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Innovation and Productivity: Using Bright Ideas to Work Smarter - TPRP 08/05

Knowledge and innovation are important drivers of productivity

Increases in knowledge and innovation by entrepreneurs have allowed living standards to rise on average by around two per cent a year for a long time

In the end, growth is about knowledge and ideas coming to fruition: inventing a new product, developing a new service, establishing a better way to manage a business and so on. Instead of rising living standards being limited by diminishing returns, increases in knowledge and innovation by entrepreneurs have allowed real incomes per head to rise by an average of around two per cent a year for at least the last century in the leading economies. The next section tells the amazing tale of advances in lighting technology over the last two centuries and we then look at the broader evidence on the key role of innovation in raising living standards.

An ‘illuminating’ tale

A modern day family consumes more than a hundred times as much artificial illumination as its predecessor of two centuries ago but at a fraction of the price

In a fascinating study, the American economist William Nordhaus (1997) analysed the real price of light and showed how it has fallen by over a thousandfold over the last two centuries. Whereas a typical American household in 1800 spent around four per cent of its income on illumination - candles, oil, lamps and matches – a modern-day family spends around one per cent on average. Yet, the quantity of artificial illumination that the modern family consumes is more than a hundred times as much as its predecessor of two centuries ago.

The huge advances in artificial illumination technologies have been an enormous boon and source of value – Nordhaus estimated that it has contributed seven percent to the growth of real wages over the nineteenth and twentieth centuries. Yet the impact of this revolution is comparatively minor compared with the development of general purpose technologies such as steam, electricity, the internal combustion engine, plastics and ICT.

All these breakthroughs were technological in nature. It is worth noting however that other innovations – social, economic, legal and institutional – were needed alongside to fully translate them into rising living standards. Examples of these are the system of mass production, the development of the joint-stock company, the large industrial enterprise and the social-insurance state.

The crux of the story of light and the many other stories of dramatic changes in technology and knowledge is that at least in rich countries these developments appear to have made a huge difference to living standards. The next section briefly examines whether rigorous scholarly studies confirm this insight.

There is a large base of evidence about innovation and productivity

Growth accounting is a method of decomposing the growth in real GDP per head into the proximate factors of labour utilisation (number of hours of paid labour per head of population) and labour productivity (output per hour worked). Labour productivity in turn is driven by capital intensity (the amount of capital per worker) and multi-factor productivity or MFP (a measure of how much output is produced for given inputs of labour and capital). MFP is influenced by a variety of things but the level of knowledge and technology is the most important. Thus growth accounting studies that break down historical growth in GDP per head into these factors can indicate the relative importance of advances in knowledge to lifting living standards.

There is good evidence that over half of differences in output per worker across countries come from multifactor productivity – a proxy for knowledge and technology

Klenow and Rodriguez-Clare (1997) is a good example of a growth accounting study that examines the proximate causes of growth in labour productivity. They find that over half of 1985 differences across countries in levels of output per worker are accounted for by differences in MFP rather than in physical and human capital. The same goes for growth rates: differences in MFP growth from 1960 to 1985 between countries explained the overwhelming majority of the differences in growth rates in GDP per worker.

Recognising the central role of knowledge and innovation in economic growth, economists have come up with a whole generation of growth theories that model the mechanisms whereby this happens. While the evidence is not conclusive on which particular one of these “endogenous growth models” is most credible, increasing returns from knowledge[1] play a critical role in most of them. This is not only a key ingredient to explain the on-going rise in living standards over several centuries, but also has important implications for policies designed to foster growth.

Countries divide crudely into technological leaders and followers

Countries divide crudely into technological leaders and followers. On the one hand, a group of leading countries invest heavily in science and research (within the OECD over 80 per cent of R&D is performed in just 6 countries[2]) and push out the global technological frontier. These are generally also the richest countries in terms of real GDP per head. On the other hand, remaining countries, including New Zealand, are largely technological followers. This gives them the opportunity of becoming “fast followers” by importing knowledge from the leaders – either embodied in equipment and services such as computers and engineering expertise, or in the form of the knowledge itself which they can absorb, adapt and apply within their own economies. Some of the most successful fast followers have been the small Asian ‘tiger’ economies of Singapore, Hong Kong, South Korea and Taiwan. More recently, and very significantly, the huge economies of China and India have joined them.

New Zealand can surely learn valuable lessons from the economic history of the Asian tigers and before them, Japan. They have all been successful in taking existing knowledge, understanding it, adapting it, applying it, and spreading it. However, it is other small, open, developed economies with strong natural-resource bases that are probably even more relevant as models for New Zealand. Examples of this group are the Netherlands, Canada, Australia, Finland, Sweden, Norway and Denmark.

New Zealand can likely learn valuable lessons from other small open economies with strong natural resource bases such as the Netherlands and Finland

Keith Smith is a leading scholar on the role of innovation in these economies that he labels of the “New Zealand type”. He found (see Smith, 2006) that their successes have come from (i) building innovation gradually and pervasively on their traditional low and medium-tech resource base; and (ii) developing high-value-added niche industries arising from upstream and downstream activities linked to the traditional base, for example in electronics, chemicals, machine tools, paper machinery, navigation systems and telecommunications. While the niches under (ii) are important, Smith notes that these sectors are relatively modest in size, and “prosperity continues to depend on continuously upgraded traditional industries”.

One further set of findings is important to note: even within quite narrowly defined industries, there are typically large differences in productivity levels across firms and these persist over time (Law, Buckle and Hyslop, 2006; Dunne et al, 2002). This evidence and other studies that have built on it indicate that high-value-added firms tend to use combinations of skills, modern technology and good organisational practice and they co-exist over long periods with firms that adopt none of these. This suggests that these features (i.e. skills, technology etc) strongly complement each other and that a low-productivity firm somehow needs to engineer simultaneous progress on all of them in order to transform itself to a high-productivity firm. This is likely to be hard and means that the upgrading process is complex and not automatic.

Both the findings reported by Smith, and the findings on persistent firm productivity differences, point to the phenomenon of path dependence - not only for economies as a whole but also for individual firms[3]. In terms of policy, path dependence sometimes means it is better to work with the grain of what is already there, but in other cases it means finding interventions that are effective in helping to escape from an undesirable path.

In summary then, there is strong evidence that knowledge and innovation are key drivers of productivity and living standards over the medium to long run. New Zealand is more of a technological follower than a leader and can likely learn valuable lessons about successful development from other small, open, resource-based economies. The process whereby firms upgrade the skills of their workforce, their technology and organisational practices to achieve high productivity is complex and not automatic.


  • [1]Economists refer to returns to scale being either decreasing, constant or increasing depending on whether output increases proportionately less than, the same as or more than increases in inputs.
  • [2]The countries (in order of R&D expenditure) are US, Japan, Germany, France, UK and Korea; see OECD (2008) Main Science and Technology Indicators dataset
  • [3]Path dependence means broadly that the future development path of a firm or economy is strongly influenced by the characteristics of its path (product mix, skills, technology etc) up to the current time.
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