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Symposium 2015

Solution for Developing Modern Sustainable Industrial Policies through Innovation-focused "Co-opetition"

The Challenge

How to design an industrial policy for Europe, which spurs innovation and enables European industries to lead in the low carbon “space race”? This is a key challenge related to two agendas on wh ...

How to design an industrial policy for Europe, which spurs innovation and enables European industries to lead in the low carbon “space race”? This is a key challenge related to two agendas on which international attention is currently focused: the COP21 of the United Nations Framework Convention on Climate Change in Paris, and Europe's recent agenda for growth, jobs, and competitiveness. Much like climate policy, the need for a new industrial policy is widely acknowledged among politicians, businesses, and the wider society. However, there is little confidence that an innovative and effective industrial policy can be designed to fit all sectors, regions, and stakeholders alike. Yet, with a low carbon market estimated at more than 4.5 trillion euros, progress in this area is vital. One promising approach is to develop a modern understanding of the role of public policy and free markets. With this in mind, the idea of "co-opetition" seeks to stimulate industrial innovation through a combination of both cooperation and competition among countries and enterprises.

Defining Competitiveness—On how to Measure the Largely Underestimated Role and Overall Impact of Innovation

Summary
Despite the fact that innovation is generally seen as an important factor driving economic success, a lot of uncertainty remains about its quantitative importance and impact on a firm’s or a country’s competitiveness. Due to the better availability of cost statistics compared to softer factors like innovation, there is a clear bias towards costs as the determining factor. Nevertheless, a new stream of research and work in recent years tries to better capture and quantify innovation and its importance. This very tentative work seems to converge to an estimated relative impact on competitiveness of around 30 to 40 percent. If this scope of influence were confirmed, it would force all parties involved to profoundly re-­think competitiveness policies, as those still are overly concentrated on cost measures.

Why rethink—or better define —competitiveness?
The notion of competitiveness1 is at the heart of most economic discussions about the future of Europe, the solution of crises, or the possible impact of policy measures, such as climate policies. Nevertheless, the word’s frequent usage seems to be in stark contrast to the uncertainty about how to define and explain competitiveness. What is the relative importance of different possible factors—cost factors, non-cost factors, institutions etc.—in defining competitiveness? And where should thus lie the political priorities?

Competitiveness and the energy cost puzzle
The starting point of our work was an insightful study of the challenges of the chemical industry, as a typical energy intensive industry, in a context of rising energy prices and highly ambitious climate policies in the EU. The study showed that, despite a lot of challenges ahead, the chemical industry has globally succeeded to manage rising energy prices. Furthermore, pure energy costs did not appear to play a major role in defining the industry’s competitiveness. Diving deeper into specific chemical products and production lines revealed a potential to reduce carbon emissions while at the same time maintaining or even strengthening the firms’ competitiveness. This is usually the case with innovation, when a product becomes lighter, cheaper and poorer in terms of carbon emissions. The study predicted a potential of further reducing emissions, and that about 60 percent of this reduction would have either no, or even a positive impact on competitiveness.

These estimates in the specific case of the chemical industry are a first hint that innovation—compared to pure cost factors—is largely underestimated when it comes to explaining competitiveness and its drivers. Large parts of the debate still concentrate on international cost comparisons, especially since the shale gaz revolution in the US.

Competitiveness and the more general cost puzzle
What is true for the specific case of the chemical industry seems to be equally the case in a broader sense. At first glance, the importance of innovation as a driving factor of competitiveness is widely recognized. Since Schumpeter’s era, it has been acknowledged by management theory, as well as by both micro-­ and macro-­economists. Innovation is a magic word used everywhere.

Nevertheless, the fact is striking that, when it comes to practical macro policy recommendations or the measurement of competitiveness, the importance of innovation is not reflected accordingly. These debates are still dominated by cost measures and indicators. The EU commission explicitly defines prices as the primary factor to improve export market shares. In the current euro crisis, there have been a number of complaints—beyond the debt question—about how far costs in the crisis countries have risen above the acceptable level. Consequently, the proposed solutions to competitiveness problems very much focus on reducing costs. Germany’s leading economist Hans-­Werner Sinn recently put it like this:

“In the long-­run, Spain, Greece and Portugal have to become about 30 percent cheaper than the Euro-­zone average to become competitive again (…).”

Not surprisingly, programmes thus emphasise the reduction of costs, sometimes leading to cuts in research and development spending, which will obviously not help to foster innovation.

The same is true when it comes to climate policy debates, as we have already seen. Often, discussions focus on the impact of (higher) energy costs, but do not consider other ways of improving competitiveness in a context of relatively higher energy prices.

Competitiveness—the measurement issue
So, how can we explain that cost factors remain in the centre of the debate? A very likely explanation is that costs are much easier to measure than most soft factors of competitiveness like innovation. They are also available in a relatively detailed and comparable form on a national accounts basis (which does not mean that they are beyond any doubt when it comes to their interpretation in detail). This availability has most probably lead to a clear bias towards cost measures. In fact, it has been quite difficult to quantify the relative importance of innovation in a coherent way.

Some economists may at this point object that soft factors are still taken into account by conventional unit cost indicators. Indeed, innovation generally has an impact on the output and productivity (the relation between output and input factors) of a firm or country. It thus influences the unit cost, which is defined as the ratio between productivity and input costs. If innovation has a positive impact, this will raise productivity and therefore reduce unit costs. Innovation indirectly enters the calculation of unit cost measures. Nevertheless, and problematically, its relative impact remains invisible in the statistics. There is still no way of identifying what share of the productivity progress has come from innovation, or any other factor.

The difficulty of measuring competitiveness in general, and the relative importance of innovation in particular, is reflected in the very confusing differences between different competitiveness rankings.

Competitiveness rankings in comparison*

WEF IMF
1 Switzerland USA
2 Singapore Hong Kong
3 USA Singapore
4 Finland Switzerland
5 Germany Canada
6 Japan Luxembourg
7 Hong Kong Norway
8 Netherlands Denmark
9 UK Sweden
10 Sweden Germany
11 Norway
13 Denmark
15 Canada Netherlands
19 Luxembourg UK
20 Finland
27 Japan

*World Economic Forum—Global Competitiveness Index versus IMD World Competitiveness Ranking, 2014 results

The headlines are dominated by two global rankings, which regularly try to measure competitiveness of countries: The ranking established by the World Economic Forum (WEF), and the ranking done by the IMD World Competitiveness Center. Both rankings attempt to measure and compare countries’ global competitiveness. Strikingly, the results of this supposedly common exercise diverge notably in some cases. For example, Finland is considered to be one of the most competitive countries (ranked 4th in 2014) in the WEF Global Competitiveness Report, whereas it was placed only 20th in the IMD ranking. The same is true for Japan (ranked 6th by the WEF, but only 27th by the IMD). On the other hand, Luxemburg ranks 6th in the IMD ranking and only 19th in the WEF list.

This divergence seems to reflect the difficulty to find a common definition of what drives competitiveness. A number of factors taken into account are derived from polls, which are intrinsically influenced by mood changes. In addition to that, the divergence probably also demonstrates the particular challenge to properly take innovation into account as a factor. In fact, the WEF has started to integrate factors related to innovation, some years ago already. The WEF experts have found that the importance of these innovation factors rises with the level of income and technological progress of a country. In highly developed countries, the innovation and sophistication subindex accounts for 30 percent of the global competitiveness index, according to the WEF definition.

Recently, the WEF has started a review process in order to update its index. A particular goal of this modernisation is an extended integration of innovation into the concept of competitiveness. Indeed, work that documents this process largely concentrates on innovation, which is considered crucial to productivity gains and accordingly integrated into nearly every aspect of the new ranking index. Apart from pure idea generation in terms of research and development, innovation is considered an ecosystem, also including implementation of ideas (e.g. by bringing innovative products to the market), as well as surrounding elements, such as education, competition and technology. The updated ranking will be launched in 2016.

On the other hand, the IMD has also recently started to thoroughly reconsider the definition of their competitiveness index. One of the main objectives of this work is to better integrate innovation as a factor. The fact that it has not been taken fully into account by the most recent IMD rankings might explain why countries that heavily count on innovation, like Finland and Japan, are ranked highly in the WEF ranking (which is already taking innovation into account more heavily), while they are much less competitive according to the current IMD definition, where innovation does not yet play a considerable role.

A new wave of research—Innovation beats costs
In recent years, a new round of research has evolved, which tries to find ways to better capture and more precisely measure the relative impact of innovation in overall competitiveness. This could potentially lead to a completely new understanding of competitiveness and industrial policies.

The European Central Bank (ECB) has created a Competitiveness Research Network, that aims to identify what drives the dynamics of competitiveness in EU countries. In a recent paper, two ECB economists found that none of the major industrial and emerging countries they analysed had succeeded in gaining market shares by purely pushing price-­competitiveness. Any price effects had been overcompensated by non-­price competitiveness. In other words: non-­price competitiveness had been the decisive factor in all investigated countries, its relative impact being consistently bigger than the price effect. Interestingly enough, since 2000, France succeeded to gain in terms of cost competitiveness compared to others, but lost a huge amount of market shares due to losses in non-­price competitiveness.

A study by Nikolaus Kowall recently attempted to define the relative importance of different factors of competitiveness by using a new bottom-­up approach. Given the fact that there is no official overall data on innovation as a driver, Kowall used case studies and interviews to identify the main factors in mid-­tech firms, in order to derive quantified macro variables. He concluded that innovation (defined as a cluster including several elements, including quality and technology) accounts for around 40 percent of overall competitiveness, whereas costs play only a minor role (12 percent). Kowall’s results seem to confirm—and even go beyond—the estimates, which are at the basis of the competitiveness index run by the World Economic Forum.

The IMD, as already mentioned, has started to revise their competitiveness ranking approach, trying to progressively integrate innovation as a key factor. This is work in progress, with a considerable indication that the institute will prospectively take innovation into account in a very noticeable way.

Tentative conclusion
If the results of recent research are confirmed, this may very profoundly change the way we think about competitiveness. The current mainstream approach assumes that (low) costs are most essential to success, with innovation being just one of many supplementary factors. If estimates are confirmed and innovation in reality accounts for at least 30 to 40 percent of competitiveness, then policies should be redefined in a way that playing on the cost side is at best a minor supplementary approach to regain competitiveness. Consequently, not only industrial policies, but also economic policies at large should focus more intensively on how to promote innovation. This is important to keep in mind in order to better explain why the initiative taken is so hugely important for Europe’s industries at a whole, and well beyond climate considerations.

 



1 We do not want to focus on the more technical question of how to define competitiveness, here. One definition of being competitive may be the level of productivity, as one of the most fundamental factors explaining a country’s prosperity (WEF).

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