4.1 The key to competitive advantage in the knowledge driven economy is the capability of firms and other institutions to acquire and absorb knowledge, to exploit it to develop new products and processes, and to learn from best practice.

4.2 If we are to compete in a world economy increasingly driven by knowledge, we need to improve our capabilities in four areas:

• We need to improve our capacity to create and exploit scientific knowledge and technology successfully.
• Securing this improvement, together with the need for greater dynamism in the knowledge driven economy, requires improved enterprise and innovation.
• Finance for enterprise depends in turn on well functioning capital markets.
• Firms also need access to skilled workers and the successful organisations will be those who make the best use of their people and skills.

Creating and exploiting knowledge
4.3 As discussed in Chapter 2, developments in science and technology, including ICT, are important forces behind the rising importance of knowledge in the economy. These are not just exogenous trends but developments which can be influenced by the actions of governments, firms and educational institutions. Part of the drive towards embracing the knowledge driven economy must be to accelerate the pace of development in science and technology and make sure that the UK keeps up with best practice internationally.

4.4 There is an important role for government in ensuring that our science and engineering base and our ICT infrastructure continues to strengthen. Government has a role in encouraging investment in basic science, which may not have immediate commercial application, and in fostering investment in new technology where the risks may be too great for a single firm. It also has a role in technical education, in the spread of best practice and in encouraging scientific excellence. Development of our ICT infrastructure also requires government action in establishing the right regulatory environment and setting technical standards.

4.5 But excellence in the science and engineering base and developing our ICT infrastructure is not enough. Our record in commercial exploitation of these advantages must improve. Expenditure on R&D is one measure of the extent to which business is developing and exploiting new technology and ideas. Overall business expenditure on R&D in the UK has fallen to fifth in the G7 (Chart 4.1).

4.6 This would not matter if the UK were more effective at turning R&D into new products or processes, but the patent data suggests otherwise (Chart 4.2). On the other hand, the UK is the only major country in which foreign affiliates' share of manufacturing R&D is higher than their share of production.(26) The fact these affiliates are doing so much R&D in the UK suggests they believe their R&D will be more productive here.

4.7 Investment in fixed assets is an important vehicle for ensuring that the latest technology is available to business. But fixed investment per worker in the UK is also relatively low. This is apparent from an analysis of data on fixed investment from company reports(29) and from figures on business investment compiled by the OECD (Chart 4.3).

4.8 Exploitation of the new opportunities afforded by the information highway also lags behind some of our main competitors. For example, use of ICT by business falls short of the US and Japan, although we are ahead of France and Germany (Chart 4.4).

4.9 Encouraging stronger links between business and universities is also important if we are to be more successful in the commercial exploitation of technology. Firms are increasingly developing direct links with the academic science and engineering base, currently maintained by only a minority of high-technology businesses. At the same time, firms are making more use of qualified scientist and engineers in local higher education institutions as a source of expertise, participating in expert networks of graduates, and making more use of the results of scientific research themselves (see box).

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 to address the consequences of market failures across a wide range of areas, including strengthening collaboration between firms and between science 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 and skills are considered in this chapter and collaboration between firms in the next.

Enterprise and innovation
4.11 Enterprise is crucial to success in the knowledge driven economy. Successful exploitation of scientific advances and other new opportunities requires a culture of entrepreneurship in firms large and small. Firms have to act faster than before to respond to more intense competition. The spread of codified knowledge increases the likelihood of competition by imitation. Enterprises, in turn, have to respond to best practice elsewhere. Firms which are relatively inefficient are less able to shelter behind transport and transactions costs. Innovation in products and processes is becoming a more important management function.

4.12 But with greater competition comes greater opportunity. In many knowledge-based activities (for example computer software, satellite TV) firms can grow and dominate the market quickly.(33) Small firms may soon find themselves the market leader, placing management processes and structures under stress. In a high growth firm, more management resources need to be devoted to "non-routine" activities as firms find themselves having to innovate and cope with new risks.

4.13 In particular, in the knowledge economy, firms must have managers who are able to manage the innovation process, position products in the market, build reputable brands and improve quality. Moreover, as product lives and development cycles shorten, management becomes much more of an organic process, with design, production and marketing staff all involved at the outset rather than being brought in sequentially.

4.14 All this implies a key role for entrepreneurship. The OECD defined entrepreneurship as "the ability to seize new business opportunities."(34) New ideas are the raw material of the knowledge driven economy. The ability to transform those ideas into a commodity of value, such as a piece of software, a brand or a patent, is a key determinant of success. This is not just true of the single owner-manager dictating the course of the firm. Success in the knowledge driven economy requires entrepreneurship from everybody in a position to innovate: in large and small firms, and in the private, public and voluntary sectors.

Capital markets
4.15 An enterprising economy needs flexible sources of finance. The emergence of the knowledge driven economy requires new approaches to investment and increases the costs of capital market imperfections. For example, if firms find it difficult to raise external capital, diversified companies who are already earning profits and are able to re-invest their earnings will be able to build brands and improve quality earlier and at lower cost, giving them a significant advantage.

4.16 Two features of the knowledge driven economy are of particular relevance for capital markets - the increased pace of innovation and associated need for different forms of finance for enterprise; and the importance of intangible assets, including R&D.

Pace of innovation and finance for enterprise
4.17 The shortening of product lives and greater dynamism needed to succeed in the knowledge driven economy require new relations between finance providers and borrowers. For example, when new firms are created to exploit innovations, banks and finance providers are not able to base their financing decision on trading records. High growth firms are also unable to make use of the main source of business finance - retained profits. Often, it is the smallest, youngest and most high-tech firms who face the greatest problems getting finance.(35)

4.18 Bank finance is the most important source of external finance for most small and medium-sized enterprises (SMEs). However, bank finance is not suitable for some firms, particularly technology-based firms at start-up or the early stage of growth, because such investments are often perceived as high risk, and the long lead times of some investments mean that firms can have difficulty making regular payments to service the debt.

4.19 In principle, equity finance is the most efficient way for SMEs to finance high-risk investments because it allows investors to share more fully in the rewards to a successful venture, and helps firms avoid the cashflow problems associated with debt finance. Informal venture capital ("business angel") investment and specialist "seed capital" firms can be an important source of relatively small amounts of capital. The development of improved networks between firms and these finance providers is essential if adequate funds are to be provided to finance R&D at the start-up and early stages.

4.20 As firms grow, larger amounts of equity capital can be provided through formal venture capitalists. Venture capitalists typically invest (and often help manage) the firm until an eventual stock market listing. The listing enables the company to raise larger amounts of finance and the venture capitalist to exit and re-invest in other unquoted companies. However US venture capital provision is more established, with a better supporting infrastructure and expertise than in the UK. An independent report commissioned by HM Treasury(36) concluded that it is harder to raise venture capital in the UK than the US. A higher proportion of venture capital in the US goes to high-tech companies.

4.21 The option of an exit route through a stock exchange listing is very important for venture capitalists and ambitious entrepreneurs. So is the capacity to raise money after listing. For these reasons, an effective stock market and liquid secondary markets are important. Stock markets will also have to consider whether their rules strike the right balance between providing necessary investor protection on the one hand and not constraining the opportunities for more sophisticated investors on the other. There may be scope for allowing certain investors to take greater responsibility for assessing risk in clearly defined circumstances.

Intangibles
4.22 A central feature of the knowledge driven economy is the increasing importance of intangible assets, such as human capital, R&D, brands, contacts and know-how, as a source of added value and profitability for companies. The prominence of intangible assets makes information problems more acute since they are less amenable to observation and measurement by analysts and potential investors. Often, only the firm itself can make a reliable judgement as to the knowledge and expertise embodied in the enterprise.

4.23 The importance of intangibles can be seen by a measure of the ratio of the market value of a company to its book value - Tobin's q. The book value tends only to cover physical assets. Just as expectations of future profits (over and above the normal rate) increase q, so intangible assets also increase the ratio because they increase the value of the company without appearing on the books. For the UK in 1996, q was 1.3 for the stock market as a whole, while for a knowledge-based stock such as Zeneca it was 6. In the US the average was 1.5 while for Microsoft, q was 15. In addition the value of q has tended to increase over time.(37)

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 assets? Even though few investors use historic cost to value physical assets, this option is not even available when valuing intangible assets. Measurement of their value and the rate at which they depreciate is therefore much more difficult. Valuation is especially problematic for the human capital embodied in the workforce, which for more and more companies is a major source of competitive advantage. When staff leave the firm, they take their knowledge with them. The firm then has no claim on that knowledge, except to the extent that it has become embodied in the organisation through reports, systems and procedures. While the market may have some idea of the expected future income from - and therefore the value of - a brand or patent, it is much more difficult to place a value on trained staff.

4.25 At the root of these problems over sources of finance and the value of intangible assets are different types of information failure. The Government is working with the City and industry to find ways of addressing gaps in finance provision and to improve methods of valuing intangible assets and communications between companies and their shareholders. The Accounting Standards Board has been asked to look again at the issue of intangible assets, while corporate governance issues are being considered further in the Government's review of company law.

People and skills
4.26 Success in the knowledge driven economy requires a skilled and motivated workforce and management. The effects of the knowledge driven economy are already clearly visible in the labour market. Workers everywhere are more highly educated. Advances in technology enable firms to produce the same amount with fewer unskilled employees, while at the same time increasing the demand for skilled labour to operate the equipment.(38) Shifts in demand caused by rising incomes and changing tastes also affect the composition of labour demand, for example the growth of employment in professional occupations, many of them classic knowledge workers.

4.27 The evidence suggests that globalisation has also affected the labour market by leading to some relative decline in the demand for unskilled labour within more technologically advanced countries, although the effects of globalisation are modest compared to other forces at work.(39)

4.28 While these changes have not been at the expense of a declining overall employment rate, the impact on employment can be seen in the changing skill mix. The share of services employment in the economy is increasing and within the services sector, the largest increases in employment have been in finance, insurance, real estate and business services - sectors that are all relatively knowledge intensive. This is true of other OECD countries including the US and Japan, although the difference between sectors is less pronounced.

4.29 Splitting employment by type of worker, the most pronounced growth has been in high-skilled white-collar employment within UK services.(40) Within manufacturing, growth in employment has only occurred in white-collar high skilled workers. Employment actually fell for other groups. There is also evidence within industries of large-scale substitutions away from unskilled labour, particularly in relatively high-tech industries.(41)

4.30 Changes in the relative demand and supply of skilled and unskilled workers have contributed to a pronounced shift in the relative earnings of the two groups. Wage inequality has grown in the UK and other industrialised economies since the 1970s. Between 1978 and 1996, real hourly wages in the New Earnings Survey rose by only 20 per cent for the lowest 10 per cent of earners compared to a 38 per cent increase at the median and a 66 per cent increase near the top of the earnings distribution.(42) Since 1979, there has been a steady increase in the wages of non-manual relative to manual employees, which can be taken as a rough indicator of the differential between the skilled and unskilled (Chart 4.5). Wage dispersion has also increased within skill groups, suggesting that factors other than the supply and demand for skills may have played a role.

4.31 More rapid and skill-biased technological change has contributed to a shift in the demand for labour away from those without skills - a trend which is shared with most of the developed world.(43) These skills mismatches should diminish if people and firms are able to invest in training, if labour markets are flexible and if workers are mobile across regions and occupations.

4.32 More rapid innovation and shorter product lives affect firms' incentives to provide specific training. On the one hand, the need to innovate gives firms a greater incentive to train their staff. On the other hand, skills become obsolete more quickly thus reducing the pay-off to training in specific skills. The need for general skills will grow but the risk to the firm is that the workers it trains take their new skills elsewhere. In response, firms may look for a better-educated workforce to reduce the costs of training or try to pass on more of the costs of training to employees (e.g. through greater use of sub-contractors or paying lower wages during training). Even if this happens, it still seems likely that there will be some tendency for firms to under-invest in training because of their inability to capture its full value.

4.33 The need for the right basic education - a key responsibility of government - is growing. Workers need to have good basic knowledge and core competencies so that they can be retrained and acquire new knowledge quickly. This should lead to an increase in the return to education and requires a greater emphasis on the importance of a good educational foundation and life-long learning.(44)

4.34 As the pace of change quickens, new opportunities and challenges will appear in the labour market. Flexibility will be increasingly important, both for firms wishing to recruit and retain key workers, and for individuals wishing to equip themselves for tomorrow's labour market. The UK labour market - with its long tradition of voluntarism and lack of over-prescriptive legislation - is well placed to take advantage of these opportunities, while at the same time ensuring decent minimum standards. One example of a form of work which fits these principles is teleworking: technology means this is a realistic option for more employees; firms can find this a useful way of retaining 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.