3.1 Developments in economic theory increasingly recognise the central role of knowledge as a determinant of economic growth. New theory is moving away from old models where technical progress was seen as an exogenous variable which economists were unable to explain. Labour effort and physical capital were viewed as the two inputs policy makers were able to influence, but these left much of growth unaccounted for.

3.2 Traditional economic growth theory saw technical progress disseminating costlessly from leader to follower, so that differences in productivity were believed not to persist in the long run. Those who lagged behind caught up with the leaders by following best practice. The process of technological change was not well understood. It was assumed to occur at a constant rate, regardless of policy action - in other words, technical progress was exogenous. Increases to the long run growth rate could only come about as a result of exogenous technological shocks.

3.3 However, the evidence suggests that even the economies of advanced nations seem to be converging only slowly, if at all. So catch-up is not automatic. And more attention is being paid to how policy can influence the rate of technical progress and the rate of catch-up.

Knowledge as the source of growth
3.4 The shortcomings of traditional growth theory have been tackled in the more recent economic literature.(11) Investment in the generation of knowledge, the education and training of the workforce, and the capacity for innovation and the exploitation of new ideas are now seen as the key requirements of success. Technology does not just flow from leader to follower. The capabilities need to be in place to understand best practice and exploit it effectively. The role of increasing returns to scale is given greater emphasis. Seeing growth in this way allows more of growth to be explained and is consistent with some countries being stuck on low productivity, low growth paths, while others enjoy persistently higher growth.(12)

3.5 The ability of an economy to generate new ideas is difficult to measure. Expenditure on R&D is often used as a proxy. Growth studies find that R&D expenditures provide a positive contribution to productivity growth. The intensity of domestic R&D is found to affect both the rate of domestic innovation and the quantity of knowledge that can be absorbed from others.(13) Increasingly, the import of modern technology from abroad is a factor driving productivity growth.(14) The growth in the stock of industry-funded R&D - though concentrated in certain industries, such as chemicals, engineering and electronics - has played a significant role in promoting growth in manufacturing productivity.(15) R&D spending is important in explaining the US manufacturing productivity lead over the UK and Germany.(16)

3.6 Other analysis has confirmed the importance of education in explaining the growth of national income.(17) Skills acquired after school are also important. Skill differences between UK and German manufacturing are an important factor in explaining Britain’s manufacturing productivity gap with Germany.(18)

3.7 But more investment in R&D, education and skills is not enough. It is important to create the right environment for innovation and the exploitation of new ideas, with a supportive institutional and cultural framework. Macroeconomic stability is crucial. Property rights must be established and enforced, the banking and financial system should be capable of bearing risk and society should respect, foster and encourage enterprise. The capacity for growth is reduced in societies that are unwilling or unable to innovate and change.(19)

3.8 Further evidence of the rising importance and potential of knowledge in economic development can be seen in OECD figures on the way output, employment and foreign trade are changing. Precise measurement of the knowledge component of output is difficult. As one indicator, albeit imperfect, the OECD defines a group of high-tech manufacturing and services which have a high knowledge component.(20) The value added generated by knowledge-based industries in the OECD increased at an annual average rate of 7 per cent between 1985 and 1994.(21) Compared with just over 5 per cent per annum for the business sector as a whole (Chart 3.1).

3.9 Moreover, productivity in these types of activity has grown faster than in other sectors (Chart 3.2).

3.10 In the knowledge-based industries as a whole productivity gains have not been at the expense of employment (Chart 3.3). However, employment has declined slightly in the high-technology sector.

3.11 Trade is also becoming increasingly knowledge based. There are no aggregate measures of the knowledge intensity of trade but trade in knowledge-intensive services is growing more quickly than total services trade and within goods trade, the fastest growth has been in high and medium-high technology manufacturing (Chart 3.4).(22)

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) The next chapter will look in more detail at the UK’s capabilities to make the most of the opportunities the emergence of the knowledge driven economy offers. Here we consider how the knowledge economy is reflected in UK output and employment, and look at broad indicators of strengths and weaknesses.

3.13 The composition of UK output is changing. One indicator of this is the rising share of high-tech manufacturing and knowledge intensive services in output (Chart 3.5).

3.14 Changing output is reflected in the labour market. Although knowledge is universally important for performance, employment has been growing fastest in sectors most clearly identified with the development of the knowledge driven economy (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 activities such as textile production, towards computer manufacture and telecommunications.

3.15 The growing importance of knowledge-intensive goods, and services in OECD trade is creating new opportunities for British exporters. In some areas the UK is well placed to grasp these opportunities or even leads the field. For example, we have had strong growth in high-tech exports in recent years and they comprise a relatively large share of our exports. More detailed analysis of UK manufacturing trade performance suggests that an industry is more likely to succeed in Britain if it requires a relatively high proportion of skilled employees or has a high R&D intensity. This is consistent with the knowledge driven economy thesis (Chart 3.7).(24)

3.16 In knowledge-based services we perform well too. Exports of these sectors make up a relatively high share of total UK service exports (Chart 3.8).

3.17 Another indicator is the growth of royalties received by the UK. Royalties reflect the export of intellectual property. Intellectual property earnings from overseas in the form of royalties and licence fees grew about twice as fast as all service exports between 1993 and 1996 in the five largest OECD economies. Computer and information service exports grew about four times as fast as all service exports.

3.18 The UK is the third largest earner of royalties and licence fees from abroad and the second largest exporter of computer and information (IT) services. For goods and services as a whole, we rank fifth in the world. The relative position in royalties has changed little in recent years, but the rate of growth in the UK has been lower than that in Germany and Japan but ahead of France (Chart 3.9).

3.19 The available statistics suggest that knowledge-intensive industries are experiencing fast growth and are becoming an ever-increasing component of UK output and employment. But despite this, the overall picture shows we have some way to go to reach the living standards of the best. In terms of GDP per head, we lag behind our major competitors (Chart 3.10).

3.20 This poor performance in GDP per head is primarily due to the shortfall in our labour productivity, whether measured by output per worker or output per hour worked (Chart 3.11).(25)

3.21 In part, the shortfall in labour productivity reflects the lower level of capital available per worker in the UK compared with our main competitors. Calculations of total factor productivity, which try to adjust for this, show a smaller but still significant gap, suggesting that action is needed to improve both our investment levels and other factors holding back productivity.(26)

3.22 Moreover, comparisons of productivity suggest that even in higher technology activities, the UK lags behind our major competitors in terms of productivity (Chart 3.12).

3.23 So while the UK has some areas of strength, across the board, performance is disappointing. Improving our productivity performance and matching best practice elsewhere will require progress in many areas. First among these is the achievement of a more stable macroeconomic environment than we have seen in the past 25 years. The Government has put in place new frameworks for fiscal and monetary policy to help secure this.(27) But progress is required on the microeconomic front as well. The remainder of this document considers the implications of knowledge for the economy at the microeconomic level under the three broad headings used in the White Paper, namely building UK capabilities, encouraging collaboration, and promoting competitive markets. Where possible, it benchmarks UK performance and draws out lessons for policy.