Market failures and polarization effects

Market failures make strategic industrial policy necessary to promote positive feedback mechanisms, achieve a more efficient allocation of economic activities, facilitate innovation and expand social welfare. Market failures can lead to under-investment in R&D, a lack of entrepreneurial discovery processes and insufficient social protection and cohesion.

One reason for market failures is uncertainty and the bounded rational behav-iour of agents. Uncertainty and bounded rationality, in which no economic agent alone is able to have a perfect comprehensive view of the system and its agents, interactions, technologies and causal relations, are key features of economic life.

The representative rational agent, constantly making optimal decisions based on total information, does not exist. Rather the world is dominated by routines and satisficing behaviours, market failures and rigidities. Simon (1947, 1957) pointed out that people and companies are rarely able to maximize their profits, but rather try to at least satisfy their minimum standards. He argues that usually people do not know all the relevant probabilities of outcomes and can rarely evaluate all out-comes with full information to make perfect decisions; therefore, he presents the term ‘bounded rationality’ as a more realistic approach to human behaviour, tak-ing these limitations into account. Bounded rationality refers to the idea that the rationality of the individuals is constrained by the quality and amount of available information, and the cognitive limitations of people and time. Due to these con-straints people in many cases do not behave optimally but rather apply satisficing strategies. Another effect is that rational choices for entrepreneurial actions are often dismissed. Furthermore, qualitative entrepreneurship often does not emerge (without government subsidies or incentives) because of the uncertain returns from inventions and the risk of failure from innovations.

Another key reason for market failure is the natural tendency of market forces towards short-sighted profit maximization instead of long-term social welfare maximization. Of course, market forces can be and often are an essential con-tributor to welfare and provide a powerful mechanism to deal with complexity and uncertainty through specialization, the division of labour and trade. However, drawing the best out of market forces requires capable institutions and strate-gic state interventions to tackle market failures caused by uncertainty as well as externalities. Technological externalities are probably the best known types of externalities in economic; however, Rodrik (2004) outlines the fact that techno-logical externalities are not the only, and perhaps not even the most important, factor impeding structural change and economic diversification, especially in less developed settings. Information and coordination externalities are also crucial problems. Underinvestment in R&D and lack of search mechanisms and trial and error behaviour is demand-side problem as well as being a supply-side problem.

A proper institutional framework and strategic collaboration between the pri-vate and public sectors need to enable market forces by creating the demand for entrepreneurs, for R&D, invention and innovation.

The three types of market failure – technological, informational and coordination externalities – are outlined in further detail below, together with an explanation of why they can either prevent or foster the supply and demand of R&D, entrepreneurship and innovation.

7.2.1 Technology externalities

Technology externalities refer to the indirect effects that the creation of new technologies by one economic agent has on the consumption and production opportunities of others. New technologies can have positive effects on society as a whole, but often creators of new technologies cannot appropriate all the ben-efits created by their investments in R&D, and therefore they tend not to invest sufficiently in R&D, but instead wait for others to solve the technological prob-lems. To a certain degree, technology has the non-rivalry and non-excludability characteristics of public goods. First, technical knowledge can be used simul-taneously by various producers. Second, inventors or property owners cannot entirely prevent the use of their knowledge by other firms. As a result of this non-rivalry and non-excludability, the creation of technical knowledge by one firm has positive effects, not just for that firm, but also for other firms. This leads to the freerider problem and underinvestment in R&D and technology. Investment in R&D is costly and the outcomes are uncertain. However, if the investment is successful, then the outcomes cannot be appropriated entirely by the inventor/

innovator, and thus, as noted earlier, many companies wait for other companies to innovate and solve technical problems. This leads to underinvestment in R&D as well as costly formal and informal measures to protect intellectual property. Both mechanisms impede the creation and diffusion of innovation, a higher labour productivity and the emergence of new sectors. This is especially damaging in settings where there are weak legal enforcement of property rights and high risk-aversion. Underinvestment in R&D is even more pronounced in technologies that are important for human development and well-being, but that are not expected to provide high-economic profits in return. For example, many diseases (such as malaria) are predominantly located in areas with comparatively low economic purchasing power. The cost of systemic R&D is high, the outcome for private companies uncertain and the expected potential economic gains comparatively low. In addition, the probability of copycats producing generic drugs is quite high.

Generic drugs would be extremely positive for social welfare, but not for the inventing company’s profits. A prisoner’s-dilemma type of situation can emerge, where the companies do not invest enough in R&D even though this would be in the common interest for the economy and society.

7.2.2 Information externalities

Information externalities are another factor crucial to structural change, which might (especially in less developed regions) be even more important than technology

externalities (Rodrik 2004). Especially in the case of new technologies and sectors, there is often a lack of information about which businesses are involved, and where they are located (Caplin and Leahy 1993). Information externalities appear, for instance, when companies try to produce new goods and services in locations where it has not been done before. These first movers create information about market risks, opportunities and best practices from which other economic agents can learn and imitate, reject or change their behaviour. Whereas this infor-mation can be very valuable, the first movers are typically not remunerated for providing it and take the risk alone; therefore companies are often reluctant to invest in new locations and prefer to wait until other competitors have tried it first to see if it works. The result is that many possible sectors never emerge.

This is especially true in less developed settings, where it can be very risky for entrepreneurs to test which technologies, products and services work. Whether the potential success will be appropriate is highly uncertain and the risk of failure is huge, especially for SMEs. Failure may lead to bankruptcy, and even success may be appropriated by large companies or the state.

Often the constraints on innovation and structural change come not just from the lack of R&D, but also from an institutional framework that hinders qualitative entrepreneurship and self-discovery processes. There is also a gen-eral lack of knowledge about the true costs of production and which products could be efficiently produced, and where. As pointed out by Hausmann and Rodrik (2003, p. 9):

Producing a good that has not been locally produced previously requires learning about how to combine different inputs in the right way, figuring out whether local conditions are conducive to efficient production, and discover-ing the true costs of production

Information externalities hinder the ability of companies and organizations to dis-cover by themselves which products and technologies work and which do not, and which can be produced at lower costs than in other regions (Hausmann and Rodrik 2003; Rodrik 2004). The authors, furthermore, argue that this lack of self-dis-covery processes is a major obstacle for economic development in poor regions.

The information externalities constrain the exploration of cost structures and of

‘... learning what one is good at producing’ (Hausmann and Rodrik 2003, p. 4).

In many developing countries the situation is aggravated by economic ine-quality, structural heterogeneity and power imbalances. On the one hand, large companies in developing countries can often draw upon monopolies, create high formal and informal barriers to entry and generate large profits through resource exploitation. They have little reason or incentive to change the situation. On the other hand, impoverished individuals, in most cases, are not able to engage in qualitative entrepreneurship due to financial constraints, lack of access to information and inadequate education. In the meantime, the small middle class is searching for stability and security and seeking to minimize risks. All this leads to weak self-discovery processes regarding the types of technologies and

innovations that could work. The study of micro-entrepreneurship in north-east Brazil (Section 6.5) revealed that the poor explore business possibilities, but unfortunately their search radius for technologies is rather limited. It is the lack of freedom of the poor, but also the constraints on the agency of the middle class and SMEs together, that have strong negative effects on self-discovery processes and structural transformation. This is the reason why human development policies, institutional reforms, as well as the promotion of knowledge flows, are necessary to deal with information externalities, to trigger self-discovery processes and to allow innovation.

7.2.3 Coordination externalities

Coordination externalities is the third important factor influencing the ability of a region or country to promote economic diversification (Rodrik 2004). The emer-gence of new sectors often requires concerted action and coordination between a variety of different agents from public and private institutions. ‘Coordination externalities’ refers to the simple understanding that concerted action allows the attainment of achievements and profits that each agent alone could hardly gener-ate. This is also very true for the emergence of new sectors. Often large investments in infrastructure and services and a critical mass of companies are required to enable the creation of a viable cluster or sector. Many technologies, new products and new sectors need to reach certain levels of economies of scale before they become profitable (Rodrik 2004). In some cases, the necessary investments and self-organization can be created by private enterprises alone. But in many cases large-scale initial investments are required, which requires the cooperation and concerted action of several agents, such as different small and large companies, research institutes, landowners and society. Often the different involved actors cannot (easily) reach an agreement. This is where the state must come in and provide the initial structures that make self-organization and economies of scale possible. The emergence of new sectors is dependent on a varied set of inter-related factors such as matching supply and demand, necessary infrastructures and institutions, interactive learning, cooperation and competition for profits and innovation races among the agents involved.

Several different research communities have outlined the crucial role of concerted action and prolific coordination among agents necessary to achieve economies of scale and promote knowledge spillovers, interactive learning, inno-vation and growth. For instance, polarization theory, which will be explained in more detail below, showed that systemic coordination effects are necessary to make a lead sector excel and create linkages which can translate into overall growth (Perroux 1955; Hirschman 1958). Literature from economic geography has shown the crucial role of agglomeration effects, competition and coopera-tion at the spatial level (Porter 1990, 1998; Glaeser et al. 1992; Brenner 2004).

The innovation system approach has highlighted the role of interactive learning (Freeman 1987; Lundvall 1992; Malerba 2002; Cooke and Memedovic 2003).

Governments need to facilitate the establishment of learning institutions able

to provide incentives for proper coordination among agents. A sustained fertile knowledge flow between the private and public sectors is necessary to help to understand the constraints and potentials of each side (Rodrik 2004). Coordination failures are especially pronounced in activities where we find different maximi-zation rationales in opposition to one another. Profit maximimaximi-zation versus social welfare maximization can lead to coordination failures and a lack of mutual learn-ing about social goals and economic possibilities and necessary policy measures among companies, civil organizations, NGOs and the state. Proper institutions need to be created that promote mutual learning and understanding on all sides.

If it is organized well, this can provide enormous incentives and possibilities for innovation, economic diversification and human development.

Other factors aside from the market failures outlined above can lead to low levels of diversification. For example, LASA has shown that centre-periphery positioning in global trade patterns can lead to the periphery specializing in pri-mary resource exploitation (Prebisch 1949, 1964; Furtado 1961). In this way, network and agglomeration effects can lead to income concentration. In these cases, strategic intervention is necessary to counter the negative effects and facili-tate virtuous circles of investment and economic diversification in the periphery.

7.2.4 Polarization effects

Around the 1950s the so-called development pioneers, such Rosenstein-Rodan (1943), Nurkse (1953), Hirschman (1958) and Myrdal (1957), showed that with-out appropriate government interventions free-market forces can lead to increasing polarization into poor and rich regions. They argued that a governmental push strategy is necessary to start positive systemic feedback mechanisms between supply and demand, investment and capital accumulation, and horizontal and vertical sectoral linkages in less developed regions. In sharp contrast to the neo-classical theory, they pointed out that the incomes of rich and poor regions do not automatically converge, even if they form part of the same country with similar governmental regulations and free trade between the regions. In the neoclassi-cal theory, market mechanisms lead to the reconciliation of negative events and scarcity through the price mechanism. For example, the bankruptcy of a company and consequent rise in unemployment and production losses in a region will be reconciled through lower labour costs and higher prices for the scarce product(s).

Free market forces are assumed to lead to income convergence between regions.

In contrast, polarization theory takes the view that initial positive or nega-tive dynamics can reinforce themselves through selecnega-tive migration, demand multipliers, positive or negative expectations or knowledge accumulation.

Nurkse (1953, p. 5) noted that ‘... a country is poor because it is poor’. The lack of purchasing power, demand and savings create high barriers, impeding the creation of virtuous circles of savings, investment and capital accumula-tion. Through self-reinforcing effects, initial inequalities in knowledge, capital, infrastructure and institutions can lead to different speeds of innovation and diver-sification. This leads to centre and periphery structures, in which the periphery is

systemically dependent on the dynamic diversifying centre (Prebisch 1949, 1964;

Furtado 1961; Friedmann 1972). While the periphery (such as Latin America or Africa) specializes in the provision of primary goods and inputs that have a low income elasticity of demand, the centre (such as Europe, Japan and North America) is innovating and creating new (manufactured) products that show a higher income elasticity of demand (Singer 1949; Prebisch 1950). This means that, as income rises, the demand for the centre’s manufactured products increases more rapidly than the demand for the periphery’s primary products. For instance, the demand for sugar and coffee beans does not grow at the same speed as the demand for new medical products or electronic devices. The primary input of the periphery constantly loses more and more of the global consumption basket, leading to systemic inequality reproduction between the centre and the periph-ery of the world. Indeed, the global trade system does have a centre-periphperiph-ery structure (e.g. De Nooy et al. 2005; Hidalgo et al. 2007). There are numerous linkages among the countries of the industrialized centre of the world economy.

Furthermore, there are many linkages from the semi-periphery to the centre, but few linkages among the countries of the semi-periphery. Ultimately, the poorest countries at the periphery have virtually no linkages among them, but are depend-ent on the linkages towards the cdepend-entre. Of course, this leads to asymmetries in price negotiations, global information flows and political power.

Polarization is not just limited to the country level, but can be perceived in many different spheres, such as between the countryside and the cities, or lead and dependent sectors. From the 1950s to the 1970s, many countries in the developing world, particularly in Latin America, saw the solution to polarization as leaving systemic dependence and inequality production by closing their markets and pro-moting industrialization, thereby substituting imports from foreign countries with the establishment of their own national production facilities. In some countries with large national markets, such as Brazil, this strategy – called ISI – indeed encouraged industrialization. However, closing economies deprives companies of critical inputs, in terms of primary resources, upstream products, services and knowledge (Krueger 1985). This has often led to inefficient and expensive pro-duction systems, especially in the smaller countries with small markets. Other possible side effects of closing the markets are the lack of internal competition and the threat of corruption, nepotism and rent-seeking, leading to economic inef-ficiencies and a lack of human freedom. Whereas today a strategy to close entire markets is considered very harmful, there is nevertheless a basic understanding that often policy intervention is necessary to facilitate the emergence of value added new sectors, accumulate the necessary knowledge and reach the level of competitiveness needed to compete in the global markets. These targeted interven-tions are crucial for economic diversification, the prevention of the reproduction of systemic inequality and underdevelopment, and the fostering of social cohesion.

Modern mainstream growth approaches consider some of the arguments of polarization theory in their growth models. The endogenous growth theory (Romer 1986, 1990) and new economic geography (Krugman 1991a, 1991b) provide mod-els that show how economies can diverge due to knowledge accumulation and

agglomeration effects. However, neither mainstream economics nor polarization theory has dealt properly with understanding the promotion of economic diver-sification. Mainstream economics strongly believes in the power of comparative advantage and free trade and thus suggests the need for specialization. In contrast, polarization theory highlights the importance of innovation and diversification, but does not provide a proper understanding of how these can be realized. This is where innovation economics and evolutionary economic geography can reveal the way qualitative diversification requires proper support and phasing of spe-cialization and diversification, concentration and decentralization, and related and unrelated variety growth (Saviotti 1996; Boschma and Martin 2010).

7.3 Specialization and diversification in the process of