Industrial Policy with Network Externalities: Race to the Bottom vs. Win-Win Outcome

Nigar Hashimzade and Haoran Sun

Abstract

Industrial policy has returned to the centre of economic governance, particularly in the high-tech sectors where positive network externalities in demand make market dominance self-reinforcing. This paper studies the welfare effects of an industrial policy targeting a sector with network externalities in a two-country model with strategic trade and R&D investment. We show how the welfare consequences of this policy are determined by the interaction between the strength of the externality, the type of R&D, and the degree of product differentiation between the home and the imported goods. When externalities are weak or the goods are close substitutes, the business-stealing effect produces a race to the bottom that dissipates more surplus than it creates. Under sufficiently strong externalities and weak substitutability or complementarity of the goods, industrial policy competition can make both countries simultaneously better off compared to the laissez-faire outcome because of the mutual business-enhancement effect. The case is stronger for the product innovation than for the process innovation, as the former directly affects the demand and triggers a stronger network effects than the latter which operates indirectly through the supply. Thus, the network externalities create an opportunity for a win-win industrial policies, but its realisation depends on the market structure and the nature of innovation.

Why this matters 

The status of industrial policy as a centerpiece of economic governance is not a new phenomenon, but rather a returning one. In the decades after the Second World War, governments in both advanced and developing economies routinely used tariffs, subsidies, public procurement, and directed credit to promote domestic industry and technological upgrading (Juhász et al., 2024; Aiginger and Rodrik, 2020). By the 1980s and 1990s, however, industrial strategy had fallen out of favour across much of the developed world. Globalisation, trade liberalisation, and growing scepticism about the state's ability to "pick winners" shifted the consensus toward market allocation and away from selective intervention (Pack and Saggi, 2006; Krueger, 1990). That consensus has now weakened sharply. The COVID-19 pandemic exposed the fragility of global supply chains, while geopolitical rivalry and concerns about technological sovereignty have made dependence on a small number of foreign suppliers appear increasingly costly (Millot and Rawdanowicz, 2024). As a result, governments across the major economies have become willing to intervene directly in production, innovation, and market structure in sectors viewed as strategically important.

Semiconductors provide the clearest example. The US CHIPS and Science Act of 2022 committed approximately $52 billion to domestic semiconductor manufacturing, while the EU Chips Act aims to mobilise more than €43 billion (European Commission, 2023). These initiatives combine support for domestic production with measures that disadvantage foreign rivals, including tariffs, digital services taxes, regulatory compliance costs, and export restrictions. The model in this paper captures the revenue-based side of this policy mix, in the form of R&D subsidies to domestic firms and a tax on the foreign firm's domestic sales. A central finding is that the welfare consequences of this policy competition depend on three factors acting together: the strength of network externalities, whether innovation is cost-reducing or quality-enhancing, and the degree of product differentiation. When network externalities are weak, policy competition is self-defeating. When they are strong and innovation is quality-enhancing with sufficiently differentiated goods, both countries can be simultaneously better off than under laissez-faire, because the optimal tax reverses sign and becomes an import subsidy. The results also extend to settings where foreign and domestic goods are complements rather than substitutes, as in semiconductor supply chains where foreign fabrication and domestic chip design are used jointly in downstream industries.

The model opens several directions for future research, including whether falling behind in these markets becomes permanent over time, whether new technology generations create windows for trailing countries to catch up, and how international cooperation on subsidy rules should be designed when these self-reinforcing dynamics are present. On the empirical side, I am developing a programme of work using ONS firm-level data to test whether the productivity gains from AI adoption are larger in markets with stronger network externalities, and whether the welfare effects of policy intervention differ depending on whether foreign and domestic inputs are substitutes or complements in the downstream sector. This connects the theory directly to evidence for better-targeted UK industrial policy. This is ongoing research.