Why is labor productivity in the United Kingdom so low?
The major culprit is product market regulation
Can social objectives be achieved at lower cost?
In the mid-nineteenth century, the United Kingdom I boasted the highest economic output per capita of any nation in the world, and its material standards of living were without equal. Ever since then, it has gradually lost ground. It now ranks bottom of the league of G7 countries, trailing the leader, the United States, by 30 percent [ILLUSTRATION FOR EXHIBIT 1 OMITTED].
To find out why, the McKinsey Global Institute conducted a detailed study of the United Kingdom's recent economic performance. As well as looking at the economy as a whole, we compared the productivity of UK companies with that of the world's top performers in six key product markets: automotive, food processing, food retailing, hotels, software, and telecommunications. In each case, we sought to uncover the reasons behind differences in performance.
Our principal findings were that:
* Despite the labor and capital market reforms of the past 20 years, output per capita in the market sector remains almost 40 percent behind that of the United States, and 20 percent behind that of West Germany. The root cause of this gap is low labor productivity [ILLUSTRATION FOR EXHIBIT 2 OMITTED]. The results of our productivity case studies confirm this overall trend [ILLUSTRATION FOR EXHIBIT 3 OMITTED].
* Contrary to conventional wisdom, the main causes of low labor productivity area lack of exposure to global best practices and low competitive intensity. The reasons often cited for poor performance, such as low capital investment and poor skills, are consequences of these factors.
* Lack of exposure to global best practices and low competitive intensity are often the result of product market barriers such as trade restrictions, price constraints, and land use regulations. In some cases, these barriers constrain competition and so limit the pressure on management to adopt global best practices. In others, they prevent the implementation of best practices or render it uneconomic.
* Many of these regulations have been put in place to promote legitimate social objectives, yet the economic cost of these objectives has been largely overlooked. Replacing them with more market-friendly alternatives could boost GDP growth by more than a full percentage point a year over the next ten years.
All the research carried out by the McKinsey Global Institute attests that the primary engine of productivity improvement is competition within an industry or product market. In the end, there is no substitute for the constant testing of managers by competition. Pressure from capital markets is not enough by itself. Sheltered from competition, as many UK companies are, businesses can make profits and satisfy their investors without achieving high rates of productivity, so they have no incentive to strive for productivity improvements.
Consider the UK hotel industry, for instance, where planning restrictions and high construction costs have limited competitive intensity. Leading international operators have little incentive to invest here, since they are unlikely to generate attractive returns. As a result, weaker players have felt only limited pressure to exit the market; indeed, in many cases, they lack any opportunity to do so, since planning restrictions often prohibit alternative uses for hotel properties. Much of the country's hotel stock is old and unproductive: over 3,000 hotels are in listed buildings, and nearly 50 percent are more than 100 years old [ILLUSTRATION FOR EXHIBIT 4 OMITTED].
Another example can be found in the UK telecoms industry, which remains highly concentrated: in 1996, some 12 years after privatization, BT still accounted for about 85 percent of fixed-line telephone usage. This is at least partly because. service restrictions such as constraints on number portability and network access have hindered the growth of existing and new competitors until recently, giving incumbents little incentive to stimulate demand by creating new value-added products [ILLUSTRATION FOR EXHIBIT 5 OMITTED].
Such conditions both constrain productivity within the economy and raise the prices that UK consumers have to pay. In many product markets, low productivity translates directly into higher prices. These in turn allow relatively unproductive companies to achieve acceptable margins and stay in business. The automotive industry, where competitive intensity has been depressed by voluntary trade restrictions on the market shares of Japanese car makers, is a case in point [ILLUSTRATION FOR EXHIBIT 6 OMITTED]. The restrictions have encouraged Japanese manufacturers to keep their prices high instead of using their hefty productivity advantage to cut prices and compete for market share. The result: low productivity in the UK automotive industry and a high price umbrella under which unproductive operators can continue to operate without competitive pressure.
The role of product markets
The United Kingdom and United States are often seen as models of the modern deregulated economy. But their similarity extends only to capital and labor markets. Individual product markets - identified by earlier McKinsey Global Institute work as the single most important factor in world-class productivity - could not be more different. Whereas US product markets are fiercely competitive, innovative, and open to foreign competition, their UK equivalents teem with regulations that prevent companies adopting global best practices and improving their productivity.
Restrictive building codes have prevented the development of a productive hotel industry, for example. Land use, planning, and building regulations mean that the costs of building or refurbishing a hotel are up to 40 percent higher than in the United States. Higher costs mean that the occupancy level a new hotel must reach to break even is also much higher. For one type of hotel, we found that the breakeven occupancy rate was close to 80 percent in the United Kingdom, as against just 50 percent in the United States. Not surprisingly, the rate of new hotel openings and refurbishments is relatively low.
In food retailing, supermarkets and hypermarkets are by far the most productive formats. Yet a high proportion of transactions still take place in small traditional stores with lower levels of productivity [ILLUSTRATION FOR EXHIBIT 7 OMITTED]. Even the biggest UK stores are small by international standards, since land use and planning regulations make it difficult for large-format operators to develop new sites or expand existing ones, whether in the high street or out of town. The effect is to set an artificial limit on the natural evolution of food retailing formats toward global best practice, and to hamper leading operators' efforts to achieve their full productivity potential.
In the food processing industry, the European Community's Common Agricultural Policy has limited the milk supply available to UK dairy producers. Barely enough milk has been available to satisfy consumers' continuing demand for liquid milk; there has certainly not been enough to allow dairy producers to concentrate on more productive products such as cheese and yogurt [ILLUSTRATION FOR EXHIBIT 8 OMITTED]. Other countries less constrained by the regulations have been able to build stronger and more productive dairy processing industries that now export much of their output to the United Kingdom.
In telecommunications, pricing regulations artificially constrain the productivity of the fixed network. The longstanding regulatory emphasis on cheap universal access has obliged operators to subsidize low subscription charges with high prices for calls, so that it has cost much more to make a telephone call in the United Kingdom than in the United States or Sweden. Not surprisingly, UK consumers have limited their use of the telephone. The result has been much lower network capacity utilization than in the United States, where cheap or even free calls have boosted telephone usage [ILLUSTRATION FOR EXHIBIT 9 OMITTED].
Planning regulations have even constrained the growth of new high-technology sectors such as the software industry. International experience indicates that these sectors benefit from the clustering together of many small entrepreneurial ventures in close proximity, as in Silicon Valley. But the development of such clusters around Oxford, Cambridge, and other natural communities has been slowed or even prevented by local planning restrictions.
Earlier McKinsey Global Institute studies have shown that low productivity in one sector is often a primary cause of low productivity in another. In this way, a single productivity problem can ripple out across whole swathes of the economy. Our product market case studies uncovered several examples of these spillover effects.
There is considerable evidence, for example, that many of the telephone calls forgone in the United Kingdom because of high prices are business-to-business or consumer-to-business calls - in other words, calls that might have created economic value. An example of the spillover effect from the telecoms sector can be seen in the service businesses that depend on low-cost telephony, such as mail order, electronic commerce, and call centers. In the United States, these businesses have flourished; in the United Kingdom, they have been much slower to develop.
Another case in point is the software industry, which depends on leading-edge demand in the domestic customer base to drive innovation and the development of products that can achieve global scale. But UK software suppliers have had difficulty generating that kind of demand from customers that are sheltered from competitive intensity and do not have to strive constantly to improve productivity. As a result, the country has not proved a source of innovation or productivity in the software industry.
Implications for government and companies
Conventional wisdom blames the United Kingdom's underperformance on the limited educational attainment and low skill level of its workforce, the scale penalty of operating in a relatively small market, and the capital market pressures that make companies reluctant to invest in long-term productivity-enhancing technologies. Undoubtedly, these things play a part. But our work shows that the real cause of the United Kingdom's low productivity can be traced to regulations that stifle competition and innovation in product markets.
Indeed, it is these regulations that ultimately lie behind the conventional explanations for the economy's ills. Low capital investment is largely the result of the lack of opportunities for profitable investment; new retail or hotel formats, for instance, may suffer from a dearth of sites on which to build. Low skills, meanwhile, can be ascribed to companies' limited exposure to global best practices in the organization of work processes; a number of best-practice foreign operators have shown that it is perfectly possible to achieve near-benchmark levels of productivity in the United Kingdom with a local workforce.
We believe that the primary goals of economic reform should be to change product market regulations and encourage competition. While many of these regulations have been put in place for legitimate social reasons, their economic cost is frequently overlooked. The same social objectives could often be achieved more cheaply by the use of targeted fiscal-based policies rather than market-distorting regulations. Instead of insisting on cheap subscription charges across the board to guarantee universal access to telephony, for instance, the United Kingdom could have emulated the American model and simply subsidized subscriptions for the needy, thus making it unnecessary for operators to charge artificially high prices for calls. Similarly, the newly introduced UK working families tax credit is a better alternative to a high minimum wage, guaranteeing workers a basic income without pricing the low-skilled out of the labor market.
If it carried out reforms of this nature, we believe that the United Kingdom could add over a full percentage point to its annual GDP growth rate. But UK companies should not wait for regulatory reform before they take steps to improve their productivity. After all, higher productivity often translates into higher returns to shareholders. While it is difficult for management to push for change in the absence of strong competition, to act now can help ensure that UK companies are well placed to face up to the threats and opportunities that will inevitably emerge if the regulatory changes we suggest are actually implemented.
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The automotive sector is one of the United Kingdom's biggest manufacturing industries, employing over 200,000 workers and producing close to 2 million vehicles a year. Around one-quarter of these are made by the Japanese companies Nissan, Toyota, and Honda, which have all set up new plants in the country over the past 10 years.
Labor and capital productivity in the automotive sector stand at around 50 and 70 percent of the Japanese level respectively. The shortfall can be ascribed mainly to the older vehicle assembly and component factories, which have yet fully to adopt lean manufacturing techniques. The newer Japanese transplants (and many of their suppliers) do use lean manufacturing, and as a result achieve productivity levels close to those in Japan: on average, they are more than twice as productive as traditional manufacturers.
The reason for this state of affairs is limited competitive intensity in the European automotive market, which can itself be traced to two main factors:
* Both the UK government and those of other European countries have subsidized low productivity in the industry, thus allowing some of the least competitive production capacity in the region to survive. Between 1973 and 1988, for example, state aid to the tune of [pounds]3.4 billion was provided to what is today the Rover Group.
* Volume restrictions and tariffs on Japanese cars in a number of European countries have created a strong disincentive for Japanese manufacturers to compete for market share on the basis of price. In the absence of any strong price-based competition, traditional UK manufacturers have not been under much pressure to close the productivity gap.
The impact on UK consumers of the price umbrella created by these barriers to competition is substantial: they are paying as much as [pounds]1,100 extra for the average car.
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Food processing is the largest manufacturing sector in the economy, representing about 3 percent of GDP. Since UK families spend some 20 percent of their income on food, the productivity of this sector affects the standard of living of everyone in the country.
Labor and capital productivity stand at about 75 and 95 percent of the US level respectively. The chief cause of the gap is a low value-added product mix that is exacerbated by product proliferation.
In the dairy industry, for example, 60 percent of UK output is in the least productive category, liquid milk. In the United States and Germany, by contrast, products with higher productivity such as cheese and yogurt represent a larger share of the product mix. One contributory factor is EU milk quotas under the Common Agricultural Policy, which provide for 30 percent less milk per capita than in Germany despite lower milk prices at the farm gate. UK manufacturers are thus blocked from obtaining sufficient raw material to develop dairy products with higher productivity. Overall, the U K dairy sector's labor productivity stands at around 85 percent of the US level.
In the cookie industry, where labor productivity is only about 65 percent of the US level, UK manufacturers produce nearly three times as many product lines as their US counterparts for a domestic population that is a little over one-fifth the size. This proliferation reduces labor productivity by increasing downtime and making inefficient use of R&D and marketing resources. It also hinders automation in packaging, the most labor-intensive part of the manufacturing process, where flexible technology that can cope efficiently with short runs does not exist.
The overall impact on the UK consumer of low productivity and high input costs is substantial, increasing the annual food bill of an average household by up to [pounds]1,000.
Labor, capital, and total factor productivity Index: France 1995 = 100 Labor Space Total factor productivity productivity(*) productivity France 100 100 100 United States 85 90 85 United Kingdom 75 150 100 * Used as a proxy for capital productivity
Food retailing is a very large employer, particularly of less skilled workers, and thus represents a critical sector of the economy. While labor productivity is only 75 percent of the French level, high space productivity, used as a proxy for capital productivity, gives the United Kingdom world-class total factor productivity. Indeed, the top UK food retailers are recognized as international leaders in such areas as supply chain management and fresh chilled food development.
The labor productivity gap with France is a function of regulatory differences in two main areas:
* Labor market regulation. UK food retailers are able to take advantage of flexible labor markets to provide services such as bag packing and queue busting. Fewer workers provide these services in French stores, as the national minimum wage and high employer costs often make them too expensive to employ. Although U K stores provide more services to their customers and employ more people, these lower-skilled workers tend to depress labor productivity overall.
* Land use regulation. A relatively small proportion of UK food sales takes place in highly productive large-format outlets (supermarkets and hypermarkets). Moreover, the large-format retailers that do exist are generally smaller than in France or the United States. After allowing superstores to expand rapidly during the 1980s and early 1990s, planning regulations are now making it increasingly difficult and costly for productive food retailers to find new sites or extend existing ones. Although competition between the top UK food retailers has always been intense, these regulations have essentially stalled the evolution of the industry, stifling competition in particular between different formats and operators.
In response to these regulations, players have searched for other avenues of competitive advantage and growth. This is why the major supermarket chains are now moving into new areas such as financial services and gas retailing, where they have been instrumental in stimulating competition and innovation. If regulations change, we might also see them moving into general merchandise retailing, perhaps triggering performance improvements in the broader retail industry.
The hotel industry is the linchpin of the United Kingdom's leisure-related service sector: a big business with enormous growth potential. It also contributes to the country's attractiveness as an international business destination.
Labor productivity in this sector is a mere 55 percent of the US level, largely because of the age of hotel stock. Old hotels are often poorly designed and impose inefficient operating procedures. Rooms vary in size and shape, kitchens are not always close to restaurants and stairs, and narrow corridors and doorways prevent the use of wide trolleys in room cleaning. That there are not more new hotels in the United Kingdom is the result of four main factors:
* High construction costs. Poor performance in the construction industry, combined with strict planning and building regulations, makes it much more expensive to refurbish old hotels or build new ones than in the United States. As a result, the breakeven occupancy level is much higher, confining new construction to the fastest-growing markets.
* High exit barriers, Planning and heritage regulations often make it impossible or prohibitively expensive to put unproductive hotel buildings and land to alternative uses; the result is that inefficient old hotels exit the market only very slowly.
* High entry barriers. Planning regulations also make it difficult for operators to obtain sites in good locations such as central London, limiting opportunities to build new hotels.
* Slow growth in demand. In France, strong growth in demand has prompted much of the new hotel build and helped to dilute an otherwise aging stock. In the United Kingdom, the combination of bad weather, slow population and income growth, and a less proactive leisure industry (only one of the top ten tourist attractions was built this century, compared to six in France and nine in the United States) has limited the demand for new hotel stock.
Labor productivity Index: United States 1996 = 100 Labor productivity United States 100 France 90 United Kingdom 55
The software and services sector is one of the fastest-growing global industries. It currently enjoys annual growth of around 12 percent and revenues of $230 billion.
Labor productivity in the UK industry is about 70 percent of the US level, owing to the smaller share of highly productive packaged software in the output mix, and lower productivity within the packaged software segment itself.
The primary cause of both low output and low productivity in packaged software is the lack of successful companies of the size of those in the United States. Productivity in this segment rises rapidly with output, since many of the labor inputs are fixed. The United States has produced six software companies with sales of over $1 billion, and many more with a turnover in excess of $100 million. By contrast, there is only a handful of UK companies that enjoy revenues greater than $100 million. Demand and supply factors both play a part:
* Demand. IT expenditure hinges on corporate innovation and on efforts to create advantage or wipe out disadvantage through cost cuts or marketing improvements. Intense competition within customers' industries is the driving force behind local leading-edge demand for software services. Relatively low levels of competition in many sectors of the economy have limited the demand for IT, thus hindering the growth of the UK software segment.
* Supply. The United Kingdom lacks much of the infrastructure available in the United States to support the growth of high-technology companies. The most crucial element of this is venture capital funding. Perhaps as a result of the lack of a liquid exit market such as NASDAQ, the UK venture capital community has not focused on high technology and has been reluctant to invest in startup companies.
Labor productivity Index: United States 1996 = 100 Labor productivity United States 100 Germany 75 France 70 United Kingdom 70
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The telecoms industry accounts for about 2 percent of UK GDP. In addition to this direct contribution, a strong, innovative telecoms infrastructure is vital to a vibrant economy.
Calculated as an aggregate of lines and minutes as output, total factor productivity in fixed-wire telecoms is about 60 percent of the US level. This is primarily the result of lower usage: US citizens spend nearly three times as long on the phone as the British. Part of the reason lies in income levels, part in differences in pricing structures and product innovation:
* Pricing structures, US telephone operators generally offer an unmetered service for local fee: consumers pay a high subscription charge but can make unlimited local calls free of charge. In the United Kingdom, pricing regulations designed to safeguard universal access have obliged operators to charge high calling rates to subsidize low subscription charges. The high price of calls has constrained demand and given the phone, at least until recently, the image of a luxury item for many people.
* Value-added services. US operators have been proactive in stimulating demand by introducing value-added services. In the United Kingdom, thanks to service restrictions such as lack of number portability and unequal network access that have kept out new entrants, incumbent operators have been under only limited pressure to offset market share losses by stimulating demand with such products as voicemail and freephone numbers.
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Nick Lovegrove is a director, Simon Fidler is a principal, and Vicki Harris and Helen Mullings are consultants in McKinsey's London office; Bill Lewis is director and Scott Anthony is a former business analyst al the McKinsey Global Institute.
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|Author:||Lovegrove, Nicholas C.; Harris, Vicki J.; Lewis, William W.; Fidler, Simon; Mullings, Helen M.; Anth|
|Publication:||The McKinsey Quarterly|
|Date:||Sep 22, 1998|
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