In this chapter, I address the question of how a country can induce structural change and diversification, and plan transitions to higher growth rates. This is a fundamental aspect of the problem of developing countries, namely, the need to increase productive capacity. Indeed, the transition from agriculture into a modern industrial and service economy, and decisions about how much to invest and where, can be viewed as problems of self-discovery and of understanding the externalities that lessen incentives for productive diversification. Today's developed countries directed policies to industrialize. Chang (2002) argues that today's developed countries—such as the United Kingdom, Germany, France, the United States, Sweden, and Japan—used industrial, trade, and technological policies when they were developing and catching up. They used some form of infant-industry policy or tariff protection. More recently, the Republic of Korea is the clearest case of successful economic development achieved through infant-industry protection measures.

Industrial policy has traditionally been understood as any type of selective intervention or government policy that attempts to alter the structure of production toward sectors that are expected to offer better prospects for economic growth than without such intervention. This type of intervention has its adherents-those who believe in market failures—and its detractors—those who believe in the efficient working of markets. The latter argue that industrial policy interventions have often degenerated into an exercise in “picking winners,” a game played by government officials deciding what activities and sectors to promote and to spend public money on.