ECONOMIC COMPLEXITY ANALYSIS A technical report for the research on Innovation & Global Competitiveness March 2019 Authors: Penny Mealy and Diane Coyle, Bennett Institute for Public Policy, University of Cambridge The Bennett Institute for Public Policy at the University of Cambridge seeks to rethink public policy in an era of turbulence and growing inequality. Its research, teaching and policy engagement are guided by the need to devise sustainable solutions to some of the most pressing problems of our time. The views expressed in this report are those of the authors and, as usual, errors and omissions in this report remain the responsibility of the authors alone. The Greater Manchester Independent Prosperity Review was commissioned to provide a detailed and rigorous assessment of the current state, and future potential, of Greater Manchester’s economy. Ten years on from the path-breaking Manchester Independent Economic Review, it provides a fresh understanding of what needs to be done to improve productivity and drive prosperity across the city region. Independent of local and national government, the Prosperity Review was carried out under the leadership of a Panel of six experts: Professor Diane Coyle Bennett Professor of Public Policy, University of Cambridge, and Chair of the Greater Manchester Independent Prosperity Review Stephanie Flanders Head of Bloomberg Economics Professor Ed Glaeser Fred and Eleanor Glimp Professor of Economics, Harvard University Professor Mariana Mazzucato Professor in the Economics of Innovation & Public Value and Director of UCL Institute for Innovation and Public Purpose Professor Henry Overman Professor of Economic Geography, London School of Economics, and Director of the What Works Centre for Local Economic Growth Darra Singh Government and Public Sector Lead at Ernst and Young (EY) The Panel commissioned studies in four areas, providing a thorough and cutting edge analysis of key economic issues affecting the city region: • Analysis of productivity, taking a deep-dive into labour productivity performance across Greater Manchester (GM), including a granular analysis of the ‘long tail’ of low-productivity firms and low pay; • Analysis of education and skills transitions, reviewing the role of the entire education and skills system and how individuals pass through key transitions; • Exploration of the city region’s innovation ecosystems, national and international supply chains and trade linkages; and sources of global competitiveness, building on the 2016 Science and Innovation Audit; and • Work to review the infrastructure needs of Greater Manchester for raising productivity, including the potential for new approaches to unlock additional investment. A call for evidence and international comparative analysis, developed in collaboration with the Organisation for European Cooperation and Development (OECD) and European Commission, also supported this work. All of the Greater Manchester Independent Prosperity Review outputs are available to download at www.gmprosperityreview.co.uk. This technical report is one of a suite of Greater Manchester Independent Prosperity Review Background Reports. Contents 1. Introduction and scope ........................................................................................................... 6 2. The Economic Complexity of UK Local Authorities and Industries .................................... 7 3. Economic Complexity of the GM Districts ......................................................................... 11 3.1 Mapping regional comparative advantage in the UK industry space ............................ 11 3.2 Mapping Places in the UK Industry Space .................................................................... 12 Technical Appendix ................................................................................................................. 20 Calculating the ECI and PCI ............................................................................................... 20 Constructing the Industry Space .......................................................................................... 20 Proximity density (and distance) ......................................................................................... 21 References ............................................................................................................................... 22 5 1. Introduction and scope What are places currently good at doing, and what might they be able to be good at doing in the future? These questions are central to an effective industrial strategy, but it can often be difficult to assess rigorously a place’s key areas of competitiveness and future opportunities for economic development. The economic complexity framework is a new network-based empirical methodology to study a place’s current comparative advantage and future growth potential. It provides a new tool for visualising differences in places’ productive capabilities (or ‘know-how’) and industrial structures, and it has also provided new insights into development patterns and the growth potential of countries and regions.1 This report for the GM Prosperity Review applies the analytical framework of economic complexity to study Greater Manchester’s industrial strengths and future development possibilities. Drawing on detailed employment data from the UK Business Register and Employment Survey (BRES), this report: 1) Examines GM local authorities’ current sectoral comparative advantages in terms of their economic complexity, a measure which has been shown to be linked to future growth potential; 2) Constructs the UK Industry Space, a network perspective that helps visualise structural differences between UK local authorities, both in terms of current industrial specialisations and future development possibilities; 3) Identifies possible future industrial opportunities for the 10 local authorities in Greater Manchester that are (i) well aligned with current industrial strengths and (ii) could be advantageous in terms of higher value growth and capability upgrading. Not surprisingly, the 10 authorities differ considerably in their current degrees of complexity and network structures, as described below. The key results for the purposes of the Local Industrial Strategy concern the future potential of each authority for developing higher value activities by building out from their existing relative strengths. 1 Key research includes Hidalgo et al 2007, Hidalgo and Hausmann, 2009; Hausmann et al 2014; Neffke et al 2011; Balland & Rigby, 2017; Mealy et al 2018a; 2018b; Bishop et al 2018. 6 2. The Economic Complexity of UK Local Authorities and Industries The Economic Complexity Index (ECI) and Product Complexity Index (PCI) are measures of economic activity that have been shown to provide useful insights into the type of activities that distinguish prosperous from less prosperous places. Originally developed by Hausmann and Hidalgo (2009) to understand cross-country differences in productive capabilities from export data, the measures have since proved to be particularly successful at explaining variation in per capita GDP and predicting future growth rates across countries (Hausmann et al 2014a). Similar findings have been shown to apply to regional data (Gao & Zhao, 2018; Mealy et al 2018a, 2018b). In the regional setting, the ECI and PCI provide a useful way of understanding differences in local authorities’ industrial strengths. Industrial strengths are measured using location quotients. Location quotients analyse the concentration of industrial employment in defined geographic areas. An industry �’s location quotient in a given area � is calculated as the ratio of the industry’s share of employment in that location to its share of employment nationally. So if we define �!" as the number of people employed in industry � in local authority �, then the location quotient for industry j in area i (denoted ��!") is given by �!"/ ∑! �!" ��!" = ∑! �!"/ ∑! ∑! �!" If a local authority has a location quotient greater than 1 (which indicates that the local authority’s employment share in that industry is the greater than the national average), the local authority is said to be ‘competitive’ or have ‘revealed comparative advantage’ (RCA) in that industry. Here we apply the Hausmann et al (2014a) algorithm to the location quotients to calculate the economic complexity metrics (ECI and PCI) for UK local authorities and industries. The ECI and PCI measures are calculated based on local authorities’ industrial strengths (see box). It is intuitive to think of the ECI and PCI as being related to the industrial diversity (the number of industries a particular local authority has a comparative advantage in) and the industry’s ubiquity (the number of local authorities that have an advantage in a given industry). However, a more accurate way to think about the ECI is as a measure that captures the most variation in the different dimensions of local authority industrial profiles. It provides a ranking that places local authorities with similar industrial profiles close together in the ordering, and local authorities with different industrial profiles far apart (Kemp- Benedict, 2014; Mealy et al 2018a). This ECI ranking is particularly interesting from an economic perspective because it is strongly correlated with UK local authorities’ earnings per capita (see Figure 1) and is significantly predictive of earnings growth (see the regression results reported in Table 1). The right hand side panel of