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

TL;DR

This paper analyzes how industrial policies in high-tech sectors with network externalities can lead to either a race to the bottom or mutual benefits, depending on market conditions and innovation types.

Contribution

It provides a theoretical framework showing when industrial policy can foster mutual gains versus destructive competition in network externality-driven markets.

Findings

Weak externalities lead to a race to the bottom, reducing welfare.

Strong externalities and weak substitutability can produce mutual welfare gains.

Product innovation enhances network effects more than process innovation.

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.