the innovation gap

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Research report: October 2006

The Innovation Gap

Why policy needs to reflect thereality of innovation in the UK


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The Innovation GapWhy policy needs to reflect the reality of innovation in the UK

ForewordInnovation is vital to the future economic prosperity and quality of life of the UK. The wordinnovation has become an important one in contemporary policymaking but, as this reportdemonstrates, innovation is frequently found in unlikely places. It is rarely based on traditionalunderstandings of linear, pipeline research and development that lead only to new products,drugs or technology. If that were the case, where, for example, would there be room for the retailinnovation of IKEA, Zara and eBay, or the role of the City of London as a centre for financialservices? What would we make of the UKs advertising and music industries, or of social innovationfrom the National Cycle Network and NHS Direct to the BBC and the Open University?

We need a deeper understanding of innovation based on where it actually happens, and we needto develop our approach to innovation policy based on this understanding. The current emphasison traditional research and development is necessary, but not sufficient. It has grown from aconcern over the UKs unimpressive performance on traditional innovation metrics. But thesemetrics measure inputs more than outcomes and are inherently biased against the make-up of theUK economy. The result has been an over-emphasis on a very small sector of our economy and theexclusion of the vast majority.

We need to build from the rhetoric around a national mission for innovation toward making thatvision a reality. To do this, we will need to develop a firm understanding of what the UK wants frominnovation. We need to accurately appraise our capacity in those sectors, and imaginatively buildpolicy accordingly. This is why NESTA is focused not just on increasing the number of innovations

that the UK produces, but on transforming the UKs capacityfor innovation. We focus across allsectors on the factors (financial, human and policy) that maximise our countrys ability to innovateand to capture the value from that innovation.

This report is intended to drive forward the discussion and practice of innovation policy in theUK. NESTA will seek to promote and support this through its research, its programmes and itsinvestments. We welcome your involvement and your views.

Jonathan Kestenbaum

CEO, NESTA

October, 2006

3

NESTA is the National Endowment for Science, Technology and the Arts.

Our aim is to transform the UKs capacity for innovation. We invest in earlystage companies, inform innovation policy and encourage a culture thathelps innovation to flourish.


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Executive summaryThis is not, at heart, a complex argument. Traditionally, any reference to aninnovation gap with regard to the UK is assumed to mean the UKs deficitin innovation performance compared to other leading nations. However,traditional indicators of innovation performance are heavily biased towardinvestments in scientific and technological invention and so do not capture

innovation in those sectors that represent the vast majority of the UKeconomy. Moreover, even within those sectors that they do represent,traditional indicators poorly reflect the true level of innovative activity.This gulf between practice and measurement is the real innovation gap.Understandably, policy built to remedy our historical poor performance onthese indicators has focused on scientific and technological invention.This has been necessary but partial, because it has under-represented othersectors that are valuable to the UK economy. This emphasis now needs to bebalanced against a wider agenda around the skills and attributes required tocreate, absorb and exploit innovation in the rest of the economy.

The UK underperforms on traditionalinnovation indicators and has builtpolicy and structures to remedy thisThe traditional headline data that informs theinnovation debate shows that the UK performspoorly on business expenditures on researchand development (R&D) and on the productionof patents. For example, overall per capita

expenditure on R&D in the UK is just half thatin some other countries: the UK spends $566,the US $1,005, Sweden $1,154 and Finland$999. Similarly, the UK has a triadic patentingrate of 36.7 patents per million population,while Germany achieves a rate of 90.7 andJapan reaches 92.3. As a result, policymakersacross the UK have sought to driveimprovements in these areas, and have focusedon incentives for scientific and technologicalR&D, support for high-tech manufacturingfirms, increasing public investment in thescience base and improving links betweenuniversities and industry.

Traditional indicators ignore majorsectors of the UK economyWith innovation seen as fundamental todeveloped economies in an increasinglyinterconnected world, a paradox is apparent inthe continued economic expansion of the UKdespite its supposed under-performance. Theresolution of this paradox lies in the way inwhich innovation has typically been measured.

Traditional indicators have captured onlya limited amount of the innovation andinnovative potential that exists in the UK.

First, they are more relevant to some sectorsthan to others. For example, formal R&D ismuch less important in many service sectorsthan in high-tech manufacturing. The declinein some manufacturing sub-sectors thereforehelps to explain much of the UKs relativeunder-investment in business R&D. Similarly,although universities have been a focus of

much innovation policy based on the traditionalpipeline view of innovation (where pureknowledge is created and then commercialisedin industry), they actually produce only a smallamount of the innovation relevant to themodern UK economy.

Second, the Organisation for EconomicCo-operation and Development (OECD)definition of some indicators neglects someof the UKs strengths, for example explorationactivities in petroleum, one of the UKs mostvaluable sectors. Third, traditional measuresunhelpfully aggregate data from many sectorsinto single indicators. For example, the UKpharmaceutical sector, where the developmentof new drugs in traditional laboratory settingsis crucial, outperforms its competitors ininvestment in R&D but this performance isobscured when crude economy-wide indicatorsare compiled. If these factors are taken intoaccount in the traditional metrics, the UKsperformance significantly improves against ourinternational competitors. The gap in businessR&D intensity between the UK and France

closes by 80 per cent, and between the UK andGermany by 73 per cent.

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Understanding hidden innovation isvital to the UKs future prosperityUncovering the innovation that is hidden bytraditional indicators will be a defining issuein the development of successful innovationpolicy. We have begun this process by usingfive in-depth case studies to examine how

innovation actually occurs. For example, thedevelopment of new genetic tests through thehidden research system in the NHS suggeststhat informal and iterative development andresearch (D&R) is often more significant thanformal R&D, even in scientifically advancedsectors. In engineering consultancy, we witnessmultiple forms of innovation that deliversubstantial economic and social benefits beingdriven by interactions between businesses andtheir clients. In social housing, we are seeingthe transformation of an underperformingsector by creative interventions such as new

regulations and awards.

Together, these case studies emphasise howinnovation relies on interactions between awide diversity of actors. They indicate howinnovation reaches far beyond the productionof products and into the development of newservices and organisational models to meetsocial as well as economic challenges.

The extension of our understanding of hiddeninnovation, and the development of new

metrics that more accurately represent sectorssuch as these, might allow us to be moreconfident about the UKs ability to generateand exploit innovation. It could also allow usto identify those sectors where insufficientinnovation is currently taking place.

The wide distribution of high quality skillsis crucial to the development of hiddeninnovation and the absorption of innovationsdeveloped outside of the UK. This meansthat the traditional focus on the supply ofpeople with advanced science, engineeringand technology (SET) skills into jobs in formalR&D, needs to be balanced by a recognitionthat SET graduates working in other sectorsalso make an important contribution toinnovation. However, greater levels ofinnovation might be limited by the UKs poorperformance in intermediate skills, which attheir current levels inhibit our ability to takeadvantage of technological developments andto cope flexibly with the changes brought byglobalisation.

Building the policy agenda that the UKneeds to meet the national challengesof the 21st centuryOur research has six implications for policy:

We need a broad view of where innovationcomes from and where it applies. In other

words, we need to look beyond science andtechnological invention and the obviousforms of innovation that result in newmaterials or products. We need to thinkof innovation as a process that is of vitalimportance to all sectors of the UK economy,and build innovation policy that reflects this.

We should consider the importanceof the drivers of this new and broaderdefinition of innovation. In particular, policyshould focus on an education system thatis able to develop foundation analytical

and problem-solving skills, creativity,imagination, resourcefulness and flexibility.These will support our collective capacity toinitiate, absorb, support, organise, manage,and exploit innovation in its many forms.While current policy may over-estimate theimportance of academic researchas a source of innovation, it mayunder-estimate the damage that lowper capita investments in public researchhave had on the production of skilledscientists and engineers who can apply their

skills in the wider economy.

We need a textured innovation policy thatrecognises one size does not fit all sectors.The recipe in the pharmaceuticals sector willnot work for financial services or for publicservices. This leads to a requirement for us togather sounder intelligence and analysis ofthe sources and contribution of innovationacross different economic sectors. We need amuch better understanding of the dynamicsdriving innovation in areas such as the Cityof London, popular music and construction.

Innovation policy needs to be imaginativeand encompass a wide range of interventionsthat are relevant to stimulating andsupporting innovation. It would be usefulto focus more on the multi-directional flowswithin and between science and technology,architects and developers, designers andproducers, government and industry,management and engineering, universitiesand industry, and customers and suppliers.

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We should create an innovation policy thatis appropriate to UK conditions. A strikingfeature of most innovation policies aroundthe world is their similarity. A distinctive UKinnovation system would focus on sectorsthat play a marginal role in the policies ofcountries with larger manufacturing sectors.

We need greater clarity regarding theoutcomes of innovation (rather than just theoutputs). The focus of the UKs innovationpolicy should be determined by what we asa nation want from innovation, rather thanfocusing on innovation as an end in itself.

Toward a national mission forinnovationThe UK is not alone in grappling for theunderstandings, metrics and policies that willeffectively capture and stimulate the reality

of innovation in the 21st century. Moreover,the UK has some considerable strengthsas it faces up to the challenge. We have astrong background in innovation studies andpolicymakers across the UK are increasinglyrealising that policy and measurementhave fallen out of sync with the reality ofinnovation. What is needed is the articulationof a national mission around innovation, onethat encompasses the complexity of innovationwhile remaining a simplified guide to action.

The UK is well-placed to be a leader of aninternational shift in innovation policy. Asidefrom the intrinsic benefits of becoming a moreskilled, more innovative country, the creative,open nature of our society combined with ourdeveloped system of regional and nationalgovernment means that the UK is well-positioned to take advantage of innovationsdeveloped elsewhere. The ability to generateknowledge and to be able to exploit theknowledge of others is a powerful combinationand represents what it means to be a hub inthe future global economy. By embarking upona considered, concerted drive toward a nationalmission for innovation, the UK will bewell-positioned to lead the world in theapplication of knowledge, enterprise andcreativity and to meet the national challengesof the 21st century.

AcknowledgementsThis report was produced by Dr Michael Harris,NESTA Research Fellow, in partnership with theScience and Technology Policy Research Unit(SPRU), at the University of Sussex. At SPRU,the project was led by Dr Paul Nightingale andDr Virginia Acha, with the assistance of

Professor Mike Hobday, Dr Pari Patel, DrAlister Scott, Dr Mike Hopkins and Dr CaitrionaMcLeish. Richard Halkett edited the reportand Charles Leadbeater provided crucial adviceand wording in the final stages. Additionalcontributions were made by Mitch Sava, MariaEstevez, and Andrea Mattinson.

MethodologyThe first strand of the research comprised aform of synthesis research. This combinesfindings from a wide range of credible researchsources in order to produce new insights and

to develop an integrated understanding ofan issue. It also identifies the implications forpolicy, practice and research. In this instance,this report examines empirical data relatingto innovation from a variety of well-knownsurveys, and also the academic researchliterature on the nature of innovation andinnovation policy. The second strand of theresearch focused on five new case studiesof innovation in specific sectors of the UKeconomy. These case studies are based oninterviews with individuals and representatives

of relevant organisations, as well as reviews ofthe research literature relating to these sectors.

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Contents

Part I: The UK underperforms on traditional innovation indicators 9

and has built policy and structures to remedy this

1.1. Innovation is vital to meeting the national challenges of the 21st century 9

1.2. The UK performs poorly on traditional innovation indicators 9

1.2.1. Low investment in science base, but relatively high scientific productivity 9

1.2.2. Only average private sector expenditure on R&D 10

1.2.3. UK businesses display low levels of innovative activity 11

1.2.4. UK lags behind Germany, US and Japan on patenting 11

1.2.5. Poor performance on European Innovation Scoreboard (EIS) 12

1.2.6. In sum, a distinctly poor performance 12

1.3. Public policy interventions have focused tightly on improving the 13

UKs poor performance against traditional indicators

1.3.1. Innovation has been recognised as a priority by the UK and EU 13

1.3.2. UK central government policy and structures reflect this priority 13but with a clear focus on SET

1.3.3. Scotland prioritises a broad innovation agenda, but initiatives focus 14on SET and knowledge-transfer

1.3.4. Northern Irelands policy closely resembles that of the DTI 14

1.3.5. In Wales, a linked innovation and entrepreneurship agenda 15

1.3.6. Innovation is a priority for the English Regions, but again a focus on 15SET and knowledge-transfer

Part II: Traditional indicators ignore large and important sectors of the UK economy 16

2.1. The UK Paradox: economic success without innovation 16

2.2. The understanding of innovation on which the traditional indicators are 16

based is out-dated

2.2.1. The nature of innovation has changed and so have academic 16understandings of innovation

2.2.2. Traditional indicators are weak measures for contemporary innovation, 18particularly in the UK

2.2.2.1. The UKs sectoral composition accounts for much of its poor showing 18on business expenditure on R&D (BERD)

2.2.2.2. Innovation needs to be understood in light of patterns of specialisation 20

2.2.2.3. There are inherent problems with the collection of R&D data 20

2.2.2.4. Patenting is a useful measure of innovation for only a small fraction 21 of the UK economy

2.2.2.5. Measurements of advanced scientific research and of knowledge transfer 21from research institutions to industry do not accurately represent modern

knowledge creation or the process of commercialising that knowledge

2.3. The UK performs better on new, adjusted measures of innovation 23

Part III: Hidden innovation is ignored in traditional indicators but is crucial to 24

the UK economy

3.1. Traditional innovation that doesnt show up in traditional indicators: 24

A hidden research system in the National Health Service that has

developed 300 new genetic tests

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8

3.2. Built to fit: Product, process, service and organisational innovation 26

through client collaboration in engineering consultancy

3.3. Transforming an under-performing sector through innovative interventions: 28

Regulation and incentives to improve social housing

3.4. Co-evolution of innovation: Product and service innovation by government 30

and the private sector in tax planning

3.5. National impact through local innovation: Collaborative social innovation 32

in the development of the National Cycle Network

3.6. Hidden innovation means that we need to broaden our understanding of 33

innovation

3.7. Intermediate skills and a refocused education system are critical to the 34

development of hidden innovation and the absorption of innovations

developed elsewhere

Part IV: Building the policy agenda that the UK needs to meet the national 36

challenges of the 21st century

4.1. Innovation policy does not reflect the reality of innovation in the UK 36

4.2. Six general implications for policy to effectively promote innovation 37

in the UK

4.3. Towards a national mission for innovation: The UK should seize the 38

opportunity to create a world-leading innovation policy, and reap the

resultant rewards

Appendix A Glossary 40

Appendix B Details of innovation priorities, policies and initiatives across the UK 43

B.1. Innovation policy across the UK 43

B.1.1. UK central government policy 43

B.1.2. Devolved administration policy 44

B.2. Governmental structures around science, technology, engineering 45

and knowledge transfer are extensive

B.2.1. UK central government 45

B.2.2. Direction of university research 45

B.2.3. Business support services 46

B.2.4. Regional innovation policy 46B.2.5. Devolved administrations 46

B.3. Major policies and programmes are focused tightly on science, 46

technology, engineering and knowledge transfer

B.3.1. UK central government initiatives 46

B.3.2. Regional initiatives 48

B.3.3. Initiatives in the UK nations 48

Appendix C A National Innovation Strategy: Making Finland a leading 49

country in innovation

Appendix D Building on regional strengths: Manchesters Knowledge Capital 50and Science City initiative


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Part I: The UK underperforms on traditional

innovation indicators and has built policy and

structures to remedy this

1.1. Innovation is vital to meeting thenational challenges of the 21st century

Innovation is regarded as the major source ofcompetitive advantage for mature economiessuch as the UK in an increasingly competitiveglobal economy.1 As the economist Baumolput it: Under capitalism, innovative activity which in other types of economy is fortuitousand optional becomes mandatory, alife-and-death matter.2 More recently,innovation has been closely associated withthe concept of the knowledge economy,that is, the theory that advanced economiesare increasingly based on the production,

distribution and use of knowledge, and thattheir future competitive advantage lies in howefficiently and effectively they are able toengage in these activities.3

At a national level, variations in levels ofinnovation are related to economic growth andtrade performance.4 At the level of individualbusinesses, investments in innovation enableenterprises to outperform their competitors.Innovations in processes, products, servicesand expansion into new markets are crucialif UK enterprises are to thrive in a globalisedeconomy, and so benefit UK societyby contributing to wealth creation andemployment.5

Further, there is a broader need for innovationin order to find new solutions to seeminglyintractable social problems, to improve thequality of life and to provide greater economicand social opportunities for more UK citizens.In particular, the challenges of an ageingpopulation, healthy living, social cohesionand the need for greater environmental

sustainability will require innovative solutions

However, as the OECD has noted: Innovationpolicy in OECD countries has mostly been

seen as an extension of R&D [research anddevelopment] policy. As such it has been linkedto research and technological development.This remains the case, even though thesystemic approach developed under the labelNational Innovation Systems (NIS) during the1990s expanded this perspective to includeinteractive linkages in the innovation system.6

1.2. The UK performs poorly ontraditional innovation indicatorsThe notion that the UK performs poorly

in innovation tends to rely on traditionalindicators of innovation, such as public andprivate investment in R&D, private sectorengagement in innovation activity, and thenumber of patents registered.7

1.2.1. Low investment in science base, but

relatively high scientific productivity

Public sector R&D expenditure remainscomparatively low despite significant increasesin the UKs science budget in the last fewyears (net government expenditure in science,engineering and technology by UK centralgovernment departments has risen in real termsfrom 1.55 billion in 1994-5 to an estimated2.55 billion in 2004-5). According to theOffice of Science and Innovation, governmentinternal expenditure on R&D in 2003 was 0.18per cent of GDP, up from 0.17 per cent in2002, compared to the US at 0.33 per cent, theEU average of 0.24 and the G7 average of 0.26per cent.8

However, this low spend does at least appearto be highly productive: the UK consistently

scores highly in the numbers of scientificpapers and citations per capita compared tothe US, France and Germany.9 Despite having

9

1. The Department of Trade andIndustry (DTI) defines innovationas the successful exploitationof new ideas, see Departmentof Trade and Industry (2003),Innovation Report, Competingin the Global Economy: TheInnovation Challenge, (DTI,London).

2. p.1, Baumol, W. J. (2002),The Free-Market InnovationMachine: Analyzing the GrowthMiracle of Capitalism, (PrincetonUniversity Press, Princeton).

3. For example, see Organisationfor Economic Co-operationand Development (1996), TheKnowledge-Based Economy,(OECD, Paris).

4. See Metcalf, J. S. (1998),Evolutionary Economicsand Creative Destruction,(Routledge, London). AlsoFagerberg, J. (1987), ATechnology Gap Approachto Why Growth Rates Differ,Research Policy, 16, pp.8799,and Fagerberg, J. (2002),Technology, Growth andCompetitiveness: SelectedEssays, (Edward Elgar,Cheltenham).

5. For example, see thediscussion in The YoungFoundation (2006), SocialSilicon Valleys, A Manifesto forSocial Innovation, (The Young

Foundation, London).

6. p.7, Organisation forEconomic Co-operationand Development (2005),Governance of InnovationSystems, Synthesis ReportVolume 1, (OECD, Paris).

7. International comparativesurveys tend not to providebreakdowns within countries,hence data specific to the UKnations is not available fromthese surveys.

8. Office of Science andTechnology (2003), Science,Engineering and TechnologyIndicators, (OST, London).

9. Organisation for EconomicCo-operation and Development(2005), Main Science andTechnology Indicators (MSTI):2005/2 Edition, (OECD, Paris).


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0. HM Treasury/Departmentof Trade and Industry (2006),Productivity in the UK 6:Progress and New Evidence,HM Treasury/DTI, London).

1. See: http://scientific.homson.com/products/sci/.

2. According to a studypublished in 2000, see Salter,A., DEste, P., Martin, B.,Geuna, A., Scott, A., Pavitt, K.,Patel, P., and Nightingale, P.2000), Talent, Not Technology:

Publicly Funded Research andnnovation in the UK, (Sciencend Technology Policy Research,

University of Sussex, Brighton).

3. Ibid. Also Cohen, W., andLevinthal, D. (1990), AbsorptiveCapacity: A New Perspectiveon Learning and Innovation,Administrative Science Quarterly,

5, pp.12333.

4. According to the definitionhat is used for tax purposesn the UK, R&D is defined asny project to resolve scientific

or technological uncertaintyimed at achieving an advancen science or technologyadvances include new ormproved products, processesnd services), see Department

of Trade and Industry (2004),Guidelines on the Meaning ofResearch and Development forTax Purposes, (DTI, London).This definition is based on theOECDs Frascati Manual, seeOrganisation for EconomicCo-operation and Development2002), Frascati Manual 2002,OECD, Paris).

5. Organisation for EconomicCo-operation and Development2005), OECD Science,

Technology and Industrycoreboard 2005, Briefing Noteor the United Kingdom, (OECD,

Paris).

6. European Commission2005), Annual Innovation

Policy Trends and AppraisalReport, United Kingdom 2004-

005, (European Commission,Brussels).

7. For example, Departmentof Trade and Industry (2003),nnovation Report, Competing

n the Global Economy: Thennovation Challenge, (DTI,London).

8. Gross domestic expenditureon research and developmentGERD) is the total intramuralgovernment and businessunded) expenditure on researchnd development performed

on a national territory during aiven period, see Organisationor Economic Co-operationnd Development (2002),

Frascati Manual 2002, Proposedtandard Practice for Surveys

on Research and ExperimentalDevelopment, (OECD, Paris).

9.Organisation for Economic

Co-operation and Development2005), Main Science andTechnology Indicators (MSTI):

005/2 Edition, (OECD, Paris).

0. Ibid.

0

only one per cent of the world population, the

UK is responsible for five per cent of worldscience, publishes more than 12 per cent of allcited papers and nearly 12 per cent of paperswith the highest impact.10 But the UK doesnot perform as well as some other Europeancountries such as Switzerland, Sweden, Finlandand Denmark (see Figure 1).

Further, the UK science system represents asmaller investment per capita than many ofits competitors. In 2000, a study found theUK was ranked sixteenth in the OECD in its

per capita investments in Higher EducationInvestments in R&D (HERD).12 This is abouthalf the amount of Sweden and Switzerland,just under two-thirds that of the US andslightly less than in Germany and France.

1.2.2. Only average private sector

expenditure on R&DFirms need to engage in complementaryinternal research in order to take advantageof public sector research.13 However, theUK performs only averagely in businessexpenditure on R&D (BERD).14 The UK is belowthe OECD average15 and below its peer groupof EU countries (Belgium, Netherlands, Austria,France and Italy).16 This is a longstandingissue; business expenditure on R&D (BERD)has been below that of competitors such asthe US, France and Germany for many years

(as illustrated in Figure 2), and has beenidentified repeatedly as a major issue forinnovation in the UK.17 Similarly, overall percapita expenditure on R&D (GERD)18 in the UKis just half that in some other countries; the UKspends $566, compared to $1,005 in the US,$1,154 in Sweden, and $999 in Finland.19

Figure 1: Science and engineering publications per million population (1991, 2001)

Source: Institute for Scientific Information (ISI) Science Citation Index (SCI).11

Figure 2: Business R&D (BERD) as a percentage of GDP (1990-2003)

Source: OECD.20

Publicationsper million

Japan France Germany EU15 USA UK Denmark Finland Switzerland Sweden

1,400

1,200

1,000

800

600

400

200

01991

2001

BERD as

% of GDP

2.50

2.25

2.00

1.75

1.50

1.25

1.001990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

France

UK

OECDAverage

USA

Germany

Japan


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21. The US has such a high GDPthat this means that it spendsmore on R&D than the restof the G7 combined, with itshuge subsidies to university andSME research and large internalbusiness R&D.

22. All data from Organisationfor Economic Co-operation andDevelopment (2005), OECDScience, Technology and IndustryScoreboard 2005, (OECD, Paris).

23. Department of Trade andIndustry (2004), InternationalComparisons of the ThirdCommunity Innovation Survey,(DTI, London). Innovationactive here indicates that thefirm reported the introduction ofa new product or process and/orhad innovation activities thatwere incomplete or abandonedin the period 1998-2000.Comparative international datais not yet available from themore recent survey covering2002-2004, but the UK-onlyfigures indicate an increase inthe percentage of businesses

that are involved in innovationactivities to 57 per cent, seeDepartment of Trade andIndustry (2006), Innovation inthe UK: Indicators and Insights,DTI Occasional Paper No. 6,(DTI, London).

24. Organisation for EconomicCo-operation and Development(2005), OECD Science,Technology and IndustryScoreboard 2005, (OECD, Paris).

25. Organisation for EconomicCo-operation and Development(2005), Main Science andTechnology Indicators (MSTI):2005/2 Edition, (OECD, Paris);US Patent Office (2005), Patent

Counts by Country/State andYear, All Patents, All Types,(USPTO, Alexandria VA).

26. p.24, Department ofTrade and Industry (2003), UKCompetitiveness: Moving to theNext Stage, (DTI, London).

27. Ibid.

11

Another measure is that of R&D intensity(total expenditure on R&D as a percentage of

national GDP). The UKs R&D intensity, at 1.9per cent of GDP in 2003, is below that of itscompetitors. It is lower than Japan (3.2 percent), Germany and the United States (2.6 percent), France (2.2 per cent), and the EU-15average (2.0 per cent).21 Further, the UKscurrent level of R&D intensity is below that ofthe early-1990s, when it spent about 2.1 percent of GDP on R&D.22

1.2.3. UK businesses display low levels of

innovative activity

According to the Third Community InnovationSurvey (CIS 3) only 38 per cent of UKenterprises were engaged in innovationactivities; three percentage points belowthe EU average and well below Germany (61per cent) and Sweden (47 per cent) and theNetherlands and Finland (45 per cent).23The picture is even worse when more radicalforms of innovation are considered: only 21per cent of UK enterprises were engaged inproduct innovation (firms that reported theintroduction of new or significantly improvedgoods or services in the three-year period19982000), compared to an EU average of31 per cent, and well behind the equivalentfigures for Iceland (46 per cent) and Germany(42 per cent).

Similarly, according to the OECD, UK SMEsare well below the OECD average in thepercentage innovating in-house (less than 23per cent compared to an EU average of nearly32 per cent and nearly 55 per cent of Swissbusinesses), and below the average in beinginvolved in innovation co-operation (just over

22 per cent compared to an EU average ofnearly 32 per cent and nearly 55 per cent ofSwiss SMEs).24

1.2.4. UK lags behind Germany, US and

Japan on patenting

Patenting in the US is often used as a proxyfor overall patent activity because mosteconomically significant innovations are likelyto be patented in the worlds largest market.Given the UKs comparatively low investmentin innovation, it might not be a surprise that itlags behind Germany and Japan in patentingactivity (based on the number of patentsgranted in the US, as illustrated in Figure 3).

Lastly, according to a study conducted for theDTI by Michael Porter and Christian Ketels,

UK patenting in the US is characterised by alow representation of universities and otherpublic institutions.26 By comparison, France, acountry with a roughly equal level of overall USpatenting, registers a significantly larger rolefor universities and research institutions. Thissuggests that UK universities are less active incommercialisation efforts than their peers inother advanced economies.27

Figure 3: US patents granted per million population (1990-2004)

Source: OECD, US Patent Office.25

450

400

350

300

250

200

150

100

50

0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 20002001 2002 2003 2004 2005

France

UK

USA

Germany

Japan

Patents per

million population


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8. European Commission2005), European Trend Chart onnnovation, Innovation Strengthsnd Weaknesses, (European

Commission, Brussels).

29. The EIS measures

nnovation performancecross the European Union.t uses 26 indicators under fivehemes relating to innovation

performance and comparesperformance against a Europeanverage, by combining datarom the Community Innovationurvey with related dataompiled by the OECD and

EUROSTAT.

2

1.2.5. Poor performance on European

Innovation Scoreboard (EIS)

The European Innovation Scoreboard (EIS) isa composite index of innovation (see Figure4). It illustrates the UKs performance relativeto the EU average, across a range of indicators(the EU average in this chart is representedby the value 100).29 It shows that the UK hasvariable performance across these metrics, andin particular it appears to confirm that the UKdeclines in performance as it gets closer to theexploitation of innovation. This survey suggeststhat Sweden, Finland and Switzerland are theleading innovative countries in Europe

So, for example, the UK performs above theEU average in the number of science andengineering graduates that it produces, butbelow average in the percentage ofuniversity-based R&D financed by businesses,and well below average in the public fundingof innovation (defined as the proportion offirms that have received any public financial

support for innovation from at least one ofthree government levels, namely local, nationalor EU).

1.2.6. In sum, a distinctly poor performance

The general implication created by theseindicators is that the UK wastes its innovativepotential by failing to invest in innovation,particularly the commercial exploitation ofideas, despite its strengths in developingideas in the first place. Business under-investsin innovation, does not sufficiently supportuniversity-based R&D, and under-protectsthe outputs of innovation through the use ofpatents. Similarly, public sector investmentin innovation is well below that of ourcompetitors (although this does generate highquality science). This picture suggests thatthe UK lags behind its competitors, and inparticular is failing to turn high quality scienceinto innovation, suggesting the need forgreater links between university and industry.The implication is that by not producingenough knowledge, the UK is sowing the seedsof future prolonged economic decline.

Figure 4: European Innovation Scoreboard UK performance relative to EU average

Source: European Commission.28

0 50 100 150 200 250

S&E graduates

Population with tertiary education

Broadband penetration rate

Participation in life-long learning

Youth education attainment level

Public R&D Expditures

Business R&D Expditures

Business financed university R&D

Share of med-high/high-tech R&D

Enterprises receiving public funding

SMEs innovating In-house

Innovative SMEs co-operating with others

Innovation expenditures

Early-stage venture capital

ICT expenditures

Employment in high-tech services

Exports of high-tech products

Sales new-to-market products

Sales new-to-firm not new-to-market productsMed-hi/high-tech manufacuring employment

New EPO patents

New USPTO patents

New Triad patents

New community trademarks

New community designs

Innovation

Drivers

Knowledge

Creation

Entrepreneurship

Application

Intellectual

Property


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1.3. Public policy interventions havefocused tightly on improving the UKspoor performance against traditionalindicatorsFor additional detail, please see Appendix B.

1.3.1. Innovation has been recognised as a

priority by the UK and EUAs a result of an increasing awareness of theimportance of innovation and in response tofigures such as those quoted above, the last10 years have seen innovation become a highpriority for UK policymakers.

Unsurprisingly, policy has focused aroundimproving poor performance against themeasures outlined above. Compoundedby analyses that have pointed to thepersistence of the productivity gap withmain competitors,30 the result has been a

range of central strategies and initiatives thathave focused on Science, Engineering andTechnology (SET) areas.31 The UK nations havereflected a similar emphasis on SET, R&D inadvanced technologies, and university-businesscollaborations, as have the initiatives of theEnglish regions.

The UKs concerns regarding its innovationperformance have been mirrored at theEuropean level. There is a large gap in R&Dinvestment between the EU and the US and

Japan. As a result, since the mid-1990s asuccession of measures to increase R&D spendhave been introduced, including the fifthResearch and Technological Development(RTD) framework programme, adopted in1998. This included a programme for thepromotion of innovation and the role of SMEsin particular. More recently, in March 2000,the Lisbon Council committed the EU to theobjective of becoming the most competitiveand dynamic knowledge-based economy in theworld by 2010.32 In 2002 the EU establishedthe goal of increasing its R&D expenditure tothree per cent of GDP by 2010 (it was 1.81 percent in 2003).

1.3.2. UK central government policy and

structures reflect this priority but with a

clear focus on SET

The Department of Trade and Industry (DTIs)Innovation Report(2003) stated that thegovernment wanted the UK to be a keyknowledge hub in the global economy In

terms of business R&D and patenting we willaim to be the leading major country in Europewithin ten years.33 It went on to make anumber of general recommendations, includingfor the development of a Technology Strategy.

The following year (2004), the LambertReviewof businessuniversity collaborationmade several recommendations to improvelinks between universities and businesses,which the Government accepted.34 This wasprompted by the recognition that whileUK firms have many network relationships,

relatively few cite universities or public researchinstitutes as partners in these networks. TheReview gave support to two existing schemes,LINK and Knowledge Transfer Partnerships(KTPs) and suggested an extension to theHigher Education Innovation Fund (HEIF)as ways of allocating funding for business-relevant research. TheScience and InnovationInvestment Framework 2004-2014, publishedjointly by HM Treasury, the DTI and theDepartment for Education and Skills (DfES) inJuly 2004, set out a series of goals for public

and private sector R&D activity, for interactionsbetween business and the publicly-fundedresearch base, and improvements in SET skills.35It further established a target to increase theUKs R&D intensity from 1.9 per cent in 2003to 2.5 per cent by 2014.

Because of its heritage in science andtechnology policy, the DTI has emerged as thefocal point for the governance of the currentUK system of innovation. Within the DTI, theOffice of Science and Innovation (OSI) evolvedout of the Office of Science and Technology(OST) and is responsible for the funding ofbasic university research largely via the researchcouncils. The Technology Strategy Board (TSB)is a high-level forum for interaction betweenbusiness, government and other stakeholdersthat advises the Secretary of State for Tradeand Industry on business research, technologyand innovation priorities for the UK. Followingthe publication of the Innovation Report, theSteering Group on Innovation in the KnowledgeEconomy (chaired by the Secretary of State forTrade and Industry) meets on a quarterly basis

with the intention of coordinating the work ofall Government departments on the science,innovation and wealth creation agendas.

30. For example, the reviewconducted by Michael Porterand Christian Ketels, Departmentof Trade and Industry (2003), UKCompetitiveness: Moving to theNext Stage, (DTI, London).

31. For example, Departmentof Trade and Industry (2003),Innovation Report, Competingin the Global Economy: TheInnovation Challenge, (DTI,London); Department of Tradeand Industry/HM Treasury/Department for Educationand Skills (2002), Investingin Innovation, A Strategyfor Science, Engineeringand Technology, (DTI/HM

Treasury/DfES, London); andHM Treasury/Department ofTrade and Industry/Departmentfor Education and Skills (2004),Science & Innovation InvestmentFramework 2004-2014, (HMTreasury/DTI/DfES, London).

32. See European Commission(2003), Innovation Policy:Updating the UnionsApproach in the Context ofthe Lisbon Strategy, (EuropeanCommission, Brussels),and European Commission(2003), More Research andInnovation - Investing forGrowth and Employment: ACommon Approach, (EuropeanCommission, Brussels).

33. p.3, Department of Tradeand Industry (2003), InnovationReport, Competing in theGlobal Economy: The InnovationChallenge, (DTI, London).

34. HM Treasury (2003),Lambert Review of BusinessUniversity Collaboration: FinalReport, (HM Treasury, London).

35. HM Treasury/Department ofTrade and Industry/Departmentfor Education and Skills (2004),Science & Innovation InvestmentFramework 2004-2014, (HMTreasury/DTI/DfES, London).

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36. Department of Trade andIndustry website, accessed 10thJuly 2006.

37. See the study commissionedby the Scottish Executive, Roper,S., and Love, J. (2006), TheScottish Innovation System:Actors, Roles and Actions,(Aston Business School/CardiffUniversity, Birmingham/Cardiff).

38. Scottish Executive (2001),A Smart, Successful Scotland,Ambitions for the EnterpriseNetworks, (Scottish Executive,Edinburgh), Scottish Executive(2004), A Smart, SuccessfulScotland, Strategic Direction to

the Enterprise Networks and AnEnterprise Strategy for Scotland,(Scottish Executive, Edinburgh).

39. Department of Enterprise,Trade and Investment (2003),Think, Create, Innovate, (DETI,Belfast).

40. Department of Enterprise,Trade and Investment (2005),The Regional InnovationStrategy for Northern Ireland,Action Plan September 2004 toAugust 2006, (DETI, Belfast).

41. These programmes includeCompete, START, SMART,Product & Process Development(PPD), and KTP. Increasingly,this support is being focused

on services, for example. InvestNI has made nearly 4 millionavailable for developing andadapting ICT under the Competeprogramme in 2004-2006.

These policies and structures have resulted ina number of specific initiatives, a few of whichare highlighted here (for additional detail, seeAppendix B). KTPs provide financial supportfor collaborative projects between businessesand individuals from public or private researchorganisations. Knowledge Transfer Networks

provide grants to set up networks in specifictechnology areas. The Higher EducationInnovation Fund (HEIF) is spending 187million for knowledge transfer activities in200406.

Perhaps the most prominent policy is theR&D tax credits scheme. These credits are acompany tax relief which can either reduce acompanys tax bill or, for some SMEs, providea cash sum. Their aim is to encourage greaterR&D spending in order to promote investmentin innovation. Between April 2000 and April

2005, around 17,000 claims for R&D tax creditswere made with around 1.3 billion of supportclaimed.36

1.3.3. Scotland prioritises a broad

innovation agenda, but initiatives focus on

SET and knowledge-transfer

The Scottish Executive has a dual role, inhaving responsibility for policy formulationbut also in administering a number ofschemes designed to enhance innovationin Scotland.37 Scottish Enterprise, the main

economic development agency for Scotland,plays a leading role in the direction andimplementation of policy on R&D andinnovation. These priorities have largely grownfrom the analyses set out in the Frameworkfor Economic Development in Scotland,

A Science Strategy for Scotland and the

Smart, Successful Scotland Strategy.38 Thelast of these identified four core themes:productivity (and the productivity gapwith other leading competitor nations);entrepreneurship (in particular, raising therate of new firm formation); the skills requiredfor a flexible labour market; and digitalconnections. This has led to several initiatives:the Scottish Funding Councils KnowledgeTransfer Grant (doubled in size to at least12 million for 2005-06); a newly-revampedTechnology Ventures Scotland (TVS) toadvise on policies and projects relating tocommercialisation and technology transferand the SCORE (SME Collaborative Researchprogramme); and SEEKIT (Scottish ExecutiveExpertise, Knowledge & Innovation Transfergrant scheme) initiatives intended to boost

interaction between industry and the sciencebase.

1.3.4. Northern Irelands policy closely

resembles that of the DTI

In Northern Ireland, the innovation strategywas developed in parallel with the DTIInnovation Report. This strategy, Think,Create, Innovate, was published in 2003,with an emphasis on the better integration

of public, private and higher education R&Defforts as well as the need to increase levelsof R&D expenditure throughout the region.39In the more recent Action Plan there are sixareas for action (all of which display a familiaremphasis): resourcing R&D; supportingknowledge and technology transfer; developinga greater awareness of intellectual propertymanagement; leading a regional innovationsystem (including establishing a RegionalScience-Industry Council); promotingcross-sectoral collaborations; and enhancinginterregional collaborations (across the UK,

Ireland, the EU and beyond).40

Similar to England, the lead departmentin innovation has been the Department ofEnterprise, Trade and Investment (DETI).Invest NI was established in 2002 as themain economic development organisation inNorthern Ireland and promoting innovationis one of its core objectives (especially higherR&D spending and knowledge transfer).Together, as part of the Regional InnovationStrategy, a Higher Education Innovation Fund

for Northern Ireland has been established,along with a Pilot Proof of Concept Fund and18 Research & Technological Development(RTD) centres of excellence (in areas suchas nanotech, genomics and integratedaircraft technology, where the region has theskills and institutions to be internationallycompetitive). These are in addition to InvestNIs complementary pre-competitive research,near-market and technology transferprogrammes that seek to ensure theparticipation of SMEs and micro-businesses inthe regions R&D.41

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1.3.5. In Wales, a linked innovation and

entrepreneurship agenda

In Wales, the Assembly GovernmentsInnovation Action Plan (2003) establishedfive broad themes for establishing a strongerculture of innovation in Wales: communicatingthe importance and benefits of innovation to

business; supporting high growth businesses;better equipping people to innovate; buildingthe best innovation support provision; andencouraging technology development,transfer and commercialisation, and closerlinks between academia and businesses moregenerally.42 This was followed in 2005 by theAssembly Governments Strategic Frameworkfor Economic Development consultationdocument, Wales: A Vibrant Economy.43

In Wales, the innovation agenda was initiallyled by the Welsh Development Agency through

the Innovation Works campaign and hasnow been taken over by the Welsh AssemblyGovernments Department of Enterprise,Innovation and Networks. Support for highgrowth businesses has been delivered inparticular through the network of Techniumcentres that provide high-tech incubator spaceand links to research and expertise in highereducation institutions. Support for innovationis further provided through the KnowledgeBank for Business to provide tailored adviceand support to businesses with high growth

potential. The service includes diagnosticreview and benchmarking, and trainingon finance, innovation management, andperformance improvement. Other importantscience and technology facilities include theInstitute of Life Sciences in Swansea, TheCentre for Advanced Software Technology inBangor and ECM2 in Port Talbot.

1.3.6. Innovation is a priority for the English

regions, but again a focus on SET and

knowledge-transfer

The nine Regional Development Agencies(RDAs) are the main vehicles for the deliveryof the DTIs innovation policies in the Englishregions and as such hold the lions share of

budget and responsibility for the innovationagenda. The RDAs develop RegionalInnovation Strategies (RIS) in consultationwith a wide range of regional and local actors.These typically prioritise regional networksthat foster collaboration, the exchange ofgood practice, and the level of interactionbetween universities/research institutionswith local/regional businesses, particularlySMEs. The RDAs have also establishedScience and Industry Councils (SICs) or similararrangements, to bring together science,technology and business representatives from

the private sector and universities.

Collectively, the RDAs are putting an increasingfocus on innovation as a driver of economicdevelopment. In 2001-02, the DTI establisheda 15 million Innovative Clusters Fund (ICF)for RDAs to promote cluster development andbusiness incubation. A further 35 millionwas provided by the DTI as part of the thenRegional Innovation Fund (RIF).44 Otherregional innovation support mechanismsinclude the Regional Venture Capital Funds

(RVCFs) and the Centres of IndustrialCollaboration (CICs). Further, the threenorthern RDAs have committed to promotingScience Cities as part of their 100 millioninvestment in university-business collaborationover the next six years. This has already startedwith Manchester, York and Newcastle. TheMarch 2005 budget confirmed that threefurther Science Cities are to be developed inBristol, Birmingham and Nottingham.

42. Welsh Assembly Government(2003), Wales for Innovation,The Welsh AssemblyGovernments Action Plan forInnovation, (WAG, Cardiff).

43. Welsh Assembly Government

(2003), Wales: A VibrantEconomy, (WAG, Cardiff).

44. The RIF has now beensubsumed within the single potfunding arrangements for theRDAs, increasing their flexibilityto mix funds to promote regionaleconomic development

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Part II: Traditional indicators ignore large and important

sectors of the UK economy

2.1. The UK Paradox: economic successwithout innovation

The notion of the European paradox has beenwidely discussed. This refers to the notionthat allegedly better European science is nottranslated into innovations at the same rate asin the US.45 However, another paradox existswith regards to the UK. This is that the UKapparently fails to invest in innovation and yethas retained its position as one of the largest,most advanced and most successful economiesin the world.

The UK is the fifth biggest economy in the

world and has one of the strongest economiesin Europe. The UKs GDP growth in 2005 wasabove that in the Euro area as a whole for thetenth consecutive year, with average growthsince 1997 only behind that of the US amongstthe G7 economies. More than two millionnew jobs have been created since 1997,yet economic volatility is at historicallylow levels and is now the lowest in the G7.Inflation, interest rates, and unemploymentremain comparatively and historically low.The UK came first in a recent OECD review of30 countries for macro-economic performancebetween 1998-2004 and second for liberalproduct market regulation.46

How can such an economy, such a country,appear to perform so poorly in innovationand yet still be so successful? The resolutionof this paradox lies in flaws in the traditionalindicators of innovation, and this has importantimplications for innovation policy in the UK.

2.2. The understanding of innovationon which the traditional indicators are

based is out-dated

2.2.1. The nature of innovation has changed

and so have academic understandings of

innovation

New and distinct forms of innovation areconstantly emerging, related to new industrialsectors and forms of organisation. This isreflected in the increasing complexity ofindustrial innovation processes.47

Necessarily, academic models of innovation

are historically contingent. Between the 1950sand 1980s innovation was understood byfocusing on discrete events such as discoveriesand inventions, especially within universitiesand firms. This view, the so-called linearmodel, assumed a central role for formal(especially scientific or technological) R&D inthe development of new products or processes,and that research in universities is followeddirectly by its application in industry.48This reflected the form of industrialorganisation based around the scale-intensivemass-production of consumer goods and newscience-based industries such as chemicalsthat began to emerge in the US in the latenineteenth century. These firms developedR&D laboratories and employed increasingnumbers of scientists and engineers, toensure that the complex production systemsto generate consumer goods were efficientlymanaged.

6

45. However, this supposedparadox has been heavilyriticised. Dosi et al. haveighlighted that the paradoxicalesult that more Europeancience is not translated into

more technology is based on aeeply flawed understanding

of relative performance of theEU and US science systems thatails to take into considerationhe larger population of the

EU. While it is true that the EUow produces more scientificpapers in absolute numbers,hat is not true per capita andhe US has substantially better

performance in terms of citationsnd highly cited papers. The

problem with the EU is notue to a lack of linkages to

ndustry from universities or aack of networks, but a lack ofigh quality academic research.ee Dosi, G., Llerena, P., and

Labini, M. (2005), Science-Technology-Industry Linksnd the European Paradox:ome Notes on the Dynamics

of Scientific and TechnologicalResearch in Europe, working

paper 2005/2, (Laboratory ofEconomics and ManagementLEM), Sant Anna School of

Advanced Studies, Pisa, Italy).

46. Organisation for EconomicCo-operation and Development2005), Economic Survey of the

UK, (OECD, Paris).

47. For example, see Granstrand,O., Patel, P., and Pavitt, K.1997), Multi-technology

Corporations: Why They HaveDistributed Rather thanDistinctive Core Competencies,California Management Review,

9, pp.825.

48. Kline and Rosenbergighlighted two problems withhe linear model. First, that iteneralises a chain of causationrom R&D to innovation thats true only of a minority ofnnovation processes. Second,t ignores all the feedbackoops involved in the process ofnnovation by under-estimatinghe uncertainties involved. See

Kline, S. J., and Rosenberg,N. (1986), An Overview ofnnovation, pp.275304, inLandau, R., and Rosenberg,N. (eds.), The Positive Sumtrategy: Harnessing Technologyor Economic Growth, (National

Academy Press, Washington DC).

49. Nightingale, P., Brady, T.,

Davies, A. C., and Hall, J. (2003),Capacity Utilisation Revisited:oftware Control and the Growth

of Large Technical Systems,ndustrial and Corporate Change,2 (3), pp.477-517.

0. p.12, Fagerberg, J.2005), Innovation: A Guideo the Literature, pp.1-26,n Fagerberg, J., Mowery,D., and Nelson, R., (eds.),The Oxford Handbook ofnnovation, (Oxford UniversityPress, Oxford). Also Lundvall,B., (1988), Innovation asn Interactive Process: From

UserProducer Interaction to theNational System of Innovation,

pp.34969, in Dosi, G., Freeman,C., Nelson, R., Silverberg, G.,nd Soete, L. G. (eds.), Technical

Change and Economic Theory,Pinter, London).


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For these firms, innovation involved bothproduct innovation driven by design teamsand R&D laboratories, and process innovationsproduced by internal production engineering orsourced from external capital goods suppliers.The wider contexts and consequences ofinnovation were rarely considered in the initial

post-war period of high consumer demand.This linear model may have been accurate inthe 1950s, but was less so in the 1970s, and isnot universally applicable now.

Another shift in industrial organisationoccurred towards the end of the twentiethcentury with the wider application of IT,which has transformed a range of industriesparticularly in services such as finance, mediaand telecommunications.49 In these sectors,product, service and process innovations areoften bundled together and frequently depend

on sophisticated software systems. Much of theinnovation in these sectors takes place outsideof formal R&D (this also means that much ofthe innovation in these sectors is not patented,although it is sometimes protected bycopyright). In this context, innovation dependsheavily on external sources of knowledge,and this systemic nature of innovation isincreasing.50

Academics have adapted their understandingsof innovation to reflect the prevalent forms of

innovation that have emerged. For example,progressively, attention has been placed onhow innovation is generated within the firm(organisational innovation), the factors thatshape innovation (such as regulation), andthe distribution of innovative labour andintelligence in networks. The networked modelof innovation was developed predominantlyin studies of software and IT (although itoriginated in studies of the Danish dairyindustry in the 1980s), but it has now beenapplied across many sectors as a way ofstudying the interdependencies betweenactors.

R&D remains important to innovation, butits importance and nature differs betweensectors.51 Even in R&D intensive sectors, themajority of R&D focuses on development ratherthan research,52 and knowledge often flowsfrom development to research (as developmentwork generates questions that require scientificanalysis).53 It is therefore misleading toprivilege scientific research, particularly withinuniversities, as a source of innovation. When

firms are asked about the sources of knowledgefor innovation, university research tends tocome a long way down the list, suggesting that

its importance is being over-estimated withincurrent policy thinking.54 R&D intensive firmsin the UK typically generate as much scientificoutput as a medium sized university such asSussex.55 Similarly, approximately a quarter ofthe scientific publications with multiple authorsproduced in the UK have an author located

within the NHS.

56

Further, it is now recognised that much ofthe economic benefit from innovation occurswhen knowledge and technology are diffusedwidely and other incremental innovationsdevelop as a result.57 The development anddiffusion of discoveries and inventions cantake many decades, as incremental innovationsthat improve on and adapt the original radicalinnovation are generated.58 This aspect ofinnovation is substantially more economicallyimportant than the initial introduction of the

discovery or invention.59 For example, thefirst internet was built in 1968 for UnitedStates Defense Department by the firm Bolt,Beranek and Newman, but it was only withthe invention of the World Wide Web by TimBerners-Lee in the 1990s that the internetas we know it began to transform society.Similarly, the first successful low-cost airlinewas Pacific Southwest Airlines in the UnitedStates, whose first flight was in 1949, manydecades before the highly publicised successof EasyJet, Ryanair and JetBlue. In this sense,

most innovation is not new. One well-knownstudy of product development surveyed13,000 new products introduced by 700companies and found that new to the worldproducts represented only 10 per cent of thesample; many of the products were in fact lineextensions, improvements or revisions.60

The problem is that a gap has openedup between the practice, the theory, themeasurement (and subsequently policies)of innovation. This is the true innovationgap, and it can produce a misleading view ofnational innovation performance.

51. A number of taxonomieshave been developed that showdifferent patterns of innovation.For example, Pavitts taxonomyhighlighted two high-techsectors: science based, whereinnovation involved stronglinks to research and heavyinvestments in R&D; andspecialised suppliers, involvinglots of interaction with usersand capabilities in specialised

engineering. There was alsoa scale intensive sector thatinnovated in productionengineering and supplierdominated that innovated bydrawing on technology fromsuppliers. See Pavitt, K. (1984),Patterns of Technical Change:Towards a Taxonomy and aTheory, Research Policy, 13,pp.343-74.

52. National Science Foundation(2000), Science and EngineeringIndicators 2000, (NSF, Arlington,VA).

53. This pattern can be pickedup in patent and scientificpublication data that shows that

the relative performance of post-War science in the UK, Japanand Germany has lagged ratherthan led relative performance intechnology, see Pavitt, K. (1999),Technology, Management andSystems of Innovation, (EdwardElgar, Cheltenham).

54. For example, a Cambridge-MIT study shows that in boththe US and the UK universitiesrank well down the list ofsources of knowledge forfirms (and this study focuseddisproportionately on high techmanufacturing and services). SeeCambridge-MIT Institute (2006),Measuring University-Industry

Linkages, (Cambridge-MITInstitute, Cambridge).

55. Hicks, D. (1995), PublishedPapers, Tacit Competenciesand Corporate Management ofthe Public/Private Characterof Knowledge, Industrial andCorporate Change, 4, pp.401-424.

56. Hicks, D. M., and Katz, J.S. (1996), Hospitals: A HiddenResearch System, Science andPublic Policy, 23 (5), pp.297-305. Given that the measurehere is publications, this datais likely to continue to over-estimate the relative importanceof universities compared to otherinstitutions and industry.

57. For example, in theindustrial revolutions of steamand electricity, see Crafts, N.(2004), Steam as a GeneralPurpose Technology: A GrowthAccounting Perspective, TheEconomic Journal, 114, pp.338-351, and von Tunzelmann, G.N. (1978), Steam Power andBritish Industrialization to 1860,(Clarendon Press, Oxford), andmore recently on IT, David,P.A. (1990), The Dynamo andthe Computer: An HistoricalPerspective on the ModernProductivity Paradox, TheAmerican Economic Review,80 (2), pp.355-361. Seealso Rosenberg, N. (1979),Technological Interdependencein the American Economy,Technology and Culture, 20 (1),pp.25-51.

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8. Rosenberg, N. (1982),Exploring the Black Box,Cambridge University Press,

Cambridge), and Freeman,C. (1982), The Economics ofndustrial Innovation, (Pinter,London).

9. p.283, Kline, S. J., andRosenberg, N. (1986), AnOverview of Innovation,pp.275304, in Landau, R.,nd Rosenberg, N. (eds.),

The Positive Sum Strategy:Harnessing Technology forEconomic Growth, (NationalAcademy Press, WashingtonDC). Also, Mowery, D., andRosenberg, N. (1998), Pathsof Innovation, TechnologicalChange in 20th-CenturyAmerica, (Cambridge UniversityPress, Cambridge), andp.8, Fagerberg, J. (2005),nnovation: A Guide to the

Literature, in Fagerberg, J.,Mowery, D., and Nelson, R.R., The Oxford Handbook onnnovation, (Oxford UniversityPress, Oxford).

60. Booz, Allen and Hamilton

1982), New ProductManagement in the 1980s,Booz, Allen and Hamilton, New

York).

61. Office for National Statistics2005), United Kingdomnput-Output Analyses, (HMSO,London). GVA measures theontribution to the economy

of each individual producer orector.

62. Organisation for EconomicCo-operation and Development2005), OECD Science,

Technology and Industrycoreboard 2005, (OECD, Paris).

63. Office for National Statistics2005), United Kingdom

nput-Output Analyses, (HMSO,London).

64. Organisation for EconomicCo-operation and Development2005), The Service Economy in

OECD Countries, (OECD, Paris).

65. These figures relate to990-2000. See Griffith,

R., and Harrison, R. (2003),Understanding the UKs PoorTechnological Performance,Institute for Fiscal Studies,

London).

66. Godin, B. (2002), TheNumber Makers: Fifty Years ofOfficial Statistics on Science andTechnology, Minerva, 40 (4),pp.375-397.

67. For example, from thelassic SAPPHO project:

Rothwell, R. (1972), Factorsor Success in Industrialnnovations from ProjectAPPHO A Comparativetudy of Success and Failure inndustrial Innovation, (SPRU,Brighton); Rothwell, R.,Freeman, C., Horsley, A., Jervis,V. T. P., Robertson, A. B., andTownsend, J. (1974), SAPPHOUpdated Project SAPPHOPhase II, (Harvard School Press,Cambridge, Massachusetts).

68. p.165, Smith, K. (2005),Measuring Innovation, chapterix in Fagerberg, J., Mowery, D.,nd Nelson, R. R., The Oxford

Handbook on Innovation,Oxford University Press,

Oxford).

2.2.2. Traditional indicators are weak

measures for contemporary innovation,

particularly in the UKTraditional indicators neglect the extentand diversity of innovation in the UK, andso produce an unfairly negative analysis.They conceptualise innovation primarily as anew product or process developed throughtechnological advancement (more akin to thelinear model of innovation described above).This is relevant to high-tech manufacturing butfar less so for other sectors that are vastly moreimportant to the UK economy.

Manufacturing now accounts for less than15 per cent of total GVA in the UK, and itscontribution has fallen every year since 1998.61This is less than half that of the businessand financial services sector, which formsthe largest single sector of the UK economy,accounting for 31.7 per cent of the totalGVA of the economy in 2003. High-techmanufacturing sectors account for only 2.5 percent of the UK economy (medium-high techmanufacturing sectors account for a further3.6 per cent of the economy).62 Business andfinancial services are continuing to increase inimportance, growing by more than 8.4 per centfrom 2002-2003, faster than the overall growthin GVA of 5.5 per cent.63 Comparative datafrom the OECD suggests that the growth ofthe UKs services sectors has been particularlypronounced compared to other countries.64

Since most innovation in the UK thereforeoccurs outside of manufacturing, it followsthat most innovation is not based ontraditionally-defined formal R&D; informaldevelopment activities (that is, more iterative

and recursive processes of design, buildingand testing of new products, processes andservices) are more significant and more

common in most sectors. This has importantimplications for the interpretation of the

traditional indicators of innovation.

2.2.2.1. The UKs sectoral composition accounts

for much of its poor showing on business

expenditure on R&D (BERD)

The UKs relatively poor showing on traditionalindicators of investment in formal R&D isprimarily down to business sectors. Duringthe 1990s, compared to the US, the fall inindustry-funded BERD in the UK accountsfor the whole of the UKs poor relativeperformance in gross domestic expenditure on

R&D (GERD) (while government-funded R&Dmade a positive contribution).65

However, R&D spend is a poor indicator ofinnovation for UK business. R&D statistics firstemerged in the 1930s in countries such as theUK, the US, and Canada, but their subsequentdevelopment and adoption internationallyowes much to the OECD, in particular theFrascati Manual which established a standardmethodology for data collection.66

Yet numerous studies have shown that firmscreate new knowledge from a variety ofsources such as their expertise in production,quality control and testing, and experiencein marketing and feedback from customers.67Both non-R&D spending and spending oncapital goods represent a larger proportion ofinvestment in innovation than R&D (especiallyin small businesses, which tend not to havea formal R&D division).68 Taking this intoaccount, the picture is considerably differentand much more positive. For instance, the UKperforms very strongly in comparative spending

on R&D in the pharmaceutical sector, a majorsector of the UK economy where formal R&D iscritical to new product development (Figure 5).

8

Figure 5: R&D as a proportion of value added in the pharmaceutical sector

Source: SPRU calculation based on OECD data.

55

50

45

40

35

30

25

20

15

10

1995 1996 1997 1998 1999 2000 2001 2002

R&D valueadded

France

UK

USA

Germany

Japan


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74. Department of Trade andIndustry (2005), The 2005 R&DScoreboard, The Top 750 UK and

1000 Global Companies by R&DInvestment, (DTI, London).

75. See also Patel, P., andPavitt, K. (1998), Uneven(and Divergent) TechnologicalAccumulation Among AdvancedCountries: Evidence and aFramework of Explanation,in Dosi, G., Teece, D.J.,and Chytry, J. (eds.),Technology, Organization, andCompetitiveness: Perspectiveson Industrial and CorporateChange, (Oxford UniversityPress, Oxford). See alsoArchibugi, D., and Pianta, M.(1992), The TechnologicalSpecialisation of Advanced

Countries, (Kluwer AcademicPress, Dordrecht).

76. For the FT Global 500, see:http://www.ft.com/reports/ft5002006.

77. This indicator is used innumerous international surveysand is based on an agreeddefinition of what constitutesR&D as set out in the FrascatiManual, see Organisation forEconomic Co-operation andDevelopment (2002), FrascatiManual 2002, ProposedStandard Practice for Surveyson Research and ExperimentalDevelopment, (OECD, Paris).

78. Based on average oil

exploration and appraisal (E&A)data 1990-2000 in the UK,see Department of Trade andIndustry (2001), Developmentof Oil and Gas Resources 2001,(DTI, London).

79. See Organisation forEconomic Co-operation andDevelopment (2005), OECDScience, Technology and IndustryScoreboard 2005, (OECD, Paris).

2.2.2.2. Innovation needs to be understood in

light of patterns of specialisation

The UK has developed strongly inpharmaceuticals, biosciences more generally,chemicals, oil, many service sectors, particularlyfinancial services, law and design, and theproduction and operation of the complex,

software-intensive capital goods that underpinmuch of the global economy (such asaerospace, military systems, and complex ITsystems). By contrast, we have slipped in massproduction sectors, such as car production, andother sectors related to IT such as consumerelectronics (although even here there arepockets of strong performance, particularlyamong foreign-owned firms operating in theUK).

The UK is not a high-tech manufacturingeconomy akin to Sweden, Finland, Switzerland,

Japan or the US, so to make comparisonsas if it is makes little sense. The DTIs R&D

Scoreboard illustrates the importance of sectorsand how, because sectors differ substantiallyin their use of R&D as a source of innovation,sectoral composition has a major influence oninternational performance.74 Different countrieshave different R&D sector specialisations:IT, software and pharmaceuticals in the US,automotive and electronics in Japan, andpharmaceuticals and aerospace in the UK.75

Indeed pharmaceuticals and aerospace and

defence together contribute 52 per cent of theUK 750s R&D (UK top 750 companies list).

Comparisons of the number of firms in theR&D Global 1,000 and the FT Global 500 list ofthe worlds largest companies show that Japanand Germany have high R&D scores becausethey are R&D specialists. Both have more thantwice the proportion of top R&D companiesthan top firms by size.76 The US is balancedand has similar proportions in both lists, whilethe UK, with its strength in financial services,resources and retailing, has a 50 per cent largerproportion in the FT Global 500.

This suggests that R&D spending figuressubstantially under-estimate the innovativenature of the UK economy. More importantly,the UK specialises in sectors with high wealthcreation efficiency, whether R&D-intensive(such as pharmaceuticals), capital equipmentintensive (oil and gas) or services (finance).In general, it is more useful to examine theUKs performance at a sectoral level, that is,to compare our performance in, for example,

retailing or chemicals with the same sectorsin other countries, rather than to aggregatedata across sectors. Further, it is important to

consider the wealth that is generated by certainsectors, that is, to look at the outcome, ratherthan focus on selected inputs such as R&D.

2.2.2.3. There are inherent problems with the

collection of R&D data

There are also biases in the definition of

such indicators. For example, the agreeddefinition of the business R&D as aproportion of GDP excludes developmentactivities such as petroleum explorationeven though these generate innovations andnew scientific discoveries.77 This example isparticularly pertinent to the UK with its largeoil exploration sector. This sector spends onaverage 1.11 billion per year in the UnitedKingdom Continental Shelf (UKCS) area aloneon activities that could be interpreted as thesector-specific equivalent of R&D.78 Includingthis expenditure alone as R&D would increase

the UKs business R&D intensity by more than11 per cent (increasing it from 1.8 to 2 percent).

Similarly, the measure of the public fundingof innovation is defined as the proportion offirms that have received any public financialsupport for innovation, but excludes taxincentives. The UK favours the use of taxincentives, rather than having business relyingon direct support (as in some other Europeancountries).

Finally, there are methodological issues withthis data, despite the considerable effortsthat have been devoted to the developmentof indicators such as business R&D. Countriesthat contribute to these figures collect R&Ddata in different ways. For example, there arevariations in the way in which a firms R&D isassigned to an industry, in particular for firmsconducting heterogeneous research activities.The OECDs Frascati Manual recommendsbreaking R&D down by product field, thatis, the R&D is assigned to the industriesof final use. Not all countries follow thismethod, however. Some countries follow aprincipal activity approach in which a firmsentire R&D is assigned to that firms principalindustrial activity code. Many countries followa combination of these approaches. As a result,the OECD suggests that caution should beexercised when using this data.79

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2.2.2.4. Patenting is a useful measure of

innovation for only a small fraction of the UK

economy

It follows that countries specialising in sectorsthat have a high propensity to patent, suchas biotechnology or IT, will have a higherperformance in overall patenting per capita,

even though their patenting performance inthat or other sectors may be poor. On the otherhand, countries that specialise in sectors thathave a lower propensity to patent, such asaerospace, will perform badly, although theymay be world leaders in such areas. Logically,firms are less likely to patent in sectors wherepatents are poor barriers to imitation. Forexample, patents do not yet fully measuretechnological activities in software, and socopyright law is often used as the primarymeans of protection against imitation in thissector.

Sectoral diversity in patterns of innovationshow that the number of patents grantedper 10 million of R&D investment variessignificantly. Investments in electronicsor IT hardware R&D generate nine timesas many patents as similar investments inpharmaceuticals. This makes the number ofpatents a very poor indicator of a countrysinnovation performance.80 According to theFourth Community Innovation Survey (CIS 4),across all sectors of the UK economy factors

such as lead-time advantage over competitorsand secrecy are far more important forbusinesses than are patents (31 and 30 percent of businesses cite the former as importantfactors, while only 15 per cent cite the latter).81

The UK may have a comparatively low shareof businesses that apply for patents, but it hasthe highest proportion of businesses across theEU that use some form of protection (such astrademarks, copyrights or secrecy).82 Again, thisrelates to the sectoral composition of the UKeconomy. For example, the financial servicessector is generally regarded as one of theUKs most innovative sectors, as well asone of its most important.83 The UK hasthe largest international banking sector,accounting for 20 per cent of globalcross-border lending, and (as a possible proxyfor its investment in innovation) spent $6.6billion on information technology systemsin 2004.84 Yet it (unsurprisingly) scored thelowest of all sectors in the UK in applicationsfor patents in the CIS 3.85 This is more likelyto indicate a problem with the indicators used

to measure innovation and the models ofinnovation that underpin them, than with theUKs booming financial services sector.

A fairer and more accurate method is to correctfor the differing propensities to patent amongstboth countries and sectors, something that wemake an initial attempt at in Part II, Section 3.

2.2.2.5. Measurements of advanced scientific

research and of knowledge transfer from

research institutions to industry do notaccurately represent modern knowledge

creation or the process of commercializing that

knowledge

The implicit assumption in traditional surveysof innovation is that R&D (or patenting, orscientific publication) is synonymous withinnovation, which is itself synonymous witheconomic growth and social progress. However,innovation is not simply the generation ofknowledge; it is the diffusion, integrationand exploitation of knowledge that leads toeconomic and social value.

For example, aggregate comparisons ofscientific publications across countries can bemisleading. This is because journal publicationas an output of research varies in importancebetween scientific fields, and differentcountries have different areas of emphasis(the UK tends to focus on the medical, life andenvironmental sciences, but is weaker in thephysical sciences and engineering). Further, therelationship between research, developmentand diffusion will differ across these fields.

The UK invests less in university research thanthe US. Yet university-based research is nota primary source of knowledge that can beapplied directly for the purposes of innovationin the majority of the UK economy.86 Moreover,the fact that the UK does not invest in R&D atanywhere near the same level as the US andmany Nordic countries also does not excludethe UK economy from benefiting from researchconducted in these and other countries, solong as we have the systems and skills requiredto absorb it effectively. Indeed, the diffusion oftechnology and its incremental adaptation tonew environments is frequently more importantto economic growth than the initial invention.87However, training and skills remain a keyissue in determining the ability of countries toexploit externally produced innovations.

80. Department of Trade andIndustry (2005), The 2005 R&DScoreboard, The Top 750 UK and1000 Global Companies by R&DInvestment, (DTI, London).

81. Department of Trade andIndustry (2006), Innovation inthe UK: Indicators and Insights,DTI Occasional Paper No. 6,(DTI, London).

82. Jaumotte, F., and Pain,N. (2005), Innovation inthe Business Sector, OECDEconomics Department WorkingPaper No.459 (OECD, Paris).

83. The UK financial services

sector accounted for 5.3 per centof GVA in 2003, employed morethan one million people, andgenerated 20 billion in exports(7.2 per cent of total UK goodsand services exports combined).These figures increaseconsiderably if other servicesclosely associated with financialservices are included, suchas management consultancy,legal and accountancy services.See HM Treasury (2005), TheUK Financial Services Sector:Rising to the Challenges andOpportunities of Globalisation,(HM Stationery Office, London).

84. Flowers, S. (2006), Systems

of Systems - Exploring theInnovation Array, workingpaper, (Centrim/University ofBrighton, Brighton).

85. According to this survey,only one per cent of enterpriseswho were involved in innovationactivity in the Financialintermediation sector hadapplied for at least one patent.Table UK. 14A, EuropeanCommission (2004), Innovationin Europe, Results for the EU,Iceland and Norway, (EuropeanCommission, Brussels). This datarelates to 1998-2000.

86. For example, only twoper cent of UK businesses

identify universities or otherhigher education institutions asimportant sources of informationfor innovation, see Departmentof Trade and Industry (2006),First Findings from the UKInnovation Survey, 2005, (DTI,London). Of those businessesthat are involved in cooperativeventures for innovation, onlya third have universities aspartners, while three-quartershave suppliers as partners,see Department of Trade andIndustry (2006), Innovation inthe UK: Indicators and Insights,DTI Occasional Paper No. 6,(DTI, London).

87. Mowery, D., and Rosenberg,N. (1989), Technology and thePursuit of Economic Growth,(Cambridge University Press,Cambridge).

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88. Financial Times (2006),Britain Tops World in Foreignnvestment, 24th January.

89. For example, anecdotalvidence suggests that Japanesear manufacturing in the UKchieves much higher levels

of productivity than UK basedfirms, while US firms operatingn the UK achieve substantiallyigher productivity outputs fromheir investments in ICT than

UK firms. Nissans Sunderlandactory, for example, produced30,000 cars in 2002. It is also

mportant to be clear about sub-ectors in these industries: whilear production may be slowingown in the UK (although it istill very high by EU standards)ngine production is doingxtremely well.

90. Arthur D. Little (2005),nternationalisation of R&Dn the UK, A Review of theEvidence, (Department of Tradend Industry/Office of Sciencend Technology, London).

91. Department of Trade andndustry (2005), The 2005 R&Dcoreboard, The Top 750 UK and000 Global Companies by R&D

nvestment, (DTI, London).

92. Thomas, L. G. (1994),mplicit Industrial Policy: The

Triumph of Britain and theFailure of France in GlobalPharmaceuticals, Industrial andCorporate Change, 3, pp.451-489.

93. Lattimore, R., and Ravesz,. (1996), Australian Science:

Performance from PublishedPapers, Bureau of IndustryEconomics, Report 96/3,Australian Government Printing

Office, Canberra).

94. Jagger N, Nesta L, Gerova V,Patel P. (2005), Sectors Matter:An International Study of Sectorkills and Productivity, SSDA

Research Series RR14, (Skillsector Development Agency,

London).

95. Department of Trade andndustry (2006), Innovation inhe UK: Indicators and Insights,

DTI Occasional Paper No. 6,DTI, London).

96. p.10, Smith, K. (2002), Whats the Knowledge Economy?Knowledge Intensity andDistributed Knowledge Bases,ntech Discussion Paper 2002-6.

97. It has been suggested high-ech manufacturing added lesshan one per cent to US GNP

between 1980 and 1995, seep.13, Smith, K. (2002), Whats the Knowledge Economy?Knowledge Intensity andDistributed Knowledge Bases,ntech Discussion Paper 2002-6.

International consultancy firms have beenparticularly important in helping to diffuse

technology and new management techniquesto the UK from other nations. The same istrue of foreign direct investment (FDI) bymultinational corporations. In recent yearsthe UK has been the worlds most successfuleconomy at attracting FDI. In 2005, $219billion came to the UK which, even without theapproximately $100 billion that came from themerger of Shell with Royal Dutch Petroleum,still surpassed our nearest rival the US (with$106 billion).88 In some sectors, foreignfirms have demonstrably superior managerial

capabilities and the very open nature of theUK economy has enabled them to succeed insectors even where the UK has a relatively poorinnovative performance.89 The very open natureof the UK economy has allowed it to benefitfrom international innovation; internationalfirms setting up here have been verysuccessful. UK R&D is more internationalisedthan its competitors, and foreign-owned firmsare more active in supporting R&D in the UKthan they are in other countries.90 Twelve ofthe 17 foreign-owned companies in the UKthat invest more than 50 million in R&D havea much larger R&D intensity than their parentcompanies, suggesting that they prefer toconduct their R&D in the UK.91

More generally, the UK tends to performwell when businesses operate within anenvironment that encourages or forces theaccumulation of technological capabilitiesand supplies appropriate workforce skills andtechnology. The UK pharmaceutical industryhas a regulatory environment that encouragestechnological accumulation,92 and the UK

science system has been responsive to thedemands of the industry for skilled biomedicalresearchers and graduates.93 Indigenous

automobile manufacturers on the other handwere unable to accumulate the required

technological capabilities and exhibited poortraining and skill levels compared to Germanyand Japan, contributing to the decline of thesector.94

Further, investments in capital goods andnon-R&D investments are more important thanformal R&D for commercial inn

the innovation gap

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