164 NEW ECONOMY

JONATHAN MICHIE &CHRISTINE OUGHTON

Birkbeck, University ofLondon

Defining industrial policy has neverbeen easy, not least because its objec-tives are wide-ranging and delivery

requires integration over a number of policyareas. Traditionally, industrial policy has beenconcerned with enhancing productivity andeconomic prosperity. Within this broad agen-da, regional industrial policy measures havebeen targeted at laggingregions (and declining sec-tors), while horizontal indus-trial policy measures, such asexport credits, loan guaranteeschemes and certain types ofinvestment incentives, havebeen available to all firmsand regions.

These two sets of policymeasures have operatedalongside science and tech-nology policies designed toincrease the rate of innovation via stimulationof investment in R&D and in education andtraining. Three strands of industrial policy canthus be identified: regional industrial policy,horizontal industrial policy and innovationpolicy. Understanding the relationship betweenthese strands is essential to good policy design.This article explores the evolution and inter-action of these three policy strands. It does so

in the context of UK and European industrialpolicy, with particular regard to the develop-ment of regional innovation strategies.

ProductivitySuccessive governments have adopted indus-trial policies with a view to reversing the UK’srelative economic decline and closing the

productivity gap between theUK and other leading indus-trialised countries (see IPPRIndicators, page 148). It isimportant to note that target-ing productivity is not thesame as targeting per capitaincome or living standards.Improvements in productivi-ty can be realised by down-sizing the workforce, butunless the downsized workersare gainfully employed in new

jobs, overall income per capita may fail to rise.Policies to target productivity growth need tobe conducted within the context of stable orincreasing employment. Industrial policymust therefore be co-ordinated with employ-ment policy.

In the UK, productivity gains have beenused disproportionately to cut employmentrather than raise output. Other countries have

1070-3535/01/030164 + 05 © 2001 IPPR

Regional innovationstrategies

Integrating regional, industrial andinnovation policy

“targetingproductivity is not

the same as targetingper capita income or

living standards.Improvements in

productivity can berealised by

downsizing theworkforce”

REGIONAL INNOVATION STRATEGIES 165

seen a far greater proportion of their manu-facturing productivity growth translated intoincreased output – with rising output itselfencouraging further productivity growth.Comparing the growth of manufacturing out-put and employment, over the three eco-nomic cycles of 1964-73, 1973-70 and 1979-89,the UK’s manufacturing output growth waslower than that of Italy, France, Germany, theUS and Japan in all three cycles. The onlyexception was that France’s was lower thanthe UK’s in the final cycle, suffering as she wasunder the franc fort regime.

The difference between this poor perfor-mance for the UK and the experience of theother industrialised economies has resultedin the UK moving, in the early 1980s, from itshistorical position as net exporter of manu-factured goods into net importer – a positionin which we have remained stuck.

Take the high roadOne measure that Gordon Brown has takento boost productivity has been to give taxincentives to employee shareholder trusts toencourage greater commitment from workersto the organisations for which they work. Thisrecognition that the way to improve eco-nomic performance is to invest in the work-force is to be welcomed. It is in markedcontrast to the previous Conservative admin-istrations, which regarded the workforce asthe problem for British industry rather thanas part of the solution. Successive labourmarket deregulation and anti-trade unionlegislation aimed to create a flexible hire-and-fire labour market. All the evidenceshows that this is a low road to nowhere.Firms that took this option during the 1980sproved to be less innovative, not more. Insome cases there was a positive effect on theshort-term financial performance of thesefirms, but invariably the effect on labour pro-ductivity and product quality was negative.

Short-term financial gain may explain theuse by some employers of these types of

flexible work practices, particularly if undershort-term financial pressure, but the gainsmade in short-term profitability are not gen-erated from improved productivity. Rather,they represent a shift from wages to profits.While the reasons for firms resorting to suchpractices are understandable, succumbing tosuch temptation represents ultimately self-defeating short-termism. This proves detri-mental to the productivity and productquality on which the firm’s financial successis dependent.

The best-performing companies are thosethat have invested in progressive humanresource practices, including employmentguarantees and employee involvement. Work-places with trade unions and active employ-ee participation and involvement have beenfound to be more likely to invest in R&D andnew products than other companies (Michieand Sheehan Quinn, 2000).

The Government therefore needs to build onthe moves made on employee shareholdertrusts in Budget 2000, to commit decisively tothe high road option of employee involve-ment and commitment, innovation and pro-ductivity growth. The low road option of aderegulated labour market must be discarded.

Innovation systems and economicperformance

In recent years, considerable progress hasbeen made in understanding the factors thatunderlie productivity and income gapsbetween nations and regions. In particular,the growing literature on national systems ofinnovation has highlighted the positive rela-tionship between innovation and economicperformance. The systems approach viewsthe ability of an economic system to innovateas one of the key determinants of economicperformance.

Here, innovation is defined broadly toinclude new products and processes, newforms of organisation, new markets and thedevelopment of new skills and human cap-

166 NEW ECONOMY

ital. Factors affecting an economic system’sability to innovate include: its industrialstructure; its financial system; the system ofeducation and training; industrial relations;R&D and technology provision; the strengthof the science base; the system of technolo-gy transfer and the institutional environ-ment – particularly the relationshipsbetween industry, the science base and gov-ernment.

The systems approachAccording to the systems approach, incomegaps between countries are associated withgaps in a nation’s capacity to innovate. It fol-lows that closing the innovation gap betweennations and regions is a necessary prerequi-site to closing income and productivity gaps.Hence, industrial policy that targets livingstandards or productivity must also work toimprove the innovation system. In essence, ifproductivity and income per capita are thepolicy targets, innovation is the key policyinstrument.

The systems approach differs from theearlier and now discredited linear model ofinnovation, in that it focuses on the interac-tion between investment in fixed capital,investment in education and training andinvestment in R&D. Innovation arises as aresult of co-ordinated investment in knowl-edge, people and business capital. Theapproach also emphasises that innovation isdetermined, in part, by how well the differ-ent parts, such as industry and the sciencebase, interact. Evidence on the UK’s relativeperformance in investment in education, R&Dand fixed capital is reported in Figure 1, illus-trating one of the fundamental weaknesses ofthe UK economy: under-investment.

The UK has the lowest level of fixed capi-tal investment, which has been a long-stand-ing problem. Comparing the growth of thetotal manufacturing capital stock over thethree economic cycles of 1964-73, 1973-79 and1979-89, the UK experienced lower growththan in the US, Germany, France or Japan. Dur-ing the 1980s cycle, it averaged precisely zero.

0 5 10 15 20 25 30 35

UK

Ital;y

France

US

Germany

Japan

Figure 1 Investment in fixed capital, human capital and knowledge, 1998black: investment; white: public expenditure on education; grey: R&D expenditure (all as % of GDP)

REGIONAL INNOVATION STRATEGIES 167

UK R&D expenditure is heavily concen-trated in a few industries and regions, andmuch of government R&D expenditure goeson defence. Although defence related inno-vations often have civil applications, such asthe liquid crystal display, the speed and rateof transfer of knowledge from defence use tocivilian industrial use is lower than for non-defence related R&D.

Regional innovation systems The national innovation systems literaturepoints to the importance of innovation inexplaining differences in economic perfor-mance between countries. There are compellingarguments to extend this analysis to the region-al level. First, it is apparent that many of the fac-tors identified as important – such as industrialstructure, inter-firm relationships, R&D inten-sity and the link between industry and the sci-ence base – vary significantly across regions.

Second, innovation activity itself is morevariable across regions than between nationstates, indicating that there is indeed a set ofregional factors explaining such variation.To illustrate this point, Table 1 presents analy-sis of variance results for a number of keyindicators of regional innovation activity. Animportant result comes out of this analysis.

Variations in innovation performance withinEU countries are far greater than those acrossthem. Almost 70 per cent of the total varia-tion in R&D expenditure is within-countryand only around 30 per cent is across-coun-try. Similarly, over 70 per cent of the total vari-ation in living standards across regions isaccounted for by within-country regionalvariation and only some 28 per cent by dif-ferences across nation states in the EU.

The regional innovation paradoxThe persistence of regional differences inincome levels (and employment rates) isexplained in part by the regional innovationparadox (Oughton, Landabaso and Morgan,2001). The paradox is that those regions thatmost need to innovate in order to catch up,are the least able to absorb funds for innova-tion, even when offered as public subsidies.As a result, funds earmarked for innovationare disproportionately absorbed by richerregions, exacerbating the gap between therichest and poorest regions. This is illustrat-ed in Table 3 which reports income per capi-ta and total spending on R&D by business,government and the education sector for eachof the English regions, plus Northern Ire-land, Scotland and Wales.

Table 1 Analysis of variance in R&D intensity, innovation activity and living standards across 178 regions and 12 nations of the European Union

% variation % variation Total F-statisticacross regions across nations variationwithin nations

R&D expenditure as a percentage of GDP 68.9 31.1 100 5.047* Patents per head of the population 64.4 35.6 100 6.182* Government R&D expenditure as a percentage of GDP1 89.7 10.3 100 1.165 Business R&D expenditure as a percentage of GDP1 67.4 32.6 100 5.360* R&D expenditure in education as a percentage of GDP2 67.9 32.1 100 5.280* Gross domestic product per capita (ppp)3 72.3 27.7 100 5.792*

1 Number of observations for these variables is 134 and degrees freedom are 133, 122, 112 Number of observations for this variable is 129 and degrees freedom are 128, 117, 113 Number of observations for this variable is 178 and degrees freedom are 177, 166, 11* denotes significance at one per cent level for test of difference between means across nations

Source: Regions Statistical Yearbook 1999 Eurostat, European Commission, April 2000

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Two English regions – Eastern and theSouth East – benefit from disproportionateamounts of R&D expenditure, more than athird of which comes from the public purse.In 2000/01, the largest allocations of theRegional Selective Assistance (RSA) budget– the UK government’s main regional indus-trial policy instrument – went to the WestMidlands (£35m), the North West (£33m)and the North East (£25m). Clearly, thesesums are relatively small compared to gov-ernment funded R&D spending. EU Struc-tural Funds are the other element of regionalindustrial policy, also targeted at laggingregions. In 1998, UK regions and nationsreceived £1,107 million, with the North West,Scotland and Northern Ireland taking thebiggest shares.

Thus, while RSA and the Structural Fundshave been targeted at the poorest regions,R&D subsidies have not, until 2001, been tar-geted at any specific type of region, but havetended to be absorbed by the richest. Richerregions have a greater capacity to absorbfunds earmarked for R&D, while poorerregions that need to invest in R&D in orderto catch-up, paradoxically, find such fundsmore difficult to absorb.

Resolving theparadox through

RIS and RIFThe Governmenthas recently intro-duced two policymeasures withpotential to helpresolve the para-dox. The first is therequirement thatevery region shoulddevelop a RegionalInnovation Strategy(RIS) designed tore-focus existingfunding streams,including RSA and

the Structural Funds, on innovation-relatedactivities. This policy has developed out of theEuropean Union’s RIS initiative, fundedunder Article 10, and is discussed in moredetail below.

The second is the introduction this year ofthe £50 million per year Regional InnovationFund (RIF), to be spent via the RegionalDevelopment Agencies (RDAs). Allocationacross regions has been decided by a formu-la that takes account of regional GDP per headand unemployment rates. Although smallcompared to the total government R&D bud-get (in excess of £5000 million), it representsa new regional innovation policy instrumentthat ties together the regional and innovationstrands of industrial policy.

What is likely to be of more immediate sig-nificance for improving the lot of laggingregions is the development and implemen-tation of RIS. Part of the explanation for theregional innovation paradox is to be found inthe relationship between the three key play-ers in innovation: business, the universitysector and government funded research estab-lishments. Innovation is about the commer-cial exploitation of knowledge and, as such,requires close links between the science base,

Table 2 Income per head and R&D by region, 1998

GDP per head R&D expenditureper head

UK=100 UK=100

North East 79 42 North West 88 85 York & Humber 88 42 East Midlands 95 91 West Midlands 92 76 Eastern 114 203 London 130 85 South East 117 178 South West 92 107

Scotland 96 75 Wales 79 38 Northern Ireland 76 34

UK 100 100

REGIONAL INNOVATION STRATEGIES 169

which generates new ideas, and industry,which turns these ideas into new productsand processes for economic gain. Not sur-prisingly, the R&D activities of business, uni-versities and government researchestablishments are complementary. Analysisof data from 178 European regions shows thatR&D activity is positively and significantlycorrelated across all three sectors.

Given this complementary relationship, itfollows that increasing the innovation activityof a region requires policy measures that alsooperate across all three dimensions. The Euro-pean Commission’s RIS initiative – started in1994 – aims to encourage lagging regions to re-focus the use of the Structural Funds on inno-vation related activities. EachRIS costs around 500,000 Euro.The European Commissionprovides 250,000 Euro, withmatched funding from theregion and it is thus a rathermodest policy initiative. Themoney is used to fund a broad-based partnership that bringstogether representatives frombusiness, the university sector,government funded research establishments,local and regional government officials, tradeunion representatives and business serviceproviders, to develop a strategic framework forinnovation initiatives to be funded from Struc-tural Funds. The cost of each RIS should there-fore be seen in relation to the bigger industrialpolicy (Structural Funds) budget that it seeksto drive. Typically, the RIS cost is significantlyless than one per cent of the total StructuralFunds budget.

The RIS initiative is grounded in threeprinciples:� bringing together the key players of a region

to design the strategy� the conducting of research analysing the

region’s innovation system, focusing onthe supply and demand of innovationinputs/services

� stimulating business demand for innova-tion services by, for example, spreadingbest practice, and networking firms to sharethe cost of joint innovation initiatives. Then,the role is to ensure that such demand is metby adequate supply from the science baseand business service providers. This thirdpart operates across all three R&D relateddomains – business, university and gov-ernment establishments – by using publicfunding for innovation to leverage privatesector investment.

ConclusionThe EU’s RIS initiative represents an impor-tant development in industrial policy in that

it provides a vehicle forcatalysing innovation in lag-ging regions and co-ordinat-ing innovation policy withregional industrial policy. TheUK government has alsoincreasingly prioritised inno-vation as a policy instrumentto close the UK’s productivi-ty gap and increase livingstandards. Historically, the

regional innovation paradox has meant thatthe science/innovation strand of UK indus-trial policy and the regional strand werepulling in opposite directions.

The new regional industrial policy basedon the establishment of the RIF and a re-focus-ing of RSAtowards innovation and skills, allo-cates innovation funding to lagging regions.While the size of the fund is too small to makea significant difference, it does represent animportant and welcome point of departure inUK policy design. There is a need to boost thesize of the fund, but given the UK’s under-investment in R&D, it is important that thisshould not simply be taken out of the exist-ing science and technology budget. Newmoney is needed if the Government’s region-al, industrial and innovation aims are to berealised �

“those regions thatmost need to

innovate in order tocatch up, are the

least able to absorbfunds for innovation,even when offered as

public subsidies”