Understanding the drivers of productivity: Innovation

This blog is the third in our new series on the drivers of productivity. The drivers of productivity include skills, capital, innovation, enterprise and competition, and land. This blog focuses on innovation, and complements the blogs on GVA and productivity published in summer 2024.

This series adds to our Understanding core concepts in local economic growth series, and is aimed primarily at those working in local and central government. The series provides deep-dives into various components of economic growth, and some key concepts to consider when thinking about local economic growth.

What is innovation?

The innovation that impacts productivity is businesses applying new knowledge to:

• Products – to bring a new good or service to the market or improve an existing good or service.
• Processes – to implement a new way of producing goods or services (e.g. the assembly line, just-in-time manufacturing, mobile ordering). 
• Business models – to fundamentally change how businesses operate (e.g. Amazon started running physical shops on high streets).

How innovation affects productivity depends on the type of innovation and whether innovation is incremental (i.e. improvements to an existing good, service, process, technology or business model), breakout (i.e. something new to customers that changes the value proposition, redefines the business model, or alters the customer experience), or breakthrough (transformational advancements that dramatically improve existing products, services, or processes  – a new industry). It also depends on how the innovation spreads throughout the economy (i.e. diffusion – implementing something already in place in other businesses).

Why do we need to think about innovation?

Innovation affects productivity by making products better, processes more efficient, and businesses more effective. It enables individuals, businesses, and economies to produce more output with the same—or even fewer—resources, allowing economies to grow.

Product innovation can lead to more high-value goods and services. This is often a result of spend on research and development (R&D).  

Process innovation can improve efficiency in how businesses work – either making more goods or services (outputs) or reducing costs (inputs). For example, this can include leaner supply chains, faster delivery, changes to management practices, or more effective use of data. Incremental process innovation can keep businesses competitive.

New industries and business models can also emerge from innovation—creating new types of jobs and markets. Policymakers can help smooth the transition for workers and businesses affected by change.

How can we boost innovation?

Boosting innovation requires creating the right conditions, removing barriers, and actively supporting experimentation and collaboration. Central government support on innovation often focuses on businesses trading in national and international markets. There is also a role for local government to support both innovation and diffusion in tradeable and non-tradeable sectors.

Some policy levers available for local government are:

• Business advice programmes, especially those that provide advice on how to access experts, industry networks and partners for product innovation, or provide support on process innovation.
• Making sure the planning system allows for the development of suitable commercial premises.
• Support to university-industry partnerships, co-location of researchers and university spins-off.
• Promotion of central government innovation programmes, including R&D grants, tax credits, sector-focused business advice, and other national funding.

What to consider when thinking about innovation?

• Innovation can be difficult to measure – Often investment in R&D or the number of patents and trademarks are used as proxies to measure innovation. The UK Innovation Survey is run every two years and provides useful information on process and business model innovation.
• The effects may vary across types of businesses – Programmes to support innovation often benefit skilled workers, large businesses, and urban areas more. Those without access to digital tools, skills, or finance may be left behind.
• Innovation interacts with other drivers of productivity – Innovation often requires access to skills and capital investment, especially in product innovation.
• Results of innovation are often uncertain – Things don’t always work, and failure rates of innovation are high, particularly in product innovation. This can represent a challenge for innovation funding, especially if the funding available is based on value for money assessments or demands specific outcomes.
• Target innovation support on tradable sectors – For growth in local economies, innovation is particularly important in tradable sectors—either developing new products and services, particularly for export, (product innovation), or improving efficiency and boosting their competitiveness (process innovation). In contrast, innovation in non-tradable sectors is more likely to lead to displacement. For example, if one hairdresser is better able to manage client bookings, other salons may lose those same customers.   
• New to business innovation – New to market innovation (new technology) can affect productivity in a whole sector. However, new to business innovation (diffusion) is a more appropriate focus for policy aimed at increasing productivity in a local area, particularly where there is a high concentration of businesses (e.g. clusters) that can benefit from innovation. In these cases, policies that encourage businesses to adopt new technologies and processes already available in the market can have a positive effect on productivity.
• Other effects may play a role – Effects such as agglomeration (geographic concentration of activity), spillovers (benefits and costs experienced beyond the area or sector) and crowding out may also affect the way innovation produce changes in productivity.

Where can I learn more about innovation?

• What Works Growth resources on innovation
• How do we know where innovation takes place?, a blog from UKRI
• Innovation and Growth: Chasing a Moving Frontier, a report from the OECD
• The OECD Science, Technology and Innovation Outlook
• Competition and Innovation: A Theoretical Perspective, a policy report from the OECD
• The Innovation Growth Lab has a series of blogs, working papers and case studies that explore different aspects of innovation and some.
• Productivity, innovation and technological progress, an article by the European Central Bank
• Understanding the importance of innovation and productivity in the UK, a blog from the National Centre for Social Research.

The next blog in our drivers of productivity series will be on enterprise and competition. Sign up to our newsletter to get an update on our next blogs, briefings and events.