Will Sydney become internationally competitive?

International competitiveness is a useful concept to apply to cities that are competing globally. Major cities are in competition to attract people with scarce skills and entrepreneurial ability, and to maintain reputations as attractive places for people to do business, invest, innovate and develop skills.

Liveability is important, but it does not encompass everything that is important. International competitiveness also involves natural advantages - including location, human resources and business culture - the regulatory environment and the efficiency of organisations providing infrastructure and other services.

Unfortunately, there is probably as much room for confusion in writing about the international competitiveness of cities as there is in writing about the international competitiveness of industries. Advocates of various industry interest groups in Australia have sometimes argued that they need tariff protection, import quotas, subsidies and tax concessions in order to become internationally competitive. I have the impression that such advocacy has diminished in recent years, but that might be because it is now a long time since I was paid to listen to it. The important point is, of course, that internationally competitive industries should be able to thrive without government assistance.

Similarly, the representatives of particular cities sometimes argue that they need central government assistance to fund infrastructure that will help make them internationally competitive. The merits of such claims are particularly difficult to assess in Australia, given overlapping responsibilities for funding of federal, state and local government activities. Nevertheless, the point stands that within a sensible funding framework, internationally competitive cities should be able to thrive without central government subsidies to fund infrastructure.

Another potential problem in talking about the international competitiveness of cities is that some people will assume that if a city is lacking in some aspect of competitiveness this can be remedied by more intensive planning and regulation by an ‘entrepreneurial state’. We don’t hear the term ‘Australia Inc.’ so often these days, but it is not difficult to find academic commentators who have faith in the ability of governments to perform entrepreneurial miracles. The recent contribution of Roy Green, Ian Marsh and Christos Pitelis to the CEDA publication ‘Australia’s Future Workforce?’ comes to mind in this context.

My interest in the international competitiveness of Australian cities was aroused by a couple of other contributions to the CEDA publication (which I have previously written about here).  Steven Callander makes the point that Australia needs liveable cities in order to be good at innovation: 
“Turning a city into a great place to live is often taken as an end in itself, and in many respects it can and should be. Yet it is also a starting point for innovation. … Moreover, the benefits are widespread: When a city becomes a ‘brain hub’, jobs for plumbers, teachers, nurses and other local services are created at a rate of five to one over other cities, raising salaries and standards of living for all. A more liveable city attracts knowledge workers who affect change that makes the city ever more liveable”.

Fiona McKenzie makes the point that growing population is likely to add to costs of urban congestion with increasing city density placing more pressure on infrastructure, the environment and the social fabric of cities.

Sydney is generally ranked fairly highly as a global city. With regard to liveability, The Economist ranks Sydney in 7^th place, behind such cities as Melbourne and Toronto; Hong Kong is 31^st, Singapore and San Francisco are 52^nd, London is 55^th and New York is 56^th. Sydney is ranked 10^th in Mercer’s quality of living index, behind Vienna, Zurich, Auckland, Munich, Vancouver, Dusseldorf, Frankfurt, Geneva and Copenhagen. Singapore is in 26^th place in this index.

Sydney also ranks fairly highly in indexes that cover a wider range of aspects relating to competitiveness. A T Kearney’s Global Cities Index ranks Sydney as currently in 15^th place, with prospects of rising to 11^th place. These indexes are intended to measure global engagement and cover business activity, human capital, information exchange, cultural experience and political engagement. The current world leaders are New York, London, Paris and Tokyo, but those cities are expected to be overtaken by San Francisco and joined by Boston in the years ahead. A T Kearney’s current rankings put Sydney behind Singapore and their prospective rankings put Sydney ahead of Singapore.

Sydney ranks in 11^th place in the Global Urban Sustainable Competitiveness Index (GUSC) which covers economic dynamism, social cohesion, environmental quality, cultural diversity, technological innovation, global connections and government management. The world leaders according to this index are London, New York, San Jose, Paris, Hong Kong, Seoul and Tokyo. Singapore is in 12^th place. It is worth noting that the rating given to Sydney by the GUSC is 0.698, far below London’s rating of 1.000.

The other index I have looked at is PWC’s cities of opportunity index, which ranks Sydney in 9^th place behind London, New York, Singapore, Toronto, San Francisco, Paris, Stockholm and Hong Kong. Sydney’s overall rating is equal to 89.4% of the highest overall rating (London’s). The graph below suggests that Sydney’s competitiveness in relation to the PWC’s indicators varies from world best to being a long way from world best. (The best performing cities in the world are shown in brackets).

In some instances where Sydney’s performance is relatively poor, this is attributable to natural disadvantages. But poor policy performance has contributed to Sydney’s relatively low rating on some indicators, including transport and infrastructure. For example, Sydney’s performance in terms of numbers of licensed taxis relatively to total population is abysmal. Perhaps Uber might make it easier for people to get around in Sydney in future, provided it is not excessively taxed and regulated to protect the incumbents.

Unfortunately the competitiveness indexes I have looked at do not provide a very clear picture of how Sydney stands relative to cities in other parts of the world in terms of restrictions on economic freedom associated with regulation of incumbent service providers and artificial scarcity created by land-use regulation. A recent article by Brink Lindsey suggests that such regulation constitutes ‘low- hanging fruit’ that could readily be picked in the United States if politicians become interested in lifting economic growth.

The general impression these indexes give me is in that Sydney is in some respects already an internationally competitive city. Sydney may not have what it takes to become a major centre for software development, like San Francisco or Boston, but it has good prospects of becoming a major centre for highly innovative service sector activities in the Asia-Pacific region. The main downside risk, in my view, comes from powerful interest groups opposed to increases in population density and innovations that have potential to reduce the cost of transport, including congestion costs.

What are the policy implications of widening productivity diffusion gaps?

When I read the suggestion in the foreword of the OECD’s recent publication The Future of Productivity that governments should be “reviving the diffusion machine” to “promote inclusive growth” my initial reaction was that the OECD would have a difficult task persuading me that markets could not deal with diffusion of new technology without government help. However, it turned out that I had grasped the wrong end of the stick. The OECD researchers have been investigating whether diffusion gaps might be linked to government policy failures. Reviving the diffusion machine involves, among other things, reducing government regulation that prevent markets from functioning efficiently.

The growing diffusion gap in OECD countries is shown in the graphs below. The graphs have been reproduced elsewhere, including by Timothy Taylor, the conversable economist, but they deserve to be widely published.

 The frontier firms are the top 100 firms in terms of productivity levels in each year. These firms are from a range of different countries and many are very much global firms. The data for non-frontier firms is the average of all other firms. Charts for multi-factor productivity show a similar pattern. See the supporting paper by Dan Andrews, Chiara Criscuolo and Peter Gall, Figure A2.

The graphs suggest that productivity growth at the global frontier has remained relatively robust, despite the slowdown in productivity growth in many OECD countries during the 2000s (as previously discussed on this blog). It is interesting that the productivity divergence between top performers and the rest began to widen prior to the financial crisis. That is particularly evident in the case of service sector firms.

The authors acknowledge that the productivity gap is consistent with winner-take-all dynamics or “superstar effects” as well as slower diffusion of new technologies. However, the former explanation is discounted because the divergence is not confined to the ICT sector where winner-take-all dynamics might be expected to be most important. For a discussion of this point by Dan Andrews see the video of the launch of The Future of Productivity at the Petersen Institute (Dan’s response to the relevant question is near the end of the session).

Regression analysis suggests that the ability to learn from the global frontier is stronger in economies that are more open to international trade and more integrated in global value chains (GVCs). The productivity of national frontier firms is negatively influenced by cumbersome product market regulation, and positively influenced by quality of education systems, R&D subsidies, closer R&D collaboration between business and universities, and stronger patent protection. In some economies where national firms have productivity that is close to the global frontier, the impact of those firms on national productivity is muted because they are undersized. The difference between the size of national frontier firms and global frontier firms tends to be smaller in industries with higher job layoff rates, less stringent employment regulation and bankruptcy laws that do not overly penalize failure.

The growth of innovative firms is restricted by high rates of skill mismatch in many countries.  The authors suggest that skill mismatches can be exacerbated by high transactions costs in housing markets (e.g. stamp duties) and bankruptcy legislation that leaves people with valuable skills employed in zombie firms.

The report suggests:

“It is important that young firms either grow rapidly or exit but no longer linger and become small-old firms”.

That set off alarm bells in my mind. What the authors meant to say, presumably, is that governments should reform regulation that assists low-productivity firms to hold resources that could be used more efficiently elsewhere. The idea that young firms should grow rapidly or exit brought to mind memories of the phrase “get big or get out”, coined by an Australian agricultural economist in the early 1970s, and used by industrious bureaucrats and politicians to justify questionable interventions in the normal functioning of credit markets.

A question some of my readers might be asking themselves at the moment is how well Australia scores in relation to the policy variables noted above. The question is not easy to answer because Australian data is not included in some parts of the analysis.

• Australia’s participation in GVCs is relatively low for a small economy. (GVC participation is measured in terms of imported inputs used in exports and exports used as inputs in other countries’ exports.) This reflects Australia’s remoteness, but it may nevertheless make it more difficult for Australian firms to maintain close linkages with the global frontier.
• Some OECD data on product market regulation (Koske, I et al,2015, The 2013 update of the OECD’s data base on product market regulation …) suggests that Australia is among the best for OECD countries. Our regulation is apparently more restrictive than that for the Netherlands, UK and Estonia, but less restrictive than for Greece.
• In 2013 Australia’s score on the OECD’s data base on restrictiveness of labour market regulation – covering ease of dismissal etc. - was 1.94 out of a possible score of 6 (higher scores indicate more restrictions). Australia’s score implies somewhat less restrictions than the OECD average (2.21) and Greece (2.41), but more restrictions than New Zealand (1.01) and the US (1.17).
• The World Bank’s Doing Business ratings suggest that Australia’s performance in resolving insolvency (rating of 81.6%) is somewhat better than the OECD average (76.9%) although not as good as the US (90.1%) or Canada (89.2%). The average time required to resolve recover debt in Australia is 1 year, considerably lower than for the OECD average (1.7 years) the US (1.5 years) but higher than for Canada (0.8 years).

The fact that some of Australia’s policies look relatively good by comparison with OECD averages is hardly grounds for complacency.  OECD averages are heavily influenced by some of the most sclerotic economies in the world which have had woeful productivity performance over several decades.  

Does capital deepening reduce labour's share of national income?

The share of wages and other labour remuneration in national income has been declining in most high income countries over the last few decades. I have previously argued that if we are concerned with the well-being of the poor, we should be more concerned about trends in real wages than about trends in the distribution of income between labour and capital. That is still my view, but it hasn’t stopped me trying to understand the reasons why labour’s share has been declining.

My interest has been aroused, in particular, by the claims of some researchers that capital deepening (increases in capital per unit of labour) have contributed to the decline in labour’s share of national income. For example, the OECD’s Employment Outlook 2012 provides the following answer to the question: What explains the decline in labour’s share?

“Total factor productivity (TFP) growth and capital deepening – the key drivers of economic growth – are estimated to jointly account for as much as 80% of the average within-industry decline of the labour share in OECD countries between 1990 and 2007”.

The message that seems to be giving is that if a country or a region has the institutions, people and natural advantages needed to attract substantial additional investment, don’t expect the associated capital deepening (increase in capital to labour ratio) to have a strong positive impact on demand for labour. 

There are some circumstances where that might be a reasonable proposition. For example, as Dean Parham has shown in work for the Productivity Commission, the growth of the capital-intensive mining sector in Australia during the 2000s was strongly associated with the decline in labour’s share of national income over the same period.

However, the circumstances of Australia’s mining boom are somewhat peculiar. If it is generally true that capital deepening doesn’t have a strong positive impact on demand for labour I might need to make some fundamental revisions to my views about how economic systems work.

Dear reader, the next few paragraphs are somewhat abstruse, but please bear with me because I need your practical wisdom about production technology and the elasticity of substitution between capital and labour.

The elasticity of substitution between capital and labour is the critical factor determining the impact of capital deepening on demand for labour. It can be defined as the percentage change in capital deepening for a 1% change in the ratio of the wage rate to the rental price of capital (making the standard assumption that factors are paid the value of their marginal products). The sensitivity of the impact of 1% capital deepening (a 1% change in the capital to labour ratio) on labour’s share of output and real wages is shown below (assuming labour’s share of national income is 62%, the median for OECD countries).

The graph is drawn under the assumption of zero technological change. The underlying equation for percentage change in labour’s share is Equation 3 of Robert Lawrence’s recent working paper for the Peterson Institute on the decline in labour’s share in the US. The equation for the change in real wage is as derived in the end note below.

The OECD’s assertions about capital deepening reducing labour’s share were backed up by what appears to have been a fairly sophisticated econometric study by Samuel Bentolila and Gilles Saint-Paul (published in 2003) subsequently updated by OECD staff. These analyses suggest that capital and labour are gross substitutes (i.e. the elasticity of substitution between them is greater than 1) and attribute the decline in labour’s share to both capital deepening and capital augmenting technological change (i.e. technological change that has an impact similar to adding more capital).  

However, other econometric studies suggest that the elasticity of substitution between capital and labour is less than 1. For example, Robert Lawrence’s recent analysis of the decline in labour’s share of US income provides econometric evidence that it is attributable to technological change being so strongly labour augmenting (labour saving) that it has more than offset the positive impact of capital deepening. His results suggest that as a result of technological change “effective capital-labour ratios have actually fallen in the sectors and industries that account for the largest portion of the decline in labor share in income since 1980”.

I will leave it to others to attempt to unravel the mysteries of these conflicting econometric findings. It probably makes more sense for me to focus here on considering which set of results seems more plausible in terms of what you and I know (or think we know) about production functions at the level of the individual firm.

Think of any firm in any industry. In order to keep the analysis simple, assume that the firm leases the capital equipment that it uses and that the firm is small enough not to have any impact on either the rental price of capital or the prevailing wage rate. In the hypothetical situation I want you to consider there is no potential to change technology, only the potential to vary the amount of equipment or labour that is hired (and to vary other inputs in proportion to output). Now, consider to what extent the ratio of capital to labour is likely to change if the rental price of capital equipment declines by 10%, thus causing an increase in the ratio of the wage rate to the rental price of capital.

The answer that some readers may come up with is that the ratio of capital equipment to labour is fixed by existing technology, so that it will not change even if output changes in response to the lower input costs. For example, there is not much point in having more taxis than drivers or more desk-top computers than staff to use them. That corresponds to Wassily Wassilyevich Leontief’s assumption that the elasticity of substitution between capital and labour is zero.

The assumption of zero substitution possibilities is too extreme in my view, but I can’t think of an industry where it would be reasonable to expect a change in the wage rate to rental price of capital ratio to result in a more than proportionate change in capital deepening. Perhaps the time is approaching when firms will be employing both driverless vehicles and human-driven vehicles, so a decline in rental price of driverless vehicles could easily displace humans. But I don’t think that time has yet arrived. (Of course capital equipment can often be substituted for labour by introducing new technology, but the elasticity of substitution relates to unchanged technology.) Perhaps these comments just reflect the limits of my experience. Please enlighten me if that is so.

My bottom line is that unless I am persuaded otherwise I will cling steadfastly to the belief that capital deepening normally tends to raise real wages and labour’s share of national income, and that the decline in labour’s share of national income in high-income countries is attributable to labour augmenting technological change.

Endnote: some of the math behind the graph

Assume CES technology and that labour and capital are paid their marginal products. The rate of growth in the real wage is given by:

(1)     d log W = [(Ϭ – 1)/Ϭ]g + [1/Ϭ][d log (Y/L)]      

where W is the real wage rate, Ϭ is the elasticity of substitution between capital and labour, g is the rate of labour augmenting technological change, Y is output and L is labour input, so Y/L is average labour productivity.

We also know that the rate of growth of output is given by:

(2)    d log Y = S_L(d log L + g) + (1-S_L)(d log K + h)

where S_L is labour’s share of output, K is capital services, h is capital augmenting technological change, if we assume constant returns to scale and Euler’s theorem.

Substituting (2) into (1) and rearranging terms I obtained:

(3)    d log W = g + (1/Ϭ)(1 – S_L)[d log (K/N) – (g – h)]      (Both times I tried!)

The graph is drawn assuming no technological change i.e. that g and h are both zero. However, it is apparent from (3) that technological change tends to have a positive impact on real wages (assuming g>0). This impact is diminished when technological change has a labour-augmenting bias (g>h) and amplified when it has a capital-augmenting bias (g

Where will the future jobs come from?

This question is almost unanswerable, but it is easy to understand why people ask it. A definitive answer is not possible because future jobs will depend on decisions of large numbers of individual businesses, many of which do not yet exist, responding to demands of even larger numbers of consumers around the world. Some guesses are likely to be better than others, but no-one really knows what new products or new technologies will emerge, or how consumer tastes might change.

It is understandable that people ask where future jobs will come from when existing jobs are being threatened by international competition and automation. In the 1970s, when I worked at the IAC (predecessor to the Productivity Commission) many people were asking where the jobs would come from to replace manufacturing jobs then being lost to import competition. People who know about my work career sometimes still ask the same question today for the same reasons (e.g. in the context of the uncertain future of steel production in Wollongong) but these days there is greater concern about the offshoring of services and the impact of technological change.

I was thinking about the way economists answer the question of where the jobs will come from as I read a recently published report by the Committee for Economic Development of Australia (CEDA) with the uninspiring title: “Australia’s future workforce?” Fortunately, this is a good example of not being able to judge a book by its title. The report contains many fine contributions by people with expertise in technological change and/or the Australian labour market. Some of the contributors provide information highly relevant to considering the nature and extent of job losses that are likely to occur as a result of technological change and the kinds of jobs that might be in demand in future.

Some points that seem to me to be important are summarised below:

• The jobs that are disappearing involve routine tasks, not just low-skilled tasks. This is resulting in job polarisation, with computerisation or automation of many middle-level jobs in processing and servicing. See the graph in my post: Is average over? (This point is drawn from the chapter by Jeff Borland and Michael Coelli).
• The jobs that remain are unlikely to be susceptible to automation and will tend to involve perception and manipulation, creative intelligence and/or social intelligence. (Hugh Bradlow).
• Future skills and jobs will most often be concerned with the creative application of technology to solving problems. Everyone will need to be able, at some level, to architect (e.g. to integrate computing and communication resources) design (e.g. to understand problems of customers and propose solutions) and analyse (e.g. to make sense of performance data). (Hugh Durrant-Whyte).
• Large job losses are likely to occur over the next 10 to 15 years. The methodology used by Frey & Osborne for the U.S. suggests that about 40% of jobs have a high probability of being susceptible to technological change in Australia. (Hugh Durrant-Whyte et. al).
• In recent years enough new jobs have been created in Australia at a rate sufficient to replace those that have disappeared. (Phil Ruthven).
• There have been substantial changes in the pattern of employment in Australia including growth in part-time and casual work. Most workers are happy with the hours they work. Job tenure is not always short in casual work – a quarter of casuals have worked in the same job for 10 years or more. (Phil Lewis).
• Employment relationships are becoming more adult: workers desire autonomy and employers are unable to guarantee jobs for life. (Lynda Gratton).
• Digital infrastructure provides potential for greater choice about where work is done, possibly reducing the need for people movement (e.g. commuting) and associated physical infrastructure. (Hugh Bradlow).
• Self-employed people account for about 18 percent of the Australian workforce. There is a gradual trend toward independent contracting, as in many other countries. The supremacy of the large organisation is fading; technology is creating greater economic freedom for the individual. (Ken Phillips).
• There is a significant problem of long term unemployment in Australia, particularly for unskilled people. Over half of the long term unemployed have no post-school education (about 9 percent have degrees). There has also been a substantial increase in people on disability support – numbers on disability support now exceed unemployed social security recipients. (Phil Lewis).
• Education earnings gaps (skill premiums) have been fairly stable in Australia, unlike the U.S. and some countries in Europe. (Michael Coelli).
• Schools and universities face a double challenge: how to embrace new technology; and how to deliver the skills required. This involves more than just increasing the number of STEM graduates. Education institutions will need to be able to encourage students to become creative and agile in applying technology to solving problems. (Hugh Durrant-Whyte).
• Technology is challenging traditional methods of delivering education. Individuals may need to treat their careers as a business - taking more responsibility for their own education and investing in skills to adapt to changing demands throughout their working life. (Sue Beitz).
• MOOCs (massive open online courses) are the iTunes of education. The way MOOCs will change education is likely to be similar to the way iTunes has changed the way people buy music. MOOCs are not likely to replace quality campus-based education. (Jane den Hollander).
• Australian industry has largely been an exploiter of technology rather than an explorer. (This claim is seems to me to be highly questionable in relation to areas of Australia’s comparative advantage.) In terms of Joseph Schumpeter’s distinction, explorers search out new solutions to problems, while exploiters seek to make use of existing solutions (e.g. by imitating). In the new global economy new ideas will be the commodity in scarce supply, so explorers and likely to forge ahead and exploiters are likely to fall further behind. (Steven Callander).
• Australia’s comparative advantage in specific industry sectors can be a driver for technological leadership in key areas of technology and computing. The most obvious industry sectors where this applies are mining and agriculture, but it may also apply to financial services, infrastructure and medical devices. (Hugh Durrant-Whyte).
• Australia is well-placed to benefit from digital disruption because of strength of services industries including education and potential for sale of services to Asian markets. (Sarv Girn; Phil Ruthven).  

My answer to the question posed above is that the future jobs of Australians will be shaped by: 

1. the pattern of economic growth that evolves in this country in response to the changing opportunities that the world economy will provide to people living on the edge of Asia; and 
2. the human, technological and physical resources that Australians develop in the years ahead.

It might seem logical to proceed now to consider the policy proposals contained in the CEDA report. However, there are a few other questions I want to consider before I turn to policy.