Endogenous sector–biased technological change and industrial policy

We build a model of structural transformation with endogenous sector–biased technological change. We show that if the return to specialization is larger in the goods sector than in the service sector, then the equilibrium has the following properties: aggregate growth is balanced; the service sector receives more innovation but the goods sector experiences more productivity growth; structural transformation takes place from goods to services. Compared to the efficient allocation the laissez–faire equilibrium has too much labor in the goods sector, implying that optimal industrial policy should aim to increase, not decrease, the pace of structural transformation.