Industrial Policy and Competition

This paper argues that sectoral policy aimed at targeting production activities to one particular sector, can enhance growth and efficiency if it is made competition-friendly. First, we develop a model in which two firms can operate either in the same (higher growth) sector or in different sectors. To escape competition, firms can either innovate vertically or dif-ferentiate by choosing a different sector from their competitor By forcing firms to operate in the same sector, sectoral policy induces them to innovate ”vertically” rather than differentiate in order to escape competition with the other firm. The model predicts that sectoral targeting enhances average growth and productivity more when competition is more intense within a sector and when competition is preserved by policy. In the second part of the paper, we test these predictions using a panel of medium and large Chinese enterprises for the period 1998 through 2007. Our empirical results suggest that if subsidies are allocated to competitive sectors (as measured by the Lerner index) or allocated in such a way as to preserve or increase competition, then the net impacts of subsidies, tax holidays, and tariffs on total factor productivity levels or growth become positive and significant. We address the potential endogeneity of targeting and competition by using variations in targeting across Chinese cities that are exogenous to the individual firm.