1.1 "Knowledge is our most powerful engine of production" wrote Alfred Marshall in his Principles of Economics.(1) So the concept of a "knowledge driven economy" is not an unfamiliar one to economists. But today we can see a number of processes at work, some entirely new, others that have developed over many years, which together are transforming the way in which businesses, individuals and policy-makers operate. This calls for a renewed focus on knowledge as the means of improving economic performance, the underlying theme of the White Paper, Our Competitive Future: Building the Knowledge Driven Economy (Cm 4176).

1.2 The increasing importance of the knowledge driven economy is an international trend which affects economies at all levels of development. The World Bank's 1998 World Development Report took knowledge as its theme:

"For countries in the vanguard of the world economy, the balance between knowledge and resources has shifted so far towards the former that knowledge has become perhaps the most important factor determining the standard of living...... Today's most technologically advanced economies are truly knowledge-based."

1.3 The OECD has also drawn attention to the growing importance of knowledge:

".... the emergence of knowledge based economies.... has profound implications for the determinants of growth, the organisation of production and its effect on employment and skill requirements and may call for new orientations in industry-related policies."(2)

1.4 Other countries, too, have identified the growing importance of knowledge and reflected it in their approach to economic policy, as for example in the US, Canada, Denmark and Finland.

What is the "knowledge driven economy"?

1.5 A knowledge driven economy is one in which the generation and the exploitation of knowledge has come to play the predominant part in the creation of wealth. It is not simply about pushing back the frontiers of knowledge; it is also about the more effective use and exploitation of all types of knowledge in all manner of economic activity.

1.6 Authors have tried to describe aspects of the changes affecting modern economies in different ways. Terms such as de-industrialisation, globalisation, the information age, the digital or weightless economy all capture elements of what we observe. The knowledge driven economy is a more general phenomenon, encompassing the exploitation and use of knowledge in all production and service activities, not just those sometimes classified as high-tech or knowledge intensive.

1.7 The growing importance of the knowledge element of production is all around us. It is perhaps most obvious in the personal computers, mobile phones and sophisticated electronics of the information and communications industry and in other high-tech industries such as pharmaceuticals. Business consultancy, financial services and other knowledge-intensive services are growing in importance too. But knowledge is also transforming other sectors, both in their processes and the nature of their final products. Branding and design accounts for an ever-higher proportion of the value of the goods and services we consume. About 70 per cent of the production cost of a new car can be attributed to knowledge-based elements such as styling, design and software.(3) A modern luxury car includes more computing power than Apollo 11.

1.8 Investors increasingly recognise the growing importance of knowledge assets in the way they value firms. In fast-growing sectors like biotechnology and computer software, the value of the company resides almost entirely in the knowledge embodied in its patents and in its staff.

Why is knowledge becoming more important?

1.9 Knowledge has always been important, but now four mutually reinforcing processes are increasing its importance for prosperity. The first, and most conspicuous, is the extraordinary progress in Information and Communications Technology (ICT). Information spins round the world at an ever-faster rate, in ever-greater quantities and much more cheaply with implications for every type of economic activity. Entirely new products (e.g. digital television) and services (e.g. software services) have been created and more sophisticated production processes developed.

1.10 The second force at work is the increased speed of scientific and technological advance. Increases over the years in basic scientific research and business enterprise R&D have led to an acceleration in the growth of the stock of codified scientific and technological knowledge. At the same time, the potential scope and productivity of R&D has increased as equipment has improved, and better communication technology has facilitated the widespread diffusion of research findings.

1.11 The third factor is increased global competition. Competition has been facilitated in part by reduced communication costs, which have opened up markets to consumers by reducing search costs. International transport costs have fallen for many businesses, while other businesses can deliver their products or services down a phone line. The size of the market available to these companies has correspondingly increased. The ease with which information can be transferred also means that products and processes can often be quickly imitated. Knowledge spreads more quickly, making us all better off, but in order to compete a firm needs to innovate more quickly and make use of its distinctive know-how.

1.12 Competition is also fostered by trade and capital market liberalisation. With low transport costs, trade liberalisation opens up whole new markets. Liberalisation of foreign direct investment has also opened up markets where a local presence is important. Both developments increase competition, while enabling firms to take advantage of scale economies and exploit their comparative advantage.

1.13 The final driver is changing demand, associated with rising incomes and the changes in tastes and attitudes to leisure that come with greater prosperity. Changing attitudes to new technology and to risk are also important. At the same time, increasingly sophisticated and demanding consumers are driving changes in traditional corporate values and behaviour, particularly in relation to environmental and social performance.

1.14 With rising prosperity, a smaller proportion of income is spent on essential goods. People value their leisure more highly and spend more of their income on it. Consumers place more emphasis on the quality of the goods and services they buy and, more generally, on the quality of life. As economies develop, and environmental pressures mount, people attach higher priority to the preservation and improvement of the environment. And the Government also has a key role in ensuring that the future pattern of development is sustainable. All these factors imply increasing pressure on firms to reduce their dependence on the physical components of production (the part derived from land, raw materials and unskilled labour), limit pollution and give a greater role to innovation, creativity and technical sophistication.

How is it changing the way we do business?

1.15 The development of the knowledge driven economy inevitably involves a period of adjustment and structural change. It is changing the way firms compete, allowing them to access global markets more readily. Competition and the advance of technology are working to accelerate the pace of innovation and change. These technological developments and changing demands are creating whole new kinds of products. Increasing returns to scale are more prevalent in products with a large knowledge component, offering huge potential for growth. For economies to deliver rising living standards, greater emphasis must be placed on innovation, scientific development, knowledge management and human capital. Entrepreneurship has a crucial role in exploiting the economic opportunities presented by change.

1.16 The implications are being felt right across the economy and involve new ways of working. For firms, competitiveness increasingly requires them to build distinctive capabilities.(4) These may reside in a brand name or in R&D performance or in the tacit knowledge of their employees. For the manager of a firm, the quest for competitive advantage increasingly implies the need to maintain, develop and utilise these knowledge assets. Shorter product lives and increased competition require managers to increase efficiency and devote more resources to innovation. Technological developments are helping them to do so, but organisational change and increasing workforce skills also play a role.

1.17 On the input side, managers may need to bring in specific expertise by working with other firms. Research joint ventures and ways of sharing best practice are examples of this. Co-operation between producers and their suppliers to reduce lead times and eliminate costs is becoming increasingly common. In some cases, the need for proximity to other firms or a pool of skilled and complementary labour has led firms to cluster together in specific locations.

1.18 Where the employees in the company embody the firm's assets, new types of incentive structures are required to ensure they are motivated and retained. For individuals to take advantage of the opportunities presented by the knowledge driven economy, they will need to acquire and maintain relevant skills. Investment in skills also needs to be supported by a culture in the workplace that allows the knowledge, creativity and commitment of the workforce to be fully exploited.

1.19 The knowledge driven economy is having profound implications for the investor and the financial community. More of a firm's wealth-creating potential is tied up in intangible assets, including the knowledge of the workforce. The value of these assets is hard to measure and even more difficult to communicate to shareholders. In many instances these assets are also becoming increasingly mobile. All this adds to the risk and uncertainty surrounding investment decisions. Flexibility in financing is required as product lives shorten and individual firms have potential to grow faster within a global marketplace.

1.20 For the policy maker, the challenge is to create a framework which supports continued development of scientific and technological excellence, greater competition and a culture of enterprise and innovation, and which ensures effective protection of the environment. Enterprise is more likely to thrive where there is a stable financial and economic backdrop; a supportive business and social environment; good access to markets, technology and finance; and a flexible, highly educated and skilled labour force. Helping those adversely affected by the adjustment to the knowledge driven economy is another role for government.

1.21 For the regulator, some features of the knowledge driven economy have implications for the nature of competition. Co-operation between firms is becoming more common. Innovating firms also look for some temporary market power to recoup their investment in R&D and other knowledge assets. Regulators need to weigh up the costs with the benefits in terms of incentivising and facilitating innovation. Regulation also becomes harder where output is knowledge driven and the regulated body increasingly has more information than the regulator. This makes it more difficult for the regulator to assess accurately the position of the regulated and therefore make policy that is economically efficient.

Forces for improved performance

1.22 The paper starts by looking in more detail at the four processes that lie behind the knowledge driven economy and what this means for overall performance.It then goes in to greater depth on the microeconomic implications of the knowledge driven economy under three headings:

• capabilities to adapt and to embrace change encompassing the exploitation of science and technology, enterprise and innovation, capital markets, people and skills
• collaboration, both within firms in the way they organise themselves and their employees, and between firms in the way they interact in networks and in clusters
• 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 consumer choice.

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.