined, and this in turn raises the question of the relationship between competition and cooperation. Boltho’s interpretation of Japanese industrial policy in the two decades following 1945 illustrates the point at issue. He argues that priority sectors were identified by MITI on the basis of some sort of consensus and allowed to develop behind a protective wall. The structure of individual sectors was carefully controlled, with the number of firms only allowed to increase as first the domestic and later the export market expanded. Thus, corporate strategy was constrained by MITI’s sectoral strategy. Competition as a spur to efficiency and innovation was promoted, but market forces were not allowed to determine the structure of priority sectors (Boltho 1985). Of course, corporate strategy is not industrial strategy. However, the basic problem of the relationship between competition and cooperation remains. Whether industrial strategy is developed at the level of local government, regional government, nation states or the European Community (Union), it has to take account of comparable strategies being pursued by similar decision-making units. Cowling and Sugden’s response to this is to argue that ‘in Europe industrial policy must be regional policy, inspired and created within the regions, but regional policy must be coherent as a whole, at the interegional level, and common desires across regions should be pursued collectively’ (Cowling and Sugden 1993: 96; see also Chapter 3 of this volume). An important area of future work must be to investigate how the competence of different levels of decision making can be agreed and through what institutional framework coherence and the collective pursuit of common interests can best be achieved. Finally, the purpose of the interlinked participatory processes through which communities seek to arrive at a coherent and compatible set of industrial strategies is to enable them to make conscious choices about the sort of society and economy they wish to develop. This means that substantive decisions about the sorts of economic activity that are desired, the geographical distribution of that activity and the policy instruments needed to further these objectives, including ways of controlling transnational corporations, cannot be avoided. What sort of Europe do Europeans want at the turn of the century? NOTE This chapter draws on work done jointly with Fikret Adaman. BIBLIOGRAPHY Barry, N. (1984) ‘The “Austrian” Perspective’, in D.Whynes (ed.) What is Political Economy?, Oxford: Blackwell. Bergson, A. (1948) ‘Socialism’, in H.Ellis (ed.) A Survey of Contemporary Economics, New York: Blakiston. Boltho, A. (1985) ‘Was Japan’s industrial policy successful?’, Cambridge Journal of Economics 9:187–201. Cowling, K. and Sugden, R. (1993) ‘Industrial strategy: a missing link in British economic policy’, Oxford Review of Economic Policy 9:83–100. Dobb, M. (1935) ‘Economic theory and socialist economy: a reply’, Review of Economic Studies 2:144–51. —— (1960) An Essay on Economic Growth and Planning, London: Routledge. Ellis, H. (1948) A Survey of Contemporary Economics, New York: Blakiston. Hayek, F. von (1945) ‘The uses of knowledge in society’, in F.von Hayek (ed.) Individualism and Economic Order, London: Routledge.

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—— (1949) Individualism and Economic Order, London: Routledge. —— (1988) The Fatal Conceit: The Errors of Socialism, ed. W.Bartley, London: Routledge. Kirzner, I. (1973) Competition and Entrepreneurship, Chicago, University of Chicago Press 2:1–18. —— (1988) ‘The economic calculation debate: lessons for Austrians’, Review of Austrian Economics. Lavoie, D. (1985) Rivalry and Central Planning, Cambridge: Cambridge University Press. —— (1990) Computation, incentives, and discovery’, in J. Prybyla (ed.) Privatising and Marketising Socialism, Annals of the American Academy of Political and Social Science, London: Sage. Mises, L.von (1949/63) Human Action, London: William Hodge. Prybyla, J. (ed.) (1990) Privatising and Marketising Socialism, Annals of the American Academy of Political and Social Science, London: Sage. Schumpeter, J. (1942) Capitalism, Socialism and Democracy, New York: Harper & Bros. Whynes, D. (ed.) (1984) What Is Political Economy? Oxford: Blackwell.

6 INNOVATION, ENTREPRENEURSHIP AND INDUSTRIAL DISTRICTS Peter Dorman

This chapter is the result of a confluence of two ongoing research areas, the analytics of interactive economic models and the nature and specific content of entrepreneurial activity. Each has its own motivation and trajectory, and their connection, documented here, was quite unexpected. The interactive approach to economic modelling stands in contrast to the conventional approach in which it is assumed, generally for convenience, that the relevant opportunity and preference sets are convex, such that myopic optimizing rules are globally efficient. In an earlier paper (Dorman 1990) I demonstrated that the hypothesis of non-market interaction between economic agents is inconsistent with these convexity assumptions, and that interactive non-convexity is not, in the general case, altered by the assignment of property rights. The paper also makes the claim that non-market interaction, modelled as ‘off-diagonal’ nonconvexity, is equivalent to the social-theoretic stance of the post-individualist social and natural sciences. Above all, my purpose in this work was to locate and begin to remedy the atomistic (and anachronistic) bias of formal economic theory. Concern for the nature of entrepreneurship, on the other hand, stems from an openly political interest. Proposals for expanding worker and community ownership and control rights are countered by the claim that, lacking entrepreneurial resources and incentives, democratic production regimes are dynamically inefficient. But Austrian1 and other proponents of the entrepreneurship/privateownership connection have not provided an account of entrepreneurial functions that is sufficiently precise to demonstrate that the insufficiency of alternatives to privatization is necessary rather than contingent (see also Pat Devine’s contribution to this volume in Chapter 5). By the same token, however, those who advocate democratic reforms have largely failed to incorporate entrepreneurial functions in their own proposals, leaving the impression that innovation and social control are indeed conflicting objectives. The way out can only be found through an account of entrepreneurial activities that reduces them to their specific productive kernel, so that it can be seen whether they can be conducted on some basis other than their current institutional and even psychological context. In addition, we need a better understanding of entrepreneurship, since the supply of this commodity from the private sector is notoriously uneven. The living standards of entire regions have become hostage to the innovative qualities of their resident business class; when that class falls short, as it so often does, public intervention must be based on a clear sense of what needs to be done. These strands come together in this chapter in the form of a theory of entrepreneurship based on the task of innovation under conditions of interactively non-convex production structures. I shall argue that this offers a more general basis for the entrepreneurial function than that predicated on increasing-returns nonconvexity. It also offers a richer framework for the discussion of industrial strategies designed to promote dynamic efficiency. In particular, I shall consider two implications for policy, the promotion of public

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sector entrepreneurship and the role for polycentric industrial structure, such as industrial districts, in competition policy. The chapter will trace the argument in the following steps. First, I shall summarize the characteristics of interactive modelling, which apply to the entire range of economic phenomena and not only to production. In Section II I shall develop a theory of entrepreneurial innovation under conditions of interactive nonconvexity. Section III applies this approach to the specific issue of industrial districts and briefly surveys the empirical literature to determine the extent to which the theory actually applies. In the final section I shall consider the more general question of how publicly sponsored entrepreneurship can be propagated without sacrificing progressive social and political objectives. I Consider first the general role of convexity assumptions in economic theory.2 A concave function can be viewed as generating, for example, a perfectly smooth mound. The space incorporated within the surface of the mound is convex, since it entirely encompasses any straight line connecting two surface points. The mound has a single peak, and if you wish to climb it all you need to know is to travel in the direction that offers the greatest immediate increase in elevation. No real-world mountain, of course, fits this description. All of them have gullies and ridges, promontories and false summits; in other words, as three-dimensional spaces they are all non-convex. It is no longer enough for the mountain climber to attain a summit; he or she must have additional information as to whether it is the highest summit. Moreover, the simple decision rule ‘always go uphill’ is no longer an adequate guide, since scaling the peak will generally require periods of going downhill as well. Opportunity and preference sets in economics generally take the form of idealized mounds, not mountains. This permits a wide range of panglossean results in virtually every field employing rational choice methodology. Myopic decision rules are adequate, with vast savings in information gathering and processing costs, and multi-agent equilibria are optimal, since the inability to identify pareto-preferred incremental adjustments is assumed to extend to the entire domain of feasible adjustments. There are no false summits in these models. Of course, conventional theory does recognize certain departures from assumed convexity. Increasing returns, particularly in the sphere of production, have been regarded as widespread since the days of Adam Smith. This raises the problem of foresight, for instance in attaining the scale economies of mass production. (I shall have more to say about scale economies and entrepreneurship in the following section.) Externalities, in the Coasian (1960) sense of missing markets, also generate non-convexities, as Baumol and Bradford (1972) and Starrett (1972) have shown. There is considerable debate over the frequency and importance of these two departures, as well as over the adequacy of market-based correctives such as special taxing and pricing schemes and the reallocation of property rights. But the issue of non-convexity can be clarified by going directly to its source, the formal properties of functional relationships. Non-convexity can arise in one of two ways. (1) There can be wrongly signed elements along the principal diagonal of the matrix of second derivatives; i.e. the own second derivative of some arguments may explode, rather than dampen, the first derivative effect. This is the case where there are increasing marginal returns to the arguments of the function. In increasing marginal returns to a productive factor, for instance, the first-derivative effect — increasing output—is itself increased by expanding the use of the factor. (2) Even though the elements of the principal diagonal are correctly signed, the determinant is not, because of large offsetting values in the off-diagonal elements.3 These elements, the cross-partials of the function, represent interaction effects between the arguments.

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Consider the simple production function q=f(x1, x2) where x1 and X2 are any two inputs. Convexity properties depend on the matrix of cross-partials: Since f1 and f2 are both positive, non-convexity due to increasing returns occurs when either f11 or f22 is also positive. Interactive non-convexity depends, by contrast, on whether the absolute value of f11f22 exceeds the absolute value of f122, where this latter term measures the intensity of interaction effects, positive or negative, between the two inputs. Any relationship between these two factors, however indirect—that is, however mediated by additional factors unrepresented in the original production function—can, if sufficiently strong, give rise to such characteristic outcomes as multiple equilibria and the breakdown of myopic optimizing rules. It is this second, interactive class of non-convexities I wish to focus on in this chapter. Interactive non-convexities are sometimes mistakenly conflated with those emanating from uncompensated externalities. They share the common attributes of multiple equilibria and the inadequacy of marginalist adjustment, but there is an important difference. Externalities are the product of property rights (or their absence), whereas interaction effects exist whether compensated or not. Thus externalities can be eliminated through negotiation or internalization, but not interaction effects. Unfortunately, the issue has been clouded since some models of external effects in the literature also incorporate interaction effects, while others (such as those discussed by Coase) do not. It is important to be aware of the difference between these two mechanisms, since, in principle, non-convexities due to externality can always be mitigated by extensions of market relations, whereas interactive non-convexities are impervious to and may indeed undermine them. What basis is there for asserting the importance of interactive non-convexity? In the absence of detailed empirical evidence one way or the other—although some exists, e.g. Repetto (1987)—we can permit ourselves to fall back on underlying theory. It can be demonstrated that the canonical statements of postindividualist social science, such as those of Durkheim and Weber, are formally equivalent to the claim that social aggregates display sufficient interaction to offset predictions based on the choices of their component individuals considered in isolation. This in turn suggests that, by routinely assuming non-convexity—by deriving its core results from ‘well-behaved’ models and considering ‘illbehaved’ subsets on an exceptional basis—modern economics clings to the social theory of its eighteenth- and nineteenthcentury ancestors. Moreover, the natural sciences, particularly ecology, have embraced interactive modelling, indicating that the physical interactions between agents and their activities may be as profound as their social interactions.4 Fortunately, even without a conscious reconsideration of its core assumptions, economics is gravitating to a new appreciation for interaction. This is due to the increasing use of game theory to depict collective behaviour. Game theory investigates strategic action, the way individual choices are influenced by the expected response of other players. Not surprisingly, games frequently display multiple equilibria, and the use of game-theoretic concepts to frame economic discourse has made this result a commonplace in much of the recent literature. Of course, strategic behaviour is just one form of interaction. Game theory is still (and may remain) a niche methodology, however, and in any event its incompatibility with prior non-interactive approaches has not yet been viewed in general terms. >To close, it will be useful to summarize once more the consequences of assuming widespread nonmarket interaction in the economy. 1 The inadequacy of marginal adjustment Small adjustments may possess all the equimarginal properties enshrined in conventional economic theory, yet they may be counterproductive in terms of an agent’s ultimate objectives. Positively, this indicates that agents may possess incentives to engage in ‘non-

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marginal’ behaviour; instead of passively adjusting to an existing array of choices, they may use either market or non-market mechanisms to assemble a new array.5 Normatively, it means that competitive market relations may be less efficient than non-competitive or non-market relations, even in the absence of externalities and transaction costs. 2 Multiple equilibria Non-convex economic environments are characterized by a multiplicity of stable equilibria, in the sense that each equilibrium is stable within a neighbourhood of potential marginal adjustments. Positively, this implies that market analysis, which purports to explain adjustment to equilibrium, is insufficient to explain which equilibrium will be selected. The most likely additional explanans is hysteresis: economies tend to adjust to equilibria whose neighbourhood of stability encompasses the previous equilibrium. Normatively, invisible hand arguments, even when augmented by sophisticated marketbased strategies for dealing with increasing returns and missing markets, are insufficient. Since historical inertia is not a satisfactory basis for choosing between equilibria, social welfare requires some other form of intervention. This, in turn, suggests a potential division of labour between market and non-market mechanisms. Planning or other forms of socially responsive coordination can be employed to choose between broad equilibrium positions (neighbourhoods); markets (or other decentralized algorithms) can fine-tune the results. II What follows is not a general theory of the firm, since that would encompass many topics, such as the nature of financial and employment relationships, that are beyond the scope of this chapter. Nor is it intended to provide a general theory of entrepreneurship, since entrepreneurial individuals or institutions perform diverse economic functions. Rather, it is an attempt to identify one particular sort of entrepreneurial activity: the organization of innovation in non-convex environments. Let us begin at the level of a product. We can define a product as a complex set of component activities, or subproducts, which has the characteristic of being single valued in an economy. In a market context this simply means that products are sold. Of course, defined in this way, products exist at many levels, and the subproducts of a higher-level product may themselves be products with subproducts of their own. There is a hierarchical relation between product and subproduct, although there need be no hierarchy among subproducts; i.e. we need not assume that subproducts lie upstream or downstream from one another, although they may. Subproducts can be tangible or intangible. If ‘car’ is the product, ‘fan belt’, ‘tires’, and ‘marketing strategy’ are all subproducts. In formal terms, we can imagine that each product has a production function whose arguments are not scalar quantities of factors, as in conventional analysis, but vector-valued subproducts. Variation along each dimension of subproduct supply has associated with it a marginal contribution to the value of the overall product. Thus there are as many marginal products in such a production function as there are subproducts times the average number of dimensions. The first-order conditions of product value maximization (incorporating the relevant constraints) generate the marginal properties of optimal subproduct quality choices. If the entire feasible production set is convex, it is sufficient for producers of subproducts to make continuous small adjustments in the direction of these conditions until they are fully met. Indeed, if there is a market for subproducts capable of generating implicit prices for each qualitative dimension, one could invoke an invisible hand postulate in support of the claim that product value maximization will be achieved in equilibrium. Consider now the problem of new knowledge. Suppose new options become available for subproduct quality—either new dimensions, new positions along old dimensions or new relationships between existing

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subproduct qualities and the value of the overall product. In a convex environment, the agent responsible for selecting subproduct characteristics would now notice a new set of marginal products and would be able to recognize that the optimal conditions are no longer being met.6 He or she would be able to move incrementally along both old and new quality dimensions until the discrepancy is resolved. But these actions, in turn, would throw other agents off their equilibrium position, requiring adjustment on their part as well. As we have already seen, it is a consequence of strict convexity assumptions that this is a convergent process, leading to a new (stable) product-wide equilibrium/ optimum. To be precise, this process has two properties: (1) agents whose subproducts initially stand in a new relation to the finished product can identify the local adjustments necessary to initiate optimal product-wide adjustment, and (2) a decentralized algorithm of mutually responsive local adjustments can arrive at a general product-level optimum. Here is an example. Suppose there is a grocery store whose product to be maximized is its daily cash register receipts. Let us assume that the only subproducts are particular food items that compete for shelf space. Each food category has a buyer and, through some mechanism, buyers identically share the store’s objective of sales maximization. Moreover, assume that buyers have perfect information concerning the contribution of each can or jar ordered on the store’s final sales. In the initial position, the store is maximizing receipts and the buyers are in equilibrium with respect to one another. Now, suppose a new, more appealing variety of canned tomatoes appears on the market. The tomato buyer, armed with instant market research, knows that ordering an additional case of tomatoes will be revenue maximizing, even if the other buyers continue exactly as before; so more tomatoes are ordered. Now the shelves are somewhat more crowded, other items are not as well displayed, and their buyers quickly determine that slightly reduced orders will be in the store’s interest. In the third round, the tomato buyer may well find that, with more shelf space to play with, yet another case is in order. There would follow further rounds on all sides until just the right mix of foods are in stock. Under the stringent convexity (and information) assumptions attached to this example, both properties of convex systems hold: the tomato buyer has an incentive to respond to new opportunities by making an initial adjustment, and the buyers as a group can arrive at a new optimum in a perfectly decentralized manner. In the general case, however, productive environments cannot be assumed to be convex. This may be due to increasing returns or interaction effects. Under increasing returns, for instance, five additional cases of tomatoes may help the store, while only one or two could hurt it. The tomato buyer would have to make a largescale change in orders, which might have to be negotiated in advance with the other buyers.7 Interaction effects, on the other hand, are more complicated. In the store example, for instance, these may arise if tomatoes and pasta are complements. Thus, it may not pay to order more tomatoes or more pasta separately, but sales would increase if new orders of both are entered at the same time. Indeed, there is no end to the number of interactive nonconvexities we might introduce: the new tomatoes may begin to alter the store’s overall image in the eyes of consumers, with subsequent effects on the sales of completely unrelated goods; or, the tomatoes must be ordered from a different distributor, changing the availability of other items; and so on. Again, in each case it can no longer be assumed that the tomato buyer, in isolation, will know whether a change in this department is in the store’s overall potential interest, and, even if he or she does, whether a decentralized process of mutual adjustment can arrive at the new, preferred store-wide equilibrium. I take it as axiomatic that interactive non-convexity is ubiquitous in real-world economic, as well as social and physical, environments. Indeed, it may be the case that interaction effects are obscure and difficult to trace, since long chains of indirect effects can generate non-convexity as readily as the more direct connections depicted in the grocery example above. In a world of atomistic individuals, coordinated solely

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through market or other decentralized mechanisms, only a small subset of potential feasible, desired innovations would be implemented. This suggests that there are large gains available from coordination to enlarge this set. I propose that this is an essential function of entrepreneurship. To innovate in the face of interactive non-convexity, an entrepreneur needs information and the institutional means for imposing a plan. Unlike agents who passively adjust to existing conditions, an entrepreneur cannot restrict his or her information set to the range of available options—even new options— and their current value. It is also necessary to have information about the options available to other agents, whether chosen or not, in order to locate potential system-wide improvements. And since incremental adjustments cannot be relied on to make the transition to a new system-wide optimum, the entrepreneur must be in a position to coordinate or command discontinuous or simultaneous adjustment. To achieve these purposes, entrepreneurs require organizations that assemble information and implement plans. Such organizations serve not to internalize economies of either scale or scope (which may or may not exist), but to internalize non-convexities. Two final comments on this approach to entrepreneurship should be made. First, entrepreneurs, in the context of this discussion, are any agents, individual or collective, who fulfill these functions. There is no presumption that they are owners of capital or individual agents thereof. Morover, unless it can be shown otherwise, we may assume that entrepreneurship can be practiced by either public or private entities. Second, since the preceding analysis offers a functionalist approach to entrepreneurship, it is legitimate to ask whether there is any reason to suppose that entrepreneurial tasks will actually be carried out in the real world. Perhaps the gains to entrepreneurial intervention will go unrealized. To an extent, it may be argued that competitive forces will select for effective entrepreneurial entities, but this claim is not entirely convincing, since the very logic of interactive nonconvexity undermines the mechanism of spontaneous evolution. The failure to undertake innovative leaps will be punished only if others undertake them, but, in the absence of incrementalist paths to innovation, why should any competitor be expected to innovate? It seems reasonable to adopt the intermediate position that, in practice, some opportunities for entrepreneurial innovation are seized, while others are not. III There are two (non-mutually exclusive) bases for non convexity, increasing returns and non market interaction, as discussed in Section I. Since there has generally been far more interest in the first of these among economists, it is not surprising that increasing returns plays a central role in the literature that views entrepreneurship as a response to market failure. The progenitor of this view (as of so many others) was Marshall, who saw the function of the entrepreneur as the creator of large-scale enterprise—and capturer of economies of scale—under conditions of increasing returns (Marshall 1948). Markets will not assemble enterprises of the appropriate scale spontaneously; an extra measure of individual initiative is required. The difficulty with Marshallian expansion, however, is that it engenders potential diseconomies as well. As organization size grows and the scale of command lengthens, the problems of administration and information gathering grow more than proportionally. The struggle of large firms in the USA to overcome this tendency by decentralizing decision making while simultaneously centralizing information is the subject of the classic studies by Alfred Chandler, particularly Chandler (1977). Even if all internal obstacles to growth can be surmounted, however, firms generally face external constraints such as finance and the market power of competitors. It is often the case, then, that firms fail to expand or diversify sufficiently to capture all available economies of scale and scope. Fortunately, these economies can be realized on an interfirm basis, as Marshall noted in his discussion of industrial districts. Several firms, for instance, may share a

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single supplier, making it possible to operate a particular stage of the production process on the basis of large runs, even though no single firm can generate sufficient demand to justify them. By the same token, labour market specialization can create local economies in the dissemination of skill, much as if all workers were employed by a single firm. These economies of agglomeration have been offered as an explanation for the tendency of industries to be concentrated in particular geographic areas. The merits of this approach notwithstanding, Marshallian analysis has been faulted by its critics for emphasizing the static problem of achieving scale efficiencies at the expense of the dynamic problem of fostering and facilitating innovation.8 The drive toward size and agglomeration would exist even in a world of unchanging methods and products, and this is useful to know, but how would the analysis change if innovation is brought into the picture? One strand in economic theory simply assumes that forward-looking innovation requires non-market mechanisms.9 According to this view, to implement new knowledge is to reject static optimization, since the process of altering constraints differs fundamentally from that of adjusting to them. Yet much innovation can be coordinated by market relations between firms whose size and scope have been optimized on static grounds, provided the larger productive environment, as defined in the previous section, is convex. From a formal standpoint, the problem is simply one of comparative statics: is the old optimum within the new optimum’s zone of stable adjustments? If so, achieving the new equilibrium poses no problems not already encountered in the process of adjusting to the old one. A great many process improvements are of this nature and are routinely introduced by firms of all shapes and sizes, with subsequent rounds of adjustment well taken care of by the price system. Other innovations, however, and particularly those which alter or even invent complex products, do not have this property, as argued previously. Such a distinction appears to be present in Storper (1992), who claims that ‘process’ innovations tend not to challenge neoclassical prescriptions, while ‘product’ innovations do. The development of a general-purpose electric vehicle, for example, is not likely to be the outcome of a sequence of passive optimization by producers coordinated only by the price system. It will not be profitable for anyone to produce the major components of such a car given the existing output by producers of other components. If, nevertheless, a transportation system based on electricity would outperform the existing system (by some agreed criterion), we are faced with a market failure that can be rectified only by some form of non-market intervention, public or private. This conclusion would not hold, however, if it is already profitable for all the adjustments to be made separately from the status quo; i.e. if the production system were convex. Seen in this way, entrepreneurship, now understood as the formulation and coordination of new methods and products, can occur below, at or above the level of the firm. If the ‘product’, as defined in the previous section, represents only one portion of the firm’s activity, either through itself being a subproduct of a greater ‘super-product’ or through the firm’s diversification into many products, the entrepreneurial function can take place autonomously at a level below top management. Of course, if more than one such entrepreneurial centre exists, it is necessary either that they operate over local non-convexities (interaction effects restricted to their own subproduct) or that they be subordinate to a higher-level process that can adjudicate their potentially conflicting plans. More on this later. Most commonly, we identify entrepreneurship with the firm’s strategic core itself. In this conception, the functions of administering the organization and accounting to external sources of finance is integrated with the innovative function. This is plausible, since administrative control facilitates the gathering of information and the implementation of strategies, and since innovations are often expensive and need to be financed.10 To the extent this view is accepted, the theory of entrepreneurship developed in this chapter contributes to a more general theory of the firm. Put somewhat differently, firms may be created or their boundaries may be altered in order to internalize the non-convexities relevant to an intended innovation. To

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take a simple example, an inventor may develop a product which requires a new sort of motor. Since the new motor is not an incremental variation on the old one it is impossible to tell at the outset whether the product as a whole will be profitable. In the first instance, then, the inventor needs to know information about alternative motor production possibilities beyond those revealed in the market. But the product may also require a new type of cooling system, also currently unavailable. So information on this and other subproduct modifications is required as well. Once the information has been assembled and the inventor can judge whether the product is feasible, it still remains to organize the enterprise. Since neither the motor producer, nor the cooling system producer, nor any of the other subproduct producers who would have to alter their output in order to accommodate the inventor has any incentive to do so independent of the decisions of the others, some form of non-market coordination is necessary. Either some or all of the subproduct activities must be assembled under a single authority or tied relations of some sort (an ongoing agreement between enterprises as opposed to a simple exchange of commodities) must be established. In this way, from the information and coordination requirements of innovation under conditions of interactive non-convexity we can derive the extra-market basis for entrepreneurship. More generally, if firms engage in ongoing competitive innovation, as claimed by Schumpeter, the boundaries of firms and the forms of organizations between them that supplement or replace arm’s length market transactions will be responsive to expected future needs for coordination and information.11 Thus the patterns of non-market organization cannot be explained solely by past or present instances of innovation. It should be noted once more, however, that the argument developed in this chapter is only one of many that can be made concerning the structure and activity of firms. There is no guarantee that firms will be organized to facilitate innovation, nor, even if they are, that they will take advantage of the full range of opportunities that come their way. As we have seen, firms cannot grow at will, nor is it always efficient for them to do so. Important interactions may occur at a level above the firm, encompassing the activities of many firms or even many industries. If the sole organizational alternatives available to the economy were inter-firm arm’s length competition (markets) and intra-firm administration (hierarchies), all potential opportunities for innovation at this higher level would be lost. It is possible, however, for additional mechanisms to emerge, powered by enlightened self-interest. Firms may form alliances and consortia precisely for the task of coordinating the development of new methods and products, or their relevant departments—those responsible for managing the activities that are interactively linked —may cooperate across enterprise lines. Like all forms of voluntary economic cooperation in the marketplace, these practices are fragile: they are not likely to be widespread and they may depend on the support of broader cultural or political institutions. But even a few examples of this form of organization are sufficient to demonstrate that entrepreneurship may transcend the apparent limitations of a private ownership economy. This suggests an interpretation of industrial districts: they arise on the basis of mechanisms that permit innovative activity when individual firms are not extensive enough to embrace the relevant productive nonconvexities. But there is a second possible role for inter-firm cooperation, irrespective of firm size. Recall that, as a single-centred decision-making entity, the firm cannot permit multiple entrepreneurial centres to implement conflicting plans. This places it at a potential competitive disadvantage in an environment of rapid, multifaceted and uncertain product change, since overlapping networks of separate firms can simultaneously experiment with several innovative plans.12 This poses benefits not only for the rate at which alternatives can be developed and tested (parallel processing), but also for the acquisition of experiential learning. To survive over time, however, an industrial district of this sort needs not only mechanisms for cooperation, but also institutions that can enable firms (or elements of firms) that guess

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wrong to gain a share of the markets opened up by those who guessed right, so that they can remain available for the next round of innovation. The recent literature on entrepreneurship provides examples of all three types of firm—entrepreneur relations. Japanese production methods are often cited for the emphasis they place on subproduct innovation. Best (1990) cites an account by KenIchi et al. (1985) of sashimi, a process of ‘layered’ innovation, occurring sequentially along the production process. Indeed, the use of quality circles and other participatory vehicles at the shop floor level can be viewed as a way to invest teams of workers with the responsibility of entrepreneurship.13 Multiple entrepreneurial centres of this sort can be accommodated, since their innovations are unlikely to conflict with one another. Firm-level entrepreneurship is the best-known phenomenon; I would contend that much of what is described as ‘strategic planning’ constitutes innovation across non-convexity as described in this chapter (Cowling and Sugden 1993). In recent years many firms have experimented with organizational models that separate the entrepreneurial function from the administrative function, suggesting that entrepreneurship need not be associated with hierarchy. Again, Japanese practices, such as flexible, companywide development teams, are significant. Best (1990) describes the use of ad hoc entrepreneurial groups assembled by management from a variety of divisions, areas of expertise and positions on the corporate ladder. Their mission is to acquire the information and perform the planning necessary to bring about coordinated change in the firm’s product or practices. Another option, even more striking in its departure from the conventional, hierarchical approach, is to grant substantial autonomy to different inhouse product groups, and then encourage their representatives to formulate their own ‘inter-firm’ structures of entrepreneurship.14 Scott (1992) finds examples of this approach in the large aerospace and electronics firms of southern California. Referring to them as ‘systems houses’, he constructs the typology given in Table 6.1 to differentiate them from mass production and flexible specialization. Scott questions whether there is anything the small units within the systems houses cannot do that systems of small firms within an industrial district can. Perhaps the only answer is that given above: the simultaneous implementation of contradictory plans. Inter-firm entrepreneurship has come to be associated with new, flexible-specialization industrial districts in much of the recent literature, particularly under the influence of Piore and Sabel (1984). The Third Italy of Emilia-Romagna and, to a lesser extent, Tuscany is held up as an example of the ability of small firms to achieve coordinated innovation, enabling the region as a Table 6.1 A typology of production forms Batch size Establishment size

Small

Large

Small Large

Flexible specialization Systems house

Mass production

whole to enjoy a large trade surplus in niche-oriented products like apparel, furniture and ceramics (Russo 1986; Capecchi 1989; Goodman et al. 1989; Perulli 1990). Characteristic features, corroborative of the analysis presented above, include industrial associations and consortia, productivist union structures, public subsidies for infrastructure and joint research and informal interfirm collaboration.15 Similar, if less pronounced, forms of coordination have been identified in France, and Silicon Valley has been held up as the US representative (Lorenz 1988; Saxenian 1990). In most of these instances, ongoing innovation in

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complex, evolving products is accomplished by networks of relatively small firms whose batch orientation and low overheads give them greater flexibility than their more integrated, mas s-production rivals. It is not preordained, however, that inter-firm networking must be the privilege of the small. Once more, Japanese producers have pioneered new forms of non-market relations, with design and production units of core firms collaborating directly with their counterparts in supplying (‘satellite’) firms. Scott (1992) has documented similar interrelations between systems houses and small firms in California. Indeed, in the context of vast uncertainty in the emerging field of digital multimedia, entrepreneurial networking is proliferating rapidly among many of the largest multinational corporations (Yoder and Zachary 1993). Dozens of alliances and joint ventures by giants such as Matsushita, AT&T, Time Warner and Microsoft are pursuing alternative approaches to formulating and marketing multimedia products. Of course, we are no longer in the realm of industrial districts, since the scope of the cooperators is global, but, I would argue, much of the motivation and structure of cooperation is the same.16 Whether similar networks will develop in other industries depends, on this view, on the appearance of other complex products-in-process whose constituent non-convexities span the outputs of many global firms. IV As mentioned at the outset, a principal motivation of this work is furthering the understanding of the entrepreneurial function, so that its socially desirable aspects can be integrated into future models of workplace democracy. Even under the current system of business organization, however, there is scope for public intervention to promote entrepreneurship. The same property of interactive non-convexity that requires innovators to transcend market relations also renders the invisible hand mechanism insufficient to compel them to do so. Public policy can either supply the missing incentives or perform some of the requisite institution-building itself. The incentive-based approach is associated above all with the successful export-led strategies of the East Asian industrializes (Amsden 1989; Wade 1990). Specific policies include preferential access to capital coupled with export conditionality, guaranteed domestic markets, including public sector purchases, at artificially elevated prices for new products, and other inducements. It should be noted, however, that these policies have been employed in a context of catch-up industrialization; while real innovation is being engendered there are fewer uncertainty and learning costs to be borne by producers, since the same products are already being produced elsewhere. In Europe and North America, by contrast, policy has tended to focus less on incentives for innovation than on measures to promote agglomeration for its own sake, under the supposition that the primary objective is achieving economies of scope and scale. This mechanistic approach to the problem of fostering dynamic efficiency is particularly questionable in light of the likelihood that the most far-reaching innovations—those least likely to be developed by private firms, however large and well-integrated, acting independently—will require coordination across conventional industry lines. (This need for coordination that spans multiple industries may provide part of the explanation for the relative success of the US Department of Defense as a locus of industrial policy.) Direct support for the creation of inter-firm networking mechanisms is one of the hallmarks of the Third Italy, of course, and it has become fashionable to attempt to replicate this model in other already industrialized regions (Shapira 1990; Hirst and Zeitlin 1989). At this point the perspective offered in this chapter may be relevant. The vitality of industrial districts, compared with large, integrated firms, depends not only on the institutions that undergird them, but also on the nature of the products they produce. The relative advantage of small-firm networks arises where products are complex, embracing (in a non-convex fashion) many qualitatively distinct component processes, and where future product development is

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uncertain, placing greater emphasis on dynamic rather than static considerations and multi-threaded rather than single-threaded paths to innovation. Not all products adhere to this formula, and even if they do now, they may not later. Policy making needs to be sensitive to this consideration. Thus, the time is probably ripe (if not overripe) for support for collaborative mechanisms to develop electric-powered vehicles; the corresponding era may already be over, however, for the personal computer. This is not to deny, of course, that there are many innovations in store for the personal computer industry; there are. But it is probable that most of them will be capable of being introduced in a more-or-less piecemeal manner. (That is, we do not anticipate discontinuities at the level of the overall product.) However, even in the event that these technical conditions apply, it is still not certain that industrial district promotion can succeed. As we have seen, it is quite possible for large firms to erect networking institutions amongst themselves, and in capitalintensive product areas their form of collective entrepreneurship may be more potent than that of the idealized flexible specialists. This poses a quandary for policy. To permit the further conglomeration of already massive enterprises would appear to violate the long-standing preference among reformers for decentralization—a preference that underlies much of the attention given to industrial districts. In addition, collaboration between large firms, as in the multimedia example, is geographically decentred: it offers no expectation that production will be concentrated in any particular country, much less region or locality. It may be that the development of digital multimedia is an exception, and that policies to promote collective entrepreneurship will remain regional development policies as well, but there is no guarantee. There is, however, another perspective on the potential public response to productive non-convexities. While most of the interest in industrial promotion stems from the competitive challenge to regional economies, the logic of non-market intervention in the presence of non-convexity extends beyond the profitability criterion. Ultimately, what is at stake is not simply the competitive question of where and by whom the next generation of products will be produced—although, under current conditions, that is obviously important—but also what these products will be and how they will reshape our physical and social environment. Recall that, in a world of multiple potential equilibria, in the absence of any coordinating mechanism historical inertia governs the path of development. There are abundant reasons to reject this process and seek conscious, publicly accountable control over the quality of economic growth. In practical terms, this suggests that the resources of the public sector, including government procurement, regulation and public enterprise, ought to be enlisted directly in the effort to influence the path of innovation. This programme would, if adopted, represent a dramatic break with much of the traditional thinking on government intervention. Those who advocate an active role for the public sector in economic life often do so in the name of redressing market failure. Thus, policies are devised to offset imperfect competition and externalities, to make adjustments required to achieve the second best or to provide public goods. I would not argue, of course, that it is wrong to do this. But in addition to these static objectives, public policy can also respond to the dynamic need to elicit and guide innovation. Since market forces, on their own, can guarantee neither the full exploitation of an economy’s innovative potential, nor the social desirability of the resulting selection among potential innovative trajectories (the breakdown of local/global optimality conditions), this argues for a new rationale for public action. An analogy might be made to the role of the state in the East Asian model in fostering the growth of new industry (Amsden 1989), except that the relatively narrow criterion of export promotion is replaced by a broader goal, democratically formulated, of humane and sustainable development. Formulating the objective in this way has particular implications for the role of public enterprise. Traditionally, the public sector has been employed to produce standardized goods in industries with welldefined products, under the supposition that, as infrastructure or the output of natural monopolies, they are

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unsuitable for private production. Examples include telephone and mail services, electricity, etc. These may continue to offer appropriate venues for public enterprise. But dynamic considerations call for public intervention in the most fluid sectors, with the goal of influencing the development of new methods and products rather than reproducing existing ones. Under such objectives, for instance, public enterprise may best serve to augment rather than replace private enterprise. Public firms can elicit private innovation by engaging in intense, even unprofitable, competitive innovation on their own. They can guide innovation, on the other hand, by taking the lead in redirecting development efforts in socially appropriate directions. Interestingly, the claim that entrepreneurship can emerge at the level of inter-firm networks suggests the possibility that this can be true for mixed, public—private ventures. Consider this possibility: public firms can be seeded into the economy with the explicit mission of building alliances with established producers for the development of new products that, in turn, will be granted favourable treatment via procurement and regulation. By targeting these initiatives at the most promising opportunities for inter-firm collaboration (including collaboration with systems houses and other large enterprises), public resources can be leveraged far beyond their initial outlay. This sort of approach aims at two objectives, fostering innovation where it might not otherwise occur and channeling it in socially desirable directions. The familiar pitfalls of public enterprise remain, of course; for example, it is important that such projects be thoroughly accountable to the wider public, in order to avoid capture by local development interests for whom even blind-alley expenditures are better than none. It also raises new ones, such as the potential for capture by the private firms with whom alliances are made. (This is also a problem for programmes that subsidize existing firms in return for performance agreements or other considerations.) The greatest barrier to this sort of departure in public policy is not technical but contextual. As long as the policy needs of advanced industrial economies are defined in terms of ‘competitiveness’, public interventions to promote innovation will be rightly feared as subservient to corporate interests domestically and antagonistic trading practices internationally. It is only the replacement of myopic or historically inertial market criteria, such as profitability, with social criteria governing a future we choose to select that permits public entrepreneurship to play a progressive role. The message of interactive non-convexity, that spontaneous forces of adjustment can lead to many ostensibly ‘optimal’ outcomes but cannot select among them, and that the collective interest therefore requires a domain of collective choice, is directed at the political case for a public strategy as well as the technical means for implementing it. NOTES 1 Or Austro-Hungarian? See Kornai (1990). 2 This section presents a non-technical summary of Dorman (1990), which contains formal demonstrations of the following propositions. 3 It would be more precise to say that their absolute value is large since, due to Young’s theorem, it does not matter whether these elements are positive or negative. 4 It can be argued that the resistance of professionally trained ecologists to economic models of valuation and policy design stems from their more sophisticated analytical posture. 5 Note that this is not the same as rent-seeking, since in a non-convex environment there can be unrealized gains from trade even in equilibrium, where equilibrium is defined in terms of the agents’ separate choice (reaction) sets. 6 More precisely, it is the new feasible product-quality set that must be convex. 7 To put it differently, between the old low-tomato and the new hightomato equilibria, there may be a zone of overshelving and low sales. Myopic decision making (should I buy more tomatoes under the current allocation?) cannot get from here to there.

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8 A classic statement of this position in the context of development economics is Scitovsky (1954). 9 Despite his other virtues, this is the position of Schumpeter (1942), shared by Scitovsky (1954). 10 I am not concerned here with the larger question of whether the existing patterns of corporate hierarchy and accountability are superior to actual or potential alternatives. 11 A form of this argument can be applied to the organization of labour, where each individual worker’s activities represent a subproduct within the larger (non-convex) production process. Unless the same tasks are to be repeated endlessly, there is a return in any period to non-market forms of coordination to achieve expected future innovations. 12 A large firm can entertain mutually inconsistent alternatives at the level of design, but not at a level at which they would have command of the full range of the firm’s resources. 13 In the language used above, each individual worker’s activity takes the form of a subproduct; the output of the team is the product’. While the purpose of the circle may be simply to exchange ideas, it is also likely that some of the innovations it generates cannot be introduced in an uncoordinated way, one worker at a time. This discussion, incidentally, does not pass judgement on the issues raised by critics of Japanese practices, such as the cooptation of participation in these circles, or the other role that circles may play in intensifying work effort (Dohse et al. 1985; Parker and Slaughter 1988). 14 This would be equivalent to a Japanese development team if top management were to leave it to the various units to select their own representatives on the team and even the structure of the team itself. 15 Many similar features can be found in the New York garment district dating back several decades, e.g. the roles of the International Ladies Garment Workers Union and the Fashion Institute of Technology. 16 An important difference may pertain to the role of trust, more readily generated in the face-to-face world of local agglomerations (Gambetta 1988; Harrison 1992). The multinational corporations described by Yoder and Zachary are more likely to engage in formal joint ventures and equity trades that are the equivalent, in one executive’s term, to ‘blood exchanges’.

BIBLIOGRAPHY Amsden, A. (1989) Asia’s Next Giant: South Korea and Late Industrialism, New York: Oxford University Press. Baumol, W. and Bradford, D. (1972) ‘Detrimental externalities and the nonconvexity of the production set’, Economica 39 (2):160–76. Best, M. (1990) The New Competition: Institutions of Industrial Restructuring, Cambridge: Harvard University Press. Capecchi, V. (1989) ‘The informal economy and the development of flexible specialization in Emilia-Romagna’, in A.Portes, M.Castells and L.Benton (eds) The Informal Economy: Studies in Advanced and Less Developed Countries, Baltimore, MD: Johns Hopkins University Press. Chandler, A.D. (1977) The Visible Hand: The Managerial Revolution in American Business, Cambridge: Harvard University Press. Coase, R.H. (1960) ‘The problem of social cost’, Journal of Law and Economics, October, 3:1–44. Cowling, K. and Sugden, R. (1993) ‘Behind the market facade: an assessment and development of the theory of the firm’, Research Centre for Industrial Strategy (University of Birmingham) Occasional Paper No. 14. Dohse, K., Jurgens, U and Malsch, T. (1985) ‘From “Fordism” to “Toyotism”? The social organization of the labor process in the Japanese automobile industry’, Politics and Society 2:115–46. Dorman, P. (1990) ‘Nonconvexity and interaction in economic models’, Unpublished manuscript. Gambetta, D. (ed.) (1988) Trust: Making and Breaking Cooperative Relations, Oxford: Basil Blackwell. Goodman, E., Bamford, J. and Saynor, P. (eds) (1989) Small Firms and Industrial Districts in Italy, London: Routledge. Harrison, B. (1992) ‘Industrial districts: old wine in new bottles’, Regional Studies 26 (5): 469–85. Hirst, P. and Zeitlin, J. (eds) (1989) Reversing Industrial Declined Oxford: Berg.

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Ken-Ichi, L, Nonaka, I. and Takeuchi, H. (1985) ‘Managing the new product development process’, in K.Clark, R.Hayes and C.Lorenz (eds) The Uneasy Alliance, Boston, MA: Harvard Business School Press. Kornai, J. (1990) The Road to a Free Economy: Shifting from a Socialist System: The Example of Hungary, New York: W.W.Norton. Lorenz, E. (1988) ‘Neither friends nor strangers: informal networks of subcontracting in French industry’, in D.Gambetta (ed.) Trust: Making and Breaking Cooperative Relations, Oxford: Basil Blackwell. Marshall, A. (1948) Principles of Economics, 8th edn, New York: Macmillan. Parker, M. and Slaughter, J. (1988) Choosing Sides: Unions and the Team Concept, Boston, MA: South End Press. Perulli, P. (1990) Industrial flexibility and small firm districts: the Italian case’, Economic and Industrial Democracy 11: 337–53. Piore, M. and Sabel, C. (1984) The Second Industrial Divide: Possibilities for Prosperity, New York: Basic Books. Repetto, R. (1987) The policy implications of non-convex environmental damages: a smog control case study’, Journal of Environmental Economics and Management 14 (3): 13–29. Russo, M. (1986) ‘Technical change and the industrial district: the role of interfirm relations in the growth and transformation of ceramic tile production in Italy’, Research Policy 14:329–43. Saxenian, A. (1990) ‘Regional networks and the resurgence of Silicon Valley’, California Management Review 33: 89–112. Schumpeter, J. (1942) Capitalism, Socialism, and Democracy, New York: Harper and Brothers. Scitovsky, T. (1954) ‘Two concepts of external economies’, Journal of Political Economy April, 62 (2): 143–51. Scott, A. (1992) ‘ZThe role of large producers in industrial districts: a case study of high technology systems in Southern California’, Regional Studies 26 (3): 265–76. Shapira, P. (1990) Manufacturing Modernisation: New Policies to Build Industrial Extension Services, Washington, DC: Economic Policy Institute. Starrett, D. (1972) ‘Fundamental nonconvexities in the theory of externalities’, Journal of Economic Theory 4 (2): 180–99. Storper, M. (1992) ‘The limits to globalization: technology districts and international trade’, Economic Geography, January, 68 (1): 60–93. Wade, R. (1990) Governing the Market: Economic Theory and the Role of Government in East Asian Industrialisation, Princeton, NJ: Princeton University Press. Yoder, S.K. and Zachary, G.P. (1993) ‘Vague new world: digital media business takes form as a battle of complex alliances’, The Wall Street Journal, 14 July: A1, A4.

7 EUROPEAN COMMUNITY R&D SUPPORT Effects on the cooperative behaviour of firms Y.Katsoulacos and E.Nowell

INTRODUCTION Objective and rationale The primary objective of this chapter is to examine the extent to which firms that have participated in European Community (EC) funded projects or in making non-selected proposals for EC funding (nonselected applicants) have been involved subsequently in further collaborative activities and to investigate the nature of these activities. For the first time a detailed analysis is made of the behaviour of non-selected applicants. The rationale of the chapter is to examine whether and the extent to which, by supporting cooperative research and development (R&D) activities, the Commission of the European Communities’ (CEC’s) objective to achieve an increase in industrial competitiveness is reinforced by an indirect beneficial effect on competitiveness from a stimulation of subsequent collaborative activities. Background Economics have long recognized that markets suffer from serious failures in generating innovations. Starting with the seminal analysis of Arrow (1962), modern economic theory has clarified the precise nature of the market failures characterizing the process of new knowledge creation (see, for example, Dasgupta and Stiglitz 1980a, 1980b; and Stoneman 1987). Of course, market failure provides a rationale—not a justification —for some sort of intervention. Justification requires the stronger condition that intervention does not in itself create distortions that reduce social welfare—or, as is usually termed, does not result in ‘regulatory failure’. Nevertheless the market failure argument has often been used in arguments that seek to justify active intervention in the firms’ R&D decisions. Three types of intervention are usually considered: direct support of firms’ research effort; promoting cooperation between firms to overcome market failures; or a combination of the two, i.e. subsidizing cooperative R&D, which is the approach adopted in the CEC’s framework programmes. All these aim to increase the amount of R&D undertaken in specific markets and to create technological leadership. They can do so in a number of ways. Thus subsidies alleviate the disincentive from imperfect appropriability and research spillovers and may allow firms to overcome the problems from imperfect capital markets. Cooperation, even in the absence of subsidies can have the same effects (see Katz 1986) as well as reducing the amount of duplicative research efforts.

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The question is: given that research joint ventures (RJVs) are desirable will the markets not produce the right amount of cooperation if governments simply created a permissive regime in which cooperation in research was not discouraged? Is there a role for a more activist technology policy? Incentives to cooperate There are quite powerful incentives to engage in RJVs that firms will have and which should lead to the creation of RJVs in the presence of a permissive environment. These can be classified using the following categories. Coordination incentives Firms can gain by coordinating their R&D effort in the sense of setting their R&D spending collusively in their laboratories. The strength of this gain depends on the extent of coordination that can be achieved. As shown by Ulph (1991), pure coordination (between direct competitors) without cost sharing does not create incentives to cooperate, unless all rival firms participate in the RJV However, cooperation between direct competitors will be desirable if it involves sharing of the costs or risks involved in undertaking a research project. A special type of this incentive to reduce the cost or risk involved in undertaking a project arises when the firms are engaged in complementary activities: in this case coordination of the research effort allows firms to get access, at a lower cost than otherwise, to other firms’ expertise and/or results. Firms will also gain through coordination if it results in internalization of spillovers. On top of incentives to cooperate that result from benefits from the coordination of research activities that would exist even if all markets were perfect, firms will often engage in cooperation because of incentives to overcome constraints imposed by market imperfection. Incentives to overcome constraints imposed by market imperfection In this case cooperation is motivated by the inability of firms to undertake the cost or risk involved in undertaking certain R&D projects. It is clear from the above that even in the absence of subsidization there are strong incentives to form RJVs. We shall term the gains that firms can realize purely from cooperation the ‘pure benefits of cooperation’. Disincentives and obstacles to cooperation Whilst there are powerful incentives to engage in RJVs, there are also disincentives and obstacles which have to be taken into account when thinking about whether or not the market will produce the right amount of research. The following three are the most important. 1 Coordination costs Coordination costs are transaction costs involved in setting up and running a cooperative agreement. 2 Obstacles to achieving ‘full coordination’ Full coordination implies that the research cost to each participating firm of achieving any given innovation for the consortium is minimized. This may not be possible for various reasons. A common one is that in order to achieve this minimum cost it will often

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be necessary to concentrate effort in a single laboratory. This will be difficult if partners belong to different countries and there is no adequate mobility of the relevant manpower. 3 Product market competition Product market competition can provide a very powerful disincentive for forming RJVs between firms that are direct competitors in their product markets. If these firms act independently in research they incur higher costs for achieving any given innovation relative to their share of the cost in an RJV. On the other hand, through independent research they could be the first to develop the innovation, reaping for some time monopoly profits from it, whilst through the RJV each firm has to share the benefits of the innovation with all other firms in the RJV. The more intense is product market competition the smaller the profit from sharing the innovation relative to the profit from ‘being first’ and the greater the incentive to ‘go it alone’. Also, the more difficult it is for firms to imitate each other’s research results the greater the incentive to try to develop the innovation alone (Beath et al. 1988). The intensity of product market competition will often depend on the extent to which firms can engage in cooperative ventures in the product market too. Anti-trust or competition law will often make this difficult for firms to achieve. In this sense there is an obvious conflict between promoting cooperation in research and punishing cooperation in product markets: inability to cooperate in product markets may be a very powerful disincentive for firms to cooperate in their research activities. A SIMPLE FRAMEWORK OF ANALYSIS To model the RJV formation process that results from firms’ natural incentives to cooperate between themselves in research, we shall now think of a firm’s R&D projects as investment projects that vary in terms of costliness, uncertainty, duration of development period and anticipated benefits. A firm will enter an RJV if by doing so it can increase its anticipated profit by more than it would have done if it were to stay out. Let PCB indicate the ‘pure cooperation benefit’, or the net benefit from entering an RJV. Also, let CCT indicate the total coordination cost anticipated by the firm as a result of engaging in cooperative research in this RJV.1 A firm will find it advantageous to engage in a cooperative research project i as long as (7.1) so firms will enter RJVs up to the point where PCBs do not fall short of CCTs. We can distinguish between two elements of the total coordination cost. The first, which we shall call CCP, is the coordination cost that needs to be incurred in order to find all appropriate partners, to agree common objectives and to plan out a course of action—alternatively, it is the cost that has to be incurred in preparing a proposal. The second, that we shall call CCA, is the coordination cost incurred after research on the project starts. Note that an important feature of coordination costs is that they are sunk, i.e. they are not recoverable in the event that, once they have been incurred, the firm decides to withdraw from the project. Since, CCT=CCP+CCA, we can express the condition for a firm to engage in cooperative research project i as follows: (7.2) Let us now consider the effect of the CEC deciding to subsidize cooperative research. This will have a number of effects on a firm’s incentives to join RJVs. To start with, the most obvious effect is that of introducing an additional benefit in the form of the anticipated subsidy. Let the anticipated subsidy for project i (i.e. the expected value of the subsidy) be ASi. Then the condition for a firm to engage in cooperative research project i becomes (7.3)

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Comparison of (7.2) and (7.3) indicates that the CEC’s decision to subsidize cooperative research will induce firms to undertake some cooperative projects that they would not have undertaken otherwise. In particular these are all the projects for which (7.3) holds but not (7.2). All other things equal, CEC subsidies have the effect of making firms consider cooperative projects that have a lower PCB/CCT ratio than the projects that they would normally undertake. It is thus natural to find in empirical studies (e.g. Linne 1991) that to a large extent CEC-funded projects are marginal projects, or projects firms would not have undertaken on their own. We shall call this effect of CEC subsidies the direct investment effect (DIE). Whilst, to the extent that the market mechanism generates a suboptimal amount of cooperative research, the direct investment effect is very important, it is not the only effect of CEC support of cooperative R&D. There are good a priori reasons to think that the amount of cooperative research induced in the long run by CEC support will be greater than that reflected in this effect. To see this, let us first consider the effect of CEC support on the participants of the successful projects. It is clear from the nature of the coordination costs CCT that their size will be history dependent. In particular, having taken part in a cooperative project the participants will have gained from ‘learning-by-doing’ benefits and they will face smaller coordination costs were they to be involved in a further collaborative project. To put it another way, a collaborative project will entail smaller coordination costs for its participants if they have already been involved in cooperative research. Thus, by expanding incentives to engage in RJVs, the CEC has a cumulative or dynamic effect on RJV formation, in that we would expect in the long run that a number of subsequent collaborative activities (SCAs) will be formed between participants of successful (CEC-selected) projects, even without CEC support, that would not have been formed in the absence, in the first instance, of such support. The presence or otherwise of this dynamic effect is a major issue investigated in this chapter. Of course, SCAs between participants of CEC-selected projects need not just involve cooperation in research. They could also involve, for example, cooperation in production. This is important since cooperation in areas other than R&D is more difficult to justify on grounds of improving social welfare and, indeed, such cooperation may have undesirable effects on welfare. This is an issue to which we return in the next section. Even after taking account of the above-mentioned dynamic effects on RJV formation, there are two more potential effects of CEC cooperative R&D subsidization that need to be discussed. They both concern potential effects on the cooperative behaviour and incentives to invest in R&D of non-selected applicants. The first effect we shall term the indirect investment effect. It arises as follows. The decision to take part in a bid implies that inequality (7.3) holds, i.e. If, however, the bid is unsuccessful, and given that CCP is a sunk cost that has already been incurred, the decision about whether or not to go on with the collaborative activity will depend on whether or not (7.4) Clearly (7.4) may well hold even if inequality (7.2) does not hold. If, for example, PCBi=100, ASi=50, CCPi=20 and CCAi=90, (7.2) will not hold since 10020+90, and, more to the point, (7.4) will hold since 100>90. By inducing firms to sink CCP on the anticipation of the subsidy, the CEC changes the nature of firms’ incentives in the post-selection stage. As a result, a number of firms that would not have the incentive to cooperate are induced to do so, in this case after the nonselection of their proposal. This is a rather interesting and subtle effect of CEC support on cooperative behaviour and we shall seek to find evidence for it in the empirical part of our study. There could be, finally, what we shall term a strategic effect of CEC support on incentives to invest in R&D by non-selected applicants. This will be the case if we assume that some of the direct market rivals of

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non-selected firms are successful in obtaining CEC support. If, now, the non-selected firms were among the market leaders (in terms of technological leadership), they will view the success of their rivals as an acceleration of the catching-up process and this should enhance these firms’ incentives to increase their efforts to pull ahead, possibly through cooperation. If, on the other hand, the non-selected firms were among the market followers, then their research efforts may well be dampened in response to the support given to the leaders, since their chance of catching up becomes even slimmer. The issue of downstream cooperation: price raising versus cost-reducing incentives Potential areas of subseqent collaboration The most important areas of collaborative activity including collaboration in research are: 1 collaboration in further research activities, possibly as partners to other EC-funded projects, and collaboration in product development; 2 collaboration in other non-production activities, e.g. marketing, licensing, technology transfer; 3 collaboration in production activities, e.g. to set up a joint venture in producing a new product; 4 collaboration that involves a combination of the above activities. Incentives for downstream (non-R&D) cooperation We can distinguish between two types of incentives for downstream cooperation. Those that can be broadly termed ‘cost reducing’ (or ‘pro-competitive incentives’) and those that can be broadly called ‘price-raising’. Among the former are the following. 1 Incentives to cooperate in order to join resources for further research, product development, marketing, etc. for efficiency reasons, to overcome financial constraints and/or to make possible entry into a market. 2 Incentives to cooperate in order to share resources and transaction costs involved in pursuing licensing, technology transfer and other downstream agreements with other firms. 3 Incentives to cooperate in order to exploit synergistic effects or economies of scale in production, distribution, etc. Among ‘price-raising’ incentives for downstream cooperation are the following. 1 Incentives to cooperate so as to suppress rivalry between partners in downstream activities. 2 Incentives to cooperate so as to increase bargaining strength in negotiating licensing and technology transfer agreements. When cooperative projects involve firms competing in the same final product markets there will be strong incentives to cooperate in downstream activities for ‘price-raising’ reasons: to reduce rivalry between partners. Indeed, as we noted above, unless direct product market competitors can reduce rivalry between themselves in the product market, they may have no incentive to collaborate in research in the first place.

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PRESENTATION AND ANALYSIS OF THE MAIN RESULTS Introduction The database that formed the basis for the empirical testing of our hypotheses was constructed on the basis of responses to our mailed questionnaires from partners of successful and nonselected consortia. Information was obtained for fifty-seven successful projects from an industrial programme that started prior to 1989. Questionnaires were sent to 208 participants involved in these projects and to 353 non-selected applicants that took part in the 1991 call of an industrial programme. The dynamic and indirect investment effects Table 7.1 provides information concerning the dynamic effect for successful participants, and the indirect investment effect for nonselected applicants. In this table, results shown are from analysis of 121 nonselected applicant questionnaires and eighty-three successful project questionnaires (making a total of 204 questionnaires—the number returned out of a total of 561). The results contained in Table 7.1 are rather striking. Starting with Table 7.1 (a), they indicate that 70 per cent of the successful participants were involved, after completion of their original collaboration, in SCAs, and that in only 30 per cent of the cases was there no SCA. Furthermore, 24.0 per cent of the SCAs formed by successful participants involve SCAs both with and without CEC support, 25.3 per cent led to SCAs only with CEC support and 20.5 per cent led to SCAs without CEC support. Thus for a large Table 7.1 Number and percentage of firms involved in SCAs (a) Successful participants (total: 83) NoSCA Total involved in SCA Of which: with CEC support only without CEC support only both with and without CEC support (b) SCAs in relation to successful projects (total: 57) SCA NoSCA (c) Non-selected applicants (total: 121) SCA NoSCA (d) Successful and non-selected (total: 204) SCA NoSCA

Number

Percentage

25 58

30 70

21 17 20

25.3 20.5 24

49 8

84.5 15.5

57 64

47.1 52.9

115 89

56.4 43.6

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proportion of the cases we examined (about 50 per cent), successful participants were sufficiently motivated to get involved in an SCA without CEC support. Though these results need to be treated with care they seem to indicate that the dynamic effect of CED R&D support is very powerful indeed. This result is further supported by examination of Table 7.1(b). This table gives the number of projects which led to at least one SCA. Out of fifty-seven projects for which we received information, in forty-nine cases there was at least one SCA formed after the completion of the project. Thus 84.5 per cent of the successful projects led to one or more SCAs. A conclusion similar to that regarding the dynamic effect can be reached with respect to the indirect investment effect concerning non-selected applicants (Table 7.1(c)). Out of the 121 non-selected applicants we examined, fifty-seven, or 47.1 per cent, had been involved in SCAs and sixty-four, or 52.9 per cent, had not. Given that SCAs among non-selected applicants are formed without CEC support the significance of these results is quite obvious. Finally it is worth noting (Table 7.1(d)) that out of the total of 204 cases examined, eighty-nine or 43.6 per cent were not involved in SCAs whilst 115 or 56.4 per cent were involved in such activities. Information relating to the indirect investment effect is shown in Table 7.2. This table shows how nonselected applicants’ research efforts were affected by the CEC’s decision not to select their proposal. It indicates that the results in Table 7.1(c) above should be qualified, to the extent that when an SCA took place between non-selected applicants it was often (in 45 per cent of the SCAs) on a reduced scale relative to the plans in the original proposal. This finding also emerged quite strongly during the interviews with Table 7.2 Impact of CEC decision on non-selected applicants’ research effort Research effort relative to original company plans Percentage out of total number of responses those involved in SCA those not involved in SCA

Increased

Decreased

Stayed the same

3% 2% 3%

53.6% 45% 60%

43.4% 53% 37%

non-selected applicants. On the other hand, quite a high percentage (53 per cent) of those involved in SCAs retained their research effort at the planned level. The basic result concerning the extent to which SCAs were formed for successful and non-selected applicants is statistically significant (χ2 significant at 0.01 level). In relation to Table 7.2 it is also important to note that it indicates that the formation of SCAs is associated positively with the likelihood that the research effort of firms will not decrease. Thus a smaller percentage of those forming SCAs than those not involved in SCAs (45 per cent as against 60 per cent) decrease their research effort and a higher percentage of those forming SCAs than those not involved in SCAs (53 per cent as against 37 per cent) retain their research effort unchanged. However the results in Table 7.2 are not statistically significant. Strategic effects of CEC support We noted in the section titled ‘A simple framework of analysis’ that there could be what we termed strategic effects of CEC support on incentives to invest in R&D by non-selected applicants. This will be the case if we assume that some of the direct market rivals of non-selected firms are successful in obtaining

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CEC support. If, now, the non-selected firms were among the market leaders (in terms of technological leadership), they will view the success of their rivals as an acceleration of the catching-up process and this should enhance these firms incentives to increase their efforts to pull ahead, possibly through cooperation. If, on the other hand, the non-selected firms were among the market followers, then their research efforts may well be dampened in response to the support given to the leaders, since their chance of catching up becomes even slimmer (see Beath et al. 1990 for a theoretical justification of these). Table 7.3 provides information in relation to these effects. It shows how the non-selected firms’ market position affects the possibility of forming SCAs. Thus the possibility of forming an SCA is much higher for market leaders than it is for market followers—though it is highest when the firm attempts to enter a new market. This is consistent with the hypothesis that leaders are more likely to consider rejection as indicating a rise in the competitive threat facing them to which they must respond by maintaining their collaborative venture, whilst followers consider Table 7.3 Non-selected applicants’ market position and SCAs Market followers Market leaders New market

Total number

Number forming SCA

Percentage

36 56 18

12 30 11

33 54 61

rejection as an indication that their chance of catching up becomes even slimmer and are therefore more likely to give up their collaborative venture in response. In conjunction with the result that the formation of SCAs increases the likelihood that research effort will not decrease from the previous section, this would seem to suggest at least tentatively, that in order to maximize the effect of its support the CEC should give emphasis in funding promising firms that are currently market followers: funding will expand the research incentives of these firms whilst at the same time inducing their market rivals (the leaders) to maintain or expand their research activities. However, more evidence is clearly required in order to make a definite recommendation in relation to this point. (The χ2 test for the results of Table 7.3 indicates significance at the 0.10 level only.) Nature of SCAs Tables 7.4 and 7.5 give information on the nature of SCAs. The most interesting feature of Table 7.4 is the large number of SCAs whose objective has been to engage in further research, i.e. those in categories (ii) and (iii). This clearly provides further support for our hypothesis that CEC support does have a significant ‘dynamic’ effect on firms’ incentives to get involved in collaborative research activities. The fact that a large percentage of successful participants continued to collaborate on products and ideas that were developed during the original CEC-funded research is encouraging because it indicates that CEC funds are not supporting dead-end research. Also interesting is the large percentage of those firms that were involved in SCAs for commercial development, production and/or marketing. This would seem to suggest that firms engaged in collaborative research projects do manage to get their products into the marketplace. However, the true significance of this result

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Table 7.4 Nature of SCAs among successful participants Percentage out of those firms that have been involved in SCAs (total: 58) SCA is an attempt to (i) Achieve uncompleted objectives (ii) Develop further new products already developed during OCA (iii) Develop related ideas that arose during OCA research (iv) Engage in unrelated research (v) Collaborate in commercial development, production and/ or marketing (vi) Collaborate in another way

31 57 71 28 48 5

Table 7.5 Nature of SCAs among non-selected applicants Percentage of those firms that have been involved in SCA SCA is an attempt to (i) Achieve objectives of proposal (ii) Engage in unrelated research (iii) Collaborate in commercial development, production and/ or marketing (iv) Collaborate in making another proposal (v) Collaborate in another way

45 25 41 30 13

can only be judged once we know what the exact motivation and objectives of these SCAs have been (see Tables 7.13 and 7.14 later). Table 7.5 provides some evidence concerning the direction of the indirect investment effect. It indicates that CEC subsidization of firms’ R&D is having an indirect investment effect on cooperative research. The existence of this effect is confirmed by noting in Table 7.5 that of those that did engage in an SCA about 45 per cent did so at least partly in order to carry out the research planned in the original proposal. Furthermore, another 25 per cent were induced to collaborate in research unrelated to the proposal. It is Table 7.6 Research-related outcomes from SCAs SCA involves agreement to engage in (i) Licensing (ii) Technology transfer (iii) Patenting (iv) Exchange of personnel (v) Other

27% 56% 5% 20% 7%

finally interesting to find again that a high percentage (41 per cent) did get involved in SCAs relating to commercial development, though it is not clear how many in this latter group also became involved in collaborative research.

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Below we provide some further information highlighting the nature of SCAs among successful participants. Table 7.6 provides some interesting information. Even if we supposed that SCAs did not actually lead to a net increase in the research effort of the collaborative firms (than would be the case if the SCA did not take place), it is still interesting to see whether they lead to an increase in technological activity that can result in wider diffusion of new technologies since such activity is of primary economic and social value. Of particular interest here is the extent of licensing and technology transfer taking place as a result of SCA formation since these, as well as exchange of personnel, lead to wider dissemination of information and diffusion of new technologies. From Table 7.6 it can be seen that such activities (especially technology transfer) were quite important aspects or outcomes of the SCAs among successful participants. Objectives of forming RJVs Tables 7.7 and 7.8 provide information concerning the objectives of forming RJVs. These tables provide information that was anticipated and to some extent confirms evidence provided in other studies (e.g. that of Linne 1991). In particular it is clear that the coordination incentive that was discussed above and captured by objectives (i) and (ii) in Tables 7.7 and 7.8 is very powerful indeed. Particularly interesting from our point of view is that there is a strong incentive to cooperate to ‘gain access to EC funding’ that is confirmed by both ‘successful’ and ‘non-selected’ samples, which drops in importance as between original collaborative activites Table 7.7 Objectives of forming RJVs (successful participants) Objectives in collaboration OCA

Percentage of those firms that have been involved in OCA/SCAfor whom these objectives were very or moderately significant

SCA

(i)

Access to complementary 86 84 expertise (ii) Share costs and risks 58 63 (iii) Establishment of/ familiarization 51 56 with standards (iv) Gain access to EC funding 56 50 (v) Monitor competitor’s activities 11 14 (vi) Gain experience of EC markets 25 30 (vii) Develop longer-term EC links 55 69 (viii) Appropriate potential benefitsa – − (ix) Enhance prestige 41 43 (x) Expand product range 39 48 a Note: Interviews indicated that respondents misunderstood this part of the questionnaire. Table 7.8 Objectives of forming RJVs (non-selected applicants) Objectives in collaboration

Percentage of respondents (62) for whom these objectives were very or moderately significant

(i) (ii)

87 65

Access to complementary expertise Share costs and risks

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Objectives in collaboration

Percentage of respondents (62) for whom these objectives were very or moderately significant

(iii) Establishment of/familiarization with standards 34 (iv) Gain access to EC funding 64a (v) Monitor competitor’s activities 20 (vi) Gain experience of EC markets 37 (vii) Develop longer-term EC links 60 (viii) Appropriate potential benefits − (ix) Enhance prestige 57 (x) Expand product range 85 a Note: Remember that these figures refer to objectives in making the original proposal’s collaborative project.

(OCAs) and SCAs (it is the only objective that drops quite as much in importance as between OCAs and SCAs). This again confirms our model’s prediction that the provision of CEC support reduces subsequent coordination costs and thus makes collaboration more attractive, even in the absence of EC subsidies. In this respect one may interpret CEC support as providing the means that allow firms to ‘learn to engage in cooperative research’ (e.g. in terms of management skills) and therefore one could argue that such support should concentrate on new partners. Finally, we note that there are some differences between the responses of successful participants and nonselected applicants that seem interesting (such differences also emerging with respect to some other questions). A good example is the very high percentage (85 per cent) of non-selected applicants who report that ‘expanding their product range’ was a moderately or very significant objective in forming RJVs. These differences are not, however, interprétable on the basis of the information generated by our present questionnaires or interviews and the models that provide the theoretical background to the present study. Clearly, more research is required in order to obtain a clear picture of, and to explain, the differences between the samples of successful participants and unsuccessful applicants. Market relationship of partners Table 7.9 provides information on the market relationship of the partners involved in EC-funded projects or in making proposals for EC funding. Table 7.9 Market relationship of partners in collaborative activities Market relation of at least Percentage of successful one partner participants

(i) (ii) (iii)

Direct competitors Indirect competitors Complementary activities

Percentage of non-selected applicants

SCA

No SCA

SCA

No SCA

Total sample (%)

28

28

10

7.0

16.5

29

56

25

36

34

66

72

45

39

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EC RESEARCH AND DEVELOPMENT SUPPORT

Market relation of at least Percentage of successful one partner participants

(iv) (v)

Suppliers Customers

83

Percentage of non-selected applicants

SCA

No SCA

SCA

No SCA

Total sample (%)

33 35

44 40

33 39

25 34

33 37

As noted in the section titled ‘A simple framework of analysis’, product market competition can provide a very powerful disincentive for forming RJVs between firms that are direct competitors in their product markets. If these firms act independently in research they incur higher costs for achieving any given innovation relative to their share of the cost in an RJV. On the other hand, through independent research they could be the first to develop the innovation reaping monopoly profits from it for some time, whilst through the RJV each firm has to share the benfits of the innovation with all other firms in the RJV. Table 7.9 illustrates how powerful this disincentive is for forming RJVs (category (i)). Though there is a difference between the >successful and non-selected samples in this respect it is very interesting that for both there is a relatively low participation of direct competitors. For the sample as a whole the proportion is as low as 16.5 per cent. The aversion of firms to form collaborative research ventures with their direct competitors was also confirmed—even more strongly and directly—during the interviews with both successful and non-selected firms. It was then often noted that even though the firm engaged quite often in research joint ventures it was considered ‘unthinkable’ to do so with direct competitors. The reason usually given was that direct competitors would be able to benefit from the research venture in a way that could be exploited in the product market to the detriment of the firm in question. As already noted the intensity of product market competition depends on the extent to which firms can engage in cooperative ventures in the product market too. Anti-trust (anti-monopoly) or competition law (at the Community or national levels) will often make this very difficult for firms to achieve. In this sense there is an obvious conflict between promoting cooperation in research, as the CEC is attempting to do via the framework programmes, and punishing cooperation in product markets via the rigorous application of antimonopoly legislation. In this respect, it may be useful to strengthen the links between the CEC’s Competition and Research and Development Directorates as a means of promoting further understanding of the interconnections and potential conflicts between competition and technology policies at the Community and national levels. SCAs, partnership success and reasons for not engaging in SCAs Table 7.10 relates a number of dimensions of partnership success in the OCA to the formation of SCAs. As the table indicates, in all dimensions of success a higher percentage of those that formed SCAs were moderately or very successful relative to those that did not form SCAs and a lower percentage were not or only slightly successful. Thus partnership success, as expected, does seem to provide a positive impetus to forming SCAs. However, Table 7.11 suggests that not having a successful partnership is not the most important reason for not engaging in SCAs. Tables 7.11 and 7.12 give information on the reasons for not engaging in SCAs. This information has emerged in the responses to question 14 of the successful participant questionnaire and question 12 of the

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non-selected applicant questionnaire. Note that in these tables we also give the total number of respondents —we do this when this is smaller than the potential size of the sample for the specific question. For example, in the present case the potential size of the sample is the total number of non-selected applicants involved in SCAs, which is sixty-four. Thus, for successful participants the most important reasons for not engaging in SCAs are those related to differences between partners in company and research objectives and in company strategy. On the other hand, as Table 7.12 shows, for non-selected applicants the overwhelming reason for not engaging in an SCA is Table 7.10 OCA partnership success and SCAs (successful participants) Percentage whose OCA was

Partresptnership success with pect to (i) Partners’ collaboration (ii) Satisfaction of objectives (iii) Results achieved 2 Note: χ not significant.

Very or slightly successful

Moderately or very successful

NoSCA

SCA

NoSCA

SCA

16 16 24

6.8 6.8 17

84 84 76

93.2 93.2 83

Table 7.11 Reasons for not engaging in SCA (successful participants) Percentage of those firms that have not been involved in SCA for whom these reasons were very or moderately significant (a)

(b)

(c)

OCA unsuccessful with respect to relations with partners achieving partners’ objectives (number of respondents: 17) OCA successful but no further benefits anticipated due to partners differences concerning organization objectives objectives in research (number of respondents: 18) changes in company strategy (number of respondents: 20) Benefits anticipated too small relative to coordination costs (number of respondents: 19)

53 41

67 78 70 64

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Table 7.12 Reasons for not engaging in SCA (non-selected applicants) Percentage of those firms that have not been involved in SCA for whom these reasons were very or moderately significant (i)

Project peripheral to main research activity (number of 42 respondents: 48) (ii) Too costly in absence of CEC support (number of 95 respondents: 60) (iii) Uncertainty concerning success of collaboration 49 (number of respondents: 55)

that it would be too costly in the absence of CEC support. This is consistent with (though it does not provide conclusive proof for) the hypothesis that for quite a large proportion of cases the projects of nonselected applicants were peripheral to the firms’ activities—this has been indicated, for successful participants, in the recent Linne (1991) study. Further, this hypothesis is consistent with the firms’ response indicated in the first category of Table 7.12. It remains to be established whether this in some sense ‘explains’ the reason these projects were actually not-selected. Price-raising versus cost-reducing effects of SCAs Whilst above we have stressed the effect of CEC support of cooperative R&D on subsequent collaborative research activity, we have already mentioned that there are actually various potential areas of collaborative activity in which firms are involved. Indeed, we found above that collaboration in production and/or marketing activities formed a substantial part of subsequent collaborative agreements. The number of respondents who did say that SCA was an attempt to collaborate in commercial development/production and/or marketing was twenty-seven (see Table 7.4), out of a total of fifty-eight SCAs formed among successful participants. In this section we discuss the motives for such SCAs, which as we noted above could be different from those that lead to research collaboration. Most importantly SCAs involving collaboration in non-research activities could have anti-competitive (or priceraising) effects, as well as costreducing (or pro-competitive) effects. Table 7.13 provides information in relation to the motivation of SCAs related to commercial development/production and/or marketing. The motives under (e) are those that we have broadly termed ‘price-raising’ incentives. The motives under (a)—(d) are those we have termed ‘cost-reducing’ (or ‘procompetitive’) incentives. Table 7.13 shows quite clearly that the latter motives are the most significant in the formation of commercial development/ production and/or marketing SCAs. Particularly noticeable is the high percentages in categories (c) and (d) that relate to apparently pro-competitive motives. Equally noticeable is the very low percentage in category (e)(iii) relating to a reduction in competitive pressures. It can be argued that respondents did not want to admit directly that their SCA was motivated by a desire to reduce competitive pressures and that this is why we got a very low response in (c)(iii). This argument is supported by the fact that we got a much higher response in (e)(i)—even though an increase in joint market share does lead to a reduction in competitive pressures. Even after allowing for this qualification, however, the ‘price-raising’ type motives do seem rather insignificant relative to

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Table 7.13 Motives for SCAs for commercial development, production and marketing Motive

Percentage of respondents that found motive moderately or very significant

(a) (b) (c)

Gain access to complementary assets 52 Share costs and risks 52 Gain experience of EC markets and 67 develop EC links (d) SCA allows quicker and wider diffusion of products as it (i) allows access to more customers 62 in existing market (ii) allows access to more customers 77 in new markets (iii) leads to a more competitive 77 product in terms of quality/ market appeal (e) SCA can improve company performance because (i) joint share in products is 38 substantial (ii) it improves competitive 32 advantage and thus profit margins (iii) it diminishes competitive 12 pressures Note: a In parentheses we show the total number of respondents in each case.

(27)a (27) (27)

(26) (26) (26)

(25) (25) (25)

the ‘cost-reducing’ ones. This conclusion is further supported by the responses to a question of the successful participants questionnaire in which respondents that were involved in commercial development/ production and/or marketing SCAs were asked to indicate the value of current annual demand growth and potential demand growth for the type of products marketed through the SCA, and the substitutability between the products of the firms in the SCA and rival products. The responses are summarized in Table 7.14. The higher the annual demand growth (current and potential) and the higher the degree of substitutability the less likely it is that SCAs in commercial development or production/marketing will have detrimental price-raising effects. Taking this into account, the information in Table 7.14 would seem to indicate that it is highly unlikely that the commercial development, production and/or Table 7. 14 Demand growth and substitutability of SCA products Current annual demand growth (mean of responses) Potential annual demand growth (mean of responses) Substitutability—mean response, between 100 (very good substitutes) and 0 (very bad substitutes)

15% 21% 73

marketing SCAs reported by our respondents would have any significant price-raising effects, since the mean values reported for demand growth (current and potential) and for the degree of substitutability are high.

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CONCLUDING REMARKS AND SUGGESTIONS FOR FUTURE RESEARCH There are various problems in attempting to generalize or try to judge the significance of the results discussed in the previous sections for CEC R&D and technology policy. One such problem comes from data limitations in relation to sample size, the number of R&D programmes examined, the extent to which previous links between firms could be examined, the lack of a sample of nonparticipating firms and the emphasis on industrial firms (rather than universities and research institutes). All these factors suggest that many of the results should be treated as tentative. However, the scope and original objective of the study was to get a first view of the factors involved and/or which are affecting collaborative behaviour and this has been achieved. Additional future research, based on a more balanced sample, is essential before definite conclusions and recommendations can be reached. In connection to the issues that need to be addressed in future research we would like to make the following suggestions. 1 First, research needs to be carried out concerning the methodology used in this and all other studies known to us to test the additionally issue. This consists in trying to obtain information about ‘what would happen in the absence of the CEC R&D programmes’ from responses to questionnaires and interviews of those that participated in such programmes. Our attempt to obtain such information in the interviews produced mixed and ambiguous results. Thus all firms interviewed (successful and non-selected) said that they knew some of their partners before the OCA was formed. However, in only a minority of cases were they involved in research collaboration before the SCA. Further, in only one case was it made clear that for the specific project under consideration they would be involved in collaborative activity with their partners even in the absence of CEC support. The fundamental problem in our view comes from the fact that in order to test properly whether CEC support does have a positive net effect (the additionality issue), one has to use also a sample of nonparticipating firms and to compare firms involved (as participants or applicants) to those never involved in CEC-funded R&D programmes. To put it alternatively, in order to test additionality one should use a proper ‘control group’ against which to compare the behaviour of participating firms. This can only be the group of firms not involved in CEC programmes. Assuming that the ‘control’ group and the group of participating firms are similar in terms of the important characteristics that might influence the variables under investigation (research effort or collaborative behaviour), one can then obtain an estimate, on the basis of a statistical econometric model, of the conditional research effort and/or the collaborative activity of a participating firm in a different situation. 2 The issue of cohesion needs to be addressed: does collaborative R&D support by the CEC lead to convergence in the ‘technological status’ of partners that are originally in asymmetric technological positions? What are the implications of promoting cohesion for the overall research effort of participating partners? 3 The asymmetric position of firms needs to be properly addressed in relation to incentives to enter RJVs and the implications of this for the effects of CEC R&D support also need to be considered. 4 The issue of how the distance of research from the marketplace affects incentives to form RJVs between direct market competitors and between firms having other market relationships needs further investigation in order to make more definite conclusions in relation to potential conflicts between competition and technology policies. 5 The issue of how research effort is affected by cooperation versus non-cooperation has not been given sufficient attention up to now and needs to be explored more thoroughly. In particular, does the CEC prerequisite that firms collaborate in order to obtain funding have a positive impact on their research

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effort or would this research effort be higher if they were to obtain the same amount of funding without having to cooperate? This issue is, of course, also related to that of cohesion mentioned above. 6 The issue of the interaction between firms and universities in the same consortium and resulting transfers of knowledge needs to be examined much more thoroughly, as well as the issue of whether universities do get involved in SCAs or whether they drop out in the later development stages of research. 7 Finally, one needs to examine the issue of the duration of collaboration. This report suggests that CEC support helps to induce a cooperation process which endures. However, it is unclear how long it endures and how long it takes to effectively transfer know-how and to develop the structures and mechanisms for cooperation at different levels within firms. NOTES The research reported in this chapter was supported by the CEC SPEAR Programme (Contract MOSP— 0060—GB). We are grateful to the SPEAR team and in particular to Mr M.Donato and Mr B.Sloan for their invaluable help in this research project. We are also grateful to the participants of the Birmingham Workshop on ‘Industrial Economic Strategies for Europe’, September 1993, for their comments. 1 Note that PCBi will, in practice, depend on the identity and number of the other firms entering the RJV and will be different for different RJV members. The same holds for CCTi. In the model below we abstract from such asymmetries between firms even though, if present in practice, they will be relevant in evaluating the effect of CEC support on firms’ collaborative activities. We also assume that PCB and CCT are not affected by the decision of CEC to subsidize cooperative research.

BIBLIOGRAPHY Arrow, K. (1962) ‘Economic welfare and the allocation of resources for inventions’, in R.R.Nelson (ed.) The Rate and Direction of Inventive Activity, Princeton, NJ. Beath, J., Katsoulacos, Y and Ulph, D. (1988) ‘R&D rivalry vs. R&D cooperation under uncertainty’, Recherches Economiques De Louvain 54:4. ——, —— and —— (1990) ‘Strategic innovation’, in M. Bacharach, M.A.H.Dempster and J.L.Enos (eds) Mathematical Models in Economics, Oxford: Oxford University Press. Dasgupta, P. and Stiglitz, J. (1980a) Industrial structure and the nature of innovative activity’, Economic Journal, June: 266–93. —— and —— (1980b) ‘Uncertainty, market structure and the speed of R&D’, Bell Journal, Spring. Fitzpatrick Associates (1992) ‘Study on the impact of the EC R&D framework programme on the R&D decisions of enterprises’, SPEAR Project, DGXII, CCEC. Georghiou, L. et al. (1992) ‘The impact of European Community policies for R&D upon science and technology in the UK’, report prepared for DGXII, PREST. Grossman, G. and Shapiro, C. (1986) ‘Research joint ventures: an antitrust analysis’, Journal of Law, Economics and Organisation 2:315–37. Katsoulacos, Y. and Ulph, D. (1993) ‘R&D rivalry when research paths are product specific: market equilibria and the social optimum’, Scandinavian Journal of Economics 95(3):341–55. Katz, M. (1986) ‘An analysis of cooperative research and development, Rand Journal of Economics 17:527–43. Katz, M. and Ordover, J.A. (1990) ‘R&D cooperation and competition’, Brookings Papers on Economic Activity, 137–203.

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Linne, H. (1991) ‘How prime partners, who have received an EC grant, choose appropriate collaborators for successful R&D co-operation’, SPEAR Unit, DGXII, CEC. Stoneman, P. (1987) ‘The economic analysis of technology policy’, Oxford: Oxford University Press. Ulph, D. (1991) ‘Technology policy in the completed European market’, mimeo, University College, London.

8 DOES A REDUCED PUBLIC SECTOR INCREASE WELFARE IN AN OPEN ECONOMY? Johan Willner

INTRODUCTION The so-called social dimension means that the European Union can issue guide lines on, for example, working conditions, working hours and maternity leave to its members. The rationale for such recommendations, which do not concern Great Britain, is the fear that countries may otherwise engage in a competitive lowering of wage costs and social standards, especially if they are concerned with market shares (see also Chapter 4, by Ajit Singh). For example, it has been argued that there is a pressure among welfare states to lower social standards to compensate for cost disadvantages as compared with low-wage countries. A competitive reduction of labour costs and social protection is called social dumping (Abraham 1991, 1993). Without super-national regulation, countries with less protection might gain unfair market shares. For example, Williams and Haslam (1992) argue that the initial successes of the Japanese car industry depended on a longer and more intense working time rather than technological superiority. In an attempt to attract capital and promote market shares, governments also cut public expenditures on art, research and education because they depend on tax revenues which affect the labour costs indirectly. Many countries are claimed to have lost competitiveness because of a combination of excessive regulation, strong unions and too large a public sector. A ‘trade balance burden of proof (Kalt 1988) is imposed on all forms of public policy. For example, according to a blueprint from the Ministry of Education in Finland (Opetusministeriö 1993), Finland cannot afford to give education and research a higher priority than in competing countries. Reducing the public sector to attract capital or increase market shares can be seen as a symptom of tax compétition (Sinn 1990; Haufler 1991), which means that countries pursue a beggar-thyneighbour policy (Haufler 1991). If also part of the labour force is mobile, it leads to a Tiebout type of equilibrium, as when local jurisdictions compete: those which are well educated and healthy migrate to low-tax countries. This works as if customers were allowed to choose an insurance company after learning whether or not a damage has occurred (Sinn 1990). On the other hand, there might exist mechanisms which counteract a convergence towards the conditions of the countries with the lowest labour costs and the smallest public sector. For example, the tendency towards deteriorated social protection and public services may provoke resistance. As Persson and Tabellini (1990) show, the median voter may react by preferring decision makers with a more positive attitude towards public consumption. Moreover, it may be irrational even when promoting market shares to underprovide social protection and public consumption. First, the terms of trade effect associated with increased

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91

competitiveness may not be favourable. Second, a capital inflow caused by lower taxes can have an ambiguous effect on competitiveness because of a currency appreciation (Summers 1988). Our point of departure is the notion that market shares are not an end in themselves. Reduced market shares because of higher taxes are harmful only if they offset the increase in utility from higher public consumption. We ask how the welfare-maximizing level of public consumption changes if firms can move to low-tax countries. Our method is to compare equilibria under different trade policy regimes. For example, if trade liberalization means that a previously optimal level becomes too large, the country is likely to run a deficit unless employment is reduced. Restoring external and internal balance would then require reduced public consumption and hence lower taxes. The next section introduces markets and focuses on what is optimal in a closed economy with two private goods, and in the third section an imported good replaces one of the commodities while the countries compete in selling the other. It turns out that a concern about market shares and profits may lead to lower public consumption, but the welfare-maximizing level becomes larger even if this reduces market shares. However, it is optimal for one country to react by some reduction if the other country spends less than what maximizes welfare, but in the opposite case public consumption can be further increased. The fourth section analyses the case in which both countries cooperate in maximizing utility with respect to the tax rate, which yields larger public consumption than if both countries compete. The fifth section explains the intuition by decomposing the effect of trade liberalization in an incomes and a substitution effect. The sixth section compares a competitive reduction of public consumption with an equilibrium with subsidies and shows that social dumping is a form of protectionism. The section is an extension to the cases where countries either have different labour productivity or can influence labour productivity by the level of public consumption. Finally, there are some concluding remarks in the last section. Details of the calculations are included in an appendix which is available on request. PUBLIC CONSUMPTION IN A CLOSED ECONOMY There are two private goods, x and y, in the model, and one public good, z. If the economy is closed, both have to be produced by industries which are oligopolistic. The public good is financed by taxing labour incomes, which affects the labour costs indirectly. The public sector refers to public consumption only. We ignore complementarity and substitutability because of our focus on strategic adjustments rather than relative price effects (see the section ‘The intuition: complements, substitutes and income effects’). The following Cobb-Douglas type of utility function is therefore used when deriving demand and evaluating allocations: (8.1) Alternatively, utility could depend on the amount of z per capita. However, the individual chooses between x and y only because the amount of z must be determined by a collective decision. This implies that demand can be derived using a transformed utility function. Let α denote a/(a+b); then (8.2) All individuals provide one unit of labour. Production is completely integrated vertically so that there are no other costs than labour. There are constant returns to scale; lx and ly units are needed to produce one unit of each private good. The public good is measured in units of labour time so that lz=1. All subscripts referring to country are dropped as long as there is no trade. Profits are non-zero because the economy is imperfectly competitive. There are nx and ny firms with Cournot conjectures and nonworking owners. All profits in the economy (π) are consumed. All employees get the same wage rate w which is determined in the private

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EUROPE’S ECONOMIC CHALLENGE

sector. The prices are denoted by px and py and the tax rate by t. Suppose that Nx and Ny persons are employed in the private sector and that z persons produce the public good; Nx+Ny+z= N. The public sector employees are paid by taxing wages incomes, which means that t(Nx+Ny+z)=z. This, together with the fact that Nx+Ny=N−z, implies z=tN and Nx+Ny=(1−t) N. Deriving the equilibrium in the closed economy, given the tax rate, is a standard procedure. First, take w, Nx and Ny as given and derive the demand functions for the private goods and use them to find the profitmaximizing output levels and the prices. Next, equalize the derived demand for labour, tN+xlx+yly with the supply N to get the wage rate, which is inserted in x, y, px and py By social welfare we mean the utility of a typical worker. This can be justified by assuming that workers constitute a strong majority. Under Cournot oligopoly, the prices are px=nxlxw/(nx−1) and py =nylyw/(ny–1). The utility function implies that worker is expenditures on each good are , so that they consume (8.3) and (8.4) Insert (8.3), (8.4) and tN in (8.1) to get an indirect utility function. Collect all constants into (8.5) so that the indirect utility function can be simplified as (8.6) Maximizing shows that the optimal choice equals c so that z=cN. Imperfect competition in the model distorts the proportions between x and y if and reduces the real wage but all resources are utilized. The assumption that workers provide one unit of labour means that the tax system induces no distortions, which reflects our focus on competitiveness rather than tax wedges. A TALE OF TWO COUNTRIES Suppose now that trade is liberalized so that it is preferable to import rather than to produce y. There are two identical countries in the same situation, and they have to compete in selling x to a third country or the rest of the world (ROW). Firms move from one country to the other if profits are lower because taxes affect labour costs indirectly. The external demand of commodity x is of the form E/px. To see what changes in public consumption that this necessitates, we compare the internal equilibrium from the previous section with an allocation which is consistent with internal and external balance. Internal balance means that xi/x=Ni (1 − ti), while external balance requires that pxxi=yi because py=1. The amount of the public good is tiN as before, because t(Nx+z)w= zw. There is a common currency. We ask whether the welfaremaximizing public sector becomes smaller or larger. As country 1 and country 2 jointly supply x, the market works as a Cournot oligopoly with m=n1+n2 firms. Workers are immobile but firms move to the country where they get higher profits until equality is

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93

restored. Given n1,n2,w1 and w2, the price px is proportional to a weighted average of the wage rates. The consumption of x is determined in the same way as in the last section: (8.7) To

find

the

consumption

of

y,

note

that

routine

calculations

show

that

: (8.8) Allocative efficiency would require the decision makers to maximize the utility of a typical worker. However, they may misunderstand the relationship between market shares and welfare or they may promote other objectives, like the country’s market share. Country i’s output equals (1 – ti)N. Therefore, t1 and t2 have opposite effects on its market share (1−ti)/(2−t1−t2) For example, suppose that the government maximizes a weighted sum of the market share of its firms and the welfare of a worker. To get an expression for the welfare of a worker, insert (8.7), (8.8) and tN in the utility function and collect the constants in a term C*: (8.9) Utility in country i is then (8.10) Let the weights be λ1 and λ2 so that the government maximizes (8.11) Write a+b as 1−c so that the first-order condition can be written as follows: (8.12) If both countries choose equal weights, we get a symmetric Nash equilibrium in which both governments choose the following tax rate: (8.13)

It is obvious from (8.13) that the public sector may become both smaller and larger than in the closed economy because the sign of tg−c depends on For example, if both objectives are equally important, public consumption decreases unless b>0.5. It can also be shown that before n1 and n2 are adjusted to a change in the tax rate, each firm’s profits decrease with the tax rate. We get similar results if profits are substituted for market shares, but the comparison with c then depends on as well.

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EUROPE’S ECONOMIC CHALLENGE

However, if only welfare matters, the first-order condition becomes (8.14) We get the following symmetric Nash equilibrium: (8.15) It is obvious that , which means that the welfare-maximizing public sector increases as trade is liberalized.1 However, it is often important to know what is the best strategy if other countries do not maximize welfare. For this reason, we characterize the shape of the reaction functions by solving for t2 from the reaction function of country 1 or vice versa: (8.16) It follows from (8.16) that t2 is monotone, continuous and increasing from to 1 as t1 increases from c/(a +c). Let t1(0) denote the tax rate which country 1 would choose if country 2 happens to set t2=0: (8.17) Whatever country 2 chooses from the interval]0,1[, it is rational for country 1 to respond by tax rates belonging to]t1(0),c/(1–b)[. The other reaction function can be understood in a similar way. Figure 8.1 shows the reaction functions RF1 and RF2 of country 1 and country 2. There is only one intersection in the interval]0, 1[, which implies that no non-symmetric Nash equilibria exist. Moreover, if country 2 chooses t2t1>t2; in the opposite case the optimal choice is t2> t1>t*. It follows that the popular belief that international competition forces a country to cut public spending rests on less firm ground than is usually believed. If an otherwise desirable amount of public consumption appears to damage international competitiveness, it depends on other countries striving for profits or market shares instead of welfare, not on trade liberalization as such. The present analysis does not explain the political failures which cause countries not to maximize welfare, but it helps to understand how cutting public expenditures may spread as a contagious disease. JOINT WELFARE MAXIMIZATION AND POLICY HARMONIZATION In this section we address the need for a coherent policy among the competing countries with respect to public consumption. This could be compared with a binding social treaty. Therefore, we derive the tax rate that would maximize the common welfare and compare it with t* and . We cana drop subscripts because joint welfare maximization in this model make the countries identical before differentiation as well; we get Nx=(1 −t)N and z=tN. In both countries worker j consumes (8.18) and

PUBLIC SECTOR AND WELFARE IN AN OPEN ECONOMY

Figure 8.1 The reaction functions of country 1 and country 2

(8.19) To maximize welfare, insert (8.18), (8.19) and tN in the utility function: (8.20) It turns out that each country would find the following common tax rate optimal:

95

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(8.21) Comparing (8.15) and (8.21) shows that t** > t*. To see that welfare is higher with policy harmonization, insert the t* and t** in the utility functions to get U* and U**. The difference in utility is then (8.22) This difference cannot be positive, because t** maximizes not only (8.20) but also the expression a log (1– t)+c log t. Thus, U**> U* for any t including t* such that t≠t**. If there is no authority which enforces a binding common policy, non-cooperative behaviour is rewarded whichever strategy the other country chooses. This can be illustrated by values of m, lx,ly, E and N such that C*=1 and setting a=0.2, b=0.4 and c=0.4. It then turns out that t*=0.5 and t**=0.67. As predicted, joint welfare maximization yields higher utility, but a country can reach even higher welfare choosing t* if the other chooses t**. Moreover, choosing t** if the other chooses t* yields even lower welfare than if both countries choose t*. Thus, t* represents a dominant strategy, as shown by the following pay-off matrix:

It follows that both countries would gain in welfare by transferring power to a body that enforces a common policy.2 THE INTUITION: COMPLEMENTS, SUBSTITUTES AND INCOME EFFECTS The results in the previous two sections can be described as depending on how the choice set changes with trade policy. To focus on the intuition behind this, we first abstract from firms and markets. Suppose that a social planner determines the allocation between x, z and, if there is no foreign trade, y. In a closed economy, the planner would maximize some concave function W(x, y, z) under a restriction which depends on the availability of manpower: (8.23) Denote the solution , and . Suppose now that trade is liberalized and that it is better to concentrate on producing x only. There are f competing countries. Country i, i=1, 2,…,f, sells abroad ei units of x at the world market price px(e), where px(e) is a downwards sloping function and e stands for ∑iei. Commodity y is purchased at the given price py If the country has a comparative advantage to produce x and not y,px/py ≥lx/ly holds true. External balance requires ypy=eipx Substitute eipx/py for y in w and maximize with respect to x, ei and z subject to the restriction that the workers producing x, y and z should add up to N: (8.24) In a symmetric Nash equilibrium we get ei=e/f. Denote the solution , and . Substituting imports for production of y implies two changes. First, liberalization works as if y becomes cheaper because py/px ≤ ly/lx3 To focus on this relative price effect, suppose that country i is a price taker. The solutions then differ because of the price change only; if public and private consumption are

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complements, but the opposite is true if they are substitutes. For example, let a, b and c be positive parameters such that a+b+c=1 and let xo, yo and zo represent positive quantities of x, y and z. If the welfare function is of a Stone-Geary type so that W=a log (x− xo)+b log (y−yo)+c log (z−zo) , the model defines welfare as depending on how much consumption exceeds some minimum values. It yields z*i> because goods are then complements. We have ignored these effects because they are not associated with the strategic interaction between countries. Second, liberalization implies a further gain if the country is not a price taker. Suppose goods are neither complements nor substitutes so that py has no effect on z. As trade is liberalized, the model works as if more resources than in a closed economy are to be allocated between x, y and z. Thus, if z is a normal good; if on the other hand f is large, the difference is small. For example, if xo=yo=zo=0 it can be shown that it is optimal to allocate a number which is larger than N in the proportions a, b and c. Suppose the world market price is determined by the inverse demand function px=E/e. In a symmetric Nash equilibrium we get which reduces to 2cN/(2−b) if f=2. It should be pointed out that this incomes effect does not depend on cooperative behaviour, which further increases the optimal public sector. More generally, is never smaller than unless there is a strong substitution effect, which would make the outcome ambiguous when both sources of change are present. However, a change in z which depends on y becoming cheaper should not be confused with a strategic adjustment in a game of market shares. To understand why welfare maximization with a Cobb—Douglas type of function would yield the same levels of public consumption as in the previous two sections, note that πi/ni is decreasing in both ti and ni. All firms do not leave the high-tax country because fewer firms means increased market power, which compensates for higher taxes. SOCIAL DUMPING IS A SUBSIDY As Abraham (1993) points out, the concept of social dumping is often used vaguely and without connection to traditional notions of dumping. In this section we demonstrate that a competitive reduction of public consumption in the model is formally equivalent to a subsidy. Subsidies and aggressive devaluations are often seen as ‘beggar-thy-neighbour policies’ which are harmful for all parts. Social dumping, which is often described in terms of an ‘inner devaluation’, is similar in consequences, but it is not conventionally seen as a trade distortion. Suppose that the government uses part of its tax revenues to pay a subsidy that is proportional to the wage costs with the coefficients s1 and s2. The Cournot-Nash price can then be written (8.25) Since tax revenues are now spent on more than the public good, the allocation of the work force is determined by the equation (8.26) which implies that (8.27) (8.28)

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It turns out that worker j in country i consumes (8.29)

(8.30)

(8.31) To find out the optimal allocation for, say, country 1 in the noncooperative case, insert (8.29), (8.30) and (8. 28) in the utility function and rearrange all constants as follows: (8.32) Utility is then

(8.33)

If policies are coordinated, we set t1=t2 and s1=s2: (8.34) It can now easily be seen that (8.33) and (8.34) are not concave in taxes and subsidies but they are concave in the shares and of the public sector. The interpretation is that only the amount of public and private consumption matters, not the way in which they are financed. Their optimal values are (8.35) (8.36) Thus, if production is subsidized, * and ** equal the values t* and t** associated with no subsidies. It follows that the presence of subsidies does not change the optimal public sector size. A positive subsidy can undo an excessive tax rate and vice versa. Thus, if z is below its joint welfare maximizing level, it means a sacrifice equivalent to a subsidy. We get the same pay-off matrix as on page 145 if the tax rate is fixed at t** so that non-cooperation means that public consumption is reduced by subsidies. On the other hand, subsidies can in certain situations improve welfare. Suppose that the share of the public sector is *, which

PUBLIC SECTOR AND WELFARE IN AN OPEN ECONOMY

can be reached by setting s1=s2=0 The allocation combination of taxes and subsidies.

99

** is then superior even if it is reached by a

PRODUCTIVITY DIFFERENCES AND EDUCATION In the previous sections both countries have been equally efficient. However, a perceived trade-off between international competitiveness and public consumption or transfer payments most often appears in countries where productivity is lower. It is also possible that the productivity difference is endogeneous, as when education has a favourable effect on productivity.4 First, suppose that there is an exogeneous productivity difference. Substitute l1 and l2 for lx (details are available upon request). The amount of the public good is tiN as in the previous sections. It turns out that worker j in country i in addition consumes (8.37)

(8.38)

(8.39)

To maximize welfare for, say, country 1, re-define C* as follows: (8.40) Utility is then (8.41) The first-order condition is (8.42) To show the impact of productivity differences on the welfaremaximizing tax rate, rewrite (8.42) as follows: (8.43) The optimal tax rate in a closed economy is c for any lx; it is obvious from (8.29) that t*>c. Moreover, the left-hand side of (8.43), which we call F(t1), is monotone increasing with t1=0 and t1=1 as asymptotes; it cuts the horizontal axis at the point t1=c. The right-hand side, which we call G(t1), is monotone increasing

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as well, but it cuts F(t1) from above at some point t*>c, as shown in Figure 8.2. An increase in l2 relative to l1 implies a downwards shift in G(t1); thus, the optimal public consumption decreases as compared with the situation given in the section titled ‘A tale of two countries’ and vice versa. A more efficient country can afford a larger public sector in both relative and absolute terms. Thus, there is no need to cut public expenditures as a response to higher private sector productivity. Would both countries choose the same tax rate? Harmonization implies that in (8.41) becomes which is a constant. This implies that both countries would desire c/(1–b), as when productivity is equal. However, the comparison between t* and t** is ambiguous, because if l1/l2 is very small, harmonization may in fact lower t1 and vice versa. It has been shown that common norms for social protection might hurt less productive countries, which suggests that norms within the European Community should be differentiated (Abraham 1994). Can the same be said about public consumption in this setting? To compare U* and U** is difficult when the firm’s responses are taken into consideration, but it can be shown that if f is sufficiently large for z* to approach cN, each social planner would set and . With a common of z, we get while y**=y*. A similar argument as in the section ‘Joint welfare maximiztion and policy harmonization’ shows that harmonization increases welfare for both highand low-productivity countries at least potentially. If the public good increases private sector productivity, l1 and l2 are replaced by a decreasing function l(z) of the public good; we assume that ly does not depend on z. Re-define because lx is no longer a constant, (8.44) so that the indirect utility function for a closed economy becomes (8.45) It is obvious that

is now larger than before because the derivative is positive in t=c: (8.46)

To analyse an open economy without harmonization, substitute l(t1) for l and l(t2) for l2 in (8.41) and differentiate with respect to t1: (8.47) Choosing a value of t1 that would satisfy (8.46) would make (8.47) positive because l′ is negative which implies that the welfaremaximizing tax rate is larger than before. Under tax policy harmonization, the first-order condition becomes (8.48) Suppose that (8.48) is satisfied, so that t=t**. To compare t* and t**, set t1=t2 in (8.47) so that we get the symmetric noncooperative equilibrium. We now ask whether the derivative of the utility function under non-

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Figure 8.2 The optimal public sector when productivity differs

harmonization is positive or negative for t=t**. If (8.48) is satisfied, we get l′/l=[−a/(1−t)+c/t**]/a. Inserting this in (8.47) and rearranging yields (8.49)

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This expression is unambiguously negative. If taxes are not harmonized, utility increases as t decreases from t** to t*. Thus, the welfare-maximizing tax rates become larger if public expenditures increase private sector productivity, but t**>t*> . remains true. SOME CONCLUDING REMARKS Un-coordinated welfare maximization leads to smaller public consumption than if the policies of competing countries are harmonized. Thus, our results support a common policy to prevent a competitive reduction of public consumption. However, the model suggests a stronger coordination than the Maastricht Treaty, which includes a set of non-binding recommendations on social policy. Non-binding guidelines do not prevent the prisoner’s dilemma that may appear in a game of market shares. Moreover, destructive competition might reduce both social protection and public consumption. However, international competition does not force the public sector to be smaller than in a closed economy unless there are strong substitution effects. Normally, the optimal public consumption increases, but the authorities may be irrationally concerned about profits and/or market shares. If one country chooses less public consumption than in the non-cooperative equilibrium, the other country must do the same but not to the same extent. Keeping production of the public good below the joint welfare maximizing level can be compared with subsidising production. The results are similar if public consumption increases productivity. Therefore, the emphasis on competitiveness may even be an excuse for policies that are rooted in ideology or particular interests. Our analysis suggests some topics for further research as well. We have compared equilibrium states only, in order to see what kind of allocations that trade liberalization requires. However, given the importance of macroeconomic disturbances in Europe, there is an obvious need to include unemployment and trade deficits in the analysis. Moreover, it is important to analyse why countries do not maximize welfare and what is their true objective functions, because otherwise we might get an over-optimistic view on economic integration. For example, it would be useful to consider the incentives of different groups in an open economy as well, as is done in a companion paper about a closed economy (Willner 1992). Another important issue to analyse is the welfare of the producers of the imported good. The traditional focus on competitiveness may obscure the fact that high public consumption in a country may be accomplished at the expense of its trade partners. Some minor alterations to our framework might also be needed. The analysis has focused on homogeneous goods only, which make firms react to differences in tax rates. However, countries can charge different prices with differentiated goods, which adds new dimensions to the problem. NOTES I am grateful for helpful comments to a first draft by Jan Otto Andersson, Rune Stenbacka and by participants in the Birmingham Workshop on Industrial Economic Strategies for Europe, University of Birmingham, 14– 18 September 1993. I am responsible for remaining shortcomings. 1 If there are f countries, the welfare-maximizing tax rate becomes c/(1 −b/f), which approaches c as f becomes very large. However, trade is not profitable unless which implies that t* is always larger than . 2 Associating such a common policy with agreements like the Social Treaty of the European Union might be misleading, because joint welfare maximization means binding agreements, not recommendations. As pointed out by Streeck (1993), the Social Treaty is in many respects weaker than existing International Labour Office (ILO) conventions and weaker than the European Social Treaty from 1961.

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3 It can also be shown that this effect may be reinforced if the country is not a price taker. 4 We do not have to assume that education is a strictly public good. We can formally assume that utility and productivity depend on the output of z per capita without changing the results.

BIBLIOGRAPHY Abraham, F. (1993) ‘The social dimension of an integrated EC-Nordic economic area’, in J.Fagerberg and L.Lundborg (eds) European Economic Integration: A Nordic Perspective, Aldershot: Avebury. ——(1994) ‘Social protection and regional convergence in an EMU’, Open Economics Review, 5, 1, 89–114. Haufler, A. (1991) ‘Unilateral tax reform under the restricted origin principle’ , University of Konstanz, Sonderforschungsbereich 178 ‘Internationalisierung der Wirtschaft’, Ser. II- Nr. 142, mimeo. Kalt, J.P. (1988) ‘The impact of domestic environmental regulatory policies on U.S. international competitiveness’, in A.M.Spence and H.A.Hazard (eds) International Competitiveness, Harvard: Ballinger Publishing. Opetusministeriö, Koulutus-ja tiedeosasto, 5.4.1993, Helsinki: Koulutus-ja tiedepolitiikan linja. Persson, T. and Tabellini, G. (1990) ‘The politics of 1992: fiscal policy and European integration’, National Bureau of Economic Research, Working Paper 3460. Sinn, H.-W (1990) ‘Tax harmonization and tax competition in Europe’, European Economic Review 34(3–4): 489–504. Streeck, W. (1993) ‘Europeisk socialpolitik efter Maastricht: social dialog och subsidiaritet’, Research Report 2, The Swedish Center for Working Life, Stockholm. Summers, L.H. (1988) ‘Tax policy and international competitiveness’, in A.M.Spence and H.A.Hazard (eds) International Competitiveness, Harvard: Ballinger Publishing. Williams, K. and Haslam, C. (1992) ‘Against lean production’, in Economy and Society, London: Routledge & Kegan Paul. Willner, J. (1992) ‘Incentives to support the public sector under oligopoly’, mimeo, Warwick Economic Research Papers 397, University of Warwick; or Occasional Papers in Industrial Strategy 7, Research Centre for Industrial Strategy, University of Birmingham.

9 CONTINUITY AND CHANGE IN PORTUGUESE INDUSTRIAL POLICY Mobility regulation in the textile and clothing markets (1946–92) João Confraria

INTRODUCTION The purpose of this chapter is to analyse the evolution of objectives and instruments of specific types of industrial policy, related to the regulation of entry and internal growth in the Portuguese textile markets. From 1946 to the late 1950s, textile markets were highly protected from imports and exports were a small percentage of sales; the problem was seen as devising an industrial policy to accelerate the growth of the industry and, at the same time, to increase efficiency at the plant level. From 1960 to 1974, these objectives were maintained, as exports became increasingly important and import protection was deemed to decrease following membership of the European Free Trade Association and a free trade agreement with the European Community (EC). During this period, industrial policy has been based on a set of regulatory restrictions imposed, at the plant level, on market mobility of textile firms, clothing remaining generally absent from the regulatory framework. After a period where policy trends have been somewhat ambiguous, from 1986 to the early 1990s, EC membership has decreased the protection from external competition given to Portuguese producers and at the same time the Portuguese government was able to allocate funds to improve restructuring at the firm and industry levels. The idea has been to ease some of the restrictions related to the basic conditions of the industries (e.g. financial costs, lack of technological and sales expertise) faced by entrants and incumbents. Although there are common elements in the different regulatory frameworks imposed in the last half century, it is argued that policies pursued up to 1974 have been built around a concept of minimum optimal scale that was too strict and that current policies are based on a more realistic appraisal of the nature of firms and markets. RESTRICTIONS ON MOBILITY (1946–74) For most of the time from 1931 to 1974, mobility has been regulated in the textiles markets at the plant level; any investment implying changes in the capacity of production was subject to different restrictions, according to the relation between the

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Table 9.1 The legal minimum dimension in the textile markets Number of equipment units 1946–55

1966–73a

Cotton Weaving mills Spinning mills Integrated plants

200 automatic or 300 mechanical looms 10,000 spindles 200 automatic or 300 mechanical looms and fully integrated spinning mill

100 looms 6,000 spindles 200 looms and 10,000 spindles

Wool Weaving mills Spinning mills

40 mechanical looms 50 looms 10,000 spindles for entrants 2,500 to 5,000 spindlesb and 5,000 spindles for incumbents Integrated plants 30 looms and fully 50 looms integrated spinning mill 2,500 to 5,000 spindlesb a Notes: See Despachos Normativos for the cotton and wool textile industries, 17 December 1946 (Boktim da Direcção-Geral da Indústria, n. 486, 25 December 1946) and Despacho Orientador for the textile industries, 5 May 1966 (Boletim Semanal da Direcção Geral dos Serviços Industriais, n. 20, 18 May 1966). b According to technology.

dimension of the investing plant and a minimum dimension legally set at several vertical stages of textile production (see Table 9.1)1 . Incumbents that had already installed a number of equipment units higher than the legal minima were not subject to any restrictions. However, those that did not meet the regulatory minima could only install new units of equipment if the same number of old ones were previously destroyed; if they did not have any equipment units to destroy they had to buy them in the second-hand market. Similar conditions applied to entrants: those that planned to install a plant with a number of equipment units larger than the regulatory minima, could freely build the plant; however, those planning to enter the market with a smaller ‘dimension’ had to buy previously a plant with the desired dimension and then, if necessary, they could replace the obsolete equipment. These restrictions were the result of a critical evaluation of market performance by government agencies. It was considered that, given relatively high tariff protection, firms were adjusting price behaviour to the tariff structure allowing for the survival of the least efficient; as import substitution was a stated policy objective and there was, predictably, strong opposition from incumbent firms, it would be difficult to increase competition and accelerate the restructuring of the industry by reducing tariffs. Later, by the late 1950s, it was considered that there were too many small firms in the Portuguese textile markets, unable to survive the full impact of EFTA membership that was to be felt from the middle 1970s onwards. According to the government, the problem was basically the survival of plants with inefficient scales and the restrictions were obviously set according to a concept of minimum optimal scale of production. The persistence of inefficient small firms in a given industry may be explained both by barriers to exit of inefficient firms and by the dynamics of small-scale entry. Among the barriers to exit of inefficient plants, the following should be mentioned.

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1 Immobility of capital, which is related to imperfections in the capital markets (Kahn 1988: vol. II, pp. 175–6). In this case, it may be argued that the owners of capital accept, in the short run, a remuneration rate lower than the normal profit rate, as they are not able to find better investments. 2 Sunk costs, whose importance may be reinforced in the textiles markets by the durability of capital goods (Bain 1968:475). As a matter of fact, by the middle 1960s many plants had looms and spinners installed forty years earlier that had not been subject to any major improvement. 3 A great number of plants existed where the owner and his family were also the main suppliers of labour. In these cases, the offer curve may have a downward slope, because a fall in the product’s price may lead to a higher number of working hours to maintain family income (Clark 1980:174–5). Excess capacity problems are reinforced by this kind of behaviour. On the other hand, both theoretical reasoning and empirical evidence lend support to the existence of learning processes of entrepreneurial activity. Without discussing specific learning processes (see, for example, Jovanovic 1982; and Pakes and Ericsson 1989) it seems arguable that entrants may choose to enter with small scales of production, increasing their plants size according to their own success in the marketplace. The above-mentioned barriers to the exit of inefficient plants may be considered as barriers to the mobility of the more efficient firms, because they led to excess capacity that depressed prices in the domestic market, reducing investment. On the other hand, the regulatory agency was very sceptical about the potential of entry dynamics to improve market performance. There was a very deep perception of a problem later formalized by Lucas (1978): in a low income economy, there was a large supply of would-be entrepreneurs as the opportunity cost of salaried employment was low and it was argued, by the Minister for Economy, that too much should not be expected from poorly qualified people taking their chances in the marketplace (Dias 1960). The regulation imposed on market mobility implictly shows the agency’s doubts about the potential of entry dynamics to improve market restructuring: both small-scale entries and internal growth by small-scale incumbents, already supposed to be at a cost disadvantage, were subject to regulatory restrictions that imposed distortions on their cost functions. However, the regulatory restrictions had another major consequence: they created a demand for secondhand equipment units that was, essentially, a market for the licences needed to buy new equipment. This new market had the potential to reduce barriers to exit, because it could decrease the costs sunk into the industry by each firm: inefficient firms were able to recover some of these costs, selling their licences of individual equipment units. This was an incentive to exit. In this sense, the regulatory restrictions may be seen as a policy to subsidize the exit of inefficient plants; the subsidy was directly paid by the small-scale plants with internal growth projects and by smallscale entrants that were forced to buy second-hand equipment (licences) to implement their plans. However, this restructuring policy was possible because the market was protected from foreign competition; so, it seems possible to argue that at least part of the restructuring costs were shifted to consumers. At the same time, the agency did not impose restrictions on incumbents and entrants with a number of equipment units higher than the legal minimum. So, it may be said that the objective was to create incentives for patterns of market mobility that might lead to the development of efficient plants and to accelerate the exit of the least efficient ones.

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Table 9.2 Number and size distribution of incumbents Percentage of minimum legal dimension Number of plants

100

2 0 0

0 0 0

0 1 0

0 0 1

1 0 0

8 4 18

3

3

1

1

0

4

0 0

0 0

0 0

0 0

0 0

5 4

1 0 0 6

4 0 0 7

2 0 0 4

1 0 0 4

1 0 0 2

13 2 7 65

At the end of these regulatory processes, there were very few firms in the lower neighbourhood of the minimum legal dimensions (Table 9.2), and it is arguable that this was an intended result of regulation; moreover it is arguable that regulatory restrictions did not blockade mobility as small-scale entry and growth by small firms were the most important sources of market dynamics, despite the additional burden imposed on them (Confraria 1992, 1993). However, it may be suggested that the regulatory agency overestimated the consequences in market performance of the existence of minimum optimal scales of production, and that regulation was based on concepts of firms and market dynamics that were too simple. Firms were implicitly considered ‘production functions’; given the recognized lack of widespread managerial expertise, policies aimed at improving the internal organization of the firms, the quality, trading and marketing functions were conspicuously absent (see also Jacques De Bandt’s contribution to this volume, Chapter 1). AMBIGUITIES IN INDUSTRIAL POLICY After the 1974 revolution, new governments tried to pursue a process of regulatory reform that had begun in the early 1970s.2 In the textiles markets there were different consequences, according to the vertical stages of production involved. Weaving and finishing plants were released from regulation but new sets of restrictions were imposed upstream (e.g. spinning) on entry and internal growth. First, minimum levels of production capacity were imposed at the plant level for entrants and at the equipment level for incumbents.3 Second, each plant should have a system of quality control able to fulfil a minimum set of requirements. Finally, there were entirely new restrictions related to the financial structure of the firms: equity should be at least 30 per cent of the total investment in physical capital and this investment should be higher than 20 million escudos.4

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Finally, firms that were not able to meet the legal requirements could neither enter the market nor make new investments. This new set of rules obviously has some common foundations with the previous regulatory framework. However, it implictly shows a different concept of the firm and different criteria for selecting the survivors. Restrictions related to minimum levels of production capacity were maintained, even if in a slightly different way, but the restrictions related to the financial structure of firms showed a strong emphasis on the commitment of equity capital to the industry. For spinning plants, these new restrictions may well be considered more demanding—not only because there were new restrictions concerning quality control and the financial structure, but also because firms that could not meet the minimum requirements could neither enter the market nor grow. In the previous regulatory framework these movements were possible, even if at a higher cost of capital. The restructuring effects of these restrictions seem ambiguous. They could quicken the exit of the technologically or financially weaker firms, as they would not be able to grow, but they also blockaded entry and internal growth of small firms that had been important sources of market dynamics during the previous decade. However, they were not consistently enforced5 and were abolished in the late 1970s. Up to 1988, the government has not regulated, directly, market mobility in the textile and clothing markets. In general, industrial policy was based on continuous devaluation of the currency, tax exemptions and incentives to exporters; moreover, imports were restricted by increases in tariffs and the imposition of quantitative restrictions, reversing the trend of increasing import liberalization that had began in the early 1960s (Silva 1986). INCENTIVES TO MOBILITY (1988–92) After 1986, membership of the EC, the Single European Act and the project to build an economic and monetary union in Europe imposed new restrictions on policy making and brought some opportunities. Continuous devaluations like those pursued along the previous decade were not possible, protection from EC imports disappeared and from non-EC producers decreased following the adoption of EC trade policy. On the other hand, financial resources later became available for industrial policy purposes. In this new institutional framework, the core of industrial policy has been the Program for the Development of Portuguese Industry (Pedip), which received financial support from the EC. The general approach to mobility regulation has been to grant financial incentives to investments required by entry, internal growth and firm restructuring.6 The following types of investments have been considered.7 1 Research and development (R&D) projects, development of new products and processes and the building and testing of prototypes. 2 Investments in physical capital, for innovation and modernization. 3 Projects in quality management and environmental protection. 4 Other investments in physical capital. General elegibility criteria necessitated that firms should meet minimum financial requirements and specific criteria depended upon the type of investment. Investments should have a legally set minimum value in the case of R&D activities and projects in innovation and modernization (10 million escudos in this case); the share of equity in capital after the project should be higher than 25 per cent in firms submitting projects of types 1, 2 and 3.8 Upper limits were set for the incentives, both in absolute value and as a percentage of total investment: for R&D and quality management projects 75 million escudos and 50–70 per cent of total

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investment, for investments in innovation and modernization 250 million escudos and 20–40 per cent of total investment, and for the ‘other investments’ 12 million escudos and 20–30 per cent of total investment. Incidentally, for this type of investment, specific criteria were less restrictive than in the other cases. Innovation and modernization projects were further ranked according to their relevance in terms of stated objectives of industrial policy; the rankings were computed according to well-defined and published formulae, and greater weight was given to the following sets of variables: 1 2 3 4

Use of domestic natural resources. Introduction of new technologies, processes or products. Improvements in management, quality, design and marketing. Impact on downstream and upstream industries.

These were fundamental objectives of industrial policy,9 financial incentives being granted to the best investment projects consistent with them.10 Concerning the textile markets, there are both differences and similarities between these objectives and instruments and those pursued up to the middle 1970s. The most obvious difference concerns the policy instruments. Before 1974, the growth of the supposedly more efficient firms was encouraged both by not penalizing them and by increasing the cost of capital of the smaller units; after 1988, the growth of the firms meeting the selection criteria was encouraged by financial incentives, reducing their marginal cost of capital, no penalties being imposed on other firms. However, the basic rules used for the allocation of these resources had other consequences. In Pedip, financial support awarded to each firm did not depend on size and the scale of production but on the quality of the project, evaluated according to the stated industrial policy objectives. As before the government was trying to lay down conditions facilitating the growth of the best firms, although the criteria used for selecting the firms was different: up to the late 1970s, smaller units were considered inefficient but, in 1988–92, regulation was founded on a more realistic appraisal of the sources of market dynamics, based on financial indicators that suggested the intensity of commitment of private resources to the industry and not so much a given level of technical or economic efficiency. Nevertheless, differences between the size distribution of textile and clothing firms submitting projects to Pedip and the industry Table 9.3 Size distribution of incumbents—spinning, weaving and finishing Firms submitting projects to Pedip (%) Firms with projects approved Sizea

Industry (1)