5.1 The knowledge driven economy both facilitates and requires greater collaboration at many different levels. The previous chapter discussed developing links between firms, the science and engineering base and education institutions. The next will pick up the need for transparency and confidence in the regulatory environment. Here we focus on how the development of a knowledge driven economy is changing the way firms organise themselves, promoting new partnerships between employers and employees and encouraging collaboration between firms in networks and clusters. The last of these is particularly important at a regional and local level.

5.2 Two basic processes are at work that require greater collaboration within and between firms:

• The value of the firm increasingly resides in the knowledge of individuals, be they its staff, managers or even suppliers, but once that knowledge is codified, it can be spread easily and cheaply. Tacit knowledge is the source of a firm's competitive edge but it is much more difficult to monitor than machines or manual labour. Managers therefore have to pay greater attention to ensuring that the right incentives are set and relationships established to ensure this knowledge is used effectively and developed. Meanwhile, for that part of the firm's business that can be easily codified, contracting out and other forms of business organisation are facilitated.
• Competition is intensifying, but also changing in nature, as the next chapter describes. Increasingly, costs have to be sunk at the development stage. To spread these costs (and benefit from economies of scale and scope in dealing with increasingly complex technologies) firms are finding it necessary to work together.

Partnership within the firm
5.3 Managers increasingly recognise that success in the market place requires the effective use of all the knowledge available to an organisation. This is not just about sophisticated research and development. Important knowledge may reside as much in the deliveryman who takes the product to the customer as it does in the highest paid scientist in the organisation. Knowledge of customers' preferences, or of the delivery habits of the competition, are also potential sources of competitive advantage.(46)

5.4 A whole literature on "knowledge management" has developed that describes the management practices, tools and models used to acquire, share and use the knowledge capital within organisations.(47) Key themes are the need for the contribution of every employee within an organisation to be assessed by the value added their knowledge and creativity can bring. This militates against traditional hierarchies. Command and control styles of management are often argued to be insufficiently flexible to deliver the required pace of innovation.(48) Flatter hierarchies may be more effective. Meanwhile, managers need to develop systems (e.g. by the use of intranets) to harness the knowledge within the organisation and encourage a culture of knowledge sharing.

5.5 There is considerable diversity in the actual practice of knowledge management across sectors. Organisations such as Unilever have implemented knowledge management models which facilitate the sharing of information and improve internal communications. Others have placed more emphasis on education and training to stimulate and sustain the knowledge base in the organisation. Within financial organisations, the focus is likely to be on quantifying and recognising the value of the knowledge base, whilst firms with a strong science and R&D base may look more towards exploiting the commercial value of their existing knowledge base (see following box).

5.6 However, managing the firm's knowledge assets effectively is not just about getting the processes and systems right. It is about setting the right incentives. With tacit knowledge so important to firms, but so difficult to monitor, firms have to ensure that managers, workers and suppliers want to do a good job. Employee share ownership schemes or equity-based management recruitment incentives are tools that have been used successfully by many companies. High-tech companies in the US are the most widely cited examples, although these types of schemes have been used effectively elsewhere - from management consultants to advertising agencies.

5.7 Other firms have reaped the benefits in terms of loyalty and commitment that a favourable working environment can bring.(49) Modern employee relations practices are an important part of this. Employee satisfaction, for example, is greatest where workers feel adequately consulted about changes that affect their workplace.(50) The National Minimum Wage, the Working Time Regulations, and the legislation foreshadowed in the Fairness at Work White Paper (Cm 3968) are all means by which the Government is promoting fairness and partnership in the workplace.

New forms of business organisation
5.8 The development of the knowledge driven economy has also been associated with changes in the organisation of firms. ICT has given companies the scope to contract our more of their activities, particularly where these depend on the knowledge that is codifiable. Contracting out has been encouraged where the ease of communication facilitates the monitoring and negotiation of contracts, or reduces the costs of choosing between suppliers. Over recent years, contracting out by manufacturing has become more common, contributing to the development of new forms of collaboration through supply chains. At the extreme, contracting out may lead to the emergence of "virtual companies" with most of the traditional functions, including manufacturing, hived off.

5.9 However, contracting out of activities is not without its costs. The question of what the firm should do itself and what it should contract out is the subject of a large and diverse economics and management literature.(51) Some characteristics of the knowledge driven economy can militate against contracting out. The difficulties in monitoring tacit knowledge may mean that those activities dependent on tacit knowledge need to be kept within the firm. This suggests that changes in firm organisation may be more incremental and gradual, responding to changes in the relative costs and benefits of doing things in house.

5.10 Developments in ICT have also affected the physical location of production. They influence the 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 by reducing the cost of advertising and search on the part of consumers, and by reducing transportation costs. On the other hand, such developments can strengthen head office control over its subsidiaries and thus facilitate geographical dispersion where there are clear advantages from proximity to the market. These arguments apply to firms operating within a country and to multinationals.

5.11 An alternative to the firm itself serving a particular market, whether at home or abroad, is licensing. However, for a knowledge-based company, licensing carries the dual risk that potential competitors gain access to technical secrets and that product quality may not be maintained (because the licensee has the incentive to free-ride on a firm's reputation for quality, cut costs and earn excessive profits). Where companies' competitive advantage depends on distinctive knowledge assets, they may therefore be less inclined to license and more likely to invest themselves.(52) Collaboration within a region and between firms: clusters and networks

5.12 Sometimes firms are finding that they can better utilise their knowledge capital, and increase the expertise available to them, if they locate amongst a cluster of other firms.(53) Social interaction and other informal links are much of the story behind the success of some clusters (e.g. Silicon Valley, City of London, Italian shoe industry). While co-location facilitates formal and informal links, it is not essential for the creation of a network, used by some firms to draw in the expertise of other firms.(54) Inter-firm co-operation of various types - for example through supply chains, mentoring, or best practice fora - is often seen as an effective way of increasing the knowledge available to firms and the effectiveness of its use.

Clusters
5.13 Economists have emphasised the benefits of clustering for almost as long as groups of inter-related firms have been a feature of the economic landscape.(55) When transport costs were high, and physical inputs were the major component of costs, firms located around areas of natural resources or around centres of population. Such factors still matter but firms are now more likely to locate near each other to tap into pools of expertise or local infrastructure.

5.14 Porter argues that clusters can be an important source of durable competitive advantage.(56) Firms in clusters can gain economies of scope - for example drawing upon companies with complementary skills to bid for large pieces of work which each of the individual firms would have been unable to complete. 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 joint marketing.

5.15 Some authors have emphasised the importance of linkages within the cluster - these can be because a firm buys final goods in the location or because it supplies intermediate goods to other firms there.(57) Reputations spread quickly within the cluster, helping finance providers to judge who the good entrepreneurs are, and business people to find who provides good support services. The concentration of firms in a cluster allows an infrastructure of professional, legal, financial and other specialist support services to develop, along with a workforce whose skills are particularly suited to their needs.

5.16 Other authors have emphasised the importance of other external benefits within a cluster.(58) Knowledge "spillovers" are an example. Empirical research has shown that there is a positive link between such spillovers and the proximity of innovative activity.(59) It may seem paradoxical that, with the advances in ICT, co-location should still be seen as important. Advances in ICT speed the flow of information but the assimilation of tacit knowledge and innovation requires the kind of repeated contact and collaboration that is easier when firms are co-located. As has been said, "Intellectual breakthroughs.... cross hallways and streets more easily than oceans and continents".(60) However, to be successful, clusters must remain outward-looking.

Networks
5.17 Clusters facilitate other forms of collaboration or networking between firms. In part, this is because co-location and repeated contact helps build up a relationship of trust. Collaboration though networking is more common when firms are located near each other but it can also occur through networks of firms in different locations. Networking can be between firms in a supply chains or between firms that are more loosely associated. Many of these networking arrangements are ways of spreading best practice and the results of research and development.

5.18 Firms work together in networks for a variety of reasons. Among them are:

• the reduction of uncertainty
• learning from others and absorbing best practice
• reducing transactions costs
• raising the profile of the company in relations with third parties
• agreeing, recognising and improving standards.(62)

5.19 Many groupings are fragile and the benefits are not always obvious in the early stages.(63) But governments in many EU countries and in North America and the EU itself have seen the potential of networking and many have sponsored programmes to promote it. Experience suggests that, to be successful, these programmes should build on existing informal links, be integrated into the business support structure and be aimed at creating a level playing field.

5.20 The potential for gains from the spread of best practice and mentoring are considerable. The White Paper cites the example of the Society of Motor Manufacturers and Traders (SMMT) Industry Forum, which has doubled productivity amongst participating vehicle manufacturers. Networks such as Business Bridge and Business Net, run with the help of Business Links, have realised significant benefits for participating SMEs.

5.21 One particular type of firm collaboration is joint research. Why should firms collaborate in this way? The economics literature suggests that R&D produces externalities or spillovers whose benefits go beyond the investing firm and that firms experience difficulties in appropriating the full returns to R&D. The empirical literature, mainly from the US, shows that the return to society as a whole exceeds the private rate of return to R&D by a considerable margin.(64) A central estimate puts the private rates of return at the firm level at between 20 and 30 per cent, with the social return (private return plus spillovers) reaching 50 per cent.

5.22 Joint research may enable firms to internalise these knowledge spillovers. It may also allow firms to benefit from economies of scale and scope in research and early-stage development. However, while collaboration with suppliers or customers, or with firms in different sectors using the same generic technologies, is becoming more common, joint research ventures are less frequent between direct competitors, particularly for near-market development.

5.23 Co-operation between competitors may be undesirable because sharing information on R&D requires some discussion of market conditions and this may lead to price-fixing in downstream markets. Alternatively, participants may come to the view that their contribution benefits rivals, and seek to minimise their input to the collaboration, or seek to slow down R&D projects which threaten to reduce their profits. The incentive for firms to co-operate on R&D may also be reduced in situations where innovation leads directly to individual market power. Indeed, the prospect of market power for the first firm to make a breakthrough may encourage vibrant competition at the product development stage.(65)

5.24 For these reasons, joint research ventures will not always get off the ground. Even with relatively high rates of private return, the large gap between private and social returns will remain, making it likely that private markets will under-invest in R&D from the point of view of the economy as a whole. This is one of the reasons for government to play a role in encouraging R&D and innovation.

Promoting collaboration
5.25 From the foregoing discussion, it is clear that the exploitation of the opportunities of the knowledge driven economy implies different forms of interaction between firms than we have seen in the past. An upsurge in interest in collaboration between firms in networks, clusters, supply chains and joint ventures can already be observed.

5.26 Collaboration is not always the way forward. It may lead to anti-competitive practices, something which the competition authorities will need to assess 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.