Competitiveness Innovation and Productivity Clearing up the Confusion

Competitiveness,Innovation andProductivity:Clearing upthe ConfusionRobert D. AtkinsonAugust 2013The Information Technology& Innovation Foundation

COMPETITIVENESS, INNOVATION AND PRODUCTIVITY:CLEARING UP THE CONFUSIONTo listen to many economists, pundits and policymakersdiscuss the economics of growth it would be easyto be confused by the commonly used terms: competitiveness,innovation and productivity. These termsare often used almost interchangeably and with littleprecise meaning. To remedy the situation, this policymemo defines these terms and explains how each isimportant in driving economic prosperity.COMPETITIVENESSWith the increased globalization of the economy,the term competitiveness has become ubiquitous.But what does it actually mean? Most seethe term as synonymous with productivity. Harvard’sMichael Porter states, “The only meaningfulconcept of competitiveness at the nationallevel is productivity.” 1 The World Economic Forum’sGlobal Competitiveness Report defines competitivenessas “the set of institutions, policies, and factorsthat determine the level of productivity of a country.”2 And IMD’s World Competitiveness Yearbookdefines competitiveness similarly, but more broadly,as how an “economy manages the totality of itsresources and competencies to increase the prosperityof its population.” 3But while these terms are related, competitivenessshould not be equated with productivity or GDP growth.To see why, it’s important to differentiate between tradedand non-traded sector industries. A traded industryis one where the firms sell a significant share of theiroutput outside a particular geographical area. Forexample, a printing firm in Michigan that sells printedmaterial to customers across the United States wouldbe a traded firm from the perspective of the Michiganeconomy, but a non-traded firm from the perspectiveof the U.S. economy. In contrast, a software firm inWashington that sells software throughout the worldwould be a traded firm from the state and nationalperspective.NON-TRADEDTRADEDThus competitiveness relates only to the economichealth of a region’s or nation’s traded sectors (for thepurpose of this memo, the term “region” shall refer toboth national and subnational economies). But howdo we define health? One definition is jobs. However, ifone region’s traded sector is highly productive it couldhave fewer jobs than another region’s even if the firstregion is in fact more competitive. Another definition isvalue-added—the amount of value that traded sectorfirms add to the inputs of production that they purchase.This is a closer definition, but fails to control forthe size of a region’s tradedsector economy, i.e. the largerthe economy the largerthe impact of the valueadded on competitiveness.In addition, if a region hasvastly more imports, even ifits traded sectors are producinga large amount, itseconomy is not holding itsown when it comes to competitiveness.But focusingIf you listen to manyeconomists, punditsand policymakers, itis easy to be confusedby the commonly usedterms: competitiveness,innovation andproductivity.on trade deficits alone fails to account for the factthat a region might run a surplus but do so by subsidizingits exporters (e.g., by manipulating its currency)or erecting barriers to importers (e.g., tariffs).In this case, the trade surplus may not be a reflectionof the true competitiveness of the region’straded sector firms, but rather a reflection of theextent of mercantilist aid the traded sectorfirms receive.The true definition of competitiveness is the ability of aregion to export more in value added terms than it imports.This calculation includes accounting for “termsof trade” to reflect all government “discounts,” includingan artificially low currency, suppressed wages inTHE INFORMATION TECHNOLOGY & INNOVATION FOUNDATION Page 2

export sectors, artificially low taxes on traded sectorfirms and direct subsidies to exports. It also controlsfor both tariff and non-tariff barriers to imports.Under this definition, a nation may run a large tradesurplus (one component of competitiveness), but if itdoes so by providing large “discounts” to its exportersor by restricting imports it would not be truly competitive,for such policies would reduce its terms of trade byrequiring its residents to give up some of their incometo foreign consumers and/or pay higher prices forforeign goods and services.We can see this by looking at past trends in theU.S. trade deficit. While the rise in the relative priceof imports brought aboutthrough the lower valueof the dollar in theThe true definition ofcompetitiveness is the last half of the 1980sability of a region to export helped reduce the U.S.more in value added terms trade deficit; it also reducedthe U.S. termsthan it imports.of trade (the UnitedStates could buy fewerimports for the same quantity of exports). Therefore,U.S. competitiveness was unchanged even as thetrade deficit declined. Likewise, the fact that the UnitedStates runs a massive trade deficit today but many ofits trading partners run surpluses by means of massive“discounting” and import blocking means that wecannot determine with certainty that the U.S. economyis uncompetitive.In fact, despite numerous studies claiming to comparenational competitiveness, no study to date has fullyaccounted for export discounting and import restricting.While data exists on trade balances for virtuallyall nations, data on the extent of export discounts andimport restricting (especially through non-tariff barriers)are difficult to obtain. Despite this, at a cursorylevel, it would appear that nations like Austria, Germany,and Sweden would be on a list of competitive economies(they run trade surpluses while also havingrelatively high wages and limited discounts). In contrast,nations like China (too much discounting) andthe United States (too large a trade deficit even whenaccounting for foreign subsidies) would likelynot make the list of competitive economies.A COMPETITIVE ECONOMY IS ONE WITH ATRADE SURPLUS, FEW BARRIERS TO IMPORTS,AND LIMITED “DISCOUNTS” TO EXPORTERS.So how does productivity fit into competitiveness? Productivitygrowth can enable competitiveness, especiallyif it is concentrated in traded sectors, which lowerscosts and enables firms to sell more in global marketswithout relying on government provided discounts. Butproductivity growth can also be relatively unrelatedto competitiveness if it is concentrated in non-tradedsectors. Imagine a nation with strong productivitygrowth but almost all of it in non-traded sectors likegrocery stores, electric utilities and nursing homes. Certainlyincomes would go up as relative prices in thesesectors fall, but firms in traded sectors would only seemodest reductions in their costs based on the extent ofpurchased inputs from non-traded firms.INNOVATIONWhile competitiveness is almost always incorrectlyequated with productivity, innovation is usually definedmore accurately, although usually too narrowly.Many see innovation as only technological in nature,resulting in shiny new products like Apple’s iPad orBoeing’s 787 Dreamliner. Still others believe innovationpertains only to the research and development (R&D)activity occurring at universities, national laboratories,and corporations.INNOVATIONTHE INFORMATION TECHNOLOGY & INNOVATION FOUNDATION Page 3

While this is all true, it is much too limiting in scope.The Organization for Economic Cooperation and Developmentproperly defines innovation more broadly as“the implementation of a new or significantly improvedproduct (that is, a physical good or service), process, anew marketing method, or a new organizational methodin business practices, workplace organization, or externalrelations.” 4 Innovations can arise at many differentpoints in the development process, including conception,R&D, transfer (the shift of the “technology” to theproduction organization), production and deploymentor marketplace usage.However, even when innovation is defined properly,many equate it with competitiveness and/or productivity.For example, Bloomberg includes productivityas one of its seven variables for ranking the 50 mostinnovative nations. 5 But while innovation is related toproductivity, and for that matter competitiveness, itis not synonymous. There are many innovations thathave little to do with productivity or competitiveness.For example, the innovation of the smart electric gridwill help boost electric utilityproductivity, but willWhile innovation is relateddo little to boost competitivenessas electric utilityto productivity, and for thatmatter competitiveness, itservices are not typically internationallytraded. Like-is not synonymous.wise, while the developmentof a new technology to enable better weatherprediction would boost quality of life, it would alsonot directly affect productivity. In contrast, thecreation of a new drug, a new kind of airplaneor a faster computer chip would not only enhancetraded sector industry competitiveness, it wouldalso improve quality of life and/or productivity.So while innovation can increase productivity andcompetitiveness, it is not synonymous with either.PRODUCTIVITYProductivity is perhaps the most straightforwardand easily defined of the three factors. Productivityis economic output per unit of input. The unit ofinput can be labor hours (labor productivity) or allproduction PRODUCTIVITY:factors including labor, machines andenergy (total factor of productivity).OUTPUTUNIT OFINPUT= PRODUCTIVITYDespite this, many analysts still use the term incorrectly.For example, some argue that moving jobs to Chinaand lowering wages raises productivity because it lowersprices. But while these actions might reduce prices, lowerprices are not the definition of productivity. In fact, movingjobs to China might actually decrease productivity sincefirms in China use fewer machines and are less efficientlyorganized than firms in the United States.To understand the sources of productivity, it’s important tounderstand that economies have three ways to grow overthe medium and long term: growth in workers, growth inproductivity across-the-board and growth in the share ofactivity in high-productivity industries. The first, growth inthe number of workers, is a non-sustainable strategy andmore importantly does nothing to increase productivity orper-capita income growth. America would clearly enjoya larger GDP if the number of workers increased tenpercent, but the average income of workers would notnecessarily increase.THE THREE SOURCES OFECONOMIC GROWTH1. GROWTH INWORKERS2. PRODUCTIVITYIN ALL INDUSTRIES3. GROWTH OF HIGHPRODUCTIVITY INDUSTRIESThe second—the across-the-board “growth effect”—occurs when a region’s productivity increases not byhigher productivity industry sectors becoming a largershare of the economy, but by all sectors, low and highproductivity ones alike, getting more productive. Forexample, retail trade, banking, health care and automobilemanufacturing all increasing their productivity.This across-the-board process can happen two ways: ifall the firms in an industry increase their productivity orif the low-productivity firms in an industry lose marketshare to high-productivity firms in the industry (e.g.,smaller less productive “bricks and mortar” bookstoresgo out of business because consumers prefer to buyTHE INFORMATION TECHNOLOGY & INNOVATION FOUNDATION Page 4

e-books). This process of change within industriesoccurs in all sectors but is not the major way industriesbecome productive. One study found that plant turnoverfrom entry and exit contributes 15 to 25 percentof Canadian manufacturing labor productivity growth,with the other 75 to 85 percent coming from individualfirms becoming more productive. 6THE“GROWTH EFFECT” OCCURS WHENALL OR MOST INDUSTRIES BECOMEMORE PRODUCTIVEThe third, the “shift effect,” occurs when the mix oflow and high-productivity industries, as opposed tofirms, in a region changes. For example, if a developingnation loses 500 agricultural jobs (which in developingnations normally have low productivity) and gains 500software jobs (which normally have higher productivity),overall productivity would increase.-500+500THE “SHIFT EFFECT” OCCURS WHENHIGH PRODUCTIVITY INDUSTRIESGROW FASTER THAN LOWPRODUCTIVITY INDUSTRIESBut which productivity strategy—the growth effect orthe shift effect—is the better path to higher productivity?The answer depends in part on the size of theeconomy and to a lesser degree on the type of sector.The larger the economy, the more important thegrowth effect is since relatively lower shares of largeeconomies’ output are in traded sectors. Moreover,the more local-serving the sector is, the greater theimportance of the growth effect. To understand why,consider an automobilefactory in a small city. Ifits managers install a newcomputer-aided manufacturingsystem andraise the plant’s productivity(the growth effect),a large share of the benefitswill flow to the firm’scustomers around thenation and even aroundthe world in the form oflower prices. The city will benefit only to the extentthat its residents buy cars from that factory, if someof the increases in productivity go to higher wages orif the factory is able to employ more workers. In general,even though most nations, especially developingnations like Brazil, China and India, have focused theirindustrial policies on boosting productivity by changingtheir industrial mix, the lion’s share of productivitygrowth in most nations comes not from changing thesectoral mix to higher-productivity industries, but fromall industries, even low-productivity ones, boostingtheir productivity. 7IMPLICATIONS FOR POLICYThe lion’s share ofproductivity growth inmost nations comes notfrom changing the sectoralmix to higher-productivityindustries, but from allindustries, even lowproductivityones, boostingtheir productivity.So if competitiveness, innovation and productivityare separate but interrelated, which is most importantfor a region’s economic well-being? As discussedabove, this depends in part on the size of the region.In general, however, productivity is the most importantdeterminant of a region’s overall per-capita income.Yet, it would be a mistake to conclude that economiescan ignore innovation or competitiveness. Spurringinnovation can help productivity and competitiveness.And innovation means that future goods andservices will not only be cheaper but better. Spurringcompetitiveness is important as well. Without competitivesectors, a nation’s standard of living will beTHE INFORMATION TECHNOLOGY & INNOVATION FOUNDATION Page 5

lower since it will have to give up more production topay for its imports. Moreover, as highlighted in InnovationEconomics: The Race for Global Advantage,a weak traded sector can have spillover effects onthe overall economy, distorting investment patternsand limiting growth 8 . Competitive weakness alsocreates a stiff headwind that other components ofgrowth (e.g., non-traded sector innovation and productivity)must struggle to overcome. In fact, thiscompetitive weakness explains many of the currentproblems faced by the U.S. and European economies.The bottom line is: nations need to have well-articulatedand distinct strategies addressing competitiveness,innovation and productivity. No one strategy caneffectively address all three factors.To date, no nation has adequately articulated thedifferences between these three factors and in turndeveloped distinct, stand-alone competitiveness,innovation and productivity strategies. Rather, nationstend to meld these together assuming that success inone will lead to success in another. But this is a recipefor underperformance. To truly succeed in today’s technology-driven,global economy nations need to develop threedistinct strategies: one for success in innovation, one forinternational competitiveness and one for productivity. Notonly will this lead to success in each of the three realms, itwill lead to reinforcing policies that benefit all three factorsand drive economic prosperity and quality of life.COMPETITIVENESSINNOVATIONPRODUCTIVITYSTRATEGY STRATEGY STRATEGYNATIONS NEED WELL-ARTICULATEDAND DISTINCT COMPETITIVENESS,INNOVATION AND PRODUCTIVITY STRATEGIESA traded sector competitiveness strategy should focusspecifically on targeted policies—including trade, tax,talent and technology polices—that improve the internationalcompetitiveness of a region’s traded sectorindustries. 9 An innovation strategy should focus on thebarriers to innovation (e.g., regulatory) and the neededsupport systems (e.g., investment in R&D, support fortechnology transfer and STEM education) that canspur more innovation in all three major sectors of aneconomy (for profit, non-profit and government). 10Finally, a productivity strategy should examine allmajor industries and functions in an economy todetermine the barriers to growth and the policiesthat can promote both the growth and shift effects.This includes support for the development of “platform”technologies, such as broadband, smartgrids and health IT. While all three strategies arerelated they are also distinct enough that they deserveto be considered separately by policymakers.THE INFORMATION TECHNOLOGY & INNOVATION FOUNDATION Page 6

ENDNOTES1. Michael E. Porter, “The Competitive Advantage ofNations,” Harvard Business Review, March 1990, http://hbr.org/1990/03/the-competitive-advantage-of-nations/ar/1.2. Klaus Schwab, “Global Competitiveness Report 2012-2013” (World Economic Forum, September 2012),http://reports.weforum.org/global-competitivenessreport-2012-2013.3. “World Competitiveness Yearbook 2012” (IMD WorldCompetitiveness Center, May 2012),http://www.imd.org/wcc/wcy-world-competitivenessyearbook.4. “Ministerial Report on the OECD Innovation Strategy”(Organization for Economic Cooperation and Development,March 2010), http://www.oecd.org/sti/45326349.pdf.5. “50 Most Innovative Countries,” Bloomberg, February2013, http://www.bloomberg.com/slideshow/2013-02-01/50-most-innovative-countries.html#slide50.6. John R. Baldwin and Wulong Gu, “Plant Turnoverand Productivity Growth in Canadian Manufacturing”(Statistics Canada, April 2003), http://www.statcan.gc.ca/pub/11f0019m/11f0019m2003193-eng.pdf.7. James Manyika et al., “How to Compete and Grow: ASector Guide to Policy” (McKinsey & Company, March2010), http://www.mckinsey.com/insights/economic_studies/how_to_compete_and_grow.8. Robert D. Atkinson and Stephen J. Ezell, InnovationEconomics: The Race for Global Advantage ( New Haven:Yale University Press, 2012). http://globalinnovationrace.com/9. James Manyika et al., “How to Compete and Grow: ASector Guide to Policy” (McKinsey & Company, March2010), http://www.mckinsey.com/insights/economic_studies/how_to_compete_and_grow.10. James Manyika et al., “How to Compete and Grow:A Sector Guide to Policy” (McKinsey & Company, March2010), http://www.mckinsey.com/insights/economic_studies/how_to_compete_and_grow.ACKNOWLEDGEMENTSThe author wishes to thank the followingindividuals for providing input: KathrynAngstadt, Will Dube, Stephen Ezell, AlexKey, and Ben Miller. Any errors or omissionsare the author’s alone.ABOUT THE AUTHORDr. Robert Atkinson is the president ofthe Information Technology and InnovationFoundation. He is also the author of the booksInnovation Economics: The Race for GlobalAdvantage (Yale University Press, 2012) andThe Past and Future of America’s Economy:Long Waves of Innovation that Power Cyclesof Growth (Edward Elgar, 2005). Dr. Atkinsonreceived his Ph.D. in City and RegionalPlanning from the University of North Carolinaat Chapel Hill in 1989.ABOUT ITIFThe Information Technology andInnovation Foundation (ITIF) is aWashington, D.C.-based think tank at thecutting edge of designing innovation strategiesand technology policies to create economicopportunities and improve quality of life in theUnited States and around the world. Foundedin 2006, ITIF is a 501(c) 3 nonprofit,non-partisan organization that documents thebeneficial role technology plays in our livesand provides pragmatic ideas for improvingtechnology-driven productivity, boostingcompetitiveness, and meeting today’s globalchallenges through innovation.FOR MORE INFORMATION VISIT WWW.ITIF.ORG.GRAPHIC ATTRIBUTIONSBohdan Burmich, Adam Heller, Luis Prado, Jon Trillana,Nicolò Bertoncin, all from The Noun Project.THE INFORMATION TECHNOLOGY & INNOVATION FOUNDATION Page 7