Over the past 15 years, the Australian economy has undergone a transformation. The government has introduced reforms in the financial system, business regulation, and industrial relations, and reduced trade protection. In parallel, business practices and relationships between employers, employees, and unions have seen significant change. Yet despite these efforts, the nation's relative economic prosperity has not altered since 1970. Its gross domestic product is still 30 percent behind that of the United States, the most prosperous country in the world (Exhibit 1).
This prosperity gap has two main causes: poorer labor productivity in the Australian economy, and lower employment per capita. If Australia is to raise its standard of living, it must address these issues—productivity in particular. To investigate what actions by corporations and government might promote productivity growth, the McKinsey Global Institute compared Australia's performance in labor productivity and employment with that of other leading economies.1 It focused on five industries: processed food, construction, retail, banking, and aviation (see case studies on pp. 98-102). Together, these industries make up about 18 percent of the economy (Exhibit 2).
The nature of the challenge
The principal research findings were:
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Australia trails behind the global benchmark, the United States, in both labor productivity and employment in all the industries studied except construction, where it is close to best practice.
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Among external factors, the market conditions that Australia can do little to change—its relatively small population, its geographical location, its lower income levels—are less important than those that lie under the direct control of government, such as product market regulation (Exhibit 3).
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Within firms, the prime causes of poor labor productivity are low management aspirations and a lack of innovation.
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If Australia tackles the key performance inhibitors and makes sub-stantial productivity gains, it will not necessarily incur a large net fall in employment. Growth in productivity can be combined with growth in jobs, especially in the service sector.
Limited aspirations and innovation
Though lower capital intensity and smaller scale explain part of Australia's productivity deficit, they are much less important than lower management aspirations and limited innovation within businesses. The industries studied were characterized in the main by:
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A slowness to adopt innovative new processes developed overseas. In retail, for instance, many best-practice management methods from America have yet to be imported into Australian stores. In banking, mobile mortgage salesforces first appeared a decade ago in the United States, but are only now being introduced in Australia as a high-productivity alternative to conventional branches. By contrast, the construction industry has been quick to adopt efficient new production processes, a trait reflected in its near-benchmark productivity.
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Laggardly product and service innovation. Australian retail is some 15 to 20 years behind the US industry in adopting productive store formats such as the category killer. In food processing, firms have been much slower than their American counterparts to rethink product categories and innovate to meet new customer demand, which has prevented them expanding their existing markets.
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A limited use of supplier relationships. In food processing and specialty retail chains, there is a tendency to keep suppliers at arm's length rather than build collaborative relationships that yield opportunities to improve products and processes.
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Modest management aspirations. Innovation transfer is more likely to occur when managers with high aspirations push for change, or when competitive pressures force firms to improve their performance in order to survive. Companies lacking these aspirations and pressures may neglect promising opportunities. Few Australian food processors focused on export during the 1980s and early 1990s, for instance, despite the high quality and low cost of local produce.
Collectively, these factors represent the main impediment to labor productivity growth at firm level.
Product market regulation
Of all the external conditions that make up the environment in which firms do business, product market regulation has the greatest impact on Australia's productivity.
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Restrictive product market regulation makes it hard for new competitors to enter a market and limits existing players' freedom to introduce innovations. These barriers inhibit productivity in most of the industries studied. In aviation, for example, legacies of the old "two airlines" policy, such as the incumbents' 20-year leases on terminals, impede market entry by other airlines. Conversely, low barriers to entry in construction have created a highly competitive industry with many players—conditions which, along with the presence of foreign firms, encourage the widespread adoption of innovative production processes.
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Though less significant than product market regulation, restrictive labor market regulation does harm productivity in some industries. In food processing, poor labor relations have historically slowed rationalization, investment, and process innovation in manufacturing and distribution, though many firms are now striving to establish the effective working relationships needed for productivity growth. By contrast, dramatic improvements in its industrial relations since the late 1980s are central to construction's strong labor productivity.
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Other factors commonly thought to obstruct Australia's productivity and ability to compete in global markets—its distance from export markets, small domestic market, and relatively low income levels—were found to have only negligible effects.
Productivity versus jobs?
The US created almost five new jobs per thousand compared with a net loss of nearly eight in the Australian retail industry
Improvements in labor productivity—whether at the level of the individual firm or within the economy as a whole—are usually thought to come at the expense of lost jobs. However, research shows that job destruction is far from inevitable, especially in the service sector. In all five industries studied, the country that enjoys the best productivity performance in the world, the United States, also has a stronger record of employment creation than Australia. The most dramatic example is provided by retail, where America created almost five new jobs per thousand working age population compared with a net loss of nearly eight jobs per thousand in the much less productive Australian industry.
Employment will not necessarily grow in every industry where productivity increases. But even if jobs remain constant while productivity rises, the result will still be a higher standard of living. The experience of other countries suggests that the removal of barriers to improved productivity in the service sector may create sufficient new jobs to offset employment losses elsewhere.
Necessary reforms
Capturing the benefits of higher productivity calls for new efforts on the part of government and business leaders.
The role of government
The next step in the government's reform agenda should be the introduction of policies to compel Australian companies to achieve much higher growth in productivity. Current regulations and policies do not create adequate incentives for firms to aspire to world-class standards of productivity and innovation. Industries suffering from low productivity, such as retail banking, also have low rates of innovation and modest aspirations because of incentive structures that serve to maintain the status quo. These incentives operate both at the product market level (regulations concerning mortgage securitization) and in the market for corporate control (competition rules that prevent banks rationalizing their branch networks).
Each of the industries studied has its own specific barriers to higher productivity, which indicates that incentive structures need to be understood and refined industry by industry. If it is to use these structures to drive productivity growth, government must rethink its approach to competition policy and review the impact of existing regulation. It may need to adjust its mergers policy in retail banking and some food processing sectors, for instance. In other industries, such as aviation and retail, its priority should be to demolish remaining entry barriers and thus increase competitive intensity.
Putting the right incentives in place at industry level would have a dramatic effect on Australia's productivity growth
The service sector in particular has been sheltered from the impact of many earlier reforms. Putting the right incentives in place at industry level would have a dramatic effect on productivity growth and enhance Australia's capability as a competitive and productive nation.
What firms can do
Business leaders can promote productivity growth in two important ways: by raising their aspirations and by encouraging innovation. At present, Australia has pockets of firms with high management aspirations that are achieving impressive improvements in performance through aggressive best-practice initiatives. To lift the nation's overall productivity, many more firms must set ambitious targets and strive for world-class performance. Discussions with business leaders suggest that companies need to focus on two areas in particular:
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Improving the effectiveness of Australian middle managers, who will play a pivotal role in determining the outcome of efforts to close the productivity gap. These individuals hold the key to the success or failure of companies' pursuit of change.
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Developing a culture that encourages innovation. Lessons from the highly productive construction industry indicate that firms need to look outside their own organization for new ideas, and to work to forge strong relationships—with leading-edge customers, suppliers, R&D providers, and specialist firms—that will help them stay ahead of the game. Managers also need to see innovation as a key driver of shareholder returns with the power to maximize the value of existing businesses and act as a major source of options for growth. Once they understand innovation's potential, they can start to treat it not as something that can be handled piecemeal, but as a core management process.
Close analysis of the case industries offers insights into the actions that businesses and government could take to close Australia's prosperity gap. If they succeeded in raising labor productivity to the global benchmark in the five industries studied, benefits worth A$7 billion (US$5 billion) a year could flow to the nation in the form of lower prices and a higher standard of living. Extending these productivity gains to other market sectors might secure as much as A$30 billion (US$22 billion) a year—a sum comparable with the estimated benefits derived from the major microeconomic initiatives undertaken in Australia over the past fifteen years. Indeed, ample rewards are waiting for those willing to raise their sights. 
About the Authors
Bill Lewis is Director of the McKinsey Global Institute, Washington, DC. Kate McCann is a consultant and Rob McLean is a director in McKinsey's Sydney office; Eric Zitzewitz is a consultant in the Washington, DC office.
We would like to acknowledge the contributions of all the members of the MGI team who put together the material for the report on which this article is based.
Notes