The Rationale for Government Incentives and Growth in an Open Economy

The Rationale for Government Incentives and Growth in an Open Economy

An investment incentive is a government-sponsored policy aimed at promoting start-ups or encouraging existing firms to either expand or not move to another country. The incentive can be financial interventions such as reduced tax rates, grants, infrastructural development, and free land. Moreover, incentives for innovation (technology and knowledge) are significant since they are the long-term economic growth drivers (Solow, 1956).

An open economy allows trade and finance to flow freely. Consequently, opening an economy has a significant impact on economic growth.

Impact of Open Economy on Economic Growth

  1. Countries can adopt technology, increasing technological development and hence overall productivity.
  2. An open economy is a requirement for global trade. International trade increases competition in the domestic markets, compelling companies to produce improved products, enhance productivity, and keep prices low.
  3. Companies in an open economy can reach the international market for their products, allowing them to utilize economies of scale and increase the potential reward from successful innovation.
  4. When a country opens its economy, it can borrow or lend funds in the global market, and international savings can finance domestic investment. Therefore, domestic savings will not restrict investments. 
  5. Countries can allocate resources to more profitable industries in an open economy and leave inefficient industries, increasing productivity and employment.

According to the neoclassical model, convergence will occur more quickly if free trade and economies open. A country’s capital-to-labor ratio coverage will increase when the economy opens. The dynamic adjustment process is described as follows:

  1. Developed countries have higher capital per work, resulting in a lower marginal product of capital. For this reason, the rate of return on investment should be lower in countries with high capital-to-labor and higher with low capital-to-labor ratios.
  2. In an open economy, capital should flow from countries with higher capital-to-labor ratios to those with low capital-to-labor ratios, as investors seeking a higher return will invest in capital-poor countries.
  3. From the capital inflows, the physical capital stock in developing countries is expected to grow faster than those of developed countries despite the low saving rate in developing countries. Rapid capital growth will increase productivity, resulting in per capita income convergence.
  4. As developed countries export capital, they tend to run trade surpluses. Developing countries, on the other hand, run trade deficits as they borrow from global markets. This is because capital flows need to be matched with offsetting trade flows.
  5. Capital inflows in developing countries will temporarily increase the growth rate above the steady-state growth rate. The growth rate in developed countries will be below the steady-state growth rate.
  6. Over time, the physical capital stock will increase in developing countries, reducing the return on investments. This will result in growth slowing down and eventually reverting to a steady state rate of growth. The country will become an exporter of capital if investments fall below the level of domestic savings.
  7. The developing and developed nations grow at a steady state rate of growth once world savings have been reallocated.

The endogenous growth models predict that the growth rate will permanently increase once due to more open trade policies. From these models, we can see that international trade increases global output through the following:

  1. A selection effect: This is when increased foreign competition causes more efficient companies to innovate and raise the efficiency of the whole country. In contrast, the less efficient companies exit the market.
  2. A scale effect: Enables manufacturers to take full advantage of economies of scale by selling to larger markets
  3. A backwardness effect: Entails less advanced sectors or countries catching up with their more advanced sectors or countries through the spillover of knowledge.

Over the past 50 years, developing nations have used the following economic development strategies.

  1. Outward-oriented policies: These are policies that seek to integrate the global economy with domestic industries through making and trading exports.
  2. Inward-oriented policies: These are policies that restrict imports to develop domestic industries.


According to the endogenous growth models, which of the following is least likely to increase global output through international trade?

  1. Inward-oriented policies.
  2. A scale effect.
  3. A selection effect.


The correct answer is A.

Inward-oriented policies are policies that restrict imports to develop domestic industries.

B and C are incorrect. International trade can increase global output through selection and scale effects.

Reading 9: Economic Growth 

LOS 9 (k) Describe the economic rationale for governments to provide incentives to private investment in technology and knowledge.

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