Picking winners in strategic emerging industries using government subsidies in China: the role of market power

China's industrial strategy since 2008 has prioritized innovative firms in emerging sectors to drive technological advancement and global competitiveness. While government subsidies aim to 'pick winners' among these firms, the influence of market power (both buyer and seller) in upstream and downstream markets on the effectiveness of these subsidies remains largely unexplored. Existing research on the effects of public R&D spending on private investment has yielded inconclusive results, particularly in developing economies. This study addresses this gap by empirically investigating the impact of government subsidies on labor productivity in Chinese emerging industries, focusing on the moderating role of market power. The paper's contributions are threefold: it offers insights into the objectives of industrial R&D policy beyond the traditional market failure paradigm; it examines the extent to which market power influences the effectiveness of industrial R&D policies; and it contributes to the limited research on this issue in the context of an emerging economy like China, providing a nuanced understanding of the interplay between government institutions, market structures, and firm-level economic activities.

The literature review examines existing research on innovative firms and labor productivity, highlighting the link between innovativeness and superior performance. It also discusses the inconclusive evidence on the impact of government subsidies on private R&D investment, noting the debate on additionality versus crowding-out effects. The review explores the role of market power, particularly buyer power, in influencing a firm's innovation incentives. Existing studies have primarily focused on markets with limited government intervention, while this study investigates the effects in a context of significant government involvement in strategic emerging industries in China.

The study uses a Cobb-Douglas production function to model labor productivity, incorporating private R&D investment, firm age, and market power as moderating variables. The econometric model includes government subsidies, buyer power (BP), seller power (SP), and interaction terms between BP/SP and subsidies. Data from 1392 listed Chinese companies in strategic emerging industries from 2006 to 2019 (excluding 2020 due to COVID-19 effects) are used. The dependent variable is log(1 + Q/L), where Q is operating income and L is the number of employees. Explanatory variables include R&D intensity (R&D/L), government subsidy (Subsidy/L), BP (proportion of total purchases from top 5 suppliers), and SP (proportion of total sales to top 5 customers). Control variables include capital input (K/L), labor input (L), firm age, industry, year, and geographic location. A two-stage least squares (2SLS) estimation with a random effects model is employed to address potential endogeneity issues, using a one-year lag of innovation input (L.R&D/L) as an instrument. Robustness checks are conducted using a two-stage least-squares first-differenced estimator. A heterogeneity analysis is performed, comparing domestic and foreign-invested companies.

The results indicate a statistically significant positive relationship between R&D intensity and labor productivity. Government subsidies show a positive effect on labor productivity, while seller power is negatively associated with productivity. The interaction analysis reveals that the positive effect of subsidies on productivity is amplified by high seller power but diminished by high buyer power. Robustness checks using different estimation methods confirm the findings. Heterogeneity analysis reveals that the effects of market power are more pronounced for domestic enterprises than for foreign-invested companies. Specifically, in Model 3, the coefficient for R&D input (R&D/L) is 0.157 (p<0.05), indicating a positive and significant effect on productivity. The coefficient for Subsidy is 0.012 (p<0.05), signifying a positive effect on productivity, moderated by the interaction effects with seller power (SP*Subsidy=0.025, p<0.05) and buyer power (BP*Subsidy=-0.048, p<0.05). The heterogeneity analysis in Table 5 shows that the impact of buyer and seller power is more substantial for domestic firms than for foreign-invested companies. Domestic firms are significantly impacted by the interaction between subsidies and both seller and buyer power.

The findings highlight the complex interplay between government subsidies, market power, and firm performance. The positive moderating effect of seller power suggests that subsidies can be particularly effective in boosting productivity for firms with strong market positions. Conversely, the negative moderating effect of buyer power indicates that subsidies might be less effective or even counterproductive for firms facing significant buyer pressure. The greater sensitivity of domestic firms to market power suggests that policy interventions should be tailored to the specific market context. This study offers empirical evidence that supports the importance of considering market power dynamics when designing industrial policies in the context of emerging economies. The findings also highlight the potential for unintended consequences if subsidies inadvertently strengthen market power, potentially leading to reduced competition and innovation.

This study provides valuable insights into the effectiveness of government subsidies in fostering productivity in strategic emerging industries in China. The findings underscore the importance of considering market power when designing and implementing subsidy programs. Future research could explore the impact of subsidies on SMEs, investigate the long-term effects of subsidies on market structures, and examine the interplay between subsidies and other policy instruments aimed at fostering innovation.

The study is limited to listed companies, potentially excluding smaller firms with different characteristics. The data only spans until 2019, potentially missing recent developments. The analysis focuses on specific emerging industries in China, limiting the generalizability of the findings to other contexts. Future research should address these limitations by including a broader range of firms and time periods and conducting cross-country comparisons.