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Chapter 3 Initiatives to establish a new industrial society for creating innovation Section 1 Enhancing Japanese global companies’ profitability

In order to invigorate the Japanese economy and achieve sustainable economic growth, it is necessary to encourage Japanese global companies to enhance their profitability. Focusing on profitability on a value added basis (value added profitability), this section identifies problems constraining the factors that enhance profitability and discusses measures to create innovation through investment. The value added profitability, which is profitability in a broader sense than profitability as defined under financial accounting and the science of economics, includes costs related to capital and labor. In light of the fact that GDP, which represents the sum of value added created in Japan, is comprised mostly of value added created by companies, companies’ efforts to maintain and expand the value added created by them represent a driving force of economic growth. At the same time, as value added created by companies is comprised of capital investment, personnel costs and profits, maintaining and expanding value added is important as the basis for increasing future capital investment and jobs. Therefore, it is necessary to observe the trend in the value added profitability as an indicator essential for debate on macroeconomic growth.

1．Enhancing the value added profitability (1) Debate on enhancement of profitability

The fact that the values of general indicators of profitability, such as sales and the operating profit margin, are lower for Japanese global companies253 than for U.S. and European global companies has been pointed out by the Whiter Paper on International Economy and Trade and other papers. For example, the White Paper on International Economy and Trade 2015 observed that Japanese global companies are low-growth and low-profitability in terms of sales, operating profit and operating profit margin compared with their U.S. and European counterparts as a result of financial analysis covering 357 global companies around the world.254 In particular, the low levels of growth potential and profitability of diversified companies were pointed out.

253 In many cases, the term “multinational companies” is used in international comparison, but in this section, the term “global companies,” which has a broader meaning, is consistently used. The global companies as referred to in this section include not only transnational corporations as defined by UNCTAD (http://unctad.org/en/Pages/DIAE/Transnational-corporations-(TNC).aspx) but also companies engaging in exports without owning foreign subsidiaries, etc. (exporting companies). 254 Ministry of Economy, Trade and Industry (2015), p. 216.

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Figure II-3-1-1-1 Profit structures of listed companies in each countries and region (median value, %)

Japanese companies US

companies European companies

Characteristics of Japanese companies

Ratio of cost of sales 74.3 ＞ 63.9 - Potential challenges in productivity, sales, etc.

Ratio of sale administration cost 20.5 22.1 31.8

Ratio of depreciation cost 2.8 - 2.6

Operating profit margin 4.2 ＜ 7.5 6.7 High sales cost ratio in Jpan pushed

down the profit margin Ratio of

non-operating profit and loss

- - -

Ratio of tax burden 38.4 30.7 24.8

Ratio of net income 3.9 ＜ 6.4 5.5 High sales cost ratio in Japan pushed down the profit margin

Source: SPEEDA. Notes: These figures are the results of calculation targeting 5,925 listed companies with accessible data

between 2006 and 2015, mainly consisting of 2,934 Japanese companies, 1,240 U.S. companies, and 1,468 European companies. These figures are mean value between 2006 and 2015. European companies are those in 15 EU member countries.

Figure II-3-1-1-1 shows a comparison between the profit structures of Japanese, U.S. and

European listed companies, with a focus on financial indicators such as the sales cost ratio. The sales cost ratio is an indicator of cost of sales, which is the accounting concept closest to value added as an important element in discussion about productivity. The sales cost ratio is higher for Japanese global companies than for their U.S. and European counterparts. Therefore, it is presumed that Japanese global companies have problems in terms of creation of value added in the sense that their sales are low or the value of intermediate inputs (e.g. manufacturing cost) is high. The difference between sales and the cost of sales represents gross profit, so a high sales cost ratio means a small gross profit margin. As a result, operating profit, which is calculated by subtracting sales and general administration costs from gross profit, is small. This automatically means that the operating profit margin, which represents the ratio of operating profit to sales, is low. As the same applies to net profit, the net profit margin is also low.

The Annual Report on the Japanese Economy and Public Finance 2013, in its analysis of Japanese companies’ competitiveness, pointed out that Japanese manufacturing companies’ profitability (gross return on assets) is relatively low compared with their U.S. and German counterparts.255 As factors behind the low profitability, the White Paper on International Economy and Trade 2015 cited the scarcity of young companies—companies which have existed for a relatively few years since their

255 Cabinet Office (2009).

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foundation or reorganization—and a decline in the efficiency of R&D investment at companies whose businesses were diversified.256

In addition, the Annual Report on the Japanese Economy and Public Finance 2013 recognized that Japanese manufacturing companies’ tendency to do as others are doing and their reluctance to take risks restrained fundamental product differentiation and promoted excessive competition, resulting in their tendency to adopt business models with a small profit margin. Based on this recognition, the report calculated the degree of oligopoly using the Herfindahl-Hirschman index concerning sales of listed manufacturing companies and pointed out the possibility that the low degree of market oligopoly in Japan compared with the degree in the United States and Germany has led to excessive competition and low profitability257 (Figure II-3-1-1-2).

If we look at the number of listed companies per 100,000 people in Japan, the result is consistent with the above-mentioned state of oligopoly258 (Figure II-3-1-1-3).

Figure II-3-1-1-2 Level of Oligopoly in listed manufacturers sales

Source: FY2013 Annual Report on the Japanese Economy and Public Finance (CAO).

256 Ministry of Economy, Trade and Industry (2015). 257 The Annual Report on the Japanese Economy and Public Finance 2013, Chapter 2. Concerning the

Herfindahl-Hirschman Index, it is stated that the index tends to show a high score when it is caliculated using only German companies because German companies share of imported products in domestic sales is large.

258 In Germany, some major global companies (e.g. Bosch, which is an auto parts maker) are not listed on exchanges, so conducting simple comparison with Japan and the United States is difficult.

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Figure II-3-1-1-3 Total number of listed companies and number of listed companies per 100,000 people in each country

Source: SPEEDA.

Source: SPEEDA, Statistics Bureau, Ministry of Internal Affairs and Communication "International Statistical Compendium 2017 ".

From the above perspective, the importance of conducting the following activities in order to enhance profitability has been emphasized: improving the business environment through industry-academia-government cooperation and enhancement of corporate governance; ensuring the

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diversity of personnel and securing personnel with innovation capability; and utilizing IT.259

(2) Relationship between profitability, productivity and pricing power For Japan to achieve sustainable economic growth, it is necessary to maintain a virtuous cycle of

income and expenditure. Therefore, companies, which implement production, conduct investment, and distribute wages as a reward for labor, play a major role in driving economic growth. The breakdown of GDP shows that value added created by market producers,260 including companies, accounts for around 90% of the overall value added on a nominal basis.261 Therefore, value added created by companies represents an important viewpoint for grasping economic activities.

Value added created by companies can be calculated by substracting costs related to goods and services procured externally (the value of intermediate inputs), such as raw materials and distribution costs, from sales.262 Generally speaking, value added is comprised of such components as personnel cost, depreciation cost, net profit and interest and rent payment. In other words, value added may be considered to represent the difference between the costs of companies’ production and sales activities and the sales achieved as a result.

Regarding nominal value added, as was mentioned above, companies’ value added corresponds to their gross profits, so it can be regarded as an indicator of profitability similar to financial indicators such as ROE (return on equity) and ROA (return on assets). Like GDP, value added is highly harmonious with macroeconomic statistics, whereas financial indicators, which are used for the purpose of evaluating companies’ profitability and the efficiency of the use of assets and liabilities, are held by them from the viewpoint of shareholders.

When companies’ profitability is considered in terms of nominal value added, real value added can be obtained by dividing nominal value added by the value added deflator.263 This relationship can be expressed as the following equation: Nominal value added = real value added x value added deflator (Figure Ⅱ-3-1-1-4).

Here, let us divide the items on both sides of the equation by the number of employees. Nominal value added divided by the number of employees, namely nominal value per employee, represents profitability. Real value added divided by the number of employees, namely real added value per employee, represents real labor productivity. The value added deflator remains as-is.

The value added deflator is an indicator of what may be considered as “price” of value added as

259 Ministry of Economy, Trade and Industry (2015). 260 Market producers, which means producers supplying services at economically significant prices,

includes non-financial corporations, financial institutions and households (companies managed by self-employed people). In addition to output produced by market producers, some output produced for final self-use (e.g. imputed rent of owner-occupied dwellings) is included in the System of National Accounts.

261 This is a figure for 2015. The website of the System of National Account (GDP statistics) (Cabinet Office) (www.esri.cao.go.jp/en/sna/menu.html, Annual Report on National Accounts, Flow, Supporting Table (2) (Gross Domestic Product and Factor Income classified by Economic Activities).

262 Other costs include the cost of exporting products in foreign currency terms and the cost of purchasing raw materials from abroad. When foreign exchange losses have arisen due to fluctuations in exchange rates, value added (on a yen basis) changes as a result of reflecting the losses in sales.

263 This is similar to calculating real GDP by dividing nominal GDP by the price deflator.

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embodied by products or services and services produced by companies. As was mentioned earlier, (nominal) value is obtained by substracting raw materials cost (procurement price x procurement volume) from sales (sales price x sales volume). Therefore, if it is assumed that sales volume and procurement volume are constant, the change in the value added deflator depends on the change in procurement price and sales price. Consequently, the value added deflator is an indicator of the trend in price pass-through. In other words, it is an indicator of pricing power.264

Figure II-3-1-1-4 Profitability, productivity and pricing power

Source: METI. Figure II-3-1-1-5 Correspondence between profitability and nominal value added

Source: METI.

264 See Small and Medium Enterprise Agency (2014), Part I, Chapter, 1, Section 3.

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What is clear from the above-mentioned equation is that in order for companies to improve their profitability, it is important not only to raise productivity but also to enhance pricing power. Productivity growth does not lead to profitability improvement if product prices decline.

Enhancement of pricing power increases the ability to pass the increase in procurement cost to the sales price (price pass-through power) in the case of a rise in the cost of intermediate input (procurement price), including raw materials cost and personnel cost (Figure II-3-1-1-6). If companies are to maintain value added when they do not have pricing power, they offset the lack of the power by reducing the profit margin or costs related to intermediate input. In this case, it is presumed that the inducement for reducing capital investment or labor cost is strengthened. From what has been discussed so far, it is clear that if companies focus on maintaining and increasing value added and acquire price pass-through power, or the ability to appropriately pass an increase in the cost of intermediate input, to the sales price, that will bring benefits for both their own profitability and economic growth. Therefore, improving productivity and enhancing pricing power with a focus on value added will help companies secure funds necessary for employment, capital investment and dividend payment, and this may contribute to Japan’s economic growth.

Figure II-3-1-1-6 Pricing power and value added

Source: METI. 2. Challenges faced by Japan

In the previous paragraph, we examined the relationship between profitability, productivity and pricing power with a focus on value added in order to consider how to improve the stagnant profitability in Japan. When we evaluate companies in terms of value added, it is clear from the share of their value added in GDP that their value creation is contributing to Japan’s economic growth. In this paragraph, in order to consider how to simultaneously achieve profitability improvement and economic growth, we will examine challenges faced by Japan from the viewpoints of the determinant

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factors of profitability, the relationship between productivity growth and job reduction, and the relationship between the return on capital and human resource development.

(1) Low pricing power (A) International comparison of pricing power (value added deflator)

When nominal value added per employee is regarded as an indicator of profitability, a company’s profitability equals the product of real labor productivity multiplied by the value added deflator, as was mentioned in the previous paragraph (Figure Ⅱ-3-1-1-4). Therefore, in order to improve profitability, companies need not only to strive to increase productivity but also to enhance pricing power.

However, in reality, even though Japanese companies may have raised productivity, they have been unable to enhance pricing power.265 Indeed, according to a questionnaire survey conducted this year by the Ministry of Economy, Trade and Industry, more than half, 58.9%, of the respondent companies replied that they do not have pricing power, whereas only 24.2% replied that they have pricing power (Figure II-3-1-2-1).

Figure II-3-1-2-1 Japanese companies recognition of their pricing power

Source: Based on the data from a questionnaire survey conducted by Mitsubishi UFJ Research and Consulting Co., Ltd. (2017).

Figure II-3-1-2-2 (A) shows the breakdown of variable factors affecting the profitability (value

added per person) of the overall industries in Japan, the United States and Germany.266 In Japan, profitability has almost consistently been declining since the 1970s, and the overall industries have failed to enjoy the benefits of the rise in real labor productivity due to the decreasing growth rate of

265 Small and Medium Enterprise Agency (2014), p. 43. 266 An equation linking nominal value added, real value added (real labor productivity) and the value

added deflator expressed as the rates of change (growth rates) in terms of logarithm value was converted into a linear relationship. Therefore, the equation is: Growth rate of nominal value added = growth rate of real labor productivity + growth rate of the value added deflator.

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the value added deflator. In other words, productivity growth has not led to profitability improvement. In the United States, between the 1970s and 1990s, the growth rate of the value added deflator declined moderately compared with Japan’s case, but the rate temporarily rose in the first half of the 2000s before decreasing again in the latter half of the 2000s. In Germany, profitability has almost consistently been declining, as in Japan, but the growth rate of profitability has not fallen to such a low level as in Japan. Presumably, there are various factors behind these differences, including the trend in the inflation rate, increased competitive pressure in the market and downward price pressure due to the commoditization of products in each country. Regarding the difference between the United States and Japan in productivity (value added per employee = profitability), the difference between the pricing strategies in the two countries—Japanese companies have maintained competitiveness by lowering prices at the expense of the profit margin in response to the deflationary pressure since the 1990s—has been pointed out as a contributing factor by a research organization.267

267 Japan Productivity Center (2016), “2016 International Comparison of Labor Productivity”

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Figure II-3-1-2-2 (A) Breakdown of variable factors affecting the profitability (value added per employee) of the overall industries in Japan, the United States and Germany

Source: EUKLEMS 2013.

Figure II-3-1-2-2 (B) shows the breakdown of variable factors affecting the manufacturing industry’s profitability. In the United States, the whole manufacturing industry has maintained a relatively high growth rate of profitability. However, in Japan and Germany, the profitability growth rate of the whole manufacturing industry has almost consistently been declining since the 1970s. In particular, in Japan, the profitability growth rate of the manufacturing industry declined as the negative growth of the value added deflator more than offset the rise in the productivity growth rate. That is partly because the Japanese industry was affected significantly by the stagnancy of the domestic economy compared with the U.S. and German industries, but it is possible that Japanese companies sought to lower prices at the expense of the profit margin, as was mentioned above. In other words, they may have been unable to exercise pricing power.

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Figure II-3-1-2-2 (B) Breakdown of variable factors affecting the profitability (value added per employee) of the manufacturing industry in the United States, Japan and Germany

Notes: The figures in these graphs show average value of year-on-year growth rates by item during the predetermined period. Same as follows. Source: EUKLEMS 2013.

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Figure II-3-1-2-2 (C) shows the breakdown of variable factors affecting individual sectors of the manufacturing industry. On a sector-by-sector basis, chemicals, pharmaceuticals, and steel and metal products recorded a high growth rate of the value added deflator in the United States, indicating that U.S. companies’ profitability rose in these sectors. In Japan and Germany, the growth rate of the value added deflator was relatively low in these sectors. Even so, in Germany, profitability growth remained relatively stable as productivity continued to record positive growth. On the other hand, in Japan, both the growth of productivity and the value added deflator turned negative in the chemicals and pharmaceuticals sectors, while the volatility of productivity and value added deflator increased in the steel and metal products sector.

In all three countries, the electrical machinery and optical equipment sectors recorded a high productivity growth rate, while the growth rate of the value added deflator declined, indicating that price competitive pressure increased in the market.

Regarding general machinery, Japanese companies’ growth rates of productivity and the value added deflator declined steeply, leading to a negative profitability growth rate. This is presumed to be due in part to sluggish domestic capital investment. On the other hand, U.S. companies have maintained a high profitability growth rate in recent years as their growth rates of productivity and the value added deflator have risen steeply. German companies have maintained a steady profitability growth rate as their growth rate of value added deflator has stayed at a high level despite the downtrend in the profitability growth rate.

Regarding transportation machinery, although Japanese companies have maintained a relatively high productivity growth rate, their growth rate of the value added deflator has declined to a low level. Among the possible factors behind this are their inabilities to raise prices because of the presence of too many competitors relative to the size of the Japanese market and the decline in the inflation rate since the 1990s. On the other hand, German companies have maintained a relatively high labor productivity growth rate despite a decline in the growth rate of the value added deflator, indicating that they are supplying products over which they can exercise pricing power.

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Figure II-3-1-2-2 (C) Breakdown of variable factors affecting the profitability (value added per employee) of the manufacturing industry by sector in the United States, Japan and Germany

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480

481

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Figure II-3-1-2-2 (D) shows the breakdown of variable factors affecting the non-manufacturing industry’s profitability. In the United States, the non-manufacturing industry has maintained a relatively high growth rate of the value added deflator compared with in Japan and Germany. This suggests that the U.S. non-manufacturing industry has a higher level of profitability than its Japanese and German counterparts. In Germany, the growth rate of the value added deflator has been on a downtrend, but the decline has not been so steep as in Japan, nor has the change in the growth rate been so volatile as in Japan. Therefore, the growth of the value added deflator is presumed to be contributing to the profitability growth in Germany. There is the view that one factor behind the Japanese service industry’s relatively low growth rate of the value added deflator is Japanese service companies’ inability to set prices at a level commensurate with the quality level, although it is

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difficult to conduct objective international comparison because of differences in the required service level across countries. In other words, it has been pointed out that although Japanese companies have increased their real labor productivity by raising the service quality level, they tend to curb personnel cost and avoid passing a cost increase to their prices.268

Figure II-3-1-2-2 (D) Breakdown of variable factors affecting the profitability (value added per employee) of the non-manufacturing industry by sector in the United States, Japan and Germany

268 Yamada (2015) and Ministry of Economy, Trade and Industry (2014).

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485

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(B) Reasons for the weak pricing power (value added deflator) and the direction of enhancement As a result of the above analysis, it is clear that Japanese companies do not have strong pricing

power as their growth rates of the value added deflator is low compared with the growth rates of U.S. and German companies. In other words, even if Japanese companies have a high productivity growth rate, negative growth of the value added deflator may reduce the productivity growth rate. As for the reasons why Japanese companies’ growth rate of the value added deflator is low, namely why their pricing power is relatively weak, the prolonged deflation is considered to have had significant effects. However, it is also possible that Japanese companies are unable to exercise pricing power due to excessive competition. In this respect, the Japan Revitalization Strategy that was adopted upon a cabinet decision in June 2013 pointed out that Japanese companies were engaging in a war of attrition

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with each other and aimed to recover profitability by resolving excessive competition as one of its goals. In addition, Chairman and Chief Executive Officer Toshiyuki Shiga of Innovation Network Corporation of Japan pointed out that Japanese companies’ low return on equity is due to excessive competition.269

An expert on pricing pointed out that Japanese companies tend to hesitate to withdraw from the market and attach great importance to market share,270 suggesting the presence of correlation between the weak pricing power and excessive competition.

According to a questionnaire survey conducted by the Ministry of Economy, Trade and Industry, while many companies are placing emphasis on the absolute level of sales and profit, rather than on the profit margin, the items on which companies will place emphasis in the future are the profit margin and capital efficiency (Figure II-3-1-2-3).

Figure II-3-1-2-3 Changes in management goals that companies place emphasis

Source: Based on the data from a questionnaire survey conducted by Mitsubishi UFJ Research and Consulting Co., Ltd. (2017).

269 An interview article dated August 28, 2015, Nihon Keizai Shimbun. 270 Simon (2016).

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According to a survey conducted by the Japan Machinery Center for Trade and Investment, Japanese companies had the largest global share in two sectors (office machinery and machine tools) compared with eight sectors for North American companies, three sectors for European companies, and six sectors for Asian companies, indicating that Japanese companies’ share in the global market is not necessarily large (Table Ⅱ-3-1-2-4). This suggests the possibility that Japanese companies’ products are involved in price competition due to a lack of differentiation from products made in other countries, or that Japanese companies are unable to secure profits because of their inability to secure market share due to a lack of price competitiveness.

Table II-3-1-2-4 FY 2015 Global share in sales by type of companies in regions

Japanese companies Share

North American companies

Share European companies Share Asian

companies Share

1 Office machinery 56.8% Medical

equipment 58.5% Automobile parts 38.6% Shipbuilding 66.2%

2 Machine tools 42.4% Aerospace 57.5% Aerospace 35.5% Information and communication equipment

53.8%

3 Semiconductor-manufacturing apparatus

33.0% Computers 53.2% Automobiles 34.9% Railways and transportation 45.8%

4 Home appliances 32.7%

Semiconductor-manufacturing apparatus

50.1% Iron and steel 32.8% Electronic parts 42.4%

5 Services software 30.8%

Construction and agricultural machinery

46.4% Machine tools 31.8% Home

appliances 37.7%

6 Heavy electric and industrial machinery

29.4% Office machinery 43.1% Chemicals 30.9% Iron and steel 36.7%

7 Automobiles 26.7% Plant engineering 41.8% Medical

equipment 29.5% Computers 34.7%

8 Automobile parts 24.3%

Information and communication equipment

37.7% Plant engineering 29.3% Chemicals 28.4%

9 Iron and steel 21.9% Services software 37.0% Services

software 28.7% Automobiles 22.0%

10 Construction and agricultural machinery

19.1% Heavy electric and industrial machinery

36.7% Construction and agricultural machinery

25.9% Machine tools 19.2%

Source: Based on data from FY2016 Nichi-Bei-Ou-Asia Seizogyo no Kokusai Kyosoryoku no Genjo, Japan Machinery Center for Trade and Investment (2017).

In this respect, according to a study analyzing Japan and Germany in terms of the export structure,

Germany’s value of exports is higher than Japan’s with regard to not only a wide range of

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low-value-added volume-zone products (foods and processed foods, oil products, lumber, miscellaneous products, etc.) but also high-value-added products (automobiles, plastics processing machinery, machine tools, power generators, etc.). In addition, Germany’s value of exports of products not competing with Japanese products in these sectors is large. Moreover, it has been pointed out that while Japan’s export growth was led by a volume increase, Germany raised dollar-denominated export prices, an indication of its emphasis on export prices.271 Therefore, there are concerns that Japanese companies have failed to increase capital intensity and efficiency regarding volume-zone products and to achieve differentiation regarding high-value-added products, resulting in failure to capture global market share with respect to both types of products. It is necessary to analyze the factors behind this situation.

The low growth rate of the value added deflator means the possibility that companies are unable to exercise pricing power, which in turn indicates the risk that they will be willy-nilly involved in price competition. In this respect, according to a report concerning an international comparison of the results of surveys that asked companies in various countries whether they see themselves as being involved in price competition, the proportion of companies replying in the affirmative was largest in Japan and far larger than in Germany and the United States (Figure Ⅱ-3-1-2-5).

Figure II-3-1-2-5 Share of companies that see themselves as being involved in price competition

Source: "Steigender Preisdruck, sinkende Gewinne – und was Schweizer Unternehmen dagegen tun", Simon-Kucher & Partners.http://gfm.ch/wp-content/uploads/2016/07/globalpricingstudy2014.pdf

The survey results indicate that in terms of companies’ perception of their own situation, the

above-mentioned analysis results—that Japanese companies are being involved in a war of attrition due to their weak pricing power and excessive competition—are valid. In response to hearings with companies conducted by the Ministry of Economy, Trade and Industry, some companies expressed concerns that Japan is failing to exercise pricing leadership in many business sectors both domestically

271 Ohki (2015).

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and internationally. Among the major factors cited as a trigger for price competition are excess capacity,

commoditization, low market growth and the industrial structure (Figure II-3-1-2-6). There is an analysis showing, based on past cases of U.S. and European companies, that continuing such competition for a long period of time is undesirable because if companies go too far in price-cutting competition to wear down competitors, their profitability will be undermined.272

Figure II-3-1-2-6 Causes of price competition

Source: Simon (2016).

272 Raju-Zhang (2010).

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Figure II-3-1-2-7 Factors considered necessary to acquire pricing power

Source: Based on the data from a questionnaire survey conducted by Mitsubishi UFJ Research and Consulting Co., Ltd. (2017).

For Japanese companies to acquire pricing power in the global market, it is necessary to create

new markets and expand business in niche markets by realizing innovations through technological superiority and by developing products differentiated from generic products (Figure II-3-1-2-7). In order to achieve successful business results by realizing innovations through technological superiority, developing products for niche markets and creating new markets, Japanese companies need to discover potential markets and identify the possibility of a new market emerging, and the technologies and products necessary for the potential and new markets, in addition to enhancing their research and development.

Above, it became clear that the growth rate of the value added deflator for Japanese companies is lower than the rates for U.S. and German companies and that this is having a negative impact on their profitability. However, it should be kept in mind that in practice, business decisions on pricing are made in consideration of various factors, including the economic and market conditions, competitors’ activities and the position of products.

In addition, there is an analysis273 showing that Japanese companies’ profitability is not so low if the risk-return balance is taken into consideration because they have a higher degree of stability than U.S. and European companies in exchange for having a low level of profitability. Therefore, it is necessary to focus attention on pricing power once again while taking account of the balance between

273 Nakano (2016).

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profitability and risk.

(2) Dilemma of co-existence of productivity growth and employment shrinkage Here, we will discuss productivity, which has already been a subject of discussion as a factor

contributing to the improvement of companies’ profitability, with a particular focus on its relationship with employment. We will analyze the Baumol effect,274 which refers to a dilemma where productivity growth and employment shrinkage co-exist, and examine the characteristics of companies belonging to industries in which productivity growth and employment expansion have been achieved at the same time (in which the Baumol effect has not appeared) based on statistical analysis.

(A) International comparison concerning the Baumol effect

Generally, productivity growth means a rise in the ratio of output to intermediate inputs. If productivity growth is accompanied by market growth (demand expansion), it helps to secure and increase employment. However, unless demand expands, productivity growth may induce reduction of workers. To explain the Baumol effect based on arithmetic, let us consider the following case. If a worker who previously produced five machines per day starts to produce 10 machines per day, that means a doubling of productivity. If there are 10 workers each of whom previously produced five machines per day and if each starts to produce 10 machines per day, the production volume per day increases from 50 machines to 100 machines. In this case, if the productivity growth is accompanied by market growth (demand expansion), it may help to secure and increase employment. However, if the production volume (supply) increases to 100 machines per day but if demand remains unchanged at 50 machines, the productivity growth may induce halving of the number of workers.

In other words, in industries with a high productivity growth rate, labor demand decreases due to such factors as capital intensification, while product prices decline due to productivity growth. As a result, unless the income elasticity concerning products manufactured by those industries is extremely high, the value of their production gradually declines and their scale (employment) also shrinks. On the other hand, industries with a relatively low productivity growth rate gradually expand their scale by absorbing a labor force that has become redundant in industries with a high productivity growth rate because they are relatively labor-intensive. In this way, industries with a low productivity growth rate continue to expand their scale (employment), resulting in a slowdown of the overall economic growth rate.

Let us take a broad look at the relationship between the labor productivity growth rate and the employee number growth rate by industry in Japan, the United States and Germany. Figures II-3-1-2-8 to II-3-1-2-10 show the distribution of industries in terms of the relationship between the annual average labor productivity growth rate between 2010 and 2012, represented by the horizontal axis, and the average employee number growth rate over the same period, represented by the vertical axis, in the

274 The term “Baumol effect” has its origin in a phenomenon called “Baumol’s cost disease,” which was identified by U.S. economists William Baumol and William Bowen (Baumol-Bowen (1965)). Baumol’s cost disease refers primarily to the tendency of salaries for jobs without productivity growth to rise in tandem with a rise in salaries for jobs with growing productivity.

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three countries.275 Figure II-3-1-2-8 shows the distribution of Japanese industries, including 11 manufacturing

industries (indicated in green) and 19 non-manufacturing industries (including agriculture, forestry and fisheries, mining, and administrative services) (indicated in red). From the figure, we can observe a tendency that the higher an industry’s productivity growth rate is, the lower its employee number growth rate is. This indicates that the Baumol effect is arising in Japan. In this figure, most industries, including both manufacturing and non-manufacturing ones, are located in the fourth quadrant, which means that their productivity is growing but their number of employees is decreasing. The industries located in the fourth quadrant include eight non-manufacturing industries—agriculture, forestry and fisheries; mining; construction; professional, scientific and technical services; transportation and warehousing; retail trade; IT and information services; eating and drinking services, and accommodation—and seven manufacturing industries—electrical and optical equipment; rubber and plastic products; nonferrous metal products; textiles; apparel; leather products; chemicals and chemical products; food, beverage and tobacco products.

Figure II-3-1-2-8 Growth rate of labor productivity and number of employees by industry in Japan

275 In principle, total factor productivity (TFP), rather than labor productivity, should be used as a productivity indicator, and the labor input index, which takes into consideration working hours, should be used instead of the number of employees as an indicator of industry scale. However, concerning Germany, data on those indicators are not available for the period since 2010 due to data constraints. Therefore, data on labor productivity and the number of employees were used with respect to all three countries.

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Source: Basic Survey of Japanese Business Structure and Activities. Industries whose productivity and employment are growing at the same time are located in the first

quadrant. The industries located there include two manufacturing industries—machinery and equipment and transportation machinery—and three non-manufacturing industries—real estate, telecommunications and wholesale trade. This means that these five industries are driving Japan’s economic growth. In the cases of the United States and Germany, which will be discussed later, there is a great diversity of industries whose productivity and employment are growing at the same time compared with the case of Japan. Therefore, we may presume that even if some particular industries’ performance deteriorates in the United States or Germany, the impact on the entire economy will be relatively small. If Japan is to achieve sustainable economic growth, it will be necessary to enable a more diverse range of industries to increase productivity and employment at the same time.

Steel and metal products are located in the second quadrant (negative labor productivity growth but positive employee number growth), but other industries located there are those related to public interests and social welfare, such as electricity, gas and water, health and social welfare, and education.

Meanwhile, in the United States, the overall picture—a rightward decline in the trend line representing the relationship between labor productivity growth and employee number growth—was the same as in Japan during that period, but there are far more industries located in the first quadrant than in Japan (Figure II-3-1-2-9). In other words, although there is a tendency that the higher an industry’s productivity growth rate is, the lower its employee number growth rate is, as is the case in Japan, there are far more industries in the United States whose labor productivity and employee numbers are growing at the same time, although a strict comparison is difficult to make given the differences between the two countries in terms of industry classification.

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Figure II-3-1-2-9 Growth rate of labor productivity and number of employees by industry in the United States

Source: U.S. Multifactor Productivity, Division of Industry Productivity Studies.

Of the 21 manufacturing industries (indicated in green), six—steel, general machinery, transportation equipment, metal products, plastics and rubber products, and foods—are located in the first quadrant, as are seven of the 13 non-manufacturing industries (indicated in red)—warehousing, truck transportation, food services and accommodation, air transportation, wholesale trade, retail trade, and healthcare. On the other hand, a total of 13 industries, including both manufacturing and non-manufacturing ones, are located in the fourth quadrant, which represents the combination of growing productivity and shrinking employment. The industries located there include computers and electronic products, nonferrous metals, wood products, furniture, apparel, and textile products.

In Germany, the trend line representing the relationship between labor productivity growth and employee number growth are declining rightward, as is the case in Japan and the United States, but the number of industries located in the first quadrant, namely industries whose productivity and employee number are growing at the same time, is by far the largest (Figure II-3-1-2-10). Although a strict comparison is difficult to make given the differences in industry classification, a total of 18 industries are located in the first quadrant. Those industries comprise 12 of the manufacturing industries (indicated in green), including automobiles and computers, electronic and optical equipment, and steel products, and six of the non-manufacturing industries (indicated in red), including programming, information services, video and programs, music production, and professional, scientific and technical services.

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In contrast, only seven industries are located in the fourth quadrant, which represents the combination of productivity growth and employment shrinkage, including mining, telecommunications, electricity, gas and heating, apparel, and textiles. No industry is located in the third quadrant, which represents the combination of productivity decline and employment shrinkage. Figure II-3-1-2-10 Growth rate of labor productivity and number of employees by industry in Germany

Source: EuroStat.

(B) Factors essential to the co-existence of productivity improvement and employment growth What characteristics can we observe with respect to industries and companies which have curbed

the Baumol effect and companies which have not through a comparison of these two groups? We will identify the factors essential to the co-existence of productivity improvement and employment growth by conducting analysis concerning companies which have simultaneously achieved both (the Baumol effect-curbing companies).

As is clear from the changes in productivity and employment (Figure II-3-1-2-8) in (A) above, fewer industries have curbed the Baumol effect in Japan than in the United States and Germany. As if to corroborate this fact, a questionnaire survey with Japanese global companies conducted by the Ministry of Economy, Trade and Industry shows a tendency that despite growth in sales and profits achieved by focusing efforts on enhancing research and development and brand superiority, they tend

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to be unable to link the efforts to increases in jobs and wages (Figure II-3-1-2-11). Although companies which are unable to do so are failing to curb the Baumol effect, there are also Japanese industries which are curbing the Baumol effect although their number is small. Companies belonging to those industries may be called “Baumol effect-curbing companies.” Below, we will conduct quantitative analysis concerning Baumol effect-curbing companies based on a panel probit model276 using raw data obtained through the Ministry of Economy, Trade and Industry’s Basic Survey of Japanese Business Structure and Activities (hereinafter referred to as the “Business Survey”).

Figure II-3-1-2-11 Impact of corporate activities to improve productivity on sales and employment etc.

Notes: Efforts that companies place emphasis on include development and introduction of new products, improvement of brand superiority, enhancement of post-sale services, and introduction of new manufacturing processes. Source: Based on the data from a questionnaire survey conducted by Mitsubishi UFJ Research and Consulting Co., Ltd. (2017).

The model’s explained variable is a condition variable (“1” or “0”) determined by the combination of the productivity growth rate277 and the employee number growth rate of each company. As there are 276 Kitamura (2005), p. 112. 277 Labor productivity as referred to in this estimation is real labor productivity. However, as the value of

the variable is represented by either of two values (1 or 0) depending on whether labor productivity or employee numbers grow or decline, it makes no fundamental difference whether the labor productivity is nominal or real. However, nominal labor productivity is used for judging the change in consideration of the absence of the deflator by industry and the impracticality of universally applying the deflator as

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four patterns278 of combination of the productivity growth rate and the employee number growth rate, we used four estimation models in which the value of the condition variable was assigned in accordance with each pattern.

The panel probit model used in this analysis is intended to use some kind of variable to explain a qualitative dependent variable representing a certain condition. In this estimation, the qualitative dependent variable is a condition variable (a two-value variable which takes the value “1” or “0”) determined by the combination of the productivity growth rate279 and the employee number growth rate. There are four patterns280 of combination of changes (growth or decline) in productivity and employee number. Therefore, the estimation was made in order to identify the corporate attributes and characteristics important for simultaneously achieving productivity growth and employee number growth by establishing four estimation formulas (models) in which the value of the variable was assigned in accordance with each pattern.

Concerning the qualitative dependent variable (explained variable), the value “1” was assigned to companies which simultaneously achieved productivity growth and employee number growth and the value “0” was assigned to other companies under the productivity growth and employee number growth model (Model 1). This model may be called the Baumol effect-curbing company model. Under the productivity decline and employee number growth model (Model 2), the value “1” was assigned to companies whose productivity is declining but employee numbers are growing and the value “0” was assigned to other companies. Under the productivity decline and employee umber decline model (Model 3), the value “1” was assigned to companies whose productivity and employee number are declining and the value “0” was assigned to other companies. Under the productivity growth and employee number decline model (Model 4), the value “1” was assigned to companies whose productivity is growing but employee numbers are declining and the value “0” was assigned to other companies. This model may be called the “Baumol effect-arising model.” The number of each model was allocated in accordance with the number of the quadrant where it is located in Figures II-3-1-2-8 to II-3-1-2-10.

Market share, in-house research and development (R&D) expenditure per employee, outsourced R&D expenditure per employee, the value of intangible fixed assets or software assets per employee, advertising expenditure per employee, and the value of direct exports per employee were adopted as explanatory variables for all of the four models. These explanatory variables were selected for their strong correlation with productivity and employment from among the items that can be selected from

price information concerning individual companies.

278 There was no need to include “no change” in the combination of patterns because change occurred at all companies. As a result, the number of patterns was limited to four.

279 Labor productivity as referred to in this estimation is real labor productivity. However, as the value of the variable is represented by either of two values (1 or 0) depending on whether labor productivity or employee numbers grow or decline, it makes no fundamental difference whether the labor productivity is nominal or real. However, nominal labor productivity is used for judging the change in consideration of the absence of deflator by industry and the impracticality of universally applying the deflator as price information concerning individual companies.

280 There was no need to include “no change” in the combination of patterns because change occurred at all companies. As a result, the number of patterns was limited to four.

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the raw data obtained through the Business Survey. A company’s market share represents the proportion of its sales in overall sales by business sector.

As this is a variable related to the strength of a company’s influence in the market, it is considered to have some effects on productivity and employment. Therefore, it was adopted as an explanatory variable.

In-house R&D expenditure per employee is expenditure on internally-implemented R&D, while outsourced R&D expenditure per employee is expenditure on externally-implemented R&D. Although R&D investment is presumed to have positive effects on productivity, its effects on employment are not clear. Here, these items were selected as explanatory variables on the assumption that expenditure on internally-implemented R&D has positive effects on employment.

The value of intangible fixed assets or software assets per employee has been confirmed to have effects on the return on capital,281 so it was also adopted as an explanatory variable on the assumption that it has effects on productivity and employment. Because of a change in the survey items of the Business Survey, the value of intangible assets per employee was used for the period from 2003 to 2014, while the value of software assets per employee was used for the period from 2006 to 2014. In the estimation, the estimation period was divided and either of these two items was used as an explanatory variable in each divided period.

Expenditure on advertising per employee is used as a proxy variable for brand superiority in many cases and is considered to have positive effects on corporate profits. Therefore, it is also expected to have effects on productivity and employment through corporate profits.

Finally, the value of direct exports per employee implicitly indicates the scale of production because the target markets include foreign markets in addition to the domestic market. Therefore, it is presumed to have effects on productivity through the economy of scale and on employment through the scale of production.

Table II-3-1-2-12 shows the results of the estimation of the above-mentioned qualitative dependent variables and explanatory variables that was made through the panel probit model based on the panel data selected from the Business Survey and processed.

According to the estimation results concerning the Baumol effect-curbing model (Model 1), the explanatory variables for which statistically significant results were obtained were market share, in-house R&D expenditure per employee, the value of software assets per employee, and the value of direct exports per employee. In the estimation for the period from 2003 to 2014, the obtained figures were 0.485 for market share, 0.0053 for own expenditure on per employee, 0.0008 for the value of software assets per employee and 0.0002 for the value of direct exports per employee. If an intuitive explanation is to be added regarding the estimation for the period from 2006 to 2014, when statistically significant results were obtained with respect to many explanatory variables, for example, those results mean that a rise of 1% in a company’s market share increases the probability of both labor productivity and employee number of the company growing simultaneously by 51.2%.

Under Model 3 (productivity decline and employee number decline), which made estimation

281 Miyagawa, et al. (2016).

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regarding companies which are in a contrary position to that of Baumol effect-curbing companies, the probability of both labor productivity and employee number decreasing rises among companies with lower figures for the value of intangible fixed assets per employee, the value of software assets per employee, advertising expenditure per employee and the value of direct exports.

According to other estimation results (Models 2 and 4), statistically significant results were not obtained regarding the explanatory variables other than market share under the Baumol effect-arising model (Model 4). In the case of companies for which only either labor productivity or employee number is growing, the correlation between the explanatory variables representing corporate attributes in this analysis and condition variables concerning productivity and employees is weak.

There are some points that should be kept in mind with respect to our estimation. The estimation results concern existing companies for which the growth rates of labor productivity and employee number compared with the previous year could be calculated. The impact of market entry by newly established companies or exit by failed and closed companies on the productivity growth rate and the number of employees at the industry level could not be measured. For example, if a company with low productivity which existed in the previous business term exits from an industry in the current term, there will be no impact on the tabulation results at the company level because the company is excluded from the tabulation for both the previous and current terms. However, regarding the tabulation at the industrial level, if there is no change in the productivity of companies other than the one that exited from the industry, the industry’s average productivity growth rate in the current year will decline. Conversely, if a company with high productivity which did not exist in the previous term enters an industry, there will be no impact on the tabulation results at the company level because the company is excluded from the tabulation for both the previous and current terms. However, regarding the tabulation at the industry level, if there is no change in the productivity of companies other than the one that entered the industry, the industry’s average productivity growth rate in the current term will rise.

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Table II-3-1-2-12 Changes in corporate labor productivity and number of employees as well as corporate attributes

Explained variables

Model 1 Productivity growth + growth in number of

employees (Baumol effect-curbing

model)

Model 2 Productivity

decline + growth in number of employee

Model 3 Productivity decline + decline in number of

employees

Model 4 Productivity growth + decline in number

of employees (Baumol

effect-arising model) Estimation

period 2003-2014 2006-2014 2003-2014 2003-2014 2006-2014 2003-2014

Market share 0.4850*** 0.5120*** 0.0410 -0.0043 -0.0570 0.4800***

In-house R&D

expenditure per employee

0.0053*** 0.0050*** 0.0020 0.0013 0.0015 -0.0001

Outsourcing R&D

expenditure per employee

-0.0007 -0.0008 -0.0013 -0.0022 -0.0013 -0.0029

Intangible fixed assets

per employee -0.0001 -0.0003 -0.0010*** -0.0004

Software assets per employee

0.0008* -0.0031***

Advertising expenditure

per employee 0.0001 0.0005 -0.0000 -0.0015** -0.0017** 0.0000

Direct exports per employee

0.0002** 0.0002** -0.0000 -0.0001*** -0.0001*** 0.0000

Estimation method

Panel probit model

Notes: Coefficients of this table show growth rates of a probability that when the predetermined explanatory variable changes by 1 unit, the value of the explained variable becomes 1 on the premise that other conditions are fixed. For example, looking at the cases for Model 1, if the market share of a company rises by 1%, the probability that both the labor productivity and the number of employees increases grows by 48.5%.

Source: Basic Survey of Japanese Business Structure and Activities (METI).

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If the shares of the four models used in the above estimation by industry (Attached Table 1) are calculated based on data concerning companies corresponding to the four models, the results are different from the distribution shown in Figure II-3-1-2-8. For example, in Figure II-3-1-2-8, the transportation machinery industry is located in the position of the Baumol effect-curbing industry (first quadrant). However, according to the classification based on the above estimation data, companies for which both productivity and employment are growing (Baumol effect-curbing companies) account for only 18.4% of the companies that belong to the transportation machinery industry.

Meanwhile, the share of companies for which productivity is growing but employment is decreasing (Baumol effect-arising companies) was 23.7%, the share of companies for which both productivity and employment are declining was 16.2% and the share of companies for which productivity is declining but employment is growing was 24.2%. In other words, even if a certain industry is located in the position of the Baumol effect-curbing industry, that does not necessarily mean that a majority of companies in the industry are Baumol effect-curbing companies.

The top industries in terms of the share of Baumol effect-curbing companies are: complex services with a share of 33.3%, healthcare and welfare services with 31.0%, steel with 26.7%, goods leasing with 26.7% and general machinery with 26.0%. The top companies in terms of the share of Baumol effect-arising companies are: lodging with a share of 32.3%, electricity, gas, heat supply and water with 32.28%, nonferrous metals with 29.4%, transportation and postal services with 26.9% and textile manufacturing with 26.5%.

3．Creation of an innovation environment conducive to improve profitability (1) Promoting realization of innovations through improvement in human resource investment

As shown by the analyses and previous studies so far cited, one factor behind the difficulty of increasing profitability, productivity, pricing power and jobs at the industry and company levels in Japan is that Japanese industries and companies may be in a situation where they cannot realize innovations that lead to the supply of new products to the market and where they have to secure profits through the sale of products with small profit margins due to intense price competition. Below, we will analyze what is necessary in order to realize innovations that lead to employment growth.

In order to increase profitability, productivity and pricing power, further innovations are essential. According the classification of innovations defined by the Oslo Manual,282 which is published by the OECD, the effects of various innovations on profitability may be explained as described in Figure II-3-1-3-1.

282 OECD (2005).

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Figure II-3-1-3-1 Relationships between profitability/productivity/pricing power and classification of innovations

*The Oslo Manual is a collection of guidelines to collect and interpret innovation data. The third edition, the latest one, was jointly compiled by the OECD and the statistical office of the European Union (Eurostat).

According to a questionnaire survey conducted by the Ministry of Economy, Trade and Industry,

Japanese companies cited the development and introduction of innovative products and services as the most important activity, which indicates that they recognize innovations as important for profitability, productivity and pricing power (Figure II-3-1-3-2). However, according to the Fourth Japanese National Innovation Survey conducted by the National Institute of Science and Technology Policy of the Ministry of Education, Culture, Sports, Science and Technology, figures concerning the status of realization of innovations are lower for Japan than for other advanced countries with respect to all types of innovations283 (Figure II-3-1-3-3).

As problems faced by Japan in relation to innovation, the Industrial Structure Council’s R&D and Innovation Subcommittee cited (A) slow response to changes in the environment related to acquisition of customer value, (B) closedness in R&D investment, (C) companies’ short-termism, (D) low mobility of human and financial resources, and (E) isolation from the global network. In recent years, the product life cycle has been becoming shorter and competition between companies has been

283 According to the National Institute of Science and Technology Policy of the Ministry of Education,

Culture, Sports, Science and Technology (2016), there are limits to international comparison because survey methods are not completely unified across countries, which means the presence of response idiosyncrasy specific to individual countries.

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intensifying284 against the backdrop of the globalization, diversification of the market needs and the rise of emerging countries. Therefore, for companies to accelerate innovation, it is necessary to promote open innovation activity conducted through appropriate cooperation with external organizations.

Figure II-3-1-3-2 Corporate efforts that companies place emphasis on

Source: Based on the data from a questionnaire survey conducted by Mitsubishi UFJ Research and Consulting Co., Ltd. (2017).

In the future, it will be necessary to train and hire workers with advanced skills capable of

284 Subcommittee on Research and Development and Innovation, Committee on Industrial Science and

Technology Policy, Industrial Structure Council, Ministry of Economy, Trade and Industry (2016)

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contributing to product innovation and to shift to technology development based on open innovation activities which do not rely only on internal technologies but use a network of cooperation with a broad range of players, including other companies, universities and research institutions.

Amid the growth in employment mobility and the increase in non-regular employees, the incentive for companies to provide in-house training has weakened, and it has been pointed out that a gap has arisen between personal and social interests with respect to training of workers to acquire advanced skills.285 Indeed, the value of investments in human resource development by Japanese companies and the share of such investments in their overall investments in intangible assets are low by the international standard (Figures II-3-1-3-4 and II-3-1-3-5).

Figure II-3-1-3-3 Ratio of Companies answer that they realized their innovations

Source: Based on the data from the MEXT National Institute of Science and Technology Policy (2016) and OECD (2017).

285 September 21, 2016, morning edition, Page 26, Nihon Keizai Shimbun.

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Figure II-3-1-3-4 International comparison of human resource investment and R&D, etc. (2002→2010)

Source: INTAN-Invest and the JIP. Notes: The term “R&D, etc.” includes other new products development, designing and research, e.g., R&D in the fields of science and engineering, resource search rights, and copyrights/licensing.

Moreover, the value of investments in human resource development286 by Japanese companies

declined after peaking in 1991. After temporarily increasing in the late 1990s, it has been steeply declining since 2000 (Figure II-3-1-3-6). In addition, it is possible that the incentive for companies to provide in-house education has weakened because non-regular employees started to perform routine jobs.

According to a comparison between Japanese and foreign global companies in terms of the tendency concerning human resource investment based on an international questionnaire survey, the proportion of companies which replied that they plan to “increase” or “significantly increase” human resource investment over the next one year in Japan was 63%, the lowest rate among the countries surveyed (Figure II-3-1-3-7).

We will examine how Japan’s economic growth will be affected if investments in human resource development continue to decline. In Japan, the capital coefficient (capital stock divided by real GDP), which is an indicator of capital accumulation, has risen little since 2000 because of sluggish capital

286 The value of investments in human resource development used here is the one estimated in Table II-2-7.

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input. It has been pointed out that one cause of the sluggishness of capital accumulation is a trend decline

in Japan’s return on capital (operating profit divided by capital stock) since the bursting of the economic bubble287 (Figure II-3-1-3-8).

Figure II-3-1-3-5 International comparison of human resource investment

Notes: Intangible assets and informatization assets consist of software and databases. Innovative assets

consist of other new products development, designing and research, e.g., R&D in the fields of science and

engineering, resource search rights, and copyrights/licensing. Economic competitiveness consists of brand

assets, human resource development by companies, and organizational change. In this figure, human

287 See Miyagawa, et al. (2016), for example. Concerning the relationship between the return on capital

and capital accumulation see Tanaka and Miyagawa (2011).

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resources are shown by breakdown in the graph.288

Source: INTAN-Invest and the JIP.289

Regarding the factors contributing to the decline in the return on capital, Miyagawa, et al. (2016),

developed a factor price frontier model using the marginal return on capital as the explained variable and real wages, IT investment, R&D investment, human resource investment290 as explanatory variables and made estimation based on this model.

The estimation results show that the coefficient concerning investment in human resource development is positive and statistically significant. The coefficient is also relatively high at 0.361 under Model a and at 0.205 under Model b. The results confirm that companies’ investments in human resource development play an important role in increasing the return on capital and, by extension, capital accumulation (capital investment)291 (Table II-3-1-3-9). In short, if Japanese companies’ investments in human resource development remain at a low level, it may become more difficult than now to raise the return on capital and increase capital investments.

Figure II-3-1-3-6 Changes in value of investments in human resource development by Japanese companies

Source: Miyagawa,T., M.Takizawa, K.Tonogi “Declining Rate of Return on Capital and the Role of Intangibles in Japan”, RIETI Discussion Papers Series 16-E-051, March 2016.

288 Regarding human resource investments in Japan, the portion of the JIP database that was estimated by Professor Miyagawa of Gakushuin University was used. 289 Miyagawa, Asaba and Hosono, eds. (2016). 290 The value of investments in human resource development used here is the value of expenditure on

off-the-job training by industry estimated on the basis of the “General Survey on Working Conditions” (Ministry of Health, Labour and Welfare) and other data. Regarding the details of the estimation of the value of IT investments, the value of R&D investments and the value of investments in human resource development, see Chun, et al. (2015).

291 Miyagawa, et al. (2016) also made an estimation using the average return on capital, but the results were not significantly different.

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Figure II-3-1-3-7 International comparison of investment in human resource development

Source: Global CEO Chosa 2014 , Accenture Japan Ltd. Notes: The figure shows shares of 1,000 global companies that responded to the question asking, “Do you have a plan to increase the investment amount in human resources of your own company?”

Figure II-3-1-3-8 Decline of return on capital and stagnation of capital accumulation (capital coefficient)

Source: Fukao (2016).

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Table II-3-1-3-9 Estimation results of variable factors of capitalization rate Market economy Explained variable: marginal efficiency of capital

Model a b

Coefficient Standard error Coefficient Standard

error Wage rate 0.491 0.052 *** -0.664 0.058 *** IT investment value / IT stock (natural logarithm) 0.071 0.103 0.147 0.083 *

R&D investment amount / R&D capital stock (natural logarithm) -0.181 0.051 *** -0.176 0.041 ***

Human resource investment amount / Human resource capital stock (natural logarithm)

0.361 0.116 *** 0.205 0.094 **

Value added (natural logarithm) 1.412 0.048 *** Constant term -2.954 0.206 *** -21.851 0.663 *** Fixed-effects model Fixed-effects model Number of samples 1,773 1,762 Number of industries 70 70 Prob > F 0 0 R-sq: within 0.3174 0.5534 between 0.2334 0.0077 overall 0.2323 0.0525

Notes: 1. ***: significant level of 1%; ** significant level of 5%; * significant level of 10% 2. All variables are deflated at the year 2000 price index. Source: Based on the data from Miyazawa, T., M. Takizawa, and K. Tonogi, “Declining Rate of Return on Capital and the Role of Intangibles in Japan,” RIETI Discussion Paper Series 16-E-051 (March 2016).

(2) Summary While the improvement in Japanese global companies’ profitability has continued to be pointed out,

we focused attention on value added and showed analysis results using productivity (real value added) and pricing power (value added deflator). From questionnaires and other surveys, it became clear that Japanese global companies have problems with their pricing power despite their high level of productivity.

As the present challenges, we pointed out the weakness of the pricing power, the need to deal with the simultaneous occurrence of productivity improvement and employment shrinkage and sluggish human resource investment. First, we showed that the decline in the value added deflator (pricing

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power) is a factor depressing profitability based on the review of concepts and data. This indicates the importance of enhancing pricing power, in addition to improving productivity, for improving profitability. We also made clear, from a panel probit model estimation based on the Basic Survey of Japanese Business Structure and Activities, that companies for which the Baumol effect has not arisen, namely companies which have simultaneously achieved productivity and employment growth, are characterized by high levels of market share and in-house expenditure on R&D, the value of software assets and the value of direct exports per employee. We focused attention on employment growth as well as productivity growth not only because personnel cost (employment) accounts for a large portion of companies’ value added but also because employment growth at the company level leads to benefits for the whole economy, such as securing jobs and lowering the unemployment rate. Moreover, the estimation concerning variable factors made clear that investments in human resource development, which show a downtrend, have positive effects on the change in the return on capital at a time when the return remains sluggish. The estimation results suggest that reversing the decline in investments in human resource development into growth may help to improve profitability.

To sum up the analysis results so far explained, Japanese companies need to increase profitability by paying attention not only to productivity growth but also to the enhancement of pricing power. Realizing innovations by expanding investments in human resources is an effective way of improving profitability. However, not only is the level of investments in human resource development in Japan remaining lower than the levels in the United States and Germany, but also the value of such investments in Japan has been declining in recent years. Therefore, currently, Japan is lagging behind other countries in realizing innovations, and in the future, it may be unable to improve profitability and may fail to establish business leadership in the global market.

In order to improve profitability, increase employment and contribute to economic growth, it is important for Japanese companies to realize innovations by enhancing human capital investment and to expand beyond the domestic market into the global market with differentiated products and services over which they have such strong pricing power that they can avoid being drawn into excessive competition. In order to connect the improvement in corporate profitability to economic growth, it is necessary to promote exports and investments in R&D programs, which are recognized as effective in improving productivity and increasing employment by curbing the Baumol effect.