What is the “knowledge driven economy”?
Why is knowledge becoming more important?
How is it changing the way we do business?
Forces for improved performance.
Why is knowledge becoming
more important across the economy?
Information and communications technology
Science and technology
Implications for performance
Knowledge as the source of growth
The UK as a knowledge driven economy
Creating and exploiting knowledge
Enterprise and innovation
Pace of innovation and finance for enterprise
People and skills
Partnership within the firm
New forms of business organisation
Collaboration within a region and between firms: clusters
Competition and the changing market place
Competition and protection of innovation
c h a p t e r o n e
1.1 “Knowledge is our most powerful engine of 1.6 Authors have tried to describe aspects of the
production” wrote Alfred Marshall in his Principles of changes affecting modern economies in different
Economics.1 So the concept of a “knowledge driven ways. Terms such as de-industrialisation, globalisation,
economy” is not an unfamiliar one to economists. But the information age, the digital or weightless
today we can see a number of processes at work, some economy all capture elements of what we observe.
entirely new, others that have developed over many The knowledge driven economy is a more general
years, which together are transforming the way in which phenomenon, encompassing the exploitation and use
businesses, individuals and policy-makers operate. This of knowledge in all production and service activities,
calls for a renewed focus on knowledge as the means of not just those sometimes classified as high-tech or
improving economic performance, the underlying theme knowledge intensive.
of the White Paper, Our Competitive Future: Building the
Knowledge Driven Economy (Cm 4176).
What do we mean by
1.2 The increasing importance of the knowledge “knowledge”?
driven economy is an international trend which affects
Knowledge is more than just information. An ever-
economies at all levels of development. The World expanding amount of information is being
Bank’s 1998 World Development Report took produced and made available. This does not
knowledge as its theme: necessarily mean that we are all more
knowledgeable. The information available in a
“For countries in the vanguard of the world economy, book or on the Internet becomes knowledge only
the balance between knowledge and resources has when it has been read and understood. How the
shifted so far towards the former that knowledge has information is interpreted and used will be
become perhaps the most important factor different for different readers depending on their
determining the standard of living...... Today’s most previous experience, expertise and needs.
technologically advanced economies are truly
To understand the role of knowledge and
knowledge-based.” information in the wider economy, it is important to
distinguish two types of knowledge: “codified”
1.3 The OECD has also drawn attention to the
and “tacit”. Knowledge is codifiable if it can be
growing importance of knowledge: written down and transferred easily to others.
Tacit knowledge is often slow to acquire and much
“.... the emergence of knowledge based economies....
more difficult to transfer. Examples include the
has profound implications for the determinants of knowledge built up during an apprenticeship,
growth, the organisation of production and its effect on understanding of how a particular market works,
employment and skill requirements and may call for or familiarity with using a particular technology or
new orientations in industry-related policies.” 2 language. This difference in transferability means
that codified and tacit knowledge need to be
1.4 Other countries, too, have identified the growing managed and rewarded quite differently. Because
importance of knowledge and reflected it in their of its nature, tacit knowledge is often a source of
approach to economic policy, as for example in the competitive advantage.
US, Canada, Denmark and Finland.
What is the “knowledge driven economy”?
1.7 The growing importance of the knowledge
1.5 A knowledge driven economy is one in which element of production is all around us. It is perhaps
the generation and the exploitation of knowledge has most obvious in the personal computers, mobile
come to play the predominant part in the creation of phones and sophisticated electronics of the
wealth. It is not simply about pushing back the information and communications industry and in other
frontiers of knowledge; it is also about the more high-tech industries such as pharmaceuticals.
effective use and exploitation of all types of
1 Marshall (1890).
knowledge in all manner of economic activity. 2 OECD (1998a).
Business consultancy, financial services and other correspondingly increased. The ease with which
knowledge-intensive services are growing in information can be transferred also means that
importance too. But knowledge is also transforming products and processes can often be quickly imitated.
other sectors, both in their processes and the nature Knowledge spreads more quickly, making us all better
of their final products. Branding and design accounts off, but in order to compete a firm needs to innovate
for an ever-higher proportion of the value of the goods more quickly and make use of its distinctive know-how.
and services we consume. About 70 per cent of the
production cost of a new car can be attributed to 1.12 Competition is also fostered by trade and capital
knowledge-based elements such as styling, design market liberalisation. With low transport costs, trade
and software. A modern luxury car includes more liberalisation opens up whole new markets.
computing power than Apollo 11. Liberalisation of foreign direct investment has also
opened up markets where a local presence is
1.8 Investors increasingly recognise the growing important. Both developments increase competition,
importance of knowledge assets in the way they value while enabling firms to take advantage of scale
firms. In fast-growing sectors like biotechnology and economies and exploit their comparative advantage.
computer software, the value of the company resides
almost entirely in the knowledge embodied in its 1.13 The final driver is changing demand,
patents and in its staff. associated with rising incomes and the changes in
tastes and attitudes to leisure that come with greater
Why is knowledge becoming more prosperity. Changing attitudes to new technology and
important? to risk are also important. At the same time,
increasingly sophisticated and demanding consumers
1.9 Knowledge has always been important, but now
are driving changes in traditional corporate values and
four mutually reinforcing processes are increasing its
behaviour, particularly in relation to environmental and
importance for prosperity. The first, and most
conspicuous, is the extraordinary progress in
Information and Communications Technology (ICT).
1.14 With rising prosperity, a smaller proportion of
Information spins round the world at an ever-faster rate,
income is spent on essential goods. People value their
in ever-greater quantities and much more cheaply with
leisure more highly and spend more of their income on
implications for every type of economic activity. Entirely
it. Consumers place more emphasis on the quality of
new products (e.g. digital television) and services
the goods and services they buy and, more generally,
(e.g. software services) have been created and more
on the quality of life. As economies develop, and
sophisticated production processes developed.
environmental pressures mount, people attach higher
priority to the preservation and improvement of the
1.10 The second force at work is the increased
environment. And the Government also has a key role
speed of scientific and technological advance.
in ensuring that the future pattern of development is
Increases over the years in basic scientific research
sustainable. All these factors imply increasing pressure
and business enterprise R&D have led to an
on firms to reduce their dependence on the physical
acceleration in the growth of the stock of codified
components of production (the part derived from land,
scientific and technological knowledge. At the same
raw materials and unskilled labour), limit pollution and
time, the potential scope and productivity of R&D has
give a greater role to innovation, creativity and
increased as equipment has improved, and better
communication technology has facilitated the
widespread diffusion of research findings.
How is it changing the way we
1.11 The third factor is increased global do business?
competition. Competition has been facilitated in part 1.15 The development of the knowledge driven
by reduced communication costs, which have opened economy inevitably involves a period of adjustment
up markets to consumers by reducing search costs. and structural change. It is changing the way firms
International transport costs have fallen for many compete, allowing them to access global markets
businesses, while other businesses can deliver their more readily. Competition and the advance of
products or services down a phone line. The size of technology are working to accelerate the pace of
the market available to these companies has
3 Quoted in Scottish Enterprise (1998).
innovation and change. These technological is hard to measure and even more difficult to
developments and changing demands are creating communicate to shareholders. In many instances
whole new kinds of products. Increasing returns to these assets are also becoming increasingly mobile.
scale are more prevalent in products with a large All this adds to the risk and uncertainty surrounding
knowledge component, offering huge potential for investment decisions. Flexibility in financing is required
growth. For economies to deliver rising living as product lives shorten and individual firms have
standards, greater emphasis must be placed on potential to grow faster within a global marketplace.
innovation, scientific development, knowledge
management and human capital. Entrepreneurship has 1.20 For the policy maker, the challenge is to create
a crucial role in exploiting the economic opportunities a framework which supports continued development
presented by change. of scientific and technological excellence, greater
competition and a culture of enterprise and innovation,
1.16 The implications are being felt right across the and which ensures effective protection of the
economy and involve new ways of working. For firms, environment. Enterprise is more likely to thrive where
competitiveness increasingly requires them to build there is a stable financial and economic backdrop; a
distinctive capabilities.4 These may reside in a brand supportive business and social environment; good
name or in R&D performance or in the tacit knowledge access to markets, technology and finance; and a flexible,
of their employees. For the manager of a firm, the highly educated and skilled labour force. Helping those
quest for competitive advantage increasingly implies adversely affected by the adjustment to the knowledge
the need to maintain, develop and utilise these driven economy is another role for government.
knowledge assets. Shorter product lives and increased
competition require managers to increase efficiency 1.21 For the regulator, some features of the
and devote more resources to innovation. Technological knowledge driven economy have implications for the
developments are helping them to do so, but nature of competition. Co-operation between firms is
organisational change and increasing workforce skills becoming more common. Innovating firms also look
also play a role. for some temporary market power to recoup their
investment in R&D and other knowledge assets.
1.17 On the input side, managers may need to bring Regulators need to weigh up the costs with the
in specific expertise by working with other firms. benefits in terms of incentivising and facilitating
Research joint ventures and ways of sharing best innovation. Regulation also becomes harder where
practice are examples of this. Co-operation between output is knowledge driven and the regulated body
producers and their suppliers to reduce lead times and increasingly has more information than the regulator.
eliminate costs is becoming increasingly common. In This makes it more difficult for the regulator to assess
some cases, the need for proximity to other firms or a accurately the position of the regulated and therefore
pool of skilled and complementary labour has led firms make policy that is economically efficient.
to cluster together in specific locations.
Forces for improved performance
1.18 Where the employees in the company embody
1.22 The paper starts by looking in more detail at the
the firm’s assets, new types of incentive structures are
four processes that lie behind the knowledge driven
required to ensure they are motivated and retained. For
economy and what this means for overall
individuals to take advantage of the opportunities
performance.It then goes in to greater depth on the
presented by the knowledge driven economy, they will
microeconomic implications of the knowledge driven
need to acquire and maintain relevant skills. Investment
economy under three headings:
in skills also needs to be supported by a culture in the
workplace that allows the knowledge, creativity and • capabilities to adapt and to embrace change
encompassing the exploitation of science and
commitment of the workforce to be fully exploited.
technology, enterprise and innovation, capital
1.19 The knowledge driven economy is having markets, people and skills
profound implications for the investor and the • collaboration, both within firms in the way they
financial community. More of a firm’s wealth-creating organise themselves and their employees, and
potential is tied up in intangible assets, including the between firms in the way they interact in networks
knowledge of the workforce. The value of these assets and in clusters
4 Kay (1993, 1996).
• competition and how increased competitive
pressures from more open markets and the growth
in foreign direct investment are interacting with
the forces driving innovation and increased
1.23 Throughout the document an attempt is made to
assess UK performance within this framework.5 The
statistics shown can only be regarded as indicative.
Many aspects of the knowledge driven economy
remain imperfectly measured. Some activities are
entirely new, while others are inherently difficult for the
statistical authorities, financial markets and businesses
to assess. For instance, the measurement of the
knowledge available to an enterprise, so important to
competitiveness, is much harder and less developed
than measuring the physical assets. The White Paper
announces plans to develop a set of Competitiveness
Indicators which will allow us to benchmark our
performance more systematically.
5 A parallel document, also published with the White Paper, looks at our
performance in ICT in more detail. DTI (1998b).
c h a p t e r t w o
Why is knowledge becoming more
important across the economy?
2.1 Chapter 1 identified four important structural 2.5 As the infrastructure for electronic commerce is
changes which are transforming many parts of the improved, the number of new products and services
economy and society: will increase still further. The infrastructure for the
information highway - an integrated, high-capacity and
• revolutionary changes in ICT
interactive communications network - is being built up
• more rapid scientific and technological advance
in most industrialised countries and is developing fast.
• competition becoming more global
• changes in tastes, lifestyle and leisure that go with
2.6 The telephone systems, high speed computing
capacity, internet and digital broadcasting that underlie
2.2 Apart from the revolution in ICT, most of these the information highway offer huge potential. The
changes have been going on for some time. But pace of development can be seen in the growth of
their combined effect appears to be bringing us to the Internet hosts (Chart 2.1).
threshold of a radical change in many parts of the
Chart 2.1: Internet hosts in the OECD
economy and society. The pace of change will differ (Per thousand inhabitants)
in different sectors of the economy, some being
transformed within relatively short time scales, while
others change only gradually. However, this global
phenomenon will affect everyone. Those countries 8
which adapt most readily and exploit the opportunities 6
offered by the knowledge driven economy will enjoy 4
rising incomes and prosperity while those which lag 2
behind may face relative economic decline. 0
1991 1992 1993 1994 1995 1996 1997
2.3 The four forces behind the increasing
importance of knowledge in economic development 2.7 The information highway allows companies to
are considered in detail below. transform the way they do business,creating and
accessing new markets and changing the way they
Information and communications relate to their customers, suppliers and competitors.
technology 6 Customers can tap into a whole new range of
information about products and alternative suppliers.
2.4 The pace of change in ICT in recent years
Businesses can gain access to large amounts of
has been extraordinary. This has led to the emergence
commercial and technical information from around the
of a whole new range of products and services, from
world. The access to codified knowledge facilitates
laptop computers and mobile phones to global
the spread of best practice and new ideas and
positioning systems and satellite TV. Advances in ICT
increases the speed of innovation.
affect anyone using a computer or telephone, from a
All these developments increase the intensity of
cornershop with computerised accounts to large
competition, call into question traditional sources of
retailers fine-tuning the distribution of their products
competitive advantage and carry implications for
using sophisticated stock-control systems. The
changes are also transforming production methods
and allowing new processes to be adopted. For
example, the wings for the Airbus 340-500/600 are
being designed by BAe and its suppliers using
Computer Aided Design without the need for paper 6 See DTI (1998b) for more detail.
7 The OECD define an internet host as ‘a domain name that has an IP
drawings, and the digitised plans are then fed directly (Internet protocol address) record associated with it. This would be any
computer system connected to the Internet, via full or part-time, direct or
into numerically controlled machines manufacturing the dial-up, connections.’ On this basis, the total number of ‘hosts’ will broadly
equate to the total number of Internet Service Providers, of servers utilised
component parts. by individual companies and special interest groups, and a number of
machines of private individuals who operate a web-site from their home PC.
Science and technology access to technology they must network with
suppliers, customers, competitors and other users of
2.8 Recent years have seen large increases in the
similar technologies. This is more important because
resources devoted to basic scientific research and by
products and processes now incorporate a much
businesses to R&D in OECD countries (Chart 2.2).
wider range of technologies than before. Increasingly
ICT has also allowed researchers to make much more
new products are not stand-alone items but
rapid and extensive searches of published research
components of broader systems. This is encouraging
results and draw upon the work of others. But it is not
firms to collaborate much more with other firms,
just that scientific knowledge is spreading more rapidly.
realising economies of scale and scope in technology
Fundamental advances have been made in areas such
creation and adaptation. Firms are also increasingly
as genetics and biology, spawning new generations of
developing direct links with the academic science and
products. Meanwhile, improvements in equipment
have also significantly increased the scope and
productivity of R&D, for example in bio-infomatics.
Chart 2.2: Business expenditure on R&D in the OECD 2.11 Since the mid 1980s, the pace of globalisation in
(US $ billion)
300 the world economy has quickened considerably. World
trade has increased almost twice as fast as GDP, in
line with its post-war trend.What is new is
the increasing integration of developing countries into
the global economy and the marked acceleration of
international capital flows. A vivid example is provided
by the growth of foreign direct investment (Chart 2.3).
Chart 2.3: Outward & inward direct investment flows in the OECD
(US $ billion)
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Note: Constant 1990 prices Source: OECD
2.9 These developments have hugely expanded
Outward direct investment flows
the stock of all types of scientific and technological 150
Inward direct investment flows
knowledge. Together with liberalisation and
globalisation, they have significantly increased the
pace of innovation and imitation. One outcome is that 50
older technologies using traditional materials and often
involving large amounts of tacit knowledge, are being Note: Constant 1990 prices
replaced by integrated approaches based on
Computer Aided Design and Manufacture (CADCAM), 2.12 Globalisation has been driven by three processes:
electronic transfer of data and design, advanced • reduction in tariffs and other forms of protection
control systems and new materials. These are more - a result of world-wide trade liberalisation
amenable to the codification of the knowledge they
• removal of restrictions on cross-border capital
embody. But tacit knowledge remains important, since movement through the liberalisation of capital
it is more easily retained by firms and is crucial to markets
securing a competitive advantage. In principle, imitation
may be easier but the successful adoption of advanced
• reduced transaction costs - aided by developments
in transport and ICT.
process technologies still involves complex problems of
systems integration and radical organisational change, 2.13 The combined effect of these processes has
the solution to which would appear to require significant been to increase the size of the market available to
amounts of tacit knowledge. firms, stimulate competition, increase specialisation
and make more distinct the international division of
2.10 Overall, the increased pace of change and
labour. Globalisation is also leading to new and
speed of imitation means firms must monitor their
unintended “spillovers” in the benefits of research and
external environment much more systematically in
development effort from one country to another.8
order to be aware of the opportunities and challenges
8 Spillovers occur when R&D spending in one country raises output in other
offered by technological and scientific change. To gain countries - see Coe and Helpman (1995).
2.14 Three main transmission mechanisms are 2.17 The combination of greater competition, the
encouraging the diffusion of codified, and to a lesser more rapid spread of ideas and the faster pace of
extent, tacit knowledge. First, free movement of innovation all help to advance the transition to the
people and ideas is important for the spread of knowledge driven economy. New products move
knowledge and best practice. The ease of much more rapidly through the product cycle from
international travel, through lower transport and specialised production using highly skilled labour in the
transaction costs, makes events such as conferences country where the innovation was made to mass
and activities like management consultancy much production using standardised processes in countries
easier. Advances in ICT, such as e-mail and video- with lower labour costs. Companies in countries with
conferencing, enable new forms of interaction. All this higher labour costs therefore have to innovate and
allows for experiences and ideas to be shared more adapt continuously to retain their competitive edge,
easily with a much wider audience. and even to survive. Recognition of this is absolutely
vital to our competitive future.
2.15 Second, exposure to international trade
contributes to the diffusion of knowledge. Domestic Changing demand
producers see innovative technology, branding and
2.18 The final driver is changing levels and patterns
design embodied in imported goods and seek to
of demand. As economies grow, a smaller proportion
match them. Exporters can become more aware of
of income is spent on basic necessities. People buy
superior products and technologies, and best
more sophisticated goods and services and value their
practice in their application, through the demands
leisure time more highly, devoting more of their income
of their international customers and the activities
to it. In the UK, expenditure on food has risen less
of their competitors.
quickly than overall expenditure, while catering has
risen much faster. In part this reflects a growing
2.16 Third, foreign direct investment allows
demand for the service element of food consumption,
industrial processes and management to be shared
but also increasingly for the knowledge component, for
with other countries. If a foreign company invests in
example the skills of the chef and the atmosphere, or
a new factory on a greenfield site, it will usually
brand name, of the restaurant. Rising incomes and
install the latest innovations and productive
changing tastes have also contributed to the growth of
processes. Where a foreign firm takes a stake in
the creative industries and the greater emphasis on
an existing company, it will often undertake some
quality and design, for example in the fashion and
investment in equipment and systems as well, and
will usually introduce new management techniques.
Increasingly, firms are internationalising their R&D
2.19 Changes in social attitudes, lifestyles and
efforts leading to an increase in the share of R&D
aspirations also have a major impact on the pace
financed from abroad (Chart 2.4).9 Furthermore there
and direction of development of the knowledge driven
is evidence that domestic firms can learn from the
economy. For example, the willingness and ability of
higher productivity of inward investors, spreading
firms and other organisations to innovate is a key
improved management and production techniques to
determinant of the demand for many new products
other parts of the economy.10
and services. Businesses which produce such
Chart 2.4: Proportion of R&D in EU countries financed from abroad
products will only develop where they can gain access
(Per cent) to leading-edge customers.
2.20 Increased demand for new products and ways
of delivering services enables producers to exploit
economies of scale and “learning by doing” thus
increasing productivity, reducing costs and prices and
providing resources for further innovation. Lower prices
and increased product quality further stimulate
demand. ICT provides a good example of this. Prices
for mainframe computers in the United States,
1981 1991 1995
9 Pearce (1997).
10 Barrel and Pain (1997b).
adjusted for the great changes in computing 2.23 Genetically altered foodstuffs are an example of
power that have occurred, have fallen to less than the importance of social attitudes. Demand for them
one thousandth of their original price over the last depends in part on whether they are regarded as safe
40 years (Chart 2.5). and wholesome and on perceived risks for the wider
environment. The way in which different countries
2.21 Changes in demand are also influenced by the perceive R&D into biotechnology is already affecting
willingness and capability of individuals to embrace where such R&D is being undertaken. Public attitudes
technological developments. For example, the spread towards science, technology and risk are therefore
of e-commerce is dependent on the existence of the potential sources of competitive advantage.
necessary skills, and on individuals’ attitudes to Government can be help by giving consumers
changing their lifestyle. confidence that their interests will be protected, and
their concerns addressed.
2.22 As economies develop, social attitudes change.
People place a greater value on environmental quality 2.24 It is by no means a foregone conclusion that
but this coexists with a greater desire to consume the UK will make the most of the potential benefits of
more resources. For example, concern about climate the knowledge driven economy - individuals and
change, air quality and transport pollution is increasing, government need to work together to take advantage
and although the energy intensity of output has fallen, of the opportunity. The role for policy makers is to
absolute energy consumption continues to rise. embrace the changes that are making knowledge
As environmental pressure increases, innovative increasingly the engine of production and to help
solutions will be required if economic development economies to adjust, while ensuring development is
is to be sustainable. If anything, the knowledge driven sustainable. But making the most of the potential
economy might be expected to reduce pressures on impact on living standards also requires the right
the environment, as the knowledge intensity of attitudes and the capacity to exploit the changes that
products increases relative to their energy and raw are taking place.
Chart 2.5: Price of computer equipment in the US adjusted for quality
1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Note: Log scale Source: Triplett (1996)
c h a p t e r t h r e e
Implications for performance
3.1 Developments in economic theory increasingly productivity growth. The intensity of domestic R&D is
recognise the central role of knowledge as a found to affect both the rate of domestic innovation
determinant of economic growth. New theory is and the quantity of knowledge that can be absorbed
moving away from old models where technical from others.13 Increasingly, the import of modern
progress was seen as an exogenous variable which technology from abroad is a factor driving productivity
economists were unable to explain. Labour effort and growth.14 The growth in the stock of industry-funded
physical capital were viewed as the two inputs policy R&D - though concentrated in certain industries, such
makers were able to influence, but these left much of as chemicals, engineering and electronics - has played
growth unaccounted for. a significant role in promoting growth in manufacturing
productivity.15 R&D spending is important in explaining
3.2 Traditional economic growth theory saw the US manufacturing productivity lead over the UK
technical progress disseminating costlessly from leader and Germany.16
to follower, so that differences in productivity were
believed not to persist in the long run. Those who 3.6 Other analysis has confirmed the importance of
lagged behind caught up with the leaders by following education in explaining the growth of national income.17
best practice. The process of technological change Skills acquired after school are also important. Skill
was not well understood. It was assumed to occur differences between UK and German manufacturing
at a constant rate, regardless of policy action - in other are an important factor in explaining Britain’s
words, technical progress was exogenous. Increases manufacturing productivity gap with Germany.18
to the long run growth rate could only come about as
a result of exogenous technological shocks. 3.7 But more investment in R&D, education and
skills is not enough. It is important to create the right
3.3 However, the evidence suggests that even the environment for innovation and the exploitation of
economies of advanced nations seem to be new ideas, with a supportive institutional and cultural
converging only slowly, if at all. So catch-up is not framework. Macroeconomic stability is crucial.
automatic. And more attention is being paid to how Property rights must be established and enforced, the
policy can influence the rate of technical progress and banking and financial system should be capable of
the rate of catch-up. bearing risk and society should respect, foster and
encourage enterprise. The capacity for growth is
Knowledge as the source of growth reduced in societies that are unwilling or unable to
3.4 The shortcomings of traditional growth theory innovate and change.19
have been tackled in the more recent economic
3.8 Further evidence of the rising importance and
literature.11 Investment in the generation of knowledge,
potential of knowledge in economic development
the education and training of the workforce, and the
can be seen in OECD figures on the way output,
capacity for innovation and the exploitation of new
employment and foreign trade are changing. Precise
ideas are now seen as the key requirements of
measurement of the knowledge component of output
success. Technology does not just flow from leader
is difficult. As one indicator, albeit imperfect, the OECD
to follower. The capabilities need to be in place to
defines a group of high-tech manufacturing and
understand best practice and exploit it effectively.
services which have a high knowledge component.20
The role of increasing returns to scale is given greater
The value added generated by knowledge-based
emphasis. Seeing growth in this way allows more of
industries in the OECD increased at an annual average
growth to be explained and is consistent with some
countries being stuck on low productivity, low growth 11 Aghion and Howitt (1998).
12 12 Romer’s ‘Ideas Gap’ quoted in Crafts (1996a).
paths, while others enjoy persistently higher growth. 13 Cameron (1998).
14 OECD (1996b).
15 Cameron (1996).
3.5 The ability of an economy to generate new ideas 16 O’Mahony (1992).
17 Levine and Renelt (1992).
is difficult to measure. Expenditure on R&D is often 18 O’Mahony (1992).
19 Societies need what Moses Abramovitz termed the ‘social capability’ for
used as a proxy. Growth studies find that R&D growth. Abramovitz (1986).
20 For definitions used in charts sourced from OECD, see box at end of
expenditures provide a positive contribution to chapter.
rate of 7 per cent between 1985 and 1994.21 3.11 Trade is also becoming increasingly knowledge
Compared with just over 5 per cent per annum for the based. There are no aggregate measures of the
business sector as a whole (Chart 3.1). knowledge intensity of trade but trade in knowledge-
intensive services is growing more quickly than total
Chart 3.1: Growth of value added in the OECD (1985-1994)
services trade and within goods trade, the fastest
(Annual average growth rates, per cent)
8 growth has been in high and medium-high technology
manufacturing (Chart 3.4).
5 Chart 3.4: Export market share by type of manufacturing industry
Manufacturing High technology ICT Business sector Knowledge
industry industry manufacturing based industries
and services 20
Note: Current prices. Constant price data not available Source: OECD
3.9 Moreover, productivity in these types of activity 0
High-Tech Med-High Tech Med-Low Tech Low
has grown faster than in other sectors (Chart 3.2). Note: Current prices Source: OECD
Chart 3.2: Labour productivity growth within the OECD (1985-1995)
(Annual average growth rates, per cent)
The UK as a knowledge driven economy
3.12 In many aspects of the knowledge economy,
the UK is already in a strong position. In areas such as
media, advertising and entertainment, financial services,
pharmaceuticals and Formula 1 cars, the UK has a
worldwide reputation as a leader of the field. But despite
a reputation for creativity and ingenuity, our overall
performance in terms of our capacity to generate high
living standards for our population is disappointing.23
Business Manufacturing HIgh & medium The next chapter will look in more detail at the UK’s
sector industry high technology
capabilities to make the most of the opportunities the
Note: Constant 1990 prices Source: OECD
emergence of the knowledge driven economy offers.
3.10 In the knowledge-based industries as a whole Here we consider how the knowledge economy is
productivity gains have not been at the expense of reflected in UK output and employment, and look at
employment (Chart 3.3). However, employment has broad indicators of strengths and weaknesses.
declined slightly in the high-technology sector.
3.13 The composition of UK output is changing.
Chart 3.3: Employment in the OECD One indicator of this is the rising share of high-tech
(1985=100) manufacturing and knowledge intensive services
in output (Chart 3.5).
Chart 3.5: Knowledge based industries’ share of UK output
95 High technology industries 15
ICT manufacturing & services
Knowledge based industries
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995
Note: Current prices. Source: DTI calculations based on ONS data
21 OECD (1998a).
22 OECD (1998a).
23 A benchmarking exercise carried out by DTI in 1997 revealed at best a
mixed performance, with a significant gap in productivity and living
standards persisting. DTI (1997).
3.14 Changing output is reflected in the labour Chart 3.8: Share of knowledge based service exports in total
service exports in 1996
market. Although knowledge is universally important (Per cent)
for performance, employment has been growing
fastest in sectors most clearly identified with the 50
development of the knowledge driven economy 40
(Chart 3.6). Within services, employment in activities
such as market research and R&D has increased.
In manufacturing, there has been a move away from 20
activities such as textile production, towards computer 10
manufacture and telecommunications.
Chart 3.6: Employment in the UK
Source: DTI calculations from IMF & ONS data
120 3.17 Another indicator is the growth of royalties
115 received by the UK. Royalties reflect the export
of intellectual property. Intellectual property earnings
from overseas in the form of royalties and licence fees
95 Knowledge based grew about twice as fast as all service exports between
Other industries 1993 and 1996 in the five largest OECD economies.
Computer and information service exports grew about
1985 1986 1987 1988 1989 1990 1991 1992 1993
four times as fast as all service exports.
3.15 The growing importance of knowledge-intensive 3.18 The UK is the third largest earner of royalties
goods, and services in OECD trade is creating new and licence fees from abroad and the second largest
opportunities for British exporters. In some areas the exporter of computer and information (IT) services. For
UK is well placed to grasp these opportunities or even goods and services as a whole, we rank fifth in the
leads the field. For example, we have had strong world. The relative position in royalties has changed
growth in high-tech exports in recent years and they little in recent years, but the rate of growth in the UK
comprise a relatively large share of our exports. has been lower than that in Germany and Japan but
More detailed analysis of UK manufacturing trade ahead of France (Chart 3.9).
performance suggests that an industry is more likely to
Chart 3.9: Overseas earnings from royalties and licence fees
succeed in Britain if it requires a relatively high
(US $ billion)
proportion of skilled employees or has a high R&D 30
intensity. This is consistent with the knowledge driven 25 Royalties in 1993
economy thesis (Chart 3.7).24 20
Royalties in 1996
Chart 3.7: Share of high-tech exports in total goods exports 15
UK Germany France US Japan
Note: Current prices. Percentage figure refers to the Source: IMF, ONS, US BEA
total increase between 1993 and 1996
3.19 The available statistics suggest that knowledge-
5 intensive industries are experiencing fast growth and
are becoming an ever-increasing component of UK
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 output and employment. But despite this, the overall
Note: Current prices. French high-tech exports include all finished Airbus exports.
Unless otherwise specified. Germany is the former West Germany until 1991 Source: Eurostat picture shows we have some way to go to reach the
living standards of the best. In terms of GDP per head,
3.16 In knowledge-based services we perform well we lag behind our major competitors (Chart 3.10).
too. Exports of these sectors make up a relatively high
share of total UK service exports (Chart 3.8).
24 Owen (1996).
Chart 3.10: GDP per head in 1997 (UK = 100) Chart 3.12: Output per employee in high technology industries
US 250 1979
Germany France Italy US Canada Japan
Note: Constant 1997 prices. Source: OECD
Finland 3.23 So while the UK has some areas of strength,
across the board, performance is disappointing.
UK Improving our productivity performance and matching
best practice elsewhere will require progress in many
Korea areas. First among these is the achievement of a more
Portugal stable macroeconomic environment than we have
seen in the past 25 years. The Government has put in
Hungary place new frameworks for fiscal and monetary policy to
help secure this.27 But progress is required on the
Turkey microeconomic front as well. The remainder of this
0 50 100 150 document considers the implications of knowledge for
Note: At purchasing power parities Source: DTI calculations using OECD data the economy at the microeconomic level under the
three broad headings used in the White Paper, namely
3.20 This poor performance in GDP per head is building UK capabilities, encouraging collaboration, and
primarily due to the shortfall in our labour productivity, promoting competitive markets. Where possible, it
whether measured by output per worker or output per benchmarks UK performance and draws out lessons
hour worked (Chart 3.11).25 for policy.
Chart 3.11: GDP per worker and per hour worked in 1996
140 Per worker
Per hour worked
OECD definitions used in charts
As the best available source of information, some of our charts use
100 OECD data classified by sector as follows. They illustrate important
points in the paper. They do not contradict our basic message that
80 the knowledge driven economy is about the effective use and
exploitation of knowledge in all areas of economic activity.
Knowledge based industries: knowledge based services and high
40 tech industry.
Knowledge based services: telecommunications; computer
and information services; finance; insurance; royalties; other
Germany France United States Canada Japan
High technology industries: aerospace; computers and office
Note: At purchasing power parities. Source: DTI calculations based on Harley and Owen (1998)
Figures for Japan relate to 1994. equipment; radio, TV and communications equipment;
Medium - high technology industries: professional goods; motor
3.21 In part, the shortfall in labour productivity reflects vehicles; electrical machines excluding communications equipment;
the lower level of capital available per worker in the UK chemical excluding drugs; other transport; non-electrical machinery.
compared with our main competitors. Calculations Medium - low technology industries: rubber and plastic products;
ship-building and repairing; other manufacturing; non ferrous metals;
of total factor productivity, which try to adjust for this, non metallic mineral products; metal products; petroleum refineries
and products; ferrous metals.
show a smaller but still significant gap, suggesting that
Low technology industries: paper, products and printing; textiles,
action is needed to improve both our investment levels apparel and leather; food, beverages and tobacco; wood products
and other factors holding back productivity.26
3.22 Moreover, comparisons of productivity suggest that
even in higher technology activities, the UK lags behind 25 DTI (1997) and HMT (1998c).
26 O‘Mahony (1998).
our major competitors in terms of productivity (Chart 3.12). 27 HM Treasury (1998b and 1998c).
c h a p t e r f o u r
4.1 The key to competitive advantage in the 4.5 But excellence in the science and engineering
knowledge driven economy is the capability of base and developing our ICT infrastructure is not
firms and other institutions to acquire and absorb enough. Our record in commercial exploitation of these
knowledge, to exploit it to develop new products advantages must improve. Expenditure on R&D is one
and processes, and to learn from best practice. measure of the extent to which business is developing
and exploiting new technology and ideas. Overall
4.2 If we are to compete in a world economy business expenditure on R&D in the UK has fallen to
increasingly driven by knowledge, we need to improve fifth in the G7 (Chart 4.1).
our capabilities in four areas:
Chart 4.1: Business enterprise R&D as a proportion of GDP
• We need to improve our capacity to create (UK=100)
and exploit scientific knowledge and France
• Securing this improvement, together with the
need for greater dynamism in the knowledge
driven economy, requires improved enterprise
• Finance for enterprise depends in turn on well
functioning capital markets.
• Firms also need access to skilled workers and the Note: Current prices
1991 1998 1995
successful organisations will be those who make
the best use of their people and skills. 4.6 This would not matter if the UK were more
effective at turning R&D into new products or
Creating and exploiting knowledge processes, but the patent data suggests otherwise
4.3 As discussed in Chapter 2, developments in (Chart 4.2). On the other hand, the UK is the only
science and technology, including ICT, are important major country in which foreign affiliates‘ share of
forces behind the rising importance of knowledge in manufacturing R&D is higher than their share of
the economy. These are not just exogenous trends but production. The fact these affiliates are doing so
developments which can be influenced by the actions much R&D in the UK suggests they believe their R&D
of governments, firms and educational institutions. will be more productive here.
Part of the drive towards embracing the knowledge Chart 4.2: Share of US and EU Patents in 1995
driven economy must be to accelerate the pace of (Per cent)
development in science and technology and make
sure that the UK keeps up with best practice United States
4.4 There is an important role for government in
ensuring that our science and engineering base and
our ICT infrastructure continues to strengthen. 10
Government has a role in encouraging investment in 0
basic science, which may not have immediate commercial
application, and in fostering investment in new technology Source: Science
where the risks may be too great for a single firm. It
4.7 Investment in fixed assets is an important vehicle
also has a role in technical education, in the spread of
for ensuring that the latest technology is available to
best practice and in encouraging scientific excellence.
business. But fixed investment per worker in the UK
Development of our ICT infrastructure also requires
is also relatively low. This is apparent from an analysis
government action in establishing the right regulatory
of data on fixed investment from company reports 29
environment and setting technical standards.
28 OECD (1998e).
29 Company Reporting Ltd., (1998).
and from figures on business investment compiled by
the OECD (Chart 4.3). Business - university links
The UK Community Innovation Survey tells us
Chart 4.3: Business investment per worker
(Average over the cycle, US $ thousands)
that 10 percent of innovators considered that
the science and engineering base (SEB) was an
UK Germany France
Italy US Canada important source of technological information.30
6 Other sources suggest that those companies that
5 collaborate with the SEB are increasing their
4 involvement. For example, industry collaboration
3 with Higher Education Institutes in the production
of scientific articles 31 has been increasing rapidly.
Universities themselves also have a role to play in
exploiting research more effectively. According to
1973-79 1979-89 1989-1996
one survey, 89 universities span out 46 companies
Note: At 1990 prices. 1989-96 is not a full cycle
between August 1994 and July 1995.32 These
universities also filed 546 patent applications
4.8 Exploitation of the new opportunities afforded by
and generated £14.9 million of licensing income
the information highway also lags behind some of our over the same period. These figures remain tiny
main competitors. For example, use of ICT by business by comparison with the US. In Massachusetts
falls short of the US and Japan, although we are ahead alone, these are estimated to be over one
of France and Germany (Chart 4.4). thousand MIT-related companies, with worldwide
sales of $53 billion.
Chart 4.4: Proportion of companies owning and using ICT in 1998
Germany across a wide range of areas, including strengthening
collaboration between firms and between science
Japan and industry, removing impediments to investment in
fixed assets and R&D, encouraging entrepreneurship,
improving access to finance and developing
management and workforce skills. Enterprise, finance
20 and skills are considered in this chapter and
10 collaboration between firms in the next.
PC with modem Internet access E-mail Web sites
Source: Spectrum Strategy Consultants Enterprise and innovation
4.11 Enterprise is crucial to success in the
4.9 Encouraging stronger links between business knowledge driven economy. Successful exploitation of
and universities is also important if we are to be more scientific advances and other new opportunities
successful in the commercial exploitation of technology. requires a culture of entrepreneurship in firms large
Firms are increasingly developing direct links with the and small. Firms have to act faster than before to
academic science and engineering base, currently respond to more intense competition. The spread of
maintained by only a minority of high-technology codified knowledge increases the likelihood of
businesses. At the same time, firms are making more competition by imitation. Enterprises, in turn, have to
use of qualified scientist and engineers in local higher respond to best practice elsewhere. Firms which are
education institutions as a source of expertise, relatively inefficient are less able to shelter behind
participating in expert networks of graduates, and making transport and transactions costs. Innovation in
more use of the results of scientific research themselves products and processes is becoming a more
(see box). important management function.
4.10 The Government is looking at ways of
improving the exploitation of science and technology
and our ICT infrastructure. Making more effective use
of our science and technology base requires action
30 Craggs and Jones (1998).
to address the consequences of market failures 31 Hicks and Katz (1997).
32 DTI (1996).
4.12 But with greater competition comes greater Pace of innovation and finance for enterprise
opportunity. In many knowledge-based activities (for 4.17 The shortening of product lives and greater
example computer software, satellite TV) firms can dynamism needed to succeed in the knowledge driven
grow and dominate the market quickly.33 Small firms economy require new relations between finance
may soon find themselves the market leader, placing providers and borrowers. For example, when new
management processes and structures under stress. firms are created to exploit innovations, banks and
In a high growth firm, more management resources need finance providers are not able to base their
to be devoted to “non-routine” activities as firms find financing decision on trading records. High growth
themselves having to innovate and cope with new risks. firms are also unable to make use of the main source
of business finance - retained profits. Often, it
4.13 In particular, in the knowledge economy, firms
is the smallest, youngest and most high-tech firms
must have managers who are able to manage the
who face the greatest problems getting finance.35
innovation process, position products in the market,
build reputable brands and improve quality. Moreover, 4.18 Bank finance is the most important source of
as product lives and development cycles shorten, external finance for most small and medium-sized
management becomes much more of an organic enterprises (SMEs). However, bank finance is not
process, with design, production and marketing staff suitable for some firms, particularly technology-based
all involved at the outset rather than being brought firms at start-up or the early stage of growth, because
in sequentially. such investments are often perceived as high risk, and
the long lead times of some investments mean that firms
4.14 All this implies a key role for entrepreneurship.
can have difficulty making regular payments to service
The OECD defined entrepreneurship as “the ability
to seize new business opportunities.” 34 New ideas are
the raw material of the knowledge driven economy. 4.19 In principle, equity finance is the most efficient
The ability to transform those ideas into a commodity way for SMEs to finance high-risk investments
of value, such as a piece of software, a brand or a because it allows investors to share more fully in the
patent, is a key determinant of success. This is not just rewards to a successful venture, and helps firms avoid
true of the single owner-manager dictating the course the cashflow problems associated with debt finance.
of the firm. Success in the knowledge driven economy Informal venture capital (“business angel”) investment
requires entrepreneurship from everybody in a position and specialist “seed capital” firms can be an important
to innovate: in large and small firms, and in the private, source of relatively small amounts of capital. The
public and voluntary sectors. development of improved networks between firms and
these finance providers is essential if adequate funds
Capital markets are to be provided to finance R&D at the start-up and
4.15 An enterprising economy needs flexible sources early stages.
of finance. The emergence of the knowledge driven
economy requires new approaches to investment and 4.20 As firms grow, larger amounts of equity capital
increases the costs of capital market imperfections. can be provided through formal venture capitalists.
For example, if firms find it difficult to raise external Venture capitalists typically invest (and often help
capital, diversified companies who are already earning manage) the firm until an eventual stock market listing.
profits and are able to re-invest their earnings will be The listing enables the company to raise larger
able to build brands and improve quality earlier and at amounts of finance and the venture capitalist to exit
lower cost, giving them a significant advantage. and re-invest in other unquoted companies. However
US venture capital provision is more established, with
4.16 Two features of the knowledge driven economy a better supporting infrastructure and expertise than in
are of particular relevance for capital markets - the the UK. An independent report commissioned by HM
increased pace of innovation and associated need 36
Treasury concluded that it is harder to raise venture
for different forms of finance for enterprise; and the capital in the UK than the US.
importance of intangible assets, including R&D.
33 Shapiro and Varian (1998).
34 OECD (1998b).
35 Bank of England (1996); Piper and Lund (1997).
36 HM Treasury (1998a).
A higher proportion of venture capital in the US goes which for more and more companies is a major source
to high-tech companies. of competitive advantage. When staff leave the firm,
they take their knowledge with them. The firm then has
4.21 The option of an exit route through a stock no claim on that knowledge, except to the extent that
exchange listing is very important for venture it has become embodied in the organisation through
capitalists and ambitious entrepreneurs. So is the reports, systems and procedures. While the market
capacity to raise money after listing. For these may have some idea of the expected future income
reasons, an effective stock market and liquid from - and therefore the value of - a brand or patent, it
secondary markets are important. Stock markets will is much more difficult to place a value on trained staff.
also have to consider whether their rules strike the
right balance between providing necessary investor 4.25 At the root of these problems over sources of
protection on the one hand and not constraining the finance and the value of intangible assets are different
opportunities for more sophisticated investors on the types of information failure. The Government is
other. There may be scope for allowing certain working with the City and industry to find ways of
investors to take greater responsibility for assessing addressing gaps in finance provision and to improve
risk in clearly defined circumstances. methods of valuing intangible assets and communications
between companies and their shareholders. The
Intangibles Accounting Standards Board has been asked to look
4.22 A central feature of the knowledge driven again at the issue of intangible assets, while corporate
economy is the increasing importance of intangible governance issues are being considered further in
assets, such as human capital, R&D, brands, contacts the Government’s review of company law.
and know-how, as a source of added value and
profitability for companies. The prominence of People and skills
intangible assets makes information problems more 4.26 Success in the knowledge driven economy
acute since they are less amenable to observation and requires a skilled and motivated workforce and
measurement by analysts and potential investors. management. The effects of the knowledge driven
Often, only the firm itself can make a reliable economy are already clearly visible in the labour
judgement as to the knowledge and expertise market. Workers everywhere are more highly
embodied in the enterprise. educated. Advances in technology enable firms to
produce the same amount with fewer unskilled employees,
4.23 The importance of intangibles can be seen by a
while at the same time increasing the demand for
measure of the ratio of the market value of a company
skilled labour to operate the equipment.38 Shifts
to its book value - Tobin’s q. The book value tends only
in demand caused by rising incomes and changing
to cover physical assets. Just as expectations of future
tastes also affect the composition of labour demand,
profits (over and above the normal rate) increase q, so
for example the growth of employment in professional
intangible assets also increase the ratio because they
occupations, many of them classic knowledge workers.
increase the value of the company without appearing
on the books. For the UK in 1996, q was 1.3 for the 4.27 The evidence suggests that globalisation has
stock market as a whole, while for a knowledge-based also affected the labour market by leading to some
stock such as Zeneca it was 6. In the US the average relative decline in the demand for unskilled labour
was 1.5 while for Microsoft, q was 15. In addition the within more technologically advanced countries,
value of q has tended to increase over time.37 although the effects of globalisation are modest
compared to other forces at work.39
4.24 The immediate problem for the capital market is
improving information flows by reporting on intangible
assets. How can the market place a value on these
37 Whittaker (1998). Since q is a ratio of market value to book value, it will
assets? Even though few investors use historic cost to also be influenced by broader macroeconomic and stock market trends,
in addition to the presence of intangible assets.
value physical assets, this option is not even available 38 Berman, Bound and Machin (1997). Machin, Ryan and Van Reenan
(1996) find that during the 1980s, over 80 per cent of the increase in the
when valuing intangible assets. Measurement of their proportion of the wage bill accruing to more skilled workers can be
attributed to technical change (R&D) in Sweden, but only 27 per cent and
value and the rate at which they depreciate is therefore 19 per cent in the US and UK respectively.
39 Slaughter and Swagel (1997), survey the literature on the impact of
much more difficult. Valuation is especially problematic increased trade and capital mobility on wages. They conclude that despite
for the human capital embodied in the workforce, widely differing methodologies the consensus is that increased trade
accounts for about 10-20 per cent of changes in wages and income
distribution in advanced economies.
4.28 While these changes have not been at the 4.31 More rapid and skill-biased technological change
expense of a declining overall employment rate, the has contributed to a shift in the demand for labour
impact on employment can be seen in the changing away from those without skills - a trend which is
skill mix. The share of services employment in the shared with most of the developed world.43 These skills
economy is increasing and within the services sector, mismatches should diminish if people and firms are
the largest increases in employment have been in able to invest in training, if labour markets are flexible
finance, insurance, real estate and business services and if workers are mobile across regions and occupations.
- sectors that are all relatively knowledge intensive.
This is true of other OECD countries including the US 4.32 More rapid innovation and shorter product
and Japan, although the difference between sectors is lives affect firms’ incentives to provide specific training.
less pronounced. On the one hand, the need to innovate gives firms a
greater incentive to train their staff. On the other hand,
4.29 Splitting employment by type of worker, the skills become obsolete more quickly thus reducing the
most pronounced growth has been in high-skilled pay-off to training in specific skills. The need for
white-collar employment within UK services. general skills will grow but the risk to the firm is that the
Within manufacturing, growth in employment has workers it trains take their new skills elsewhere. In
only occurred in white-collar high skilled workers. response, firms may look for a better-educated
Employment actually fell for other groups. There is also workforce to reduce the costs of training or try to pass
evidence within industries of large-scale substitutions on more of the costs of training to employees (e.g.
away from unskilled labour, particularly in relatively through greater use of sub-contractors or paying lower
high-tech industries. wages during training). Even if this happens, it still
seems likely that there will be some tendency for firms
4.30 Changes in the relative demand and supply of to under-invest in training because of their inability to
skilled and unskilled workers have contributed to a capture its full value.
pronounced shift in the relative earnings of the two
groups. Wage inequality has grown in the UK and 4.33 The need for the right basic education - a key
other industrialised economies since the 1970s. responsibility of government - is growing. Workers need
Between 1978 and 1996, real hourly wages in the to have good basic knowledge and core competencies
New Earnings Survey rose by only 20 per cent for the so that they can be retrained and acquire new knowledge
lowest 10 per cent of earners compared to a 38 per quickly. This should lead to an increase in the return
cent increase at the median and a 66 per cent to education and requires a greater emphasis on
increase near the top of the earnings distribution.42 the importance of a good educational foundation and
Since 1979, there has been a steady increase in the life-long learning.44
wages of non-manual relative to manual employees,
which can be taken as a rough indicator of the 4.34 As the pace of change quickens, new
differential between the skilled and unskilled opportunities and challenges will appear in the labour
(Chart 4.5). Wage dispersion has also increased within market. Flexibility will be increasingly important, both
skill groups, suggesting that factors other for firms wishing to recruit and retain key workers, and
than the supply and demand for skills may have for individuals wishing to equip themselves for
played a role. tomorrow’s labour market. The UK labour market -
with its long tradition of voluntarism and lack of over-
Chart 4.5: Ratio of non-manual to manual gross earnings
prescriptive legislation - is well placed to take
advantage of these opportunities, while at the same
1.5 time ensuring decent minimum standards. One example
1.4 of a form of work which fits these principles is teleworking:
1.3 technology means this is a realistic option for more
employees; firms can find this a useful way of retaining
40 OECD (1998a).
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 41 Berman, Bound and Machin (1997); Machin, Ryan, and Van Reenan
Note: There is a discontinuity in the definitions of
manual and non manual labour after 1990 Source: ONS 42 Low Pay Commission (1998).
43 HM Treasury (1997); Manacorda and Manning (1998).
44 Manacorda and Manning (1998) find evidence that the proportion of the
variance in observed wages that can be explained by education seems to
be rising (although modestly) over time.
valued staff; equally, it can suit very well those who
wish to combine paid work with other responsibilities.
4.35 Retaining skilled and experienced workers, and
making the most of all employees, are concerns
common to every firm. They are, however, especially
critical issues for companies in heavily knowledge and
skill-intensive industries. Modern employee relations
practices, built on a spirit of partnership in the
workplace, are an essential ingredient. Greater financial
participation - through employee share ownership or
stock options - is already a tool widely applied in some
knowledge driven industries (e.g. computing), and is
likely to become more widespread. This agenda will
require action by government, business, and
employees and their representatives.45
4.36 The long-term policy implication of the growing
importance of skills and knowledge is a need to increase
the basic skill level of the workforce. But this will
take time and is likely to result in problems of social
exclusion for the unskilled. Government has an
important role in minimising these problems.
45 The Pre-Budget Report (HM Treasury 1998c) announced a consultation
on employee share schemes and targeted incentives for managers in
smaller, dynamic enterprises.
c h a p t e r f i v e
5.1 The knowledge driven economy both facilitates 5.4 A whole literature on “knowledge management”
and requires greater collaboration at many different has developed that describes the management
levels. The previous chapter discussed developing practices, tools and models used to acquire, share
links between firms, the science and engineering base and use the knowledge capital within organisations.
and education institutions. The next will pick up the Key themes are the need for the contribution of every
need for transparency and confidence in the regulatory employee within an organisation to be assessed by the
environment. Here we focus on how the development value added their knowledge and creativity can bring.
of a knowledge driven economy is changing the way This militates against traditional hierarchies. Command
firms organise themselves, promoting new and control styles of management are often argued to
partnerships between employers and employees and be insufficiently flexible to deliver the required pace of
encouraging collaboration between firms in networks innovation. Flatter hierarchies may be more effective.
and clusters. The last of these is particularly important Meanwhile, managers need to develop systems
at a regional and local level. (e.g. by the use of intranets) to harness the knowledge
within the organisation and encourage a culture of
5.2 Two basic processes are at work that require knowledge sharing.
greater collaboration within and between firms:
5.5 There is considerable diversity in the actual
• The value of the firm increasingly resides in the practice of knowledge management across sectors.
knowledge of individuals, be they its staff, managers
or even suppliers, but once that knowledge is Organisations such as Unilever have implemented
codified, it can be spread easily and cheaply. Tacit knowledge management models which facilitate the
knowledge is the source of a firm’s competitive edge sharing of information and improve internal
but it is much more difficult to monitor than machines communications. Others have placed more emphasis
or manual labour. Managers therefore have to pay on education and training to stimulate and sustain the
greater attention to ensuring that the right incentives knowledge base in the organisation. Within financial
are set and relationships established to ensure this organisations, the focus is likely to be on quantifying
knowledge is used effectively and developed. and recognising the value of the knowledge base,
Meanwhile, for that part of the firm’s business that whilst firms with a strong science and R&D base may
can be easily codified, contracting out and other look more towards exploiting the commercial value of
forms of business organisation are facilitated. their existing knowledge base (see following box).
• Competition is intensifying, but also changing in 5.6 However, managing the firm’s knowledge assets
nature, as the next chapter describes. Increasingly,
effectively is not just about getting the processes and
costs have to be sunk at the development stage.
systems right. It is about setting the right incentives.
To spread these costs (and benefit from economies
With tacit knowledge so important to firms, but so
of scale and scope in dealing with increasingly
difficult to monitor, firms have to ensure that managers,
complex technologies) firms are finding it necessary
workers and suppliers want to do a good job.
to work together.
Employee share ownership schemes or equity-based
management recruitment incentives are tools that have
Partnership within the firm been used successfully by many companies. High-
5.3 Managers increasingly recognise that success in tech companies in the US are the most widely cited
the market place requires the effective use of all the
46 The importance of “customer capital” is seen most vividly in the
knowledge available to an organisation. This is not just financial services sector where the high street supermarkets are now
challenging the traditional banks by providing a dual function as food
about sophisticated research and development. retailer and source of financial services. This is based upon the customer
knowledge gained from loyalty cards which can be exploited to develop
Important knowledge may reside as much in the financial products to meet more precisely customer needs.
47 Knowledge capital is defined broadly as “the sum of everything that
deliveryman who takes the product to the customer as everybody in a company knows that gives it a competitive edge”.
See Stewart (1997). This is also the definition used by Warwick
it does in the highest paid scientist in the organisation. Business School.
48 David Teece, in his lecture on The Knowledge Economy and Intellectual
Knowledge of customers’ preferences, or of the Capital Management in May 1998, saw wider implications of knowledge
management for the nature of the firm. He believes competitive advantage
delivery habits of the competition, are also potential increasingly requires “dynamic capabilities” - the ability to sense,
46 understand and seize new opportunities and to reconfigure and
sources of competitive advantage. re-organise to achieve sustainable competitive advantage.
particularly where these depend on the knowledge that
The Skandia Navigator is codifiable. Contracting out has been encouraged
The “Navigator” developed by Swedish firm where the ease of communication facilitates the
Skandia is perhaps the best known business model monitoring and negotiation of contracts, or reduces
developed to identify the intangible assets that are the costs of choosing between suppliers. Over recent
key to company performance. Skandia has for a years, contracting out by manufacturing has become
number of years issued as a supplement to its more common, contributing to the development of
Annual Reports an account of the development of new forms of collaboration through supply chains.
the company’s human and intellectual capital. At the extreme, contracting out may lead to the
The distinguishing feature of Skandia’s work is its emergence of “virtual companies” with most of the
definition of the intellectual capital as not just the traditional functions, including manufacturing, hived off.
skills and expertise of its workforce, but also the
systems and processes that it has put in place to 5.9 However, contracting out of activities is not
capture and exploit all the knowledge it can. without its costs. The question of what the firm should
Skandia encourages its employees to exchange
do itself and what it should contract out is the subject
information and has set up IT systems to help
of a large and diverse economics and management
them do so. The Navigator is the tool Skandia uses 51
literature. Some characteristics of the knowledge
to identify the important areas of know-how in the
driven economy can militate against contracting
organisation which need to be developed and
out. The difficulties in monitoring tacit knowledge
shared. By identifying important assets like its
customer and innovation capital more
may mean that those activities dependent on tacit
systematically, Skandia says the Navigator has knowledge need to be kept within the firm. This
improved its management of these assets, suggests that changes in firm organisation may be
benefited overall performance and increased its more incremental and gradual, responding to
share value. Skandia says that its ability to identify changes in the relative costs and benefits of doing
and draw upon the relevant know-how easily has things in house.
enabled it to set up foreign offices much more
quickly than in the past. The model has now been 5.10 Developments in ICT have also affected the
applied by the Swedish Government and also physical location of production. They influence the
developed by other companies. relative costs and benefits of supplying markets, either
locally or at a distance, in different ways. On the one
hand, ICT facilitates production from one central office
examples, although these types of schemes have by reducing the cost of advertising and search on the
been used effectively elsewhere - from management part of consumers, and by reducing transportation
consultants to advertising agencies. costs. On the other hand, such developments can
strengthen head office control over its subsidiaries and
5.7 Other firms have reaped the benefits in terms of thus facilitate geographical dispersion where there are
loyalty and commitment that a favourable working clear advantages from proximity to the market. These
environment can bring. Modern employee relations arguments apply to firms operating within a country
practices are an important part of this. Employee and to multinationals.
satisfaction, for example, is greatest where workers
feel adequately consulted about changes that affect 5.11 An alternative to the firm itself serving a
their workplace. The National Minimum Wage, the particular market, whether at home or abroad, is
Working Time Regulations, and the legislation licensing. However, for a knowledge-based company,
foreshadowed in the Fairness at Work White Paper licensing carries the dual risk that potential competitors
(Cm 3968) are all means by which the Government is gain access to technical secrets and that product
promoting fairness and partnership in the workplace. quality may not be maintained (because the licensee
has the incentive to free-ride on a firm’s reputation
New forms of business organisation for quality, cut costs and earn excessive profits).
5.8 The development of the knowledge driven 49 For an early theoretical explanation of these benefits, see Akerlof (1982).
50 Cully et al (1998).
economy has also been associated with changes in 51 For instance, Coase (1937) and Williamson (1975) explained that
managers do not contract out everything they need doing, but organise in
the organisation of firms. ICT has given companies the firms instead, to minimise the costs of negotiating, re-negotiating and
monitoring contracts. Hart (1995) extended this analysis. The knowledge
scope to contract our more of their activities, driven economy affects transactions and monitoring costs in a number of
ways, as discussed in the text.
Where companies’ competitive advantage depends on support services. The concentration of firms in a
distinctive knowledge assets, they may therefore be less cluster allows an infrastructure of professional, legal,
inclined to license and more likely to invest themselves.52 financial and other specialist support services to
develop, along with a workforce whose skills are
Collaboration within a region and particularly suited to their needs.
between firms: clusters and networks
5.16 Other authors have emphasised the importance
5.12 Sometimes firms are finding that they can better
of other external benefits within a cluster.58 Knowledge
utilise their knowledge capital, and increase the
“spillovers” are an example. Empirical research has
expertise available to them, if they locate amongst a
shown that there is a positive link between such
cluster of other firms.53 Social interaction and other
spillovers and the proximity of innovative activity.59
informal links are much of the story behind the
It may seem paradoxical that, with the advances in
success of some clusters (e.g. Silicon Valley, City of
ICT, co-location should still be seen as important.
London, Italian shoe industry). While co-location
Advances in ICT speed the flow of information but the
facilitates formal and informal links, it is not essential
assimilation of tacit knowledge and innovation requires
for the creation of a network, used by some firms
the kind of repeated contact and collaboration that is
to draw in the expertise of other firms.54 Inter-firm
easier when firms are co-located. As has been said,
co-operation of various types - for example through
“Intellectual breakthroughs.... cross hallways and
supply chains, mentoring, or best practice fora - is
streets more easily than oceans and continents”.60
often seen as an effective way of increasing the
However, to be successful, clusters must remain
knowledge available to firms and the effectiveness of
5.13 Economists have emphasised the benefits of
The Swedish communications giant Ericsson
clustering for almost as long as groups of inter-related
recently opened a new unit in the multimedia and
firms have been a feature of the economic landscape.55
Internet-content cluster in lower Manhattan known
When transport costs were high, and physical inputs
as Silicon Alley. According to Donna Campbell,
were the major component of costs, firms located
director of Ericsson’s Cyberlab: “The reason for us
around areas of natural resources or around centres of being in Silicon Alley is that we are tapping into the
population. Such factors still matter but firms are now entrepreneurship and the energy of companies
more likely to locate near each other to tap into pools that are working here... One of the main reasons
of expertise or local infrastructure. [ for being in Silicon Alley] is to learn and emulate
some of the biggest advances that are coming
5.14 Porter argues that clusters can be an important from small entrepreneurs. And that’s a reason for
source of durable competitive advantage.56 Firms in physically being here--you have to be part of the
clusters can gain economies of scope - for example community”. Other high-tech companies such as
drawing upon companies with complementary skills to Sun Microsystems Inc., Nokia and Data General
bid for large pieces of work which each of the Carp, are also among the new arrivals.
individual firms would have been unable to complete. Source: Abramson (1998).61
Collaboration can also allow firms to take advantage
of economies of scale, by further specialising
production within each firm, by the joint purchasing of
common raw materials to attract bulk discounts, or by 52 Barrell and Pain (1997a).
53 ”Clusters” are defined here as a concentration of competing, collaborating
joint marketing. and interdependent companies and institutions which are connected by a
system of market and non-market links.
54 ”Networks” is the term used here to describe collaborative arrangements
5.15 Some authors have emphasised the importance between individuals, firms and other institutions, through which innovation
and best practice are disseminated. Networks need not involve co-
of linkages within the cluster - these can be because a location, though they often will.
55 Adam Smith noted how inter-relatedness of trade brings businessmen
firm buys final goods in the location or because it together; “artificers, too, stand occasionally in need of the assistance of
one another... they naturally settled in the neighbourhood of one another”.
supplies intermediate goods to other firms there.57 Smith (1776). See also Marshall (1890); Myrdal (1957); Krugman (1998).
56 Porter (1998a and 1998b).
Reputations spread quickly within the cluster, helping 57 Krugman (1998).
58 Venables (1998).
finance providers to judge who the good entrepreneurs 59 Jaffe (1989).
60 Glaeser et al (1992).
are, and business people to find who provides good 61 Article by Gary Abramson on “Cluster Power”. Can be found at
Networks puts the private rates of return at the firm level at
5.17 Clusters facilitate other forms of collaboration or between 20 and 30 per cent, with the social return
networking between firms. In part, this is because (private return plus spillovers) reaching 50 per cent.
co-location and repeated contact helps build up a
5.22 Joint research may enable firms to internalise
relationship of trust. Collaboration though networking
these knowledge spillovers. It may also allow firms to
is more common when firms are located near each
benefit from economies of scale and scope in research
other but it can also occur through networks of firms in
and early-stage development. However, while
different locations. Networking can be between firms in
collaboration with suppliers or customers, or with firms
a supply chains or between firms that are more loosely
in different sectors using the same generic
associated. Many of these networking arrangements
technologies, is becoming more common, joint
are ways of spreading best practice and the results of
research ventures are less frequent between direct
research and development.
competitors, particularly for near-market development.
5.18 Firms work together in networks for a variety of
5.23 Co-operation between competitors may be
reasons. Among them are:
undesirable because sharing information on R&D
• the reduction of uncertainty requires some discussion of market conditions and
• learning from others and absorbing best practice this may lead to price-fixing in downstream markets.
Alternatively, participants may come to the view that
• reducing transactions costs
their contribution benefits rivals, and seek to minimise
• raising the profile of the company in relations with
their input to the collaboration, or seek to slow down
R&D projects which threaten to reduce their profits.
• agreeing, recognising and improving standards.62 The incentive for firms to co-operate on R&D may also
be reduced in situations where innovation leads
5.19 Many groupings are fragile and the benefits
directly to individual market power. Indeed, the
are not always obvious in the early stages.63 But
prospect of market power for the first firm to make a
governments in many EU countries and in North
breakthrough may encourage vibrant competition at
America and the EU itself have seen the potential of
the product development stage.65
networking and many have sponsored programmes to
promote it. Experience suggests that, to be successful, 5.24 For these reasons, joint research ventures will
these programmes should build on existing informal not always get off the ground. Even with relatively high
links, be integrated into the business support structure rates of private return, the large gap between private
and be aimed at creating a level playing field. and social returns will remain, making it likely that
private markets will under-invest in R&D from the point
5.20 The potential for gains from the spread of best
of view of the economy as a whole. This is one of the
practice and mentoring are considerable. The White
reasons for government to play a role in encouraging
Paper cites the example of the Society of Motor
R&D and innovation.
Manufacturers and Traders (SMMT) Industry Forum,
which has doubled productivity amongst participating Promoting collaboration
vehicle manufacturers. Networks such as Business 5.25 From the foregoing discussion, it is clear that the
Bridge and Business Net, run with the help of exploitation of the opportunities of the knowledge
Business Links, have realised significant benefits for driven economy implies different forms of interaction
participating SMEs. between firms than we have seen in the past. An
upsurge in interest in collaboration between firms in
5.21 One particular type of firm collaboration is joint
networks, clusters, supply chains and joint ventures
research. Why should firms collaborate in this way ?
can already be observed.
The economics literature suggests that R&D produces
externalities or spillovers whose benefits go beyond 5.26 Collaboration is not always the way forward. It
the investing firm and that firms experience difficulties may lead to anti-competitive practices, something
in appropriating the full returns to R&D. The empirical which the competition authorities will need to assess
literature, mainly from the US, shows that the return to
62 Gibb (1998).
society as a whole exceeds the private rate of return to 63 Huggins (1998), quoted in Financial Times, 25 November 1998.
64 Nadiri (1993).
R&D by a considerable margin.64 A central estimate 65 Article by Paul Krugman entitled ‘Soft Microeconomics’. can be found at
when considering the net effect of collaboration on
R&D. Experience also suggests that government must
work with the grain of the market and be cautious
about trying to create clusters or networks from
scratch.66 But there is also reason to believe that firms
may find it difficult to come to these arrangements of
their own accord, suggesting that there may be a role
for government in brokering greater collaboration
between firms or between firms and universities. By its
nature, much of this will need to be done at the
regional or local level. In addition, the Government is
reviewing how the planning system can best help
promote the needs of clusters.
Benefits of collaboration
“Many companies fail to recognise the benefits of
collaboration. They are either unaware of firms
with complementary skills, or are unwilling to
collaborate with their competitors. A key role in
facilitating the growth of a cluster is to encourage
firms to take advantage of collaboration, and to
demonstrate that by working together their
performance will improve.”
Philip Ellin, Senior Product Innovation Officer of
Medilink, which operates a network in the medical
66 Personal communication from Professor Aoki of the University of Stanford
c h a p t e r s i x
6.1 Competition is both a spur to the knowledge 6.3 Although there is no room for complacency,
driven economy and a force for productivity overall the UK is seen as one of the most open
improvement in general. Companies are more mobile and competitive countries in the OECD.67 Measuring
internationally. Product cycles and product lives have competitive pressures in terms of openness to
been shortened. Improved information technology has trade, the UK compares well. Larger countries
given consumers and firms wider access to tend to trade less as a proportion of output. The UK
information (reducing search costs), markets are less is relatively open even when size is taken into account
protected, and firms are able to overcome entry (Chart 6.1). There is considerable evidence that
barriers more quickly because products and industries open to foreign competition perform
information are delivered faster. Meanwhile, more strongly.68
developments in science and technology have
increased the rate of technical advance. 6.4 Competitive pressures are also enhanced by
inward and outward foreign investment. The UK is the
6.2 The degree of competition of an economy main location in Europe for inward investment and the
depends on a whole range of factors determining how third largest recipient of inward investment in the world
firms interact. Across the economy, competitive after US and China. There is some evidence that
pressures depend on openness to foreign trade and inward investment boosts productivity.69 We are also
investment, on the domestic regulatory environment,
the extent to which markets are liberalised and the 67 OECD (1996a).
68 Proudman and Redding (1998); DTI (1998a).
degree of protection against monopoly power. 69 Proudman and Redding (1998); Oulton (1998); Barrel and Pain (1997b).
Chart 6.1: Relationship between openness and GDP for OECD countries in 1996
1 10 100 1000 10000
GDP (US $ billion)
Note: Openness is defined as imports plus exports as
a percentage of GDP. GDP is measured on a log scale Source: DTI calculation using OECD data
the second largest outward investor (Chart 6.2).
Chart 6.2: Share of inward and outward direct investment in the
OECD total in 1996 In book retailing, the largest bookseller in the
(Per cent) world, Barnes and Noble, found with the arrival of
Amazon.com on the internet that their huge
Inward Outward physical presence was a competitive disadvantage
by comparison to the newcomer. It was forced to
respond by setting up its own electronic sales
15 operation and by upgrading its bookstores.
UK Germany France Italy US Japan
6.7 Newer firms (mainly SMEs) can have a
Source: OECD tremendous advantage in comparison to larger
organisations. Not only do they have the speed of
Competition and the changing communication and learning but also they do not
market place bear the heavy cost of maintaining physical assets.
6.5 Companies in the knowledge driven economy They can exploit the latest technology and build their
often have the potential to be highly mobile. Those systems around that technology. And often the
commodity based industries which mass-produce traditional barriers to small firms competing with larger
relatively unsophisticated products will tend to be ones are being removed. For instance, ICT allows
mobile locating where they can find the necessary small firms to access international markets without the
basic skills, low labour costs and a favourable tax and need for a global marketing network.
regulatory system. Other companies need access to
location-specific factors - knowledge or resources - 6.8 However, wider market access can increase the
and these companies tend to cluster. The location of incentives for other types of entry barriers, like sunk
these companies depends on the continued availability costs in advertising expenditure, which small firms may
and relevance of the core skills and assets which make have problems overcoming.71 But advertising can also
that a desirable location to do business in. Between be pro-competitive, as it can help consumers
countries at the same level of economic development differentiate new products from old ones. Indeed,
and with similar innovative capacities, it is likely that advertising and brand names may be considered as
firms’ decision to locate will increasingly depend on information or knowledge products themselves. In
factors such as the tax and regulatory system, response to the challenge of cheaper products from
macroeconomic stability, infrastructure, the education abroad and the opportunity afforded by rising incomes,
system, and non-economic factors such as crime firms in industries as diverse as clothing, cars and
levels, climate and culture.70 beverages, are increasing the knowledge component
of their products through branding and advertising.
6.6 But the changes in competitive pressure also
affect companies in their domestic market. Traditional Competition and protection
organisational structures are being challenged. For of innovation
example, some companies in the financial services
6.9 Some of the developments associated with the
industry are already finding that their presence in every
knowledge driven economy imply changes - in the
high street is becoming a disadvantage when they can
nature of markets, the internal organisation of firms
be undercut by a small organisation with the potential,
and their relations with other firms - that pose
through the internet, to be in millions of homes without
questions for the competition authorities. These go
the cost of maintaining an expensive branch network.
beyond the greater information problems faced by
In order to compete with the newcomers, they need to
regulators in a world where output is driven by
find ways to make their network generate value for
knowledge, and the regulated body increasingly has
them (e.g. by offering more personalised services, or
more information than the regulator.
selling other products). Similar developments are
taking place in the retail, travel, recruitment and
69 Abramovitz (1986).
71 Sutton (1991).
6.10 One of the issues raised is the prevalence of emerged, new forms of IPRs have been developed to
increasing returns to scale in the production of goods protect them.72
and services with a large knowledge component.
Production in the knowledge driven economy is often 6.14 The challenge for the authorities is to set the
costly to produce but cheap to reproduce. The first right balance between encouraging innovation through
tape of a Hollywood film costs a great deal more to patent protection, and allowing consumers free access
produce than the second. Likewise, a new drug may to new goods and services at the lowest possible
cost millions of pounds to develop but only a few prices. The choice for the authorities is particularly
pence per unit to produce. Software, music or difficult when network effects are present (see box).
television programmes can be sent down a phone line With the development of the knowledge driven
at minimal cost. And once a piece of programming or economy, it becomes more important to get this
music is known, one person using or playing it does balance right.
not prevent somebody else doing the same.
6.11 The ease of reproduction and distribution of Network effects
these products can have great benefits to consumers. One important consequence of the features
However, they would not be produced in perfectly of competition in the knowledge driven
competitive markets since such markets would push economy is the potential for network effects
price close to marginal cost (the cost of creating an to result in “winner takes all” scenarios.
additional unit), which in these cases would be close to Network effects arise where the benefits to a
zero. If this happened it would leave no margin to customer of using a particular product
increases with the number of other people
recover the huge fixed costs or to obtain a return from
who are using it. VHS and Betamax videos
innovating. Information goods are typically highly
are a good example. Although Betamax was
differentiated and the market structure they are traded
regarded as technologically superior, the
in is one of monopolistic competition or temporary
initial popularity of VHS machines led film
monopoly. Firms compete vigorously, but the efficient
suppliers to publish more films in VHS
price will still be above marginal cost. format. In turn, this encouraged further take-
up of the VHS standard.
6.12 Global competition for many products has
made their potential market much larger. The larger the Some authors have claimed that where
market, the less margin is needed to cover fixed costs. knowledge and information are important,
there is a tendency for big networks to grow
In some cases, firms may be able to capture a large
bigger whilst smaller networks shrink.73
enough market before their product is imitated to
Where network effects are important, this will
cover their fixed costs. In other cases, some protection
affect firm behaviour by encouraging patent
may be needed to encourage for example the
races in the development process in order to
development of new drugs or the production of new
gain first mover advantages in production.
films. Governments therefore afford protection by
granting intellectual property rights (IPRs) to firms to
allow them to recoup their investments in knowledge-
based products. 6.15 The protection IPRs afford allow innovators to
trade information in competitive markets through
6.13 The perennial problem facing the IPR and licensing use of these IPRs. This market power also
competition authorities, intensified by the knowledge allows producers to recover fixed costs through more
driven economy, is for how long and over how wide a creative pricing and marketing arrangements. Price
product range protection by IPRs or market devices discrimination for information goods and services is
should be granted or tolerated. The need for drug common: different groups of consumers pay different
manufacturers to be allowed to patent their products prices, and quality discrimination is commonplace.
and for film-makers, authors and musicians to enjoy
72 Shapiro and Varian (1998).
copyright protection has long been recognised. IPRs in 73 Shapiro and Varian (1998); Blundell, Griffiths and Van Reenen (1997),
effect give these producers an element of temporary suggests that this effect may not simply apply to the information society.
They show that, due to imperfect capital markets, the innovations of high
monopoly to permit them to earn profits to cover their market share firms receive a greater value on the stock exchange hence
“all industries will have a tendency towards persistent dominance by
costs. And as new products and processes have leading firms rather than action-reaction between followers and leaders.”
Sherwin Rosen has used similar arguments to explain why income
distribution across opera singers differs from that across shoemakers.
Publishers first issue a book in hardback and only later which cannot easily be imitated, in company
in paperback. Films are released first in cinemas, then architectures, links with major customers and
on video and television. In each of these examples, the databases of potential customers, in advertising, brand
sellers use delay to “segment” the market by willingness names or reputations. All these steps increase the
to pay. Other techniques to segment the market or hurdles facing firms who would otherwise easily copy
tailor the product to new groups of consumers can be or reproduce their new products more cheaply.
used as well. Vertical restraints such as selective The complementary investment may itself have IPR
distribution of a film may also be used as part of a protection; this is often the case for brand names.
marketing campaign or to establish a brand image.
6.20 Nevertheless, all forms of effective protection for
6.16 But some innovators may not be able to take innovation, whether through IPRs or market reactions,
advantage of IPRs. Some inventions do not meet the give innovators at least temporary market power. This
criteria for being granted an IPR. For example, a new may be beneficial where the resulting high market
type of corkscrew was too obvious a new step to shares or profits are the reward for innovation, or even
those ‘versed in the art’ for it to be granted a patent where long lasting high market shares or profits are the
(although lesser forms of IPR were available and used). reward for continual innovation which keeps the leader
Others may not be able to take advantage because ahead of the pack. On the other hand too much
IPRs relevant to their innovation are not yet available. protection may unduly restrict the spread of knowledge,
inhibiting further innovation, restricting choice and
For example, software for business methods is
increasing prices to consumers.
arguably patentable in the US but not yet in Europe.
Yet others may not be able to take advantage of IPRs 6.21 The competition authorities need to be extremely
which have been granted to them because their vigilant to guard against lasting anti-competitive
products are too easily pirated. For example, artists’ practices. The Government has already taken steps in
recorded performances may now be easily this direction by introducing tough new laws to stamp
downloaded on to the Internet, making it difficult to these practices out. But the authorities also need to be
recoup legitimate fees. forward-looking, alert to changes in technology and
markets, and well focused on the key issues, without
6.17 Alternatively, some companies may not be
creating a bureaucratic burden for innocent commercial
willing to apply for IPRs because the cost of being
parties. In practice, it is difficult to generalise and a case
granted an IPR is that the innovation must be
by case approach to these issues may be required,
disclosed. Where a firm’s competitive advantage
leaving some discretion for the competition authorities.
resides in the ingenuity of a product that can be easily
codified and imitated, such disclosure may give too 6.22 However, discretion may allow uncertainty to
much of an advantage to the next round of innovators. creep into the market, raising the cost of capital and
So these innovators may prefer to keep “trade hence prices to final consumers. This uncertainty could
secrets”, an example being the Coca Cola recipe. Tacit be reduced if the authorities announced what their
knowledge is more difficult to copy, but also more general policy towards innovation was. Such a general
difficult to patent. policy could be described for example as: optimistic,
i.e. tolerant of high market shares or profits as rewards
6.18 In some of these cases, remedies may become to innovation where they were not protected by long-
available by the authorities extending the range of lasting barriers to entry; pessimistic, i.e. wary that
available IPRs, such as for business method software innovation might create more entry barriers than it
in the UK; or by increasing the penalties for piracy or withered or believing that innovation stemmed best
by third parties, such as Internet providers accepting from firms with small market shares; or even just
or having placed upon them obligations which would pragmatic, i.e. wary of any generalisation. It may
reduce the risk of piracy. But in general new however be difficult to reduce uncertainty by such
regulations will lag behind market developments. policy statements since in practice cases may vary
considerably from each other.
6.19 Meanwhile, innovators may seek some other
74 Shapiro and Varian (1998).
form of protection which will complement or bypass 75 Company architectures are what John Kay, in Foundations of Corporate
Success (1993), called combinations of internal organisation, incentives
outdated rules. They may seek to protect their and information which are hard to replicate. They may be the best way to
keep ‘trade secrets’. Complementary assets might include ready access
intellectual property through investment in to major customers who are willing to buy novel products. Such access
may be based upon the innovator’s reputation which itself could have
complementary assets, for example in tacit knowledge similar effects to a brand name.
c h a p t e r s e v e n
7.1 The analysis in this document explains why • In order to remain competitive firms need to be more
knowledge should be seen as the driver of prosperity, flexible and more innovative, managing their
both now and in the future. It examines how the knowledge assets more effectively to derive new
development of the knowledge driven economy is sources of competitive advantage.
profoundly affecting the goods and services produced • Businesses which depend on few physical assets
and the way firms behave, how they are organised and but are strongly reliant on the skills of their staff are
their relations with their employees and with other firms. becoming more mobile and less attached to their
The analysis supports the new focus on knowledge country of origin.
and the policy proposals found in Our Competitive
• Firms may have to collaborate and network more,
Future: Building the Knowledge Driven Economy.
particularly on new technologies, and strengthen
their links to the science and engineering base,
7.2 An underlying theme is the rapid pace of
sharing equipment and often people.
change. Developments in science and technology and
ICT offer huge potential for creating new products,
7.5 For policymakers, the pace of change poses
processes and services and thus for increasing
new challenges too. Governments must be sensitive to
productivity. Innovation is speeding up. Goods can be
the changing needs of business in order to understand
distributed more quickly and cheaply around the world.
how policy can go with the grain of the market and be
Information products such as recorded music, film, TV
most effective. The approach must not be one of
programs and computer software can be distributed at
heavy-handed intervention, nor can the development
minimal marginal cost. Managers have to think of ever
of the knowledge driven economy be left entirely to the
more ingenious ways of creating and exploiting
market. There is a clear role for government in
knowledge assets to secure competitive advantage,
addressing market failures to promote science and
improve productivity and stay ahead of the
technology, foster enterprise and innovation, develop
competition. They have to understand and interpret
education and skills, facilitate collaboration and
more information, develop more complex products
promote modern competitive markets. Specific policy
and processes, and operate in more markets.
initiatives are set out in the White Paper.
7.3 The challenge for the UK is to make the most of
7.6 Many of the features of the knowledge driven
the opportunities that the development of the
economy have only recently risen to prominence in the
knowledge driven economy presents. In a world of
economics and business literature. Further research is
global competition, a country like the UK cannot
required in many areas, for example in the valuation of
compete on cost alone but must concentrate on high
intangible assets, the benefits of clusters and
value-added goods and services and the component
networks, the role of IPR and competition policy in
of production that cannot easily be transferred -
promoting innovation and the implications of the
namely, the skills of the workforce and the tacit
growing importance of industries producing
knowledge possessed by employees and embedded
information and knowledge goods.
in corporate systems and culture.
7.7 This paper has also reviewed how the UK is
7.4 In many ways, the increasing dependence on
performing. We have strengths in some sectors and
knowledge has implications for the nature of the firm
are well placed in some respects to exploit the
and for business strategy. For example:
opportunities of the knowledge driven economy.
• It gives small firms new opportunities to access But in other areas we fall short.
international markets without the need for a global
marketing network. 7.8 Benchmarking our performance is important.
• It permits more contracting out of activities, The Government believes this is best done by drawing
particularly those based on codified knowledge,and on a range of experience and expertise, not least
creates possibilities for new forms of organisation because many of the activities that the analysis in this
such as “virtual” companies. paper shows are rising in importance are hard to
quantify reliably. For those that can be quantified, and
appear in the official statistics, measurement is often in
7.9 The White Paper includes a proposal to develop
a new set of competitiveness indicators to measure
the UK’s progress. The Secretary of State for Trade
and Industry is appointing a Competitiveness Council
to advise him on these indicators and other issues. A
new Cabinet Committee on Productivity and
Competitiveness will review the UK’s performance
against the indicators each year and decide what
further policies are required to keep the UK on track.
7.10 There are many possible approaches to
benchmarking. One possible structure, based loosely
on a model adopted in Massachusetts,76 would be to
include indicators of:
• the business environment - measures of
macroeconomic stability, progress on supply side
reforms and business perceptions of the UK
• resource indicators - measures of human and
physical capital, technology and R&D
• innovation process indicators - measures of
commercial exploitation of science and technology,
entrepreneurship, diffusion of knowledge across
borders and between firms
• results - GDP per head, productivity, employment,
incomes, and measures of sustainable
It will be for the Committee to decide on the approach
to be taken and the measures to be included. The
data and analysis in this paper will be made available
as background to the Committee and to the
We need to take up the challenge of the future. Only
business can deliver prosperity and jobs. Government
76 Index of the Massachusetts Innovation Economy, available at
http://www.mtpc.org/research/indica.htm must know when to act, and when to keep out of the
way. The Secretary of State has said that if business
needs to draw his attention to any actions in central
government that are holding back enterprise, it should
contact him by writing to:
The Rt Hon Peter Mandelson MP
Secretary of State for Trade and Industry
Department of Trade and Industry
1-19 Victoria Street
London SW1H 0ET
or by e-mail on: firstname.lastname@example.org
The text of this document and the White Paper are also
available on the Internet at www.dti.gov.uk/comp/competitive.
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