2.1 Chapter 1 identified four important structural changes which are transforming many parts of the economy and society:

• revolutionary changes in ICT
• more rapid scientific and technological advance
• competition becoming more global
• changes in tastes, lifestyle and leisure that go with increased incomes.

2.2 Apart from the revolution in ICT, most of these changes have been going on for some time. But their combined effect appears to be bringing us to the threshold of a radical change in many parts of the economy and society. The pace of change will differ 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 which adapt most readily and exploit the opportunities offered by the knowledge driven economy will enjoy rising incomes and prosperity while those which lag behind may face relative economic decline.

2.3 The four forces behind the increasing importance of knowledge in economic development are considered in detail below.

Information and communications technology (6)
2.4 The pace of change in ICT in recent years has been extraordinary. This has led to the emergence of a whole new range of products and services, from laptop computers and mobile phones to global positioning systems and satellite TV. Advances in ICT affect anyone using a computer or telephone, from a cornershop with computerised accounts to large retailers fine-tuning the distribution of their products 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 drawings, and the digitised plans are then fed directly into numerically controlled machines manufacturing the component parts.

2.5 As the infrastructure for electronic commerce is improved, the number of new products and services will increase still further. The infrastructure for the information highway - an integrated, high-capacity and interactive communications network - is being built up in most industrialised countries and is developing fast.

2.6 The telephone systems, high speed computing capacity, internet and digital broadcasting that underlie the information highway offer huge potential. The pace of development can be seen in the growth of Internet hosts(7) (Chart 2.1).

2.7 The information highway allows companies to transform the way they do business,creating and accessing new markets and changing the way they relate to their customers, suppliers and competitors. Customers can tap into a whole new range of information about products and alternative suppliers. Businesses can gain access to large amounts of commercial and technical information from around the world. The access to codified knowledge facilitates the spread of best practice and new ideas and increases the speed of innovation. All these developments increase the intensity of competition, call into question traditional sources of competitive advantage and carry implications for firm organisation.

Science and technology
2.8 Recent years have seen large increases in the resources devoted to basic scientific research and by businesses to R&D in OECD countries (Chart 2.2). ICT has also allowed researchers to make much more rapid and extensive searches of published research results and draw upon the work of others. But it is not just that scientific knowledge is spreading more rapidly. Fundamental advances have been made in areas such as genetics and biology, spawning new generations of products. Meanwhile, improvements in equipment have also significantly increased the scope and productivity of R&D, for example in bio-infomatics.

2.9 These developments have hugely expanded the stock of all types of scientific and technological knowledge. Together with liberalisation and globalisation, they have significantly increased the pace of innovation and imitation. One outcome is that older technologies using traditional materials and often involving large amounts of tacit knowledge, are being replaced by integrated approaches based on Computer Aided Design and Manufacture (CADCAM), electronic transfer of data and design, advanced control systems and new materials. These are more amenable to the codification of the knowledge they embody. But tacit knowledge remains important, since it is more easily retained by firms and is crucial to securing a competitive advantage. In principle, imitation may be easier but the successful adoption of advanced process technologies still involves complex problems of systems integration and radical organisational change, the solution to which would appear to require significant amounts of tacit knowledge.

2.10 Overall, the increased pace of change and speed of imitation means firms must monitor their external environment much more systematically in order to be aware of the opportunities and challenges offered by technological and scientific change. To gain access to technology they must network with suppliers, customers, competitors and other users of similar technologies. This is more important because products and processes now incorporate a much wider range of technologies than before. Increasingly new products are not stand-alone items but components of broader systems. This is encouraging firms to collaborate much more with other firms, realising economies of scale and scope in technology creation and adaptation. Firms are also increasingly developing direct links with the academic science and engineering base.

Global competition
2.11 Since the mid 1980s, the pace of globalisation in 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).

2.12 Globalisation has been driven by three processes:

• reduction in tariffs and other forms of protection - a result of world-wide trade liberalisation
• removal of restrictions on cross-border capital movement through the liberalisation of capital markets
• reduced transaction costs - aided by developments in transport and ICT.

2.13 The combined effect of these processes has been to increase the size of the market available to firms, stimulate competition, increase specialisation and make more distinct the international division of labour. Globalisation is also leading to new and unintended "spillovers" in the benefits of research and development effort from one country to another.(8)

2.14 Three main transmission mechanisms are encouraging the diffusion of codified, and to a lesser extent, tacit knowledge. First, free movement of people and ideas is important for the spread of knowledge and best practice. The ease of international travel, through lower transport and transaction costs, makes events such as conferences and activities like management consultancy much easier. Advances in ICT, such as e-mail and video-conferencing, enable new forms of interaction. All this allows for experiences and ideas to be shared more easily with a much wider audience.

2.15 Second, exposure to international trade contributes to the diffusion of knowledge. Domestic producers see innovative technology, branding and design embodied in imported goods and seek to match them. Exporters can become more aware of superior products and technologies, and best practice in their application, through the demands of their international customers and the activities of their competitors.

2.16 Third, foreign direct investment allows industrial processes and management to be shared with other countries. If a foreign company invests in a new factory on a greenfield site, it will usually install the latest innovations and productive processes. Where a foreign firm takes a stake in an existing company, it will often undertake some investment in equipment and systems as well, and will usually introduce new management techniques. Increasingly, firms are internationalising their R&D efforts leading to an increase in the share of R&D financed from abroad (Chart 2.4).(9) Furthermore there is evidence that domestic firms can learn from the higher productivity of inward investors, spreading improved management and production techniques to other parts of the economy.(10)

2.17 The combination of greater competition, the more rapid spread of ideas and the faster pace of innovation all help to advance the transition to the knowledge driven economy. New products move much more rapidly through the product cycle from specialised production using highly skilled labour in the country where the innovation was made to mass production using standardised processes in countries with lower labour costs. Companies in countries with higher labour costs therefore have to innovate and adapt continuously to retain their competitive edge, and even to survive. Recognition of this is absolutely vital to our competitive future.

Changing demand
2.18 The final driver is changing levels and patterns of demand. As economies grow, a smaller proportion of income is spent on basic necessities. People buy more sophisticated goods and services and value their leisure time more highly, devoting more of their income to it. In the UK, expenditure on food has risen less quickly than overall expenditure, while catering has risen much faster. In part this reflects a growing demand for the service element of food consumption, but also increasingly for the knowledge component, for example the skills of the chef and the atmosphere, or brand name, of the restaurant. Rising incomes and changing tastes have also contributed to the growth of the creative industries and the greater emphasis on quality and design, for example in the fashion and clothing industry.

2.19 Changes in social attitudes, lifestyles and aspirations also have a major impact on the pace and direction of development of the knowledge driven economy. For example, the willingness and ability of firms and other organisations to innovate is a key determinant of the demand for many new products and services. Businesses which produce such products will only develop where they can gain access 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, adjusted for the great changes in computing power that have occurred, have fallen to less than one thousandth of their original price over the last 40 years (Chart 2.5).

2.21 Changes in demand are also influenced by the willingness and capability of individuals to embrace technological developments. For example, the spread of e-commerce is dependent on the existence of the necessary skills, and on individuals' attitudes to changing their lifestyle.

2.22 As economies develop, social attitudes change. People place a greater value on environmental quality but this coexists with a greater desire to consume more resources. For example, concern about climate change, air quality and transport pollution is increasing, and although the energy intensity of output has fallen, absolute energy consumption continues to rise. As environmental pressure increases, innovative solutions will be required if economic development is to be sustainable. If anything, the knowledge driven economy might be expected to reduce pressures on the environment, as the knowledge intensity of products increases relative to their energy and raw material content.

2.23 Genetically altered foodstuffs are an example of the importance of social attitudes. Demand for them depends in part on whether they are regarded as safe and wholesome and on perceived risks for the wider environment. The way in which different countries perceive R&D into biotechnology is already affecting where such R&D is being undertaken. Public attitudes towards science, technology and risk are therefore potential sources of competitive advantage. Government can be help by giving consumers confidence that their interests will be protected, and their concerns addressed.

2.24 It is by no means a foregone conclusion that the UK will make the most of the potential benefits of the knowledge driven economy - individuals and government need to work together to take advantage of the opportunity. The role for policy makers is to embrace the changes that are making knowledge increasingly the engine of production and to help economies to adjust, while ensuring development is sustainable. But making the most of the potential impact on living standards also requires the right attitudes and the capacity to exploit the changes that are taking place.