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June 2018

Delivering productivity the Labour way…?

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The Financing Investment report published by Labour on 20th June set out how the opposition would approach the conundrum that is the productivity puzzle in the UK. The persistence of sluggish productivity growth since the financial crisis is not going away, but is the answer in setting the Bank of England a productivity target?

Raising productivity growth is a priority of all political parties, not least because productivity is a proxy for wage-incomes and ultimately standards of living. Therefore, while a productivity growth target is admirable, it is questionable whether this should this be required of the Bank of England let alone whether it can it ever work. Moreover, in the last four decades the highly ambitious three percent annual target has never been achieved before, and is significantly above the 0.2% per year increase seen over the last decade which has left the UK c.20% below the pre-crisis productivity growth trend.

The rationale for Labour’s proposal is the perceived failure of the UK financial system that has fueled speculation in the property market at the cost of investment in other tradable technologies and sectors.  This is a well-rehearsed argument. While access to capital for growth has been highlighted as a critical issue experienced by UK firms, in the aftermath of the 2008 crisis, access to  low cost labour may also have contributed to the  propensity for firms to prioritise employment over the propensity to invest even though the costs of borrowing have been extremely low.

The Bank of England Governor, Mark Carney, has previously expressed concern over assuming responsibility for productivity in addition to the primary target of keeping inflation at 2 per cent. The elephant in the room is whether the Bank of England, regardless of the 3% goal, is actually genuinely able to influence productivity growth in this way. Using monetary policy instruments to stimulate investment is premised on the expectation that the monetary authorities can incentivize banks to lend and firms to innovate or invest in innovations to yield productivity gains. Yet, the evidence here is mixed, to say the least, and runs the risk of confusing and conflating different sets of objectives, at least in the minds of the public and politicians.

Productivity is driven by innovation and entrepreneurship and it is not in any way clear how the monetary authorities can influence these, other than maintaining stable prices and inflation expectations so that firms, investors and entrepreneurs are able to plan effectively. Moreover, assigning a productivity growth objective to the Bank of England then largely absolves the other economy ministries dealing with regulatory issues, competition policy, research and innovation, infrastructure, land use, the coordination of different investment policy arenas etc., from their own responsibilities.

On one hand the fresh thinking in these proposals is to be welcomed, while on the other hand the proposals from Labour raise many additional questions. Given the already over-centralised and top-down system of governance in the UK, the prospect that the productivity growth is managed by the central bank is somewhat ironic – even if Labour are proposing it move to Birmingham! Given the highly regional nature of the productivity puzzle in the UK, policy needs to be more sensitive to local needs and tough institutional and governance questions need to be asked.

Despite the shortcomings of successive Governments to jumpstart productivity growth, the Industrial Strategy with its emphasis on place represents a welcome focus. However, whether or not this will provide the basis to address the structural weaknesses that are manifest in the long tail of low productivity firms and the enormous interregional productivity differences remains the subject of ongoing debate.

By Professors Tim Vorley and Philip McCann

Photo credit: PeterRoe/Pixabay.com

Improving productivity by engaging small businesses

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Improving the productivity of the long tail in the UK requires the government and other stakeholders to rethink programmes that target and engage the right companies, as well as providing more holistic tailored support. Siloed support that tackles specific areas alone, such as management skills or digital adoption, is unlikely to maximise effectiveness.  A key area of research for the Productivity Insights Network is to explore the integration of different themes that underpin the productivity challenge in the UK, for instance how management practice, employee engagement, adoption of innovative ideas and place all interact.

Recent research has highlighted the long tail of “productivity laggards” in the UK.  Analysis from Andy Haldane, the Bank of England’s Chief Economist, showed that the UK business base is characterised by a small minority of productivity leaders and a long tail of laggards.  This long tail of low productivity firms has not been able to keep up with firms at the frontier and the gap has widened in recent years.

Policy-makers and business groups believe that this issue needs to be tackled in order to help address the productivity challenge in the UK.  The Industrial Strategy White Paper highlights the need to act. Moreover, Be the Business, the campaign organisation formed to tackle the UK’s longstanding productivity challenge, has recently committed to a series of actions to help businesses improve.

Bringing together the research experience of SQW with the practitioner expertise of our sister organisation, Oxford Innovation, we have identified a series of principles that must underpin the approach taken to confronting the challenge posed by the productivity laggards in our Viewpoint, Policies and Research to Solve the UK’s Productivity Puzzle.  We urge government, Be the Business and others to consider these principles in designing approaches to working with businesses to improve their productivity.  In brief the principles are as follows:

Target companies in the long tail of productivity laggards that have potential to improve. Recent business support programmes have tended to target companies that have asked for help and been identified as having high growth potential. But these programmes exclude many ‘long tail’ laggards with potential to improve, since generally these companies neither know they have such potential nor see themselves as needing help in realising it.

Holistically strengthen all the factors affecting their productivity. Our work shows us that a range of interrelated factors affect productivity improvements in individual SMEs, notably their leadership and management strengths, workforce skills and motivation, capacity to innovate, strategic use of digital technologies and access to finance. These factors are closely interrelated. For maximum effect, therefore, support for individual SMEs needs to address these factors holistically, taking their interrelationships into account.

Engage target companies using the right channels and incentives. Haldane comments that while many business leaders recognise low productivity as a general problem, they don’t see it as their problem to fix. That makes attracting SMEs to come forward for support and make the most of it a challenge. Our work indicates SME leaders respond best to offers of practical, tangible support that come through their familiar networks, rather than official channels. They also need a lot of consistent external help in trying to improve their productivity to get significant and lasting results.

Programmes that adopt these principles will improve the chances of success. They should also build in evaluation so that they can learn fast. For instance, engaging the target companies will be a key challenge. Programmes could experiment with different engagement mechanisms and messages and see which ones work best with different companies.

We also highlight, in our Viewpoint, the need to consider whether national and local policies could complement each other more.  To take innovation policy as a case in point, it is important to distinguish between different forms of innovation, such as new-to-market or new-to-firm innovation, and between innovation at the technology frontier and the diffusion of innovation within the frontier.  This distinction matters for policy, because the balance between the frontier/new-to-market innovation and diffusion/new-to-firm innovation affects the distribution of benefits from innovation across the business base.

Whilst innovating at the frontier is important, potentially more important to improving the productivity of laggards is the diffusion through new-to-firm innovations that help ensure that more companies are adopting new practices or imitating higher value products and services.  Current policy, however, focuses on the cutting edge and new-to-market innovations, partly on the assumption that these will be diffused through supply chains or through knowledge networks.  A key question is what types of interventions could help innovations diffuse faster.  Part of the answer may lie in regional programmes.  ERC research has found that regional innovation support is important for process and organisational innovation; whereas national innovation support is important for product or service innovation.  So, striking a balance between national and regional/local support for innovation may be important in supporting diffusion of innovation, which in turn could help the long tail of productivity laggards.

 

By Jonathan Cook, Director at SQW and Co-Investigator of the Productivity Insights Network

Absorptive Capacity and Productivity

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This blog is based on: Harris, R. and J. Yan (2017) Absorptive Capacity: Definition, Measurement and Importance.

Professor Richard Harris is a Co-Investigator of the Productivity Insights Network

Government industrial policy often sets out to encourage firms with high levels of productivity to locate in geographic areas (or in industrial sectors) that are underperforming – for example, to aid rebalancing and to strengthen the resilience of such areas or sectors, as well as to provide new jobs. Examples include encouraging inward investment of foreign-owned multinational firms and facilitating the creation or strengthening of ‘clusters’ of co-located firms around a core of higher productivity firms (see the UK Government’s White Paper, 2017[1]).

Firms exhibiting higher productivity (such as multinationals) tend to spend more on R&D, and thus introduce new innovative products wanted by consumers, or new production processes which are more flexible and cost efficient. And they are more likely themselves to export into highly competitive markets (and thus need to be capable of doing so). The dynamic capabilities such firms have can potentially ‘spill over’ to other less productive firms if the latter are capable of assimilating into their business this new knowledge from the external environment in which they operate.  Engaging in cooperating or partnering with, and sharing information that is available from, suppliers, customers, competitors, or other specialised sources, is evidence that firms are involved in internalising new, external knowledge spilling over from more productive firms. Similarly, firms that introduce new business practices for organising procedures (e.g., business improvement methods) and/or new methods of organising work practices and/or new methods of organising external relationships and/or implementation of changes to marketing concepts or strategies, are also demonstrating their capability of being able to internalise new knowledge, methods and practices. Overall, the ability of firms to engage in such activities denotes their ‘absorptive capacity’; like the ability of an individual to learn, absorptive capacity (AC) is not just about firms being able to potentially benefit from spillovers but rather using knowledge from the external environment to improve their productivity. If a firm has a limited ability to learn, then new strategies or technology that spills over, and that can potentially help firms become more productive, are likely to have only limited impact. More generally, having too many firms with lower AC is also likely to be a major reason for lower productivity in general, as it is shown in Harris and Yan (2017) that the higher is absorptive capacity, the greater the likelihood that a firm will do R&D, innovate and export – with all three activities, key underlying drivers of a firm’s (and thus nation’s) long-run productivity.

Harris and Yan (op. cit.) have used nationally representative data for Britain (based on the governments’ Community Innovation Surveys for 2004-2014) to calculate the level of absorptive capacity for each firm; from this it is possible to look at which firms have higher levels of AC. Figure 1 summarises the results; it shows the cumulative distribution (i.e., from the lowest to the highest values) of absorptive capacity separately for firms with a range of different characteristics. Establishments located in the Greater South East of England (which covers the administrative regions of the South East, Eastern England, London and the South West) generally have higher absorptive capacity throughout (their distribution lies to the right of the distributions of other areas); followed by capital cities (London plus Cardiff and Edinburgh); and then other areas (excluding Leicester and Nottingham, which have the lowest levels of absorptive capacity).  The second panel shows that multinational firms are must better as well, especially establishments that belong to UK multinationals, followed by US-owned firms. Establishments employing graduates have significantly better absorptive capacity levels, as well as those that are relatively larger, innovators (product and/or process), those engaged in R&D, and to a lesser extent exporters.  Establishments involved in the chemicals, engineering and aircraft sectors perform the best, followed by other manufacturing, and other services (excluding retail, hotels and real estate). When taking account of other factors that determine a firm’s AC (such as its size, age and organisational status), the differences shown in Figure 1 remain statistically significant (i.e., they are not ‘explained away’ by other underlying firm level characteristics).

The main results obtained by Harris and Yan have important lessons for policymakers, especially in terms of whether encouraging more multinationals to locate in (underperforming areas of) the UK, and pursuing a ‘clusters’ policy, will improve productivity levels. Firms with high levels of AC do have higher productivity, but the majority of less productive firms (the ‘tail’ of underperforming businesses) are more likely to benefit from their presence only if they have sufficient capacity to absorb potential spillovers from co-location.

Figure 1: (Weighted) Absorptive capacity indices by various firm characteristics, Great Britain, 2004-2014

Source: Harris and Yan, 2017 (Table 1)

[1] https://www.gov.uk/government/publications/industrial-strategy-building-a-britain-fit-for-the-future.