a literature review on skills and innovation how does successful innovation impact on the demand for skills and how do skills drive innovation

A Literature Review on Skills and
Innovation. How Does Successful
Innovation Impact on the Demand for
Skills and How Do Skills Drive
Innovation?



A CRIC Report for
The Department of Trade and Industry






Bruce Tether, Andrea Mina,
Davide Consoli and Dimitri Gagliardi


September 2005



ESRC Centre for Research on Innovation and Competition

University of Manchester,
Manchester, M13 9QH, UK



A Literature Review on Skills and Innovation A CRIC Report for the DTI
Table of Contents

Executive Summary
5

Chapter 1 Introduction 11

Chapter 2 Context: The UK Economy’s Skills & Innovation Performance 13
Introduction 13
Productivity and Value Added 13
Structural Change 16
Growing Inactivity amongst Working Age Men 18
Skills and Educational Attainment 19
The UK’s Innovation Performance 23
Conclusions 25

Chapter 3 Innovation and Its Implications for the Demand for Skills 26
Introduction 26
Innovation and Employment 26
Innovation and Skill Biases 28
How Technical Change Affects the Demand for Skills 30
The Paradigm of the Automobile Industry 30
The Rise of Information Technologies 33
How Organisational Innovation Affects the Demand for Skills 35

Soft Skills and ‘Emotional Labour’ 38
Complementary Explanations of Skill Bias 39
Innovation, Skills and Wage Inequality 41
Conclusions 43

Chapter 4 The Instituted Supply of Skills and Implications for Innovation 45
Introduction 45
Human Capital and Its Implications for Innovation 49
Education Systems and Skill Formation – Implications for Innovation 52
Skill Formation for Work – Internal vs. Occupational Labour Markets 55
Intermediate Vocational Skill in Britain and Germany – the NIESR Studies 59
The Proliferation of Qualifications and Skill Mismatching 61
Is the UK Trapped in a ‘Low Skills Equilibrium’? 63
Skills, Innovation, Value Added and Product Strategies 64
Services, Soft Skills and ‘Emotional Labour’ 68
A Note on Consumption Skills 69
Conclusions and Moving to a High Skills Route to Development 70

Chapter 5 Innovation Cycles and Strategies, and the Role of Skills 73
Introduction 73
Changing Understandings of Innovation – from Linear to Systemic Models 74
Innovation over the ‘Stages’ of the Industrial Life Cycle 78
Technology Trajectories and Pavitt’s Taxonomy 82
Services and Organisational Innovation 86
Radical Creativity versus Incremental Accumulation 87
Innovation and Dynamic Capabilities 91
Distributed Innovation and Imbalances in the UK’s ‘System of Innovation’ 94
Conclusions 95

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
Chapter 6 Conclusions 96
Answering the DTI’s Questions 96
Question 1 - Innovation and the Demand for Skills 96
Question 2 – The Supply of Skills and their Implications for Innovation 99
Question 3 – The Interaction between Skills and Innovation 102
Policy Considerations 104
The Strengths and Weaknesses of the Evidence Base 108
Suggested Future Research Requirements 111

References 115


Figures Page
Figure 2.1 Tertiary Education – International Comparisons of Attainment of Levels by 2002 22
Figure 2.2 Expenditure on Education as a Share of GDP, 2001 – International Comparisons 22
Figure 2.3 Gross Expenditure on Research and Development as a Proportion of GDP, 2001
International Comparisons 24
Figure 3.1 Share of New Products in Sales and Employment Change in Europe 28
Figure 3.2 Skill-Biased Technical Change – An Analytical Framework 29
Figure 3.3 ‘Good Jobs and Bad Jobs’ – Change in UK Employment by Job Quality 43
Figure 4.1 International Comparisons on Illiteracy & Innumeracy amongst Young Adult 53
Figure 4.2 Categories of National Systems of Vocational Training 57
Figure 5.1 The Third Generation ‘Coupling Model of Innovation 75
Figure 5.2 The Fourth Generation ‘Parallel Process’ Model of Innovation 75
Figure 5.3 The Fifth Generation ‘Systemic Integration’ Model of Innovation 77
Figure 5.4 A Simple Life Cycle Model of Industrial Evolution 78
Figure 5.5 Innovation over the Industrial Life Cycle 78
Figure 5.6 Pavitt’s and Miozzo and Soete’s Taxonomies 84
Figure 5.7 Sources of Advanced Technology and Strengths at Innovation for Manufacturing and

Service Innovators 87
Figure 5.8 A Penrosian Model of Resources and the Growth of Knowledge in the Firm 92


Tables Page
Table 2.1 Employment in the UK by Industry, Spring 1984 and Spring 2004 16
Table 2.2 Employment in the UK by Occupation, 1971 to Spring 2004 17
Table 2.3 Employment, Unemployment and Inactivity in the UK, 1993 and 2003 19
Table 2.4 Pupils in England Reaching or Exceeding Expected ‘Key Stage ‘3’ Standards in
English Maths and Science 21
Table 2.5 Patenting in the United States, 1996 – 2000 – International Comparisons 24
Table 4.1 Factors Hampering Innovation in Europe between 1998 and 2000 46
Table 4.2 ‘Crucial’ Impediments to Growth amongst UK SMEs 46
Table 4.3 Impediments to Innovation – European Innobarometer Survey of 2001 47
Table 4.4 Educational and Skills Inadequacies for Innovation – European Innobarometer, 2001 47
Table 4.5 The Employment of Graduates and the Conduct of Research and Development 64
Table 4.6 The Employment of Graduates and Engaging in Innovation Activities 65
Table 5.1 Characteristics of Innovation, Technology and Skills over the Industry Life Cycle 81
Table 5.2 Major Technological Trajectories, their Sources of Technology, Innovation Strategies
And Key Skills 83
Table 6.1 Characteristics of Innovation and Skills over the Industry Life Cycle 97

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A Literature Review on Skills and Innovation A CRIC Report for the DTI


Case Study Boxes Page
Case Study 1 Japanese Production Practices in the Car Industry – Implications for Skills 31
Case Study 2 Innovation and Co-operation in UK Transport Services 37
Case Study 3 Poaching of Key Staff and Innovation in the West Midlands 50

Case Study 4 Educational Reforms for Increased Adaptability: The Case of Singapore 54
Case Study 5 London’s Design Consultancy Cluster 89


Disclaimer
The views expressed in this report are those of the authors and do not necessarily reflect the
views of the Department of Trade and Industry, or any other individual or body associated with
this research.

Acknowledgements
The authors would like to thank the members of the DTI’s project steering committee - David
Campbell, Ben Chesson, Maria Cody, Samantha Hanna and especially Ben Marriott, the project
manager, for their guidance, comments and suggestions, patience and understanding. We would
also like to thank Damian Grimshaw, Ian Jones, Geoff Mason and Mario Pianta for helpful
comments and suggestions.

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
Executive Summary
The Government is concerned with productivity, which is essentially a measure of ability to
create wealth. The more productive people are, the more wealth they create for every hour they
work. It has been found that the UK has a productivity gap with some of its main competitors -
including France, Germany and the US - enabling those countries to create more wealth per hour
worked. Attention has therefore been focused on what the UK can do to speed up its
productivity growth and create more wealth from the effort its workers expend.
The Government has identified five key drivers of productivity, which are innovation, skills,
investment, enterprise and competition. The direct links between each of these drivers and
productivity have been explored in detail, but thus far relatively little attention has been focused
on how some of these drivers interrelate with each other to drive productivity.
This research is intended to start to explore the links and relationships between two of the

productivity drivers: skills and innovation. It does this through pulling together theoretical and
empirical literature from across various academic disciplines, including labour economics,
management studies and innovation studies.
A skill can be defined as an ability or proficiency at a task that is normally acquired through
education, training and/or experience. It can at times be synonymous with the related concepts
of competence, expertise, knowledge and human capital. There are many different kinds of skills.
In this report, distinctions will be made between different levels of skill, and different types of
skill. The types considered include pure science, engineering, problem-solving, language skills,
team working and communication skills.
Innovation is defined as the successful exploitation of new ideas. That is the development and
commercial exploitation of a new idea for a product or process that contributes to wealth
creation and profitability. The large-scale benefits of innovation come from the eventual wider
diffusion of these new products and processes across the economy. Innovation has many forms.
It can be technological in nature (relating to new machinery or other forms of equipment),
organisational (relating to changing management practices or general structures) or even new
individual ways of working unrelated to colleagues or new equipment.
How innovation drives the demand for skills
This report finds that the impact of innovation on demand for skills is very dependent on the
type of innovation and the context. Most of the literature examined focuses on technological
innovation. In the case of process innovation,
1
the literature predicts that innovation reduces
jobs, because it tends to be of the kind where capital (new machinery/equipment) replaces
labour, particularly unskilled labour. However, this is not always the case, as a process innovation
could be of the kind where more labour is used relative to capital, or where the job losses are
offset by the creation of jobs elsewhere in the company or the economy (such as in the upstream
production of new machinery). The empirical literature suggests, however, that process
innovation, in general, implies job losses. The theoretical and empirical literature suggests that
product innovation, on the other hand, is positive to employment levels as it will often result in
an increase in demand for those products.

1
The development and commercial exploitation of a new way of producing the organisation’s product(s).

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
The report goes on to discuss what types of employment are created or destroyed by innovation,
and hence the changing demand for different types of skills. The labour economics empirical
literature is in broad agreement that technological innovation in advanced western economies has
been skill-biased. That is it has increased the demand for higher skills and reduced the demand
for lower skills. This skill-biased technical change has particularly characterised the US in recent
years, and to a lesser extent the UK. Labour economists tend to agree that skill-biased technical
change has contributed to altering the distribution of earnings, exacerbating wage inequalities and
increasing sector-specific unemployment.
Organisational innovation has been less studied but what literature there is suggests that
organisational product innovation is positive to employment and that organisational process
innovation is negative to employment. A recent study of French manufacturing firms, however,
found that both product and process organisational innovation are negatively related to
employment, except when they are both introduced in combination and aimed at increasing
market size, in which case they are positively related to employment.
In assessing the effect of innovation on the demand for skills, it is worth remembering that
innovation is only one of a series of factors affecting the demand for skills. Other factors include
labour market institutions, such as the minimum wage and trade unions, domestic changes in the
conditions of competition, the composition of public spending and changes in workers and
consumers’ preferences. The complex interactions between these factors make estimations of
their interdependent effects extremely difficult. International trade is another important factor
that drives the demand for skills. It is often framed as an alternative explanation to innovation in
changing the demand for skills, but, as researchers have realised increasingly, it can often be
complementary (reinforcing) to the effects of innovation.
How the supply of skills drives innovation performance

There is no one mix of skills that is conducive to good innovation performance in all
circumstances. Instead, the required skills vary across the type of innovation concerned, the
industry and the strategic model the firm pursues.
In the older models of (technological) innovation, such as the ‘science push’ model of Vannevar
Bush, the skills to ‘produce’ innovation are the degree and higher-level science and engineering
skills of a small head or elite in the organisational hierarchy. More recent models of innovation,
such as the ‘systemic integration’ model, allow for more democratic, distributed sources of
innovation, involving the skills of the whole workforce. In particular, this model says all workers
should have basic ‘platform’ skills that allow them to be adaptable to changing circumstances and
more open to new ideas to be innovative. This contrasts with the past, when many workers
developed only job-specific, narrow skillsets. This model emphasises the importance of
interaction and cooperation between all the actors in the innovation process, including the
innovating firms’ suppliers, commercial partners and customers. These interactions require
communicating and negotiating skills.
The report identifies management and leadership skills as being of particular importance for all
types of innovation. Without leadership, or ‘strategic intent’, firms do not innovate in any
fundamental ways, and have to rely on small incremental improvements to their ways of working
from learning-by-doing. In a competitive environment, managers have to choose between
different innovation and growth strategies, even if they are just to keep ‘treading water’. Putting
the chosen strategy into practice requires management and leadership skills at all levels of the
organisation. There is little empirical evidence about how management skills (which may be

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
imperfectly measured in a variety of ways) relate to innovation, but theoretically they are thought
to be very important.
Intermediate level technical skills are also thought to be very important for innovation, especially
in manufacturing. This is significant because the UK has a smaller proportion of people with
these skills than countries like Germany and Japan. Further, there is a concern that the quality of
these skills is relatively low in the UK because of an over-reliance on narrow job related skills

rather than underpinning knowledge (transferable skills). The German ‘dual’ apprenticeship
system teaches apprentices academic (in the sense of conceptual or theoretical understanding) as
well as vocational skills. This is thought to enhance the capacity of German workers to adapt to,
and enhance the new technologies they encounter over their working lives. Evidence about the
effect of these skill differences comes from the NIESR matched-plant studies, which show that
British managers tend to defer the implementation of new equipment until it is ‘bug-free’, in part
because of acknowledged skills weaknesses on the shop floor. These delays imply British
manufacturing firms cannot build up the valuable relationships with leading-edge suppliers,
unlike German firms. They therefore end up competing on price, and not on quality, and are
considerably less productive.
Other (mixed) evidence of the importance of the supply of skills for innovation performance
comes from surveys asking about the effects of skills shortages. The UK Innovation Survey
(relating to 1998-2000), suggested that lack of qualified personnel was not a first-order barrier to
innovation, coming fifth out of nine barriers. However, in the European Innobarometer Survey
(2001), finding and mobilising human resources was the most cited barrier to innovation in the
UK. More recent data from the National Employers Skills Survey 2003 found that over a fifth of
the firms that reported skills gaps amongst their existing workforces had delayed implementing
new products due to these deficiencies, whilst nearly a third had experienced difficulties
introducing new working practices. It is worth mentioning that skills is one of several factors
affecting innovation performance. Other important barriers include access to finance and lack of
demand for innovative products.
Since the supply of skills is less than socially optimal, the report asks why firms and workers do
not invest more in education and training. Becker’s theory of human capital suggests that there
may be several reasons, including lack of information on the returns to education and training,
lack of access to finance to fund it and, for firms, fear of not reaping the return on their
investment in training, because their trained workers may leave for another company. The latter
problem, fear of so-called poaching,
2
may be especially relevant to highly-innovative, high-
technology industries. In this case, the training may be extremely expensive, risky, yet very

valuable to the firm that reaps the return on the investment, especially if a new market is being
opened up.
The dynamic relationship between skills and innovation
The questions about how innovation drives demand for skills and which skills are required for
innovation are to some extent two sides of the same coin. It is difficult to disentangle the skills
that drive innovation from those which are demanded as a result of change brought about by
innovation. In the long term, the relationship between skills and innovation must be circular. The
skills of the workforce and management will help determine the innovation that takes place,
which will then help determine the changed demand for skills in the firm, which will influence
the innovation that takes place and so on.

2
There is evidence that fear of poaching is more of a problem than actual poaching.

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
The product life cycle theory provides some answers to how innovation changes the demand for
skills through the stages of a new product innovation, or it could also be viewed as how the skills
for successful innovation change over the cycle.
3
In the early, fluid stages of the industry where
the product is ill-defined, the key skills are those of entrepreneurs, and sometimes those of
scientific or technical specialists, which together with marketing skills realise or create the market
for the product. As time goes on, the product tends to become more standardised, until a
dominant design emerges. In this transitional stage, there is a shift from product to process
innovation. Functional, scientific management skills and specialist workforce skills are
increasingly required. Once the dominant design is established, the industry enters the specific
stage, where innovation is more incremental and cumulative. The skills required are managerial
‘command and control skills’ and low level or unspecific workforce skills. Higher-level workforce
skills may be increasingly required if the firm attempts to move into the higher quality end of the

market in response to low-cost competition. The product life cycle model had been principally
applied to manufacturing firms. There is limited evidence that some service sectors move in the
opposite direction, from large-scale provision of standard services and process innovation to
smaller-scale provision of customer-specific services, implying product innovation.
Low skill equilibrium is a relevant concept in the literature relating to the interaction of supply
and demand for skills and innovation. Essentially, this is a situation in which firms encounter a
demand for low-specification, low-value added products, which only require low skills to
produce. They therefore tend to compete on price, utilising low-skill workers. As low-skill jobs
are available, but relatively few high-skill jobs exist, workers have little incentive to acquire
higher-level skills, and so firms do not have the supply of higher-level skills that they would
require if they wanted to move to a high-specification product strategy. This situation is thought
to pertain in some parts of the UK economy. This theory is supported by the empirical work of
Geoff Mason who suggests that demand for skills in Britain is lower than that of several other
economies because a large proportion of British enterprises have adopted low specification
product strategies. Further he argues that in the absence of strong incentives like foreign
competition there is no reason for firms to change and adopt an innovation based strategy. Also
when firms wish to move up market they need different skills and so are likely to then experience
skill shortages.
Another aspect that affects the relationship between innovation and skills is the industry in which
the firms operate. In the innovation studies literature, Pavitt argued there are four different types
of (mainly manufacturing) industry that have their own patterns of innovation and requirements
for skillsets. First, science-based industries such as pharmaceuticals and electronics, require a core
of degree-level science and engineering skills, and work a lot with universities and/or have their
own R&D laboratories. Second, scale-intensive industries rely on economies of scale, exploited
by scientific managers, increasingly with cross-functional integration skills, specialist product
design, engineering and development skills, and a workforce that is able to adapt to and make the
best use of technologies. Third, specialist suppliers, which engage in a lot of cooperation with
lead users, tend to require the skills of interactive learning, the expertise to develop highly client-
specific solutions and vocational, practical development skills. Fourth, supplier-dominated
industries, where most (technological) innovation comes from outside the firm, require

entrepreneurial skills for spotting market trends, and a workforce with the ability to implement
and use new technologies.
In a later paper, Pavitt added a fifth category of information-intensive firms, largely in the service
sector. Their main source of new technology is in-house software or systems development,

3
Not all industries will follow this pattern, as has been shown empirically.

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
although some may come from outside. Here the style of innovation requires technical skills to
develop software and communication or cooperation skills to acquire technology from outside.
The empirical evidence suggests that service-sector firms are more organisationally innovative
than manufacturing firms. These organisationally-orientated service-sector firms are more likely
to emphasise the importance of supply chain interaction and external intellectual property but
less likely to emphasise in-house R&D and research based cooperation with other organisations
such as universities as their key sources of technology.
Much of the literature emphasises the systemic nature of the relationships between innovation,
skills and productivity. Florida proposes the concept of the ‘creative class’ of people – scientists,
engineers, designers and creative arts workers. He finds their concentration level in local
populations is positively related to economic performance and tolerance. Meanwhile, in the
innovation studies literature, Kodama suggests that with technological fusion and increasing
cooperation, innovations are increasingly crossing industry and technological boundaries, which
will tend to make the new innovations more widely applicable. This in turn is changing the
demand for skills by requiring that workers have broader, less specialised skills, involving multiple
disciplines.
Policy implications
With the growth of trade in goods and services, and the growing internationalisation of scientific
and technological activities, it is increasingly important that innovation in the UK involves a large
proportion of firms and their employees. No longer can companies or the country as a whole

rely heavily on small elites of highly trained or educated people. Instead, innovation needs to be
organisational as well as technological, and to involve those on the shop floor as well as those in
R&D, marketing and management positions. It follows, therefore, that one of the over-riding
points is that if the UK is to continue to have a dynamic innovative economy then all its people
need to have a good general education. This needs to provide the person who receives it with a
platform of generic skills that will prove useful in engaging with and adapting to the changing
circumstances that will doubtless pertain within and across industries and firms. That is they will
be better able to innovate and adapt to the effects of innovation in their own company, and
better able to re-enter the labour market, even moving into different fields, if they are made
redundant.
The report suggests that a certain amount of academic education alongside vocational education
raises the individual’s absorptive capacity to learn and adapt. And, again, innovation is likely to
require an increasingly adaptive workforce with a broad range of skills.
The supply of skills seems to be less than would be socially optimal, even with the current
Government interventions in this area. Therefore, perhaps some new form of cost and benefit
sharing is required between the employer, employee and the Government, to encourage greater
skill formation. The authors explore the possibility of tax credits for training, as have been
introduced in Canada. An argument against such an approach is that it would be difficult to
ensure that tax credits were not just being given for training that would have occurred anyway.
Another issue that needs to be addressed is the skills and commitment of managers to innovation
and the R&D tax credit may prove to be a valuable step in this direction. Changing routines and
ingrained practices is, of course, difficult. Encouraging more collaborative, trust-based
arrangements between firms is necessary whereby firms may gain long-term advantages from
interactive learning, even if there are additional short-run costs. This is best achieved by
confronting firms not with a single ‘best practice’ model, but rather by encouraging step-by-step

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
transformations through the adoption of practices appropriate to their stage or level of
commitment to innovation.

There perhaps should also be more consideration of the trade-off between short-run
productivity, or static efficiency, and capacity to innovate, or dynamic efficiency. In many
companies and organisations a battery of targets or financial measures encourage short-run
efficiency but fail to recognise the importance of ‘organisational slack’ and local experimentation
to achieve innovation and greater dynamic efficiency. 3M allows its engineers to spend 15% of
their time on any project that happens to interest them. This approach, while clearly not
applicable to all, has been shown to boost innovation, as well as increasing employee
commitment and motivation.

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
1 Introduction
1.1 The DTI’s definition of innovation is the successful exploitation of new ideas. That is
the development and commercial exploitation of a new idea for a product or process that
contributes to wealth creation and profitability. The large-scale benefits of innovation
come from the eventual wider diffusion of these new products and processes across the
economy. Innovation takes many forms. It can be technological in nature (relating to
new machinery or other form of equipment), organisational (relating to changing
management practices or general structures) or even outside of these two main categories.
A skill can be defined as an ability or proficiency at a task that is normally acquired or
developed through education, training and/or experience. It is, of course, related to the
concepts of competence (which tends to imply these days that there is a demand for the
skill), expertise and knowledge. There are many different kinds of skills.
1.2 The aim of this study is to review the literature in order to start answering the questions:
- Is there a mix of skills at either the firm level or within society that would increase the
amount of innovation that is undertaken?
- How does the successful introduction of new ideas change the pattern of demand for
skills in companies and the economy?
- How do these two questions relate to each other and what is the nature of the two-
way relationship between skills and innovation?

- What are the policy recommendations that arise?
- What are the gaps in the evidence base that require further research?
1.3 To address these questions we have undertaken a review of the literature, or more
specifically a review of three strands of literature, each of which is discussed in a separate
chapter.
1.4 The report is structured as follows. Chapter 2 sets the scene regarding skills, innovation
and wider economic performance in the UK. This is intended to set the study in its wider
context. Chapter 3 is largely based on the mainstream economics literature and
essentially concerns how innovation, particularly in the form of ‘technical change’ is
impacting on the demand for skills in the economy. The literature is essentially in
agreement that, for an advanced economy like the UK, innovation is positively skill
biased, although there is a debate about why this is the case. Chapter 4 is largely based
on labour process studies on the supply of labour and how the instituted processes of
skill formation provide countries with different endowments in terms of skills, which
then impact upon countries’ abilities to engage in innovation, of different forms.
Chapter 5 is based on an understanding of innovation and skill requirements from an
innovation studies / Schumpeterian economics perspective.
4
This approach is more
systemic, and is not based around the classic supply and demand framework of
mainstream economics.

4
Schumpeter (1883-1950) was an Austrian economist who placed innovation, and the ‘creative destruction’ of
innovation at the heart of his analysis. Today, Schumpeter's views are especially influential amongst heterodox
and evolutionary economists, and innovation management scholars, who are interested in how innovation shapes
competitiveness, industrial organisation and economic development. Schumpeterian ideas have also been highly
influential in shaping innovation policy. For example, the EU’s innovation program, and its main development
plan, the Lisbon Strategy are arguably based on Schumpeter. (See

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
1.5 In Chapter 6 we conclude the study, reviewing what we have learnt to answer the
questions as outlined above.

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A Literature Review on Skills and Innovation A CRIC Report for the DTI
2 Context: The UK Economy’s Skills & Innovation Performance
Introduction
2.1 Overall, relative to its historical performance, the UK economy has enjoyed a decade of
relatively strong and stable growth in GDP, with stable and low inflation, and falling
unemployment.
5
With inflation and unemployment under control, the chief concern has
been to establish the framework conditions to stimulate the development of the economy
towards higher value added activities and ‘the knowledge economy’.
2.2 To achieve its ambitions, the Government recognises the UK will have to improve its
productivity and innovation performance: “We live in a fiercely competitive global
economy. If we are to enhance our productivity and raise our standards of living we need
to improve radically our innovation performance. And we will need to innovate
continuously in the future so that we can hold our own against fast moving new
economies” (DTI’s Innovation Report, 2003, p. 16). It is argued that UK companies will
have to compete more on quality, with high value added and more innovative products
and processes. This, in turn, “will require inspirational leadership, stronger management
and leadership skills, a highly skilled workforce, a flexible labour market that promotes
diversity and fair treatment, and high performance workplaces” (op cit, p. 11). Moreover,
the Government seeks: “A highly educated workforce with a culture of lifelong learning
[which] is more likely to adapt to economic change” (ibid).
2.3 The purpose of this chapter is to set the context for the studies examined in the report in
the light of the government’s objectives and the key structural characteristics of the UK

economy. We will sketch the macro-economic context of productivity, patterns of
structural change, skills and educational attainment and innovation performance.
Productivity and Value Added
2.4 Productivity is in essence a measure of the efficiency of an economy in terms of the
amount of output produced per unit of input used. Relatively simple measures of
productivity include output per worker, or output per hour worked. More complex
measures include total (or multi-) factor productivity which takes into account not only
labour inputs but also capital (buildings, machinery, equipment, etc.), the stock of which
is estimated rather than measured precisely. The UK Government’s preferred measure is
output per worker, which has the advantage of being the most straightforward to measure
and also being immediately linked to the overall objective of raising the growth trend of
the UK economy. The Government considers that productivity is driven by five factors:
investments in capital (buildings, machinery, equipment, etc.), skills (i.e. investments in
people through education and training), innovation (i.e. the generation and application of
new knowledge), enterprise or entrepreneurship (i.e. a willingness to start new businesses,
take risks, etc.) and competition between providers of goods and services. These drivers
interact in complex ways. For example, the extent of competition is a key driver of
innovation (e.g. a monopolist has little or no incentive to innovate), whilst innovation
also impacts on competition (e.g. by creating or breaking a monopoly). In this report we
will discuss especially the inter-relationship between skills and innovation, within the
context of raising value added and productivity.
2.5 At the level of the firm, productivity can be measured by dividing value added (the value
of the outputs less the value of the raw materials and intermediate goods and services

5
In contrast, the major problems with the UK economy since the post-war boom until the mid-1980s have been
inflation and unemployment (Nickell and van Reenen, 2001).

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A Literature Review on Skills and Innovation A CRIC Report for the DTI

used in the production of these outputs) by the inputs used, such as the number of
employees, the number of hours worked, or a measure which combines both the labour
and capital used in the production process.
2.6 Measures of productivity allow comparisons between countries and firms in terms of
their performance, but the current performance of a country or company is determined
to a significant extent by decisions made some years ago. Similarly, decisions made today
will impact on productivity in the future. For example, current investments in R&D and
training are being made in the expectation that the firm will gain a greater return in the
long run than it would save in the short run by not engaging in these activities.
However, even this is complex, as many if not most firms do not have a precise
understanding of the rates of return to their R&D and training activities. Suffice to say
that particularly in the past UK firms were often criticised for being short-termist – that is
seeing to maximise their short run performance and failing to invest significantly for the
longer term through activities such as R&D and training.
2.7 At the aggregate level the UK has long suffered a productivity deficit relative to its major
competitor nations. In terms of labour productivity, the UK lags significantly behind the
US. As van Reenan (2004, p.4) puts it: “Joe Doe, our average American worker, could
take Thursday and Friday off and produce as much as poor John Bull toiling away
throughout the working week”. Although the higher productivity of US workers means
they could work fewer hours to achieve the same standard of living as UK workers, in
fact they tend to work longer hours and therefore tend to have significantly higher
incomes. Growth accounting suggests that US productivity is higher because US workers
have more and better equipment (although they have similar skills), and because of
greater past investments in R&D. But some of the US’s advantage remains unexplained.
As Van Reenan (2004) asks: “Why do US workers create so much more output for their
fixed and human capital inputs? What is it that they do more effectively that makes such
a significant difference on the macroeconomic level?” Increasing the amount of physical
capital per hour worked in the UK to American levels would only make up about half the
gap in labour productivity between the UK and US. Nor would having the same skill
distribution as the US close the gap. Around half the gap between the UK and US labour

productivity is effectively unexplained and is attributed to innovation and different ways
of working.
2.8 In recent years, the US has enjoyed a period of rapidly rising productivity. US
productivity growth rose from about 1.2% per annum between the late 1970s and 1995,
to 2.2% per annum between 1995 and 2001. Most economists reason that the diffusion
of Information Communication Technologies (ICTs) and associated innovations in
working practices is an important part of the US’s faster productivity growth since the
late 1990s (see Chapter 3 of this report), but there is a debate about whether the impact
of ICTs has been found mainly in the ICT producing sectors (such as software and semi-
conductor manufacturing), or also in the ICT producing and using sectors (such as
retailing and transportation).
6
Economists are however struggling to explain why the
uptake of ICTs and new business practices associated with these has been slower in
Europe than the US: “Since ICT is available at about the same price in Europe as in the
US it is not clear why Europe has lagged behind. So as the ICT revolution introduced
new forms of capital, European economies failed to exploit its benefits in terms of

6
Among the alternative explanations for the rise in US productivity is the growth in the number of illegal workers,
for example at retailers like Wal-Mart, whose input is not officially recorded but whose output is effectively
attributed to the legal component of the workforce.

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enhanced productivity and prosperity as fully as the US” (Van Reenen, 2004).
7
It could
be that these new business models and benefits from past investments in ICTs will soon
diffuse to Europe, and the fact that the UK has made relatively high investments in ICTs

means it should be well placed to take advantage of these.
2.9 The UK’s productivity performance relative to its major European competitors, and
France and Germany in particular, is more contentious. Simply put, the average French
and German worker is more productive than the average British worker, but fewer
French and Germans work, and those who do work fewer hours. Assuming that, in all of
these countries, the more productive people in the potential labour market tend to work,
whilst the least productive tend to be economically inactive, it is less clear that the
difference in productivity between Britain, France and Germany would still remain if the
same proportion of the labour force in each of these countries worked, and especially if
the average Briton, French and German worker all worked for the same number of hours
and had the same amount and quality of equipment available to them.
2.10 Arguably, the UK has lower productivity because it has simpler and less complicated
labour market regulations than France, Germany and most other European countries.
This has the direct effect of encouraging more people to work and encouraging
employers to offer more jobs, not least because it is also relatively easy to reduce
employment by cutting jobs. This means more marginal workers are more likely to be
employed in the UK, reducing unemployment and inactivity. But the higher labour costs
and stricter labour market regulations in Continental Europe also encourage companies
to substitute capital goods for labour, meaning that the average European worker has
better equipment (i.e. more and/or newer equipment) with which to work, which further
raises output per person employed, resulting in higher productivity amongst those in
work. One study estimates that this deficit in physical capital accounts for about 80% of
the labour productivity gap between the UK and France and Germany (van Reenan,
2004). The other 20% is very largely attributed to the lower skill levels of British workers
(which itself partly reflects the UK’s higher employment rates).
2.11 The UK therefore enjoys higher employment rates than France and Germany, to some
extent at the cost of lower average productivity amongst those employed. However, this
trade-off between the employment rate and productivity amongst those employed does
not explain how some smaller European countries (such as Switzerland, Denmark and
the Netherlands) are able to achieve higher productivity whilst maintaining high

participation rates.
2.12 The UK is home to many excellent companies which achieve high levels of value added
(and high levels of value added per employee), as is shown by the DTI’s Value Added
Scoreboard.
8
But there is also wide variation in performance between best and worst
performing businesses in the UK. According to Haskel and Martin (2001) the best

7
The reasons why uptake of ICTs might have been slower in the UK and Europe than in the US include: the US
being closer to a single market than Europe, which means there are greater economies of scale; the physical
structure of Europe and the US are very different, and this is important in ICT using sectors such as retailing. In
the UK and Europe it is difficult to build new out-of-town shopping complexes which are generally more
productive and achieve higher value added than generally small shops in historical and congested town centres.
Differences may also exist on the demand side. US consumers have more readily accepted new and more
efficient means of distribution, such as Amazon.com and eBay. Some of these differences will be overcome over
time, whilst others (such as the different physical infrastructures of town and cities) are effectively ‘locked in’.
8
See

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manufacturing establishments are about five times more productive than the worst. Such
variation is also likely to exist in other countries, although the extent of variation may be
greater or less. The existence of this ‘long tail’ probably relates to the diffusion of
technologies, managerial practices and skills. Notably, Haskel and Martin (2001) also find
that even if the lower performers were to raise their productivity to the median this
would still not close the productivity gap between the UK and its major competitors.
Structural Change
2.13 Measures of productivity permit comparisons between the performance of countries and

companies, and it is nearly always possible to find ways of increasing productivity in
existing tasks to maximise short-run efficiency. But in the longer run, such measures
may not be sufficient, as countries and companies that are highly developed in one
context may find it difficult to adapt to change. Core competences become core rigidities
(Leonard Barton, 1992). ‘Structural change’ is associated with more fundamental
changes in types of work, types of output (e.g. moving from goods to services, and mass
production to customisation) and ways of working (e.g. from integrated companies to
more distributed forms of production involving greater outsourcing).
2.14 The UK has undergone tremendous economic change in the last quarter of a century.
This has seen the decline of some industries and the growth of others, as shown in table
2.1. Scase (1999, p. 23) observes that “more people now work in Indian restaurants than
in shipbuilding, steel manufacturing and in coal mining combined. There are three times
as many public relations consultants as coal miners.”
Table 2.1
Employment
*
in the UK by Industry, Spring 1984 and Spring 2004
9

All Male Female
1984 2004 1984 2004 1984 2004
All in Employment (000s) 23,974 28,311 14,039 15,296 9,935 13,015
Agriculture & Fishing (%) 2.6 1.3 3.5 1.9 1.3 0.6
Utilities (%) 2.9 1.0 4.3 1.4 1.0 0.5
Manufacturing (%) 24.9 13.5 30.3 18.8 17.3 7.4
Construction (%) 7.7 7.8 12.0 13.0 1.6 1.7
Distribution, Hotels &
Restaurants
(%) 20.3 19.9 15.8 18.1 26.5 22.1
Transport and

Communications
(%) 6.3 6.8 8.5 9.7 3.1 3.5
Financial & Business Services (%) 9.3 15.5 8.4 16.2 10.6 14.8
Public Administration,
Education Health
(%) 20.9 28.0 13.1 15.7 31.9 42.3
Other Services (%) 5.1 6.2 4.0 5.4 6.6 7.1
All Services (%) 61.9 76.5 49.9 65.0 78.9 89.8
* includes Self-Employment
2.15 Overall, the sectors that are growing in terms of their employment are ‘business and
miscellaneous services’, ‘non-marketed services’ (such as health and education), and
‘distribution and transport’, whilst ‘construction’ is stable, and the ‘primary sector’ (i.e.
agriculture and mining), the ‘utilities’ and manufacturing are in decline. Whilst this is
particularly associated with the increasing participation of women in the labour force
(almost 90% of women who work do so in service sectors), male employment is also


9
Drawn from the Labour Force Survey (LFS) Historical Quarterly Supplement Table 22.

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changing. In 1984 half of all men in employment worked in service sectors, now that
proportion is two-thirds.
2.16 Meanwhile, the types of work that are growing are ‘managers and senior officials’,
‘professionals’, ‘associated professional and technical’, ‘personal and protective services’,
and ‘sales and customer services’, whilst those types of work in decline are ‘administrative
and secretarial’, ‘craft and skilled manual’, ‘factory operatives and unskilled manual
occupations’ and ‘elementary occupations’ as shown below in table 2.2.
Table 2.2

Employment
*
in the UK by Occupation, 1971 to Spring 2004
1971 1981 1991 1998 All Men Women
2004 2004 2004
All in Employment (000s) - - - - 28,801 15,179 12,901
Managers & Senior Officials (%) 11 10 13 13 14.7 18.3 10.5
Professional Occupations (%) 7 8 9 11 12.6 13.5 11.5
Associate Professionals and
Technical Occupations
(%) 9 9 11 12 13.8 13.3 14.4
Administrative & Secretarial (%) 14 16 16 15 12.5 4.7 21.6
Skilled Trades (%) 19 17 15 14 11.3 19.4 1.9
Personal Service Occupations (%) 34567.8 2.3 14.1
Sales and Customer Services (%) 56678.2 4.7 12.1
Process Plant and Machine
Operatives
(%) 14 12 10 9 7.6 11.9 2.4
Elementary Occupations (%) 17 18 15 14 11.8 11.9 11.6
Data for 1971-1998 from Green, 2005. Data for 2004 from the Labour Force Survey
* includes Self-Employment

2.17 This combination of changes in occupational and industrial structure has been associated
with the growth of services and the dis-integration of production (i.e. the growth of
outsourcing and the decline of the vertically integrated firm). The decline of large scale
operations, and the growth of small firms and self-employment has been associated with
a growth in small business management and administrative work, relative to production
workers. The growth of services and small firms attracts widely differing views with
regard to job quality and skills. Some commentators are very negative. Scase, for
example, observes that, “inherent in the growth of a service and information economy is

the creation of jobs that are low paid, insecure and offer limited career opportunities.
Changes in the retailing sector – the decline of traditional, independently-owned shops
and the growth of supermarket chains – have created low paid and low skill jobs. The
growing need for care assistants to care for an ageing population has led to the creation
of part-time, low paid employment. Moreover the growing use of ICTs is generating
similar low paid jobs in call centres. These are expected to make up 5 per cent of the
labour force by 2010” (Scase, 1999, p. 24). Yet the growth of services is also associated
with an expansion of high-skill-high-wage work – on average managers and senior
officials earn twice as much as process, plant and machine operatives, and on average
those working in financial services earn a third more than those in manufacturing.
2.18 These contrasting trends are associated with a growing diversity of jobs by quality in the
UK. Goos and Manning (2003, p. 77) observe that “Whichever way you look at it, there
is growing polarisation of jobs in the UK: there are more good ‘MacJobs’ and more bad
‘McJobs’. The data show there have been strong increases in the number of high paid
jobs but also significant increases in the number of low paid jobs over the last 25 years.

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Craft and clerical occupations in non-service industries are disappearing while the
importance of low and high paid service jobs has increased”. Also notable is that
evidence of job polarisation is even more marked for men than for women. This
increased job polarisation, which is to a significant extent due to the nature of the skills
British workers develop through education and training, is discussed further in chapter 4.
Growing Inactivity amongst Working Age Men
2.19 As mentioned earlier, in terms of employment and unemployment, the UK labour market
has been remarkably healthy (Nickell and Quintini, 2002).
10
But while unemployment is
relatively low, the inactivity rate
11

in the UK has not changed markedly from about 20%
for twenty-five years, and what is remarkable is the convergence in the inactivity rates of
men and women. “Since 1975, the percentage of non-student men of working age who
are inactive has risen more than five times [from 2.6% to 13.2% in 1998], around a 10
percentage point increase. By contrast, this is almost offset by a nearly 10 percentage
point decline in the inactivity rate of women [from 36.5% in 1975 to 26.9% in 1998]”

(Nickell and Quintini, 2002, p. 211). The growth in economic inactivity has been
particularly striking amongst unskilled men: “Most extraordinary is the fact that the
inactivity rate amongst men of working age without qualifications was 30% in 2000,
compared with less than 4% some 20 years before. This despite the fact that in 2000, the
UK labour market was booming” (Nickell and Quintini, 2002, p. 212). Gregg and
Wadsworth (2003) show that two in five men of working age (excluding students)
without qualifications are now economically inactive or unemployed, with the majority
being economically inactive; see table 2.3 below. This lack of work, and growing
exclusion from work, has been most marked in some northern cities, such as Newcastle-
Gateshead, Liverpool and Glasgow.
12


10
Nickell and Quintini (2002, p. 203) observe that “Since the disasters of the early 1980s, UK unemployment has
moved in parallel with the best performers in Europe (Denmark, Ireland, the Netherlands).” What is especially
remarkable is that unemployment has been able to fall without any significant inflationary pressure. Nickell and
Quintini discuss the reasons for this.
11
The inactivity rate refers to the total number of individuals of working age who are not students and who are
neither working nor unemployed, as a proportion of the non-student working population of working age.
12
“By 2002, only 25% of less skilled men [i.e. the bottom 30% by qualifications] living in social housing were in

work in [these] depressed urban conurbations, sharply down from [32% in] 1993. In contrast, the employment
rate for similar groups in the South East was around 65%” (Gregg and Wadsworth, 2003, p. 91) According the
Office for National Statistics, Newham in London had, at 42.1%, the highest inactivity rate of all local authorities
in Great Britain in 2004 (see also Anyadike-Danes, 2004).

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Table 2.3
Employment, Unemployment and Inactivity in the UK, 1993 and 2003*

Amongst those
with No
Qualifications
Amongst those
with Low
Qualifications
#

Amongst Others


1993 2003 1993 2003 1993 2003
Men
In Employment 63% 59% 66% 69% 83% 86%
Unemployed 16% 8% 15% 7% 9% 4%
Economically Inactive 21% 33% 19% 24% 8% 10%
Women
In Employment 53% 47% 55% 56% 74% 79%
Unemployed 6% 4% 6% 4% 5% 3%

Economically Inactive 41% 50% 39% 41% 21% 18%
* Working age population excluding students.
#
The 30% of the population which, for their age cohort, have the lowest qualifications.
Data source: Gregg and Wadsworth, 2003, Table 6.1 (Labour Force Survey Data)
2.20 The growth in inactivity amongst men almost certainly reflects structural changes in the
economy which are associated with an overall shift in demand towards higher skills, and a
shift away from physical labour to more cognitive work and ‘emotional labour’ (see
Chapter 4). The fundamental problem is that there is a large body of individuals of
working age who, because of lack of skills, do not command a high enough wage in the
labour market to provide a decent standard of living for themselves and their dependents.
This problem is particularly severe in Britain because the pool of very low-skill workers is
much larger than in western Europe as a whole (Nickell and Quintini, 2002, p. 215).
Moreover, not only is it larger; it is also geographically more concentrated especially in
the old industrial areas where the ‘new jobs’ created to replace those lost in heavy
industry tend to be low skill and low wage, but also increasingly ‘feminine’ (Danson,
2005). This has encouraged the expansion of women’s participation in the labour market,
whilst unskilled men have found it difficult to find or take up new forms of work.
13

2.21 By contrast, those with skills and especially degrees have prospered: “in 1980, men with
degrees earned around 63% more than those without qualifications [other things being
equal]. By the mid-1990s this had risen to 93% - this despite the fact that the percentage
of employees with degrees had almost doubled over the same period” (Nickell and
Quintini, 2002, p. 212).
Skills and Educational Attainment
2.22 At a broad level a skill is a human ability coupled with an actual or potential demand for
that ability. Narrower definitions consider that a skill is a special ability, often acquired
through specialist training.
14

Skills are directly related to employment, employability and

13
Nickell (2004) notes that the growth in women who work has been greatest amongst married women whose
partner works. Meanwhile, the rise in inactivity amongst men has been concentrated on married men whose
partners do not (or cease) work and amongst single men.
14
Thus ‘unskilled work’ is skilled under a broad definition but not under a narrow one. A good example is ironing
of clothes, which requires good hand-eye co-ordination and is very difficult to automate, yet most people can
iron and it requires little to no training. In the past, ‘skills’ have been associated with specialist abilities, especially
amongst those with vocational rather than academic qualifications (i.e. those completing apprenticeships), while
currently broader definitions of skills are being favoured.

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productivity. They are also indirectly related to productivity through innovation, as we
will argue in this report.
2.23 Although the situation is now improving, the UK has long struggled to provide a good
basic education for all. For example, according to Leach (2002), around 7 million adults
in the UK are functionally illiterate, with one in five adults unable to locate the pages for
plumbers in the Yellow Pages. Nearly half of adults have numeracy skills below those
expected for an 11 year-old. One in four adults cannot calculate the change they would
get from £2 when they buy one item for 68p and two more for 45p each. A 1996 survey
by the Institute of Directors revealed that four in five company directors were concerned
about the basic numeracy and literacy of job applicants.
2.24 International comparisons are difficult, but the Moser (1999) report found that 23% of
British adults were at the lowest levels of literacy (c.f., 12% in Germany) and numeracy
(7% in Germany), and Leach (2002) claims: “According to many international surveys,
Britain’s educational standards are poor compared with other countries. On the most
respected international surveys, including the International Adult Literacy Survey (IALS)

and the Third International Mathematical and Science Study (TIMSS) the UK has
performed relatively poorly, compared to the Far East and much of Europe. This said, in
the last round of OECD studies the UK appears to show much improved standards, and
appears to outperform other countries which are widely thought to have superior
education systems (see Prais, 2003 & 2004, vs. Adams, 2004).
2.25 At least as proxied by qualifications, the skills in the UK labour force have been
transformed in the last 30 years. In 1974 over half of all men and two thirds of women
(aged 16-69) had no qualifications at all. Now these figures are 15% and 19%
respectively. Meanwhile, in 1974 only 4% of the male workforce and 1% of the female
workforce had degrees, whist 16% and 13% respectively now do (Glennerster, 2002). In
2002/03 53% of pupils in the UK gained five or more GCSEs (or equivalent) at grades
A* to C, compared with 46% in 1995/96. Girls outperformed boys, with less than half
of boys achieving this standard. Meanwhile, the proportion of pupils gaining two or
more GCE A levels (or equivalent) has increased dramatically from 19% in 1992/93 to
39% in 2002/03. Again girls outperform boys, with 43% of girls achieving this compared
with a third of boys (Social Trends, 2005).
15

2.26 There have therefore been significant improvements, but is the glass half full or half
empty? The consensus seems to be that in the future most jobs will require higher skills.
One estimate reported in the media is that in ten years two-thirds of jobs will require A-
levels or higher education qualifications.
16
It is very difficult to assess the accuracy of
these claims. Partially it will depend on the extent to which more routine forms of work
resist or succumb to displacement through off-shoring and automation, and partially it
will depend on whether new applications are found for the relatively low skilled within
the workforce. For example, the domestic cleaning sector may expand enormously in the
next decade, as it becomes more socially acceptable both to be and have a cleaner, and as
the relatively affluent decide to ‘buy time’ (for more paid work and leisure) by

outsourcing more of their domestic chores. But it would appear that the UK cannot
afford a high failure rate from its education system, and it is worrying that around a third

15
Also controversial is whether or not qualification standards have remained constant over time. Leach (2002), for
example, claims standards have declined.
16
Reported in the Guardian and quoted by Ruth Kelly, Secretary of State for Education.


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of pupils are failing to achieve the desired Key Stage-3 standards in English, Maths and
Science, as shown in table 2.4 below.
Table 2.4
Pupils in England reaching or Exceeding Expected
‘Key-Stage 3’ (i.e. at age 11-12) Standards in English, Maths and Science
Teacher Assessment Tests
Boys Girls Boys Girls
English 62% 77% 64% 77%
Mathematics 72% 76% 72% 74%
Science 69% 72% 65% 67%
Source: Social Trends, 2005, Table 3.11
2.27 Within education and training, increasing attention is being paid to basic skills, which
reflects a number of developments.
17
Partly, it reflects a social inclusion and
‘employability’ agenda, with the ability to undertake basic tasks being seen as crucial to
the employment of the unqualified, including many of the inactive and long term
unemployed. Partly it also reflects the development of a qualifications culture, such that

any abilities, no matter how basic, are increasingly subject to qualifications.
18

2.28 International evidence shows that in virtually all OECD countries participation in tertiary
education is increasing – i.e., young adults are more likely that the rest of the workforce
to have participated in tertiary education (see Figure 2.1). The OECD data also shows
that the UK’s performance in terms of participation in tertiary education is moderate,
with the proportion of young adults in the UK who have participated in tertiary
education being higher than some countries (notably Germany, Switzerland, the
Netherlands and Italy), but lower than in others (including Canada, Japan, Korea, the US,
Sweden and France).


17
‘Basic skills’ are defined by the Basic Skills Agency as “the ability to read, write and speak in English and to use
mathematics at a level necessary to function and progress at work and in society in general”.
18
See the National Qualifications Framework (available at

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Figure 2.1
Tertiary Education - Attainment levels by 2002 (OECD Data)
0%
10%
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Figure 2.2
Expenditure on Education as a Share of GDP, 2001 (OECD Data)
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Public Expenditures Private Expenditures

2.29 Certainly if the UK wants to be at the forefront of the knowledge economy it will have to
continue to address some of its deep-seated problems and invest heavily in education.
The Labour Party Manifesto of 2005 declares that ‘Education is our number one priority’
and claims that state funding for education has risen from 4.7% of GDP in 1997 to 5.5%
in 2005. This level of spending is still not exceptionally high by international standards as
Figure 2.2 shows. Of course, it is not just a matter of spending, but also how the money
is used (Leach, 2002).


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A Literature Review on Skills and Innovation A CRIC Report for the DTI
The UK’s Innovation Performance
2.30 We now turn to innovation, which is “… a major determinant of productivity
performance and … differences in innovation performance are a significant cause of the
UK’s relatively weaker productivity performance” (DTI, Competing in the Global
Economy – the Innovation Challenge, p. 9). The DTI defines innovation as: ‘the
successful exploitation of new ideas’. These ideas must be new to the firm, and may also
be new to the world, the UK, or an industry.
2.31 As with skills, economists have tended to make the most of the available statistics, most
notably on research and development (R&D) activities and patenting, even though these
are severely biased towards technological forms of innovation (as opposed to
organisational forms of innovation).
19
The recent development of the European
Community Innovation Surveys (CIS) has broadened the available evidence on
innovation, and innovation performance, although these surveys retain a strong
technological bias. Here we provide a brief summary of the UK’s relative performance
with respect to R&D activities and patenting, before summarising the evidence from the
second and third European Community Innovation Surveys on how the UK performs in
comparison with other European countries.
2.32 The UK’s Innovation Performance – R&D. UK business expenditure on R&D
declined through the 1980s until the late 1990s (from 1.5% of GDP in 1981 to 1.16% in
1997). The UK is however seeking to raise R&D as a proportion of GDP, and has set
itself the target of increasing business expenditure on R&D to 1.67% by 2014. The
recent introduction of tax credits for R&D should encourage greater participation in
R&D amongst firms.
20

2.33 Overall, the UK’s commitment to R&D is (or appears to be) mediocre and in aggregate
significantly below that of countries like the US, Japan, Germany, Sweden and Korea as

depicted in figure 2.3 below. (see Golborne, 2005 for a detailed analysis of R&D activities
by UK firms). Having said that, there is some reason to believe there may be greater
under-recording of R&D in the UK than elsewhere, not least because before the
introduction of tax credits there was little incentive for private firms to record their R&D
activities, and many appear unsure as to whether or not they undertake R&D (Howells et
al., 2001).

19
DTI (2003b) points out that the growth sectors within manufacturing have tended to be those that invest more
in R&D and have higher qualified workforces, as measured by the proportion of employees with degrees.
20
As a whole the European Union has set itself the target of increasing R&D to 3% of GDP with two thirds of this
expenditure coming from private sector enterprises (i.e. business expenditure on R&D reaching 2%)

23
A Literature Review on Skills and Innovation A CRIC Report for the DTI
Figure 2.3
Gross Expenditure on R&D as a proportion of GDP, 2001 (OECD Data)
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2.34 Patenting - Twelve countries (the US, Canada, Japan, Germany, the UK, France, Italy,
Switzerland, the Netherlands, Sweden, South Korea and Taiwan) account for about 95%
of all the US utility patents.
21
Despite the strength of its science base, the UK’s share of
US utility patents has been in decline since the late 1960s, whilst newly emerging
countries like Korea and Taiwan are fast catching up with the UK in terms of patenting
(indeed, relatively to their size, these countries have arguably already surpassed the UK).
This situation is summarised in table 2.5 below.
Table 2.5
Patenting in the United States – 1966 – 2000 – International Comparisons
US Utility Patents Granted Per 100 Patents Granted to the UK
1966-1970 1971-1980 1981-1990 1991-2000
US 1,768 1,590 1,618 2,282
Japan 62 206 540 887
Germany 143 201 274 277

France 57 77 98 113
Taiwan 0 1 11 77
South Korea 0 0 3 62

2.35 The European Community Innovation Survey (CIS) – The CIS-3 found for the
period 1998 – 2000 that the UK had a lower than average proportion of enterprises
engaged in (technologically) innovative activities (i.e. 36% c.f. the EU average of around
40%). Only in Spain and Greece did lower proportions of enterprises report engaging in
(technologically) innovative activities. A low UK propensity to engage in innovative
activities was found for all firm sizes, including large firms. In the UK, only 57% of large
enterprises (those with 250+ employees) reported having engaged in innovation activities

21
Utility patents cover the useful features of an invention. These patents cover a broad category of sciences. Utility
patents have been issued for everything from anchors for buildings, zebra stripes as a method of camouflage,
computer software, to methods of doing business.

24
A Literature Review on Skills and Innovation A CRIC Report for the DTI
between 1998 and 2000, compared with an EU average of 80% . A lower propensity to
innovate was also found for both industry (manufacturing and construction) and services
in the UK compared with the EU average.
22

2.36 According to the CIS-3 (Lucking, 2004), 21% of UK firms had introduced product
innovations compared to an EU average of 31%. This deficit, relative to the EU average,
is again found to be consistent across both enterprise size and by sector of activity.
Meanwhile, amongst those enterprises that were innovation active, only 27% introduced a
“new to the market” product innovation, a proportion which is amongst the lowest in the
Europe (EU average = 36%).

23
Furthermore, just 17% of UK firms reported having
introduced a process innovation between 1998 and 2000. This was the lowest proportion
of any country in Europe (with the EU average being 23%). UK firms’ engagement in
process innovation was consistently lower than the EU average across all firm sizes and
sectors of activity.
Conclusions
2.37 This chapter has sought to establish the context for the review of the literature on the
relationship between skills and innovation which follows. We have seen that the
government has high ambitions for the UK: “We want the UK to be a key knowledge
hub in the global economy, with a reputation not only for outstanding scientific and
technological discovery, but also to be a world leader in turning that knowledge into new
and exciting products and services. In terms of business R&D and patenting we will aim
to be the leading major country in Europe within ten years” (DTI, 2003b, p. 12).
2.38 Ultimately the relationships between skills, innovation and productivity, now and in the
future, are complex, with decisions made today impacting on performance in years and
decades to come. We can see this, for example, in the significant proportion of working
age men without qualifications who are now economically inactive. The Government’s
challenge is to increase the productivity performance of the UK economy, whilst also
ensuring that inequality does not widen further. This involves both establishing the
framework conditions within which business operate and, whilst holding down the
overall tax burden, finding the best balance between various public investments. For
example, are further investments in the science base likely to be more effective (for
efficiency and equality) than further investments in pre-school education? Ultimately
such questions are probably impossible to answer with certainty, but it is important to
recognise that the economy is such that investments in skills and innovation are often
complementary, especially in the early stages of technological diffusion (see Chapter 3).
It is only by investing in both that large productivity gains are realised. The balance is
however often elusive. In the remainder of this report we will explore the literature on
the relationship between innovation and skills (in the context of raising value added and

productivity). We will see that whilst much is known, there are also significant gaps in
understanding.

22
Averages here exclude the UK and Ireland.
23
However, amongst those firms that did introduce product innovations, UK firms tended to claim the highest
share of turnover was due to new products – at an average of 41% of total turnover. This perhaps suggests a
polarisation of innovation performance amongst UK firms, with some being highly innovative whist others have
little or no commitment to product innovation.

25