If industrial policy is justified by market failures, the next question is how — what instruments a government uses to promote industry, and how each can succeed or fail. This module surveys the toolkit, distinguishes the broad from the targeted, and confronts the failure modes that turn industrial policy from a corrective for market failure into a source of waste and capture.
The instruments
- Subsidies — direct production or export subsidies, grants, and tax incentives. Powerful but fiscally costly, often captured, and constrained by WTO rules (which limit export subsidies).
- Directed credit and development banks — channelling finance to priority sectors at favourable terms (the classic East Asian tool, addressing the capital-market failure).
- Protection — tariffs and trade measures sheltering infant industries (the trade-and-development module, with all its risks).
- Special economic zones — geographically delimited areas with special rules and infrastructure (its own module).
- Local-content requirements — forcing firms to source inputs domestically to build linkages (effective at building supplier industries but costly and often WTO-illegal).
- Public investment and infrastructure — providing the power, transport, and skills that industry needs (a horizontal instrument).
- Public procurement — using government purchasing to create demand for domestic producers.
- R&D support, skills, and standards — building the capabilities and the innovation base.
Horizontal versus vertical
Broad enabling vs targeted promotion
A fundamental distinction: • Horizontal (functional) instruments are economy-wide — they improve the general environment for all industry without favouring specific sectors: infrastructure, education and skills, a good business climate, macroeconomic stability, R&D support broadly. These are the least controversial (they correct general failures and are hard to capture) and the foundation of any industrial strategy. • Vertical (selective) instruments target SPECIFIC sectors or activities — a subsidy for the textile industry, protection for autos, directed credit to electronics. These are more powerful (they can decisively promote a chosen activity) but more dangerous — they require the government to choose what to promote (the picking-winners problem), and they are far more vulnerable to capture and rent-seeking (a sector-specific benefit is exactly what an organised lobby will fight to obtain and entrench — the Political Economy course). The modern consensus leans toward getting the horizontal foundations right first (the binding constraints — the picking-winners module), and using vertical instruments selectively, with discipline, where a specific market failure (a coordination or discovery failure in a particular activity) genuinely warrants it. Pure horizontal policy may be too passive (it doesn't address activity-specific failures); pure vertical policy is too capture-prone — the art is the right combination.
The failure modes
How industrial policy goes wrong
Industrial policy's bad reputation comes from real failure modes, which any design must guard against: • Capture and rent-seeking — sector-specific support is a rent that organised industries will lobby and bribe to obtain and keep (the Political Economy & Governance area). The support flows to the politically powerful, not the economically promising, and persists long after any justification (protection that never ends). • No discipline — support given unconditionally, with no requirement to become competitive, produces permanent dependants rather than future champions (the ISI failure — the trade course). The absence of discipline is the single most common and most fatal flaw. • Fiscal cost — subsidies and directed credit cost real money (and create contingent liabilities — the Budgeting/Sovereign Debt courses), which revenue-constrained states can ill afford, especially if the supported industries never pay off. • Government failure exceeding market failure — the intervention can be worse than the market failure it corrects (the public-choice critique): if the government lacks the capacity and autonomy to implement industrial policy well, the cure is worse than the disease. The lesson: industrial policy requires not just a market-failure justification but the STATE CAPACITY and DISCIPLINE to implement it without succumbing to capture — which is why the developmental-state and state-capacity questions (the Governance course) are inseparable from the industrial-policy question. Bad industrial policy is worse than none.
Choosing instruments
Matching instruments to objectives and constraints is the practical craft. Principles: prefer instruments that target the specific market failure most directly (a discovery failure calls for supporting experimentation, a coordination failure for coordinating complementary investments, a capital-market failure for directed credit — don't use a tariff for a problem that isn't about trade); prefer horizontal where the failure is general and vertical only where it is activity-specific; build discipline and time limits into every vertical instrument (conditional on performance, with a sunset); choose instruments the state actually has the capacity to administer well (a low-capacity state should not attempt the discretionary, capture-prone instruments that require strong autonomous bureaucracy); and prefer cost-based over profit-based support (investment allowances over tax holidays — the Tax Policy course's lesson on incentives). The instrument must fit the failure, the state's capacity, and the discipline to make it work — not just the political demand for support.
Exercise
A government wants to develop a domestic agro-processing industry. Its options include: (a) building rural electrification and roads, (b) a 10-year tax holiday for agro-processing firms, (c) directed credit through a development bank to agro-processors, and (d) a high tariff on imported processed foods. (1) Classify each instrument as horizontal or vertical. (2) Identify which market failure each best addresses. (3) Assess the failure-mode risks of the vertical instruments. (4) Recommend an instrument mix and explain how to build in discipline.