Absorptive Capacity is Key to Improving Productivity in Wales

Throughout the last 45 years the value of economic output has generally been lower in Wales than other UK countries and regions (see chart). By 2014, Gross Value Added (GVA) per head in Wales was 28 per cent below the UK average. In comparison, the Greater South East region – comprising London, the South East, and East of England – was 28 per cent above the UK average, and the gap has widened in recent years.

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To understand the reasons for this divergence we need to focus on differences in total factor productivity (TFP), which captures efficiency and innovativeness. Recently, TFP differences between Scotland and the rest of the UK have been analysed but comparable analysis for Wales is yet to be undertaken. However, information is more readily available for research and development (R&D) spending. This shows that, in 2012, total spending on R&D was lower in Wales than any other UK country or region. This feeds through into lower product and process development, and thus lower TFP over the long-run.

Absorptive capacity and business improvement methods

Two factors that impinge significantly on TFP are absorptive capacity and the role of business improvement methods. Absorptive capacity is defined as the ability of firms to internalise external knowledge and information. For firms to increase their TFP they need to be able to assimilate new ideas and methods in order to operate at the best-practice frontier of production, both in terms of efficiency (producing goods and services in a cost effective way) and innovation (producing new quality products that customers are most willing to purchase, using the latest production processes or techniques).

Firms with the highest levels of absorptive capacity are most likely to benefit from any spillovers that originate from clusters and supply chains in general. It is known that firms with the highest levels of absorptive capacity tend to be those that export and/or undertake R&D, in both the manufacturing and service sectors, and it is also well known that such firms have the highest levels of TFP. Work has been done that shows that Scottish firms have lower absorptive capacity compared to the rest of the UK (and such a comparison could also be produced for Wales).

Across the UK, policy makers have encouraged firms to improve their management and workforce skills to improve efficiency through adopting business improvement methods such as Continuous Improvement, Total Quality Management, and Investors in People. However, efficiency (or cost effectiveness) is only one part of TFP; there is also a need for innovation. It is usually assumed that business improvement methods lead to both: increased cost minimisation AND new products and processes.

Using 2009 data for around 600 SMEs operating in the border areas of the Republic of Ireland, Northern Ireland and the West of Scotland, a recent study I was involved in found that (after controlling for a wide range of other variables) firms that used business improvement methods were:

  • 15 per cent more likely to be an unsuccessful innovator;
  • 10 per cent less likely to be a non-innovator; and
  • 5 per cent less likely to be a successful innovator.

This suggests that business improvement methods were often a substitute rather than a complement to successful product and/or process innovation in peripheral SMEs. Policy makers therefore need to be careful when implementing policy designed to boost both efficiency and innovation (i.e. TFP) to ensure against unintended outcomes.


 

About the author: Richard Harris is Professor of Economics at Durham University Business School. Before joining Durham University, Richard held the positions of Alec Cairncross Professor of Applied Economics and Director of the Centre for Public Policy for Regions at Glasgow University.


 

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