In the mid-nineteenth century, the United Kingdom 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 (Exhibit 1).

To find out why, the McKinsey Global Institute conducteda 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 (Exhibit 2). The results of our productivity case studies confirm this overall trend (Exhibit 3).
  
  
• Contrary to conventional wisdom, the main causes of low labor productivity are a 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.

Insufficient competition

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 (Exhibit 4).

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 (Exhibit 5).

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 (Exhibit 6). 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 (Exhibit 7). 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 (Exhibit 8). 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 long-standing 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 (Exhibit 9).

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.

Spillover effects

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.