Does the free market provide inadequate incentives for the acquisition of skills? What is the empirical evidence on skills gaps? What are their most serious economic consequences? What should the government do about them? These four questions were addressed at a conference on `The Skills Gap and Economic Activity', held in London on 19/20 April. The conference was organized by Alison Booth and Dennis Snower, both of Birkbeck College, London, and respectively Research Fellow in and Co-Director of CEPR's Human Resources programme. The conference was sponsored by the UK Department of Employment as part of its support for CEPR's research programme on `Labour Market Imperfections'.

It is often claimed that skills gaps are inevitable in the absence of government intervention, and that the UK and the US suffer from under-investment in human capital because their governments' policies do not attempt to correct market failures in this area. The German apprenticeship system and the Swedish government training programmes are cited as examples of how governments can induce employers and employees to undertake sufficient vocational training.

Human capital theory suggests that `general training' (useful to many employers) should be financed exclusively by employees, who have just the right incentives to invest in training since they are able to recoup their investment when it raises their productivity and hence their wages. The costs of `specific training' (useful only to a specific employer) should be shared by employers and employees, so that employees internalize the cost to their employers of quitting and employers in turn internalize the cost of dismissing to their trained employees. In either case, employers and employees are compensated for the training and there are no market failures. In practice, when training is part general and part specific, the market must also provide the right incentives for training.

This human capital analysis has undoubtedly had a strong influence on UK training policy since the early 1980s. The Thatcher government, for example, abolished the Industrial Training Boards, which imposed training levies on firms and provided grants to firms providing adequate training. More recently, however, the government appears to be moving towards more recognition of market failures in training, as is implicit in the introduction of tax relief on vocational training costs in April 1992. In the rest of Europe and the US, governments are torn between a desire to subsidize training and the need to cut budget deficits.

This conference had a simple guiding principle: only once market failures in training have been identified can policy proposals be meaningfully formulated. A number of papers showed that, contrary to the traditional human capital view, free market activity will indeed tend to provide insufficient incentives for investment in skills. In that case, however, skills gaps should be seen merely as a symptom that can be shared by a variety of diseases. For example, the mere fact that the UK government spends less on education and training than some other European countries need not imply that it spends too little; and how the available funds should be spent need not depend on inter-country comparisons but on where the market mechanism goes wrong.

The conference identified the following major sources of skills gaps under free market activity:

(1) Firms' market power: Human capital theory assumes that firms are perfect competitors for labour, whereas in practice firms generally have significant market power in the wage-setting process. Therefore, as papers by Margaret Stevens (Nuffield College, Oxford), Daron Acemoglou (LSE) and Ken Burdett and Eric Smith (University of Essex) showed, employees are not fully compensated for the costs of general training and will acquire too little.

(2) The poaching externality: When training is transferable among firms that are imperfect competitors for labour, the benefits from training go not only to employers that provide the training and employees that acquire it but also to firms that poach. Consequently, as Stevens indicated, no arrangement that shares training costs between the training firm and the employee will provide sufficient incentives for training.

(3) Credit constraints: Since human capital cannot be used as collateral against loan default, employees may be unable to acquire sufficient training on account of credit constraints. This problem was analysed by Daron Acemoglou, and Christine Greenhalgh (St Peter's College, Oxford, and CEPR) found indirect evidence of it in the UK.

4) Firms' outside opportunities: As the number of skilled workers in an economy rises, firms face improved outside options and therefore are able to capture more rent in the wage bargaining process. This reduces employees' returns from training and, as the papers by Burdett and Smith and by Stevens showed, leads to under-investment in skills.

(5) Intergenerational and production externalities: Under external production economies, each firm's output depends not only on the labour and capital it employs but also on the economy's average skill level. Individual firms do not take this externality into account and unborn generations cannot make their needs felt; Monojit Chatterji (University of Dundee) showed that free market activity then leads to under-investment in skills.

(6) Complementarities between labour and capital: Daron Acemoglou demonstrated that when labour and capital are Edgeworth complements, deficient investment in human capital (say, on account of firms' market power) reduces the productivity of physical capital and thereby leads to deficient investment and slow growth.

(7) The interaction between product quality and skills: When products of high quality require highly trained workers to produce them, economies can get stuck in a vicious cycle in which firms produce products of low quality because there are few trained workers, and workers acquire little training because few high-quality goods are produced. Geoff Mason (National Institute for Economic and Social Research (NIESR), London), Bart van Ark (Universiteit Groningen) and Karin Wagner (Wissenschaftszentrum Berlin für Sozialforschung (WZB)) presented evidence of this phenomenon in UK biscuit processing.

(8) The interaction between skills and innovative performance: When successful innovation generally requires highly trained workers, economies can get stuck in a vicious cycle in which firms do not innovate sufficiently because the work force is insufficiently skilled, and workers do not train sufficiently because there is insufficient demand for them from innovating firms. Furthermore, as David Ulph (University College, London, and CEPR) showed, a rise in labour turnover costs will increase the incentive for successful innovators to innovate (as they seek to avoid these costs by maintaining their success) while reducing this incentive for the unsuccessful (who are deterred by the higher costs of attracting new employees).

The conference included several papers that documented the existence of skills gaps arising from these various sources. The evidence that the UK lags behind its major trading partners in education and training ranged from reported shortages of skilled labour (Jonathan Haskel and Christopher Martin), to disaggregated price-based proxies of worker productivity (Nicholas Oulton), to direct measures of specific skills (Hilary Steedman and Julia Hawkins).

Moving from the causes of skills gaps to their consequences, the conference focused on the effects of deficient training on productivity, wages and competitiveness.

Jonathan Haskel and Christopher Martin (Queen Mary and Westfield College, London) argued that skill shortages lead firms to substitute unskilled for skilled labour, thereby reducing productivity. Furthermore, skill shortages that improve the skilled workers' outside options and make it more difficult for firms to induce them to work hard also reduce productivity. The authors provided evidence to show that the growth of skill shortages over the 1980s reduced UK productivity growth by about 0.4% per year. Alan Felstead and Francis Green (University of Leicester) found some evidence from the UK that there may be little relation between training and productivity when training is a response to new government regulations on health and safety.

Skills gaps may also lead to inflation, as excess demand for skilled workers tends to drive up their wages. Haskel and Martin found that the rise in skill shortages of the 1980s in the UK increased wage growth by about 1% per year.

Nicholas Oulton (NIESR) compared UK and German work force skills and provided evidence on how the UK's skills gap is mirrored in its export competitiveness in manufacturing.

The policy implications of this research are implicit in the diagnosis of the skills gap problems. Tax incentives for employees to acquire training may be appropriate when firms exert significant market power in the wage determination process. Tax incentives for not only employees but also employers to provide training may help address the problems arising from poaching, production externalities, complementarities between labour and capital, and interactions between skills and product quality and/or innovative performance.

Apprenticeship systems may also help address the problems of poaching, product quality and innovation. David Soskice (WZB) argued, however, that without appropriate regulations on wages and job security, the German apprenticeship model could probably not be successfully transferred to the UK or the US.
Peter Dolton (University of Newcastle-upon-Tyne), Gerald Makepeace (University of Hull) and John Treble (University College of North Wales and CEPR) evaluated the UK's Youth Training Scheme and found a weak short-term effect on wages and no significant effects on productivity or employment. They also highlighted the major pitfalls in policy evaluation. Hilary Steedman and Julia Hawkins (NIESR) examined mathematics in vocational youth training for the building trades in the UK, France and Germany and argued that the UK government's competence-based skill certification has reduced the quality of youth training.

The cyclicality of government expenditure on training also requires close inspection. Felstead and Green showed that not only does training in the private sector rise in recoveries and fall in business downturns, but public-sector training expenditures in the UK do so too, which tends to have socially undesirable effects.

Just as there are good reasons why the market may fail in the provision of adequate skills, there may also be good reasons why governments are unable to rectify the problem. David Finegold (Rand Corporation) investigated the reasons for inefficiencies in governments' response to skills gaps in the UK education and training (ET) initiative.

The following papers were presented:

`Matching and Education', Kenneth Burdett and Eric Smith

`Transferable Training and Market Failure', Margaret Stevens

`Labour Market Imperfections, Innovation Incentives and the Dynamics of Innovation Activity, Daron Acemoglou

`Skills Gaps, Differential Firm Performance and Economic Growth', David Ulph

`Skills, Diffusion and Economic Growth, Monojit Chatterji

`Skill Shortages, Productivity Growth and Wage Inflation in UK Manufacturing', Jonathan Haskel and Christopher Martin

`Cycles of Training? Evidence from the British Recession of the Early 1990s', Alan Felstead and Francis Green
`Evaluation of Training Schemes: Lessons from Britain', Peter Dolton, Gerald Makepeace and John Treble

`UK Training Policy Assumptions and Reality', Ewart Keep and Ken Mayhew

`Market and Non-market Failure in Skills Investment', David Finegold

`The German Apprenticeship System: A Simple Model', David Soskice

`Workforce Skills and Export Competitiveness: An Anglo-German Comparison', Nicholas Oulton

`Mathematics in Vocational Youth Training for the Building Trades in Britain, France and Germany', Hilary Steedman and Julia Hawkins

`Productivity, Product Quality and Workforce Skills: Food Processing in Four European Countries', Geoff Mason, Bart van Ark and Karin Wagner

`The Role of Career Aspirations and Financial Constraints in Individual Access to Vocational Training', Christine Greenhalgh and George Mavrotas

`The British Training Problem: Market Failure and Intervention', Paul Chapman