Capability Failure and Industrial Policy to Move beyond the Middle-Income Trap: From Trade-based to Technology-based Specialization

This paper compares market, system, and capability failures as a justification for industrial policy, to argue that capability failure is most serious and unique in developing countries. It identifies failure of technological capability as the source of the middle-income trap. For a developing country to go beyond the middle-income stage, this paper suggests the implementation of technological specialization in a shorter cycle technology sectors where new technologies emerge frequently and existing ones become obsolete quickly, and the latecomers thus do not have to master existing technologies dominated by the incumbent. This paper suggests a three-stage based implementation strategy to build technological capabilities. The first stage involves the assimilation of foreign technology (operational skills and production technology) and know-how through licensing, FDI, or technology transfer from public research agencies, and the second stage involves learning via co-development contracts and public-private consortia once the latecomer firms establish their own in-house R&D labs as a physical bases for more indigenous learning. The final stage of learning is leapfrogging to emerging technologies which involve public-private R&D consortia and/or exclusive standard policy, procurement, and user subsidies for initial market provision.