Industrial Policies vs Public Goods under Asymmetric Information

This paper presents an analytical framework that captures the informational problems and trade-offs that policy makers face when choosing between public goods (e.g., infrastructure) and industrial policies (e.g., firm or sector-specific subsidies). After a discussion of the literature, we set up the model economy, consisting of a government and a set of heterogeneous firms. We first present the first-best allocation (under full information) of government resources among firms. We then introduce uncertainty by restricting information regarding firm productivity to be private to the firm. We develop an optimal contract (which replicates the first best) consisting of a tax-based mechanism that induces firms to reveal their true productivity. As this requires high government capacity, we consider other simpler policies. We conclude that providing public goods is likely to dominate industrial policies under most scenarios, especially when government capacity is low.