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Trade, Foreign Investment, and Industrial Policy for Developing Countries 4043

barriers to firm exit and expansion, which suggests a need to take into account comple-
mentary policies on entry and exit. We finish Section 4 with an analysis of whether
learning by exporting seems to be quantitatively important, and a discussion of the
empirical evidence regarding other mechanisms through which trade policy might
affect growth.
Aside from intervening in trade, many developing countries deviate from policy
neutrality by introducing tax breaks and other policies to attract FDI. While econo-
mists are generally skeptical regarding the benefits of intervening in trade, they are
much more likely to have interventionist priors when it comes to FDI. In Section 5,
we review the microstudies which have identified a number of important effects of
inward foreign investment flows. While most of the empirical literature focuses on pro-
ductivity spillovers, there is also a growing literature that examines export promotion
through foreign investment, input linkages, and labor market effects. We argue that
FDI is associated with technology transfer and positive labor market outcomes in
developing countries, but that the empirical literature on FDI does not show evidence
of horizontal spillovers, and that benefits from vertical spillovers may not exceed the
cost of FDI subsidies.
At the end of this survey, we provide some broad suggestion for industrial, trade,
and foreign-investment policy in developing countries. To preview our conclusions,
we find no support for “hard” interventions that distort prices to deal with Marshallian
externalities, learning by exporting, and knowledge spillovers from FDI. Nevertheless,
we still envision an important role for what we refer to as “soft” industrial policy. The
goal is to develop a process whereby government, industry and cluster-level private
organizations can collaborate on interventions to increase productivity. We suggest
programs and grants to help particular clusters by improving the formation of skilled
workers, regulation, and infrastructure.

2. THE THEORETICAL JUSTIFICATION FOR INDUSTRIAL POLICY


The textbook model of IP is based on the idea that some sectors or industries exhibit
Marshallian externalities, which are local externalities that increase with the size of the
industry. These externalities can arise through localized industry-level knowledge spil-
lovers, input-output linkages together with transportation costs to ensure that the
externalities remain local, and labor pooling (see Krugman, 1991; Marshall, 1920).
Marshallian externalities give rise to geographic agglomeration of industries (e.g., soft-
ware in Silicon Valley), which have been emphasized in the literature on economic
geography.
The simplest model of IP entails a small-open economy with two sectors, 1 and 2.
Sector 1 has constant returns to scale (CRS) while Sector 2 has Marshallian external-
ities. The key result is that under some conditions there are multiple equilibria, with