Externalities, Optimal Subsidy and Growth

Abstract

The experiences of East Asian countries (China is an example of this) have brought the role of subsidies in promoting economic growth back into the public discussion. Hence, we study the relationship between subsidies and economic growth with a multi-sector endogenous growth model. The economy has two sectors, manufacturing and nonmanufacturing. The manufacturing (learning) sector is the only sector that generates domestic technological knowledge through learning by doing. This knowledge is used in the nonmanufacturing (non-learning) sector. We find the planner’s solution in order to obtain the optimal subsidy for the market economy. We study how the economy responds, in the steady state, when the government establishes the optimal rate of investment subsidy in the manufacturing sector. Thus, the proportion of labor in the manufacturing sector, the relative price of the nonmanufacturing good and the ratio of consumption to nonmanufacturing capital are higher, and the ratio of nonmanufacturing to manufacturing capital is lower. Therefore, the market economy has a higher growth rate.