Rationale for Government Investment in Economic Development
Capacity building requires government investment: there is simply no other entity that
has societal benefit as its main objective and is able to command the resources required to have
significant impact. Government is a vehicle for collective action: an agent for whom the
principal is its citizens and the businesses within its borders. While the not-for-profit and even
for-profit sector has taken over many functions previously allocated to government (Salamon
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2002), the results of this privatization are mixed. Government is the principal inclusive vehicle
for organizing economic, social and civic life. In contrast, markets are concerned with
transactions and coordinating activity through prices.
The invisible hand works on the logic that
firms attempt to maximize profits or shareholder value while workers seek to maximize their
wages. The result is the all too familiar race to lower costs through relocation or the de-skilling
of the labor force to lower wages. This market logic does not account for the potential longerterm benefits to firms if skilled worker suggest new product improvements. Moreover Henry
Ford’s epiphany that if he paid his workers a good wage they could afford to buy his cars.
Government seeks to allocate resources for the collective good and tries to
simultaneously satisfy a large number of constituencies. In reality, private businesses’ profit
maximization goal is much easier to achieve than satisfying the diverse aims required for the
achievement of government effectiveness. While it has become popular to bemoan the quality of
government services, a reasonable benchmark may be our levels of satisfaction with mobile
phone service, computer operating system, insurance claims or consumer choice in many product
markets. We hold government to a higher standard because, implicitly at least, we acknowledge
its functions are critically important.
Economists have traditionally relied on the theory of market failures to justify
government investment in economic activity. However, markets are concerned with transactions.
In a variety of circumstances, specifically those concerning public goods; information
asymmetries; industry conditions that provide a barrier to new firms being able to enter; and the
difficulty of pricing externalities, markets yield less than efficient outcomes. An easy illustration
of the market failure justification for government investment is Research and Development
(R&D) investment. Nelson (1959) cogently argues for federal funding to support R&D activity
within the U.S. by observing that when the marginal value of a good to society exceeds the
marginal value of the good to the individual who pays for it, the allocation of resources that
maximizes private profits will not be optimal. Of course the problem lies in estimating the
marginal value of goods to society. Strict reliance on the private sector results in an underinvestment in R&D. Econometric estimates find that the rate of return on R&D investments are
higher than for ordinary capital and the social rates of returns are even higher (Hall, Mairesse
and Mohnen 2009). However, realizing the benefits of investing in R&D critically depends on
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complementary social capabilities and infrastructure to support and bolster economic growth
(Galor 2011; Fagerberg et. al 2014).
Market failure has become a primary rationale for all government investment in the
economy. The logic of market failures, though appropriate to justify R&D investment, should not
be uncritically extended to all government investment. In the discourse of market failure, the
market takes primacy while the government’s role is minimized. Amsden (1997: 470) makes the
case that the market failure approach, while useful in considering economic exchanges, is
inadequate when the focus is on economic development, which requires building and sustaining
markets and communities. Markets only work when there are well-defined property rights, a
valid medium of exchange and enforceable contracts. These require agreement, collection action
and enforcement.
There are many attempts to substitute market mechanisms for the provision of
government services. For example, support for public funding for higher education has eroded
(Bok, 2009). The argument is frequently made that educated individuals receive higher wages as
a result of their investment in human capital (Spence, 1973). This suggests that it is rational for
individuals to make the investment rather than rely on public funding. However, job markets are
highly uncertain and individuals invest without a guaranteed return (Green & Zhu, 2010).
Moreover, a well-educated workforce generates larger social returns (Greenstone, Hornbeck and
Moretti 2010). The consensus in both the theoretical and empirical literature is that spillovers
from human capital have a positive significant impact on firm and industry productivity, and
economic growth (Jaffe & Trajtenberg, 1993). These real, beneficial externalities represent a
subsidy that is impossible to price or even attribute. Indeed, despite the potential to apply the
logic of the marketplace, public provision of higher education has long been justified in the U.S.
as a building of capacity to allow citizens to fully participate in social and economic life (Nash
1963).
Neoclassical economics is centrally concerned with the efficient allocation of goods. It
treats the creation of knowledge as exogenous – ideas simply appear (Arrow, 1962; Romer
1995). A fuller consideration of the benefits of government R&D investment suggests that the
private benefit may be recast as increased capacity. Indeed, Salter and Martin (2001) highlight
that government R&D investments creates additional long-term dynamic externalities as skills
and capabilities are developed, thereby lowering the cost of subsequent inventive activity.
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Investments in R&D offer opportunities for experimentation and learning that enhance the ability
to solve complex technological problems and extend the scope of inquiry. Additionally,
government R&D investments make it easier for firms to absorb information, and in so doing
they improve private sector decision-making and ability to innovate (Cohen & Levinthal, 1990).
With a more nuanced understanding of the nature of innovation and entrepreneurship, the
case for government involvement is stronger (Feldman & Kelly, 2003). At the point when
technology has the greatest potential for creating new industries, the frontiers are poorly defined
and the chances of failure are high. Complex new technologies require collaboration and
information sharing; however, the upfront cost of establishing research and development
partnerships and making them work productively is a disincentive to the private sector despite
the high potential to create new industries. As evidenced by pharmaceutical manufacturers’ focus
on blockbuster life-style drugs or incremental changes in current drugs in order to keep them
under patent., the profit motive favors short-term activity with large market potential – not the
most important societal concerns. Based on short-run profit motive alone, much of potential
return on investment may be left on the table.
