International Competitiveness

What is international competitiveness?

International competitiveness is the ability of firms inList an the economy main factors to match affecting the international and quality ofcompetitiveness other nation’s output. . International competitiveness is largely determined the relative price and quality of domestic and services relative to foreignIdentify products. factors which influence  Relative costs of productionthe relative price of and .  productivity eg between different countries  ExchangeRelative rates of labour. A rise in productivity reduces labour costs and so improves competitiveness impact on the price of imports and exports. A depreciation lowers the How canprice quality of exporfactorsts in affect terms competitiveness?of foreign and increase the price of imports Price is just one factor affecting demand. The relative design, appearance and functionality of a productWhat isaffect a competitivenesscompetitiveness. pyramid?

The competitiveness pyramid is a model that shows sustainable growth as an outcome of competitiveness. policy inputs essential conditionsAt the base of the pyramid are that impact on the for competitiveness, hence sustainable growth.

State action to make it easiereventually to do business (deregulation) or improve education and training provides the conditions necessary for sustainable growth. Note the link between this model, developed by Ireland’s Competitiveness Council, and the TradeTreasury’s andproductivity integration drivers. Supply side policies require state funding and are long term Distinguish between open and closed economies.

A closed economy is self-sufficient and thereDefine is .no intentional trade. An open economy engages in . Why do regionsTrade and is countries the exchange trade? of . Different countries trade because they have different factor endowments eg climate, skilled labour force, and natural resources vary between nations. ThisExplain means specialisation some countries are better placed in the production of certain products than others. . Specialisation is when individuals, firms, regions or countries concentrateWhat are thein benefits the production of specialisation? of particular good and services.  Concentrating on a particular product or task means:   Increased total output so that more wants can be satisfied A greater variety of products ie more choice An increase the size of the offering opportunities for

24 International Competitiveness | What are the risks of specialisation?

Specialisation makes individuals, firms, regions or countriesExplain interdependence.interconnected and interdependent, relying on others to supply key products How are specialisation, tradeTrading and interdependence partners become mutually linked? dependent on one another. Specialisation creates surpluses.specialisation These surpluses aresurpluses traded. Each party in exchangetrade becomes dependentinterdependence on the other. Absolute and

Define international trade International trade

. is the exchange of goods and services across nationalDefine absolute borders. advantage. occurs when a country can make more of a givenDefine productcomparativeusing feweradvantage resources. than another nation. Unit cost of production is lower. Comparative advantage occurs when a country can make a productHow do atcountriesrelatively acquirelower opportunity a comparative cost advantage?than another nation. Different factor endowments mean countries have different opportunity costs. Countries with abundant supplies of low wage workersHow is absolute have a comparative advantage advantageidentified? in labour intensive industries. Give a worked example of absolute advantage.Productivity is an indicator of absolute advantage. Assume that with 10 workers, Country A can produce either 40 computers & zero bikes or zero pcs & 100 bikes. Country B can produce either 200 pcs and zero bikes or no computers and 40 bikes.  In country A each worker makes 40/10 = 4 computers or 100/10 = 10 bikes In country B, each worker makes = 200/10 = 20 computers and 40/10 = 4 bikes Country A has an absolute advantage in making bikes because labour productivity is 10 bikes and only 4 in B. Nation B has an absolute advantage in making computers where each worker, onGive average, a worked produces example 20 pcs of comparative while labour inadvantage nation A make only make 4 pcs.  Computers . Using the data in the previous question:

In Country A one worker makes either 4 pcs or 10 bikes so the opportunity  Bicyclescost of one extra pc is 10/4=2.5 bikes. In Country B the = 4 bikes lost for 20 extra pcs ie only 4/20 = 0.2 bikes for one more computer. In Country B the opportunity cost of one extra bike is 20 pcs for 4 extra bikes = 20/4 = 5 pcs. Country A gives up 4 computers for 10 extra bikes so the opportunity cost Constructof one a worked extra bike example is just 0.4to demonstrate pcs the benefits of specialisation and trade

Position Pre Specialisation Country Computers Bicycles Assume a simple two country, two product world A 20 50 with no trade. Using the data in the previous two B 100 20 questions, if each nation allocates half its resources to the production of both goods, the production Total 120 70 possibilities are as shown in the table opposite. World output is 120 pcs and 70 bicycles.

Countries benefit if they specialise in a product in which they have a comparative advantage ie a lower opportunity cost. It makes sense for County A & B to specialise in the production of the product in which they have the comparative advantage & trade:

| Absolute and comparative advantage 25 

Country A is relatively efficient in making bicycles because it has a lower internal  opportunity cost than Country B. A gives up just 0.4 of a computer for one extra bike while B gives up 5 computers. Country A has the comparative advantage in bicycles. Country B is relatively efficient in making computers because it has a lower internal opportunity cost than Country A. B gives up just 0.2 of a bicycle for one extra PC while B gives up 2.5 bikes. Country B has the comparative advantage in computers.Position Post Specialisation Country Computers Bicycles Now assume complete specialisation, where each A 0 100 country specialises in the products in which it has B 200 0 the comparative advantage. Total output of both products increases representing a potential gain in Total 200 100 economic welfare. The two countries must now Gain 80 30 trade to acquire products they are relatively inefficient at making Position Post trade Country Computers Bicycles If County’s A & B trade half the surpluses created A 60 65 through specialisation both nations are better off B 140 35 than when they were self-sufficient and produced all products, themselves. This assumes an appropriate Total 200 100 that lies between the opportunity cost ratios. Use production possibility curves to show the potential gains from international trade

40 K: after The diagram shows production possibility

Good Y 30 J: before curves (PPCs) for two countries, A and B, PPC for mapping combinations of good X and good 20 Country B Y that can be produced when all resources are used. The slope at each PPC reflects the 10 PPC for pattern of opportunity cost for each Country A country. Good X 0 20 40 60 80 For simplicity assume each country devotes half its resources to producing each product. Total world output is given by point J. 30Y and 50X is made. Assume now complete specialisation in the production of items in which a country has a comparative advantage. Country A produces 80 of good X. Country B makes 40 Y. total world outputList factors moves that to pointmight K. limit Both specialisation countries can benefit and trade from specialisation and trade. 

 InterThe benefitsdependence: of trade are reduced by transaction costs and transport costs which may be as to cancel out the benefits of specialisation based on comparative advantage.  Structural change:countries become reliant on importsDeclining of essentialsindustries from other countries. Eg a strike in the French electricity industry can mean power cuts for the UK.  Infant industry argumenttrade increases may need protection from overseas competitors to give them time to restructure and regain competitiveness . An infant industry has a potential comparative advantage  Tradewhich Restrictionsis currently underdeveloped. Infant industries need protection from overseas  competitorsterm to allow of trade them time to acquire that such as tariffs and quotas restrict trade Acceptable The ToT must lie within the relative opportunity cost ratio of the trading nations

26 Absolute and comparative advantage | What is the Heckscher-Ohlin model?

Specialisation reflects factor endowments. Eg the USA with highly skilled work force and high tech capital exports aircraft to China who specialise in exportingIs compara productstive advantage that make a staticuse of concept?abundant labour and low tech capital eg toys and shoes Comparative advantage can be acquired. Eg, investingHow can comparativein latest technologies advantage improves change the over productivity time? of labour, reducing opportunity cost. Nations lose or acquire comparative advantage overtime if there is a change in relative efficiency in making products. Comparative advantage can be gained in given products through  Human in education and training and,  Capital investment in new equipment, infrastructure, and research & development to improve competitiveness ie lower unit costs, better product design, and reliability ExplainLower dynamic efficiencies rates than competitors Dynamic efficiencies are improvements in productivity causing Thelower effectsunit costs thatof internationaloccur over time as atrade result of eg investment trade or knowledge transfers

Give examples of changing patterns of trade

. Comparative advantage in the production of lower valued added manufactured goods has shifted away from developed countries to developingExplain the economies gains from such international as China where trade unit in labourgeneral costs terms are. lower.  increases total output Trade allows  Specialisation that therebylower increasing unit costs economic welfare.  ImprovesFirms have consumer greater scopechoice for economies of scale. Trade opens up foreign markets and  Increasedallows firms competition to increase production. Resultant reduce . Domestic consumers have access to overseas goods reduces the power of domestic and encourages firms  to become world-class and adopt best practicetechnology product and knowledgeand process tran innovationssfers to reduce unit costs. FDI, licensing and result in .

| The effects of international trade 27 The terms of trade

What are the terms of trade?

The terms of trade (ToT) is the ratio of prices to pricesHow are expressedthe terms as an of trade measured. The ToT show the volume of imports one unit of export buys. ? The ToT is measured using the formula: Terms of tradeWhat =is index an improvement of export prices/ in the index terms of import of trade? prices x 100 An improvement in the ToT comes about when export prices rise faster than import prices. Eg a rise in the ToT eg from 110 to 115 means aWhycountry are thehas termsto give of up trade fewer important? exports for the imports it receives. The terms of trade are an indicator of the benefits of trade. A fall in the ToT means a country must export a larger amount of exports to pay for a givenWhat amountis the Presbisch of imports-Singer hypothesis? The Presbisch-Singer hypothesis states the terms of trade between primary products and manufactured goods tend to deteriorate over time. This limits the benefits of developing economies whose main exports are primary commodities eg coffee,Explain bananas the development and metals. trap. The Presbisch-Singer hypothesis suggests that by specialising in primary commodities, deteriorating terms of trade mean that more and more exports are requiredWhat are to thepay implications for the same of volume the Presbisch of imports-Singer hypothesis? To avoid the development trap, developing economies must change the structure of the economy and acquire a comparativeOutline limitations advantage of theintroduction terms of tradeof non-primary products eg textiles . Movements in the terms of trade reflect relative price changes but give no information about import and export volumes. The impact on the Patterncurrent account of global depends tradeon the price of demand for imports and exports.

What is a bloc?

Distinguish betweenA bloc intra is a group and interof countries regional in trade.allianceIntraeg the-regional EU same Inter-regional different trade is the exchange of products between nations in the geographical area eg the UK and France. tradeDistinguish is the exchange between of intra products and inter betweenindustry nationstrade. in Intra-industrygeographicaltrade areas eg UK and USA same Inter-industry trade different is the exchange of products made by the industry. is the exchange of products made by Identify industriesthe main features of global trade:   Developed economies dominate international trade.  International trade typically takes place within regional trading blocs such as the EU so as to minimise transport costs. Does thIntere theory industry of comparative rather than intraadvantage industry expla trade.in the pattern of global trade ? The potential Regional benefits trade of comparative blocs advantage tarerade negated barriers by:

 Transport costs which establish such as tariffs and quotas which restrict specialisation and trade  Intra industry tradewhich encourage intra-regional trade between nations in the same geographical area where nations trade the same type of product eg the car industry

28 The terms of trade | Exchange rate systems Floating exchange rates

Define the exchange rate

. An exchange rate is the price of one currency expressed in terms of anotherWhat is egthe $2/£ value of sterling? The pound is also known as sterling. The value of the pound is measuredGive an example in terms of of exchange the amount rates of foreign currency it can buy. . There are many exchange rates eg the £ against the US$, , yen, etc. For the UK, the dollar exchange rate means the number of dollars ($) one pound (£) can buy and is determined by the for sterling (pounds). If the exchange rateWhat is, is say, an $2exchange then onerate £ buys system? two $ - the buyer must give up $2 for every £1 required. An exchange rate system is the method selected by governmentWhat does the for termdeterminingeffective thee xchangevalue of therate currency mean against another currency. weighted average of a currency’s exchange rates ? The effective exchange rate is the with its major trading partners' . The weightingsExplain a strongreflect pound. the proportion trade with each trading partner. A strong pound suggests a historically high exchange rates eg $2:£1. SHowterling are is exchange appreciating rates relative determined? to other currencies. The value of a nation’s currencies against other currenciesWhat is purchasing can be set powerby the governmentparity (PPP)? or market forces. occurs when the price of identical products sold in different countries are the same, when expressed in terms of a commonWhat is the currency purchasing eg the power$. This assumesparity exchange no transaction rate? costs or trade barriers. The PPP is the exchange rate that equalises the prices of a given basket of products in two countries. Eg if a bar of chocolate priced at £1 in the UK sells for $2 in the USA, then PPP exchange rate is $2/£. $2 buys the same bar of chocolateWhat happens in the ifUK the and market USA. and PPP exchange rates diverge? If the market and PPP exchange rates diverge, the $ price of products is different in the two countries. Economic agentsDefine canarbitrage. make a by buying products one country and reselling them in another. Arbitrage is the practice of exploiting price differences in different markets. A profitWhat is madethe law by ofbuying one price? cheap and selling dear – assuming low transaction and transport costs. The impact of arbitrage and international trade results in one commonWhat is a$ freely price’ forfloatingproducts exchange in different rate? nations. Assumes floating exchange rates Forex The value of the currency is determined in markets called Foreign Exchange MarketS£ ( Draw), without a diagram any government to illustrate intervention a market set exchange

$/£ rate. FXM for £:$ The exchange rate for eg the pound against the dollar $2 is determined by the interaction of the forces of supply and demandDemand for £s

D£ : the demand curve for sterling D£ shows the amount of pounds demanded at each and every exchange £Bn rate. Holders want to exchange dollars for pounds to buy UK products (exports X) or buy UK assets (inward investment) or put deposits in UK banks.

| Floating exchange rates 29 Supply of £s

: the supply curve for sterling S£ shows the number of pounds supplied at each and every exchange rate. Holders want to exchange pounds for dollars to buy US made products (imports M) or buy UK assets (outward investment) or put deposits in UK banks. There is only one exchange rate, two dollars to the pound, where the number pounds supplied equalsWhy do the exchange number poundsrates fluctuate? demanded. The price of a currency is determined in Forex markets. A changeWhat factors in any factordetermine affecting the supplydemand an andd demand supply for of a a currency currency? affects the clearing price  International trade in goods and services

 Long term Capital flows ie imports and exports ie the relative competitiveness in terms of price and quality of UK products  Short-term capital flowsfrom the purchase of assets eg FDIhot andmoneyshares ie the relative the merits of inward investment or in to the UK () in and out of bank accounts ie largely affected by Explainrelative an appreciation rates of sterling and expected movements in future exchange rates An increase in demand, or fall in supply, of sterling causes an increase or appreciation in the exchange rate: one pound buys more foreign currency. UK priceWhatcompetitiveness is a depreciation deteriorates of sterling? as the price of UK imports fall whilst UK export prices rise. A fall in demand, or rise in supply of pounds causes a decrease or depreciation in the exchange rate: one pound buys less foreign currency. UK price competitivenessWhat are the effects improves of a fallas the in exchangeprice of UK rate? imports rises & UK export prices fall. Exchange rate changes have wide impact on key economic variables. Assume the demand for imports and exports is price elastic:

 The price of UK imports rise in terms of sterling while the price of UK exports falls in terms of foreign currencies  Depreciation of sterling exerts inflationary pressure because of higher import prices that increase costs to UK firms using overseas raw materials & components;  The terms of trade deteriorate as export prices have fallen and import prices have risen.  As demand is elastic, the UK has to give up more exports for the imports it receives. exports eventually rise stimulating and improving the BoP Structural change occurs as UK firms respond to price changes brought about by the Is a stabledepreciation. exchange rate desirable? Frequent and significant changes in the exchange rate are destabilising.How are exchange rates and increasedthe balance risk of reduces payments confidence, linked? investment and stability When Forex markets are in equilibrium, the demand for pounds to pay for UK products and assets exactly matches the supplyExplain of how pounds balanceto pay of for payments overseas problems products and are assetsautomatically. The balance corrected of payments by floating is in balance exchange rates.

Suppose the current account and capital and finance account are together, in deficit. This means the supply of pounds to pay for foreign products and assets exceeds the demands of pounds to pay for UK products and assets. The exchange rate automatically depreciates, lowering export prices while increasing import prices. Improved price competitivenessIdentify the merits helps of movea floating the balance exchange of payments, rate system. back into balance.   Automatic correction balance of payments problems  The exchange rate is not a constraint on macroeconomic policy. Eg interest rates can be set to affect domestic AD, ignoring any potential impact on exchange rates Helps economies adjust to external economic shocks three exchange rate adjustment

30 Floating exchange rates | 

 Reduces the ability of speculators to bet against government inability to maintain fixed exchange rates IdentifyReduces the limitations the need offor a governments floating exchange to hold rate reserves system. of foreign currency The J curve effect means that Fixedexchange e ratexchange changes initiallyrates worsen any balance of payments problem

What is a fixed exchange rate system?

In a fixed exchange rate system the value of one currencyHow can againstgovernments other currenciesintervene is to heldfix constant.an exchange rate ? Maintaining an official exchange rate requires government action to exchange controls

Restrict currency flows through that limit the amount of the domestic  currencyreserves that of can gold be and taken foreign out of currencies the country. The UK stopped exchange controls in 1979.  Use interest rates to buy and sell foreign currencies for sterling to maintain the fixed rate. Forex interventions are carried out by the

Use to encourageS£ Drawthe purchase a graph or to sale illustrate of the cu governmentrrency intervention

$/£ to maintain the value of sterling at a fixed rate. FXM for £:$ $2.2

$2.0 In the diagram opposite, the Forex price of sterling is two dollars to the pound. D £ If the government wants to maintain the exchange rate at Q1 Q2 £Bn $2.20 to the pound then it must buy up excess supply of [Q2Outline-Q1] thepounds ben usingefits of its a reserves fixed exchange of US$s. rate system.

 A fixed exchange rate system:  Increases exchange rate certainty encouraging investment trade and growth  Removes the need for firms who want exchange rate certainty to insure against exchange rate changes (hedge) Discipline for firms who can no longer rely on exchange rate corrections to restore Outlineinternational the drawbacks competitiveness of a fixed exchange rate system.  A fixed exchange rate system:

 Requires the government to hold adequate reserves of foreign currency. The opportunity cost of foreign reserves is foregone interest  Linking domestic to the exchange rate as interest-rate changes may cause the exchange rate move outside its target rate Can encourage speculation if speculators believe the government cannot maintain a Identifyfixed other exchange exchange rate.-rate Read systems up on the UK’s in 1992 for an example  Managed float

 Adjustable peg whether central bank intervenes to buy and sell foreign currency to maintain the value of sterling at some target rate  Exchange rate bandwhere the official exchange rate is fixed in the short term but can be revalued periodically in the long-term where the currency is allowed to move a few percentage points around a central target before government intervenes to stabilise. For example a $2.20 to $1.80 ceiling and floor value of sterling

| Fixed exchange rates 31 Exchange rate volatility

Why do exchange rates change?

Without government intervention, exchange rate fluctuations are caused by shortchanges term in the supply and demand for currency on the Forex markets

 In the exchange rate changes are mainly caused by speculators who buy and sell a currency having to make a capital gain What areIn theeconomic longer run,fundamentals? exchange rates are determined by economic fundamentals Economic fundamentals are the underlying key characteristics of an economy including productivity and international competitiveness and InterestHow can rates,depreciation growth ratesaffect andnet inflation exports rates [X-M]? A fall in the value of the pound has an uncertain effect on X-M because price and quantity are inversely related. Depreciation means:

The price of exports falls causing an expansion in demand. More exports are sold but at lower prices. The overall impact on revenue depends on the price elasticity of demand.  Only if the percentage increase in quantity demanded is greater than the percentage fall in price does a fall in the value of the pound increase the value of exports The price of imports rises causing a contraction in demand. Fewer imports are bought but at higher prices. The impact on the value of imports is uncertain and can rise or fall depending on the price elasticity of demand The value of exports rises only if the demand for exports is relatively price elastic. The value of importsWhat is fallsthe Marshallonly if the-Lerner demand condition for imports is relatively price elastic combined elasticities of demand for imports & exports are greater than one ? This predicts that depreciation improves the current accountDoes a fallonly in if the the exchange rate guarantee an improvement in the current account? . If the Marshall-Lerner condition is met then a depreciation of sterling improves the current account providingExplain the there J curve is spare effect capacity. in the economy to increase output to meet extra demand.  Prices tend to adjust Followingquickly a fall in the value of a currency:

 Quantities adjust slowly . UK consumers face higher prices for imports while UK firms selling overseas can reduce prices. often after a time lag of up to 12 months. Consumers may be X-M slow to notice relative price changes while firms may have fixed price contracts in place. J Curve Effect This means the price elasticity of demand of imports and exports is likely to be inelastic in the short run,

Surplu s 0 but become more elastic over time Deficit Time The initial impact of devaluation is to decrease import prices & raise export prices while volumes are largely unaffected - the current account deteriorates.

After a period of about 12 months, economic agents have had time to adjust fully to relative price changes in foreign & domestic products. The volume of imports falls while the volume of exports rises. Given the combined elasticities of demand for imports and exports is greater than one,Define the the current J curve account effect. begins to improve. The J curve is the path followed by the current account following exchangeWhat is therate inverted depreciation J curve where effect?the trade balance initially worsens before it improves. The current account initially improves following an appreciation of a currency where the trade balance initially improves before it worsens.

32 Exchange rate volatility | What is the single currency?

The single currency is a term used to describe the Eurozone where member countries have abandoned their own currency and adopted the euro. Advocates argue that a permanently fixed exchange rate in a regional reduces the risk and uncertainty associated with volatile exchange rates and so encourages international trade and Bassociatedalance benefits of payments problems

What is external balance?

Explain ‘a balance of paymentsExternal prob balancelem’. is when the balance of payments is in equilibrium A balance of payments problem arises when there isGive an imbalancean example between of a balance the two of main payments sections:imbalance the current account and the capital account. . China is running a $ 426,100,000,000 surplusIdentify on the itslikely currencausest accountof a whilecurrent the USAaccount is operatingdeficit a $ -673,300,000,000 deficit (CIA)  :

 Excessive spending on imported goods and services as a result of the loss of  international competitiveness Domestic firms purchasing foreign-made capital goods to increase productive capacity How is Ana current overvalued account currency deficit resulting financed? in high priced exports and low-priced imports The current account deficit is financed by a capital accountIs a current surplus. account For example deficit sustainable? the USA attracts large capital inflows from China The USA can continue to finance its current-account deficit because overseas investors have confidence in the American economy. The economic fundamentalsHow can a balance and future of payments prospects imbalance of the American be corrected? economy are viewed with confidence. Where the imbalances are caused by the currentExpenditure account reducing, there are two main options:  Expenditure switching policies cut GDP and so lower the demand for imports policies that increase the price of imports and/or lower the price Identifyof potential exports so expenditure reducing net reducing exports policies. Expenditure reducing policies reduce the level of aggregate demand eg increasing taxes or reducing cover spending and increasing interestWhat are rates.the drawbacks of expenditure reducing policies? Expenditure reducing policies to improve the current account reduce the level of GDP causing cyclical and threateningWhat is free economic trade? stability. occurs when a county abolishes any controls or restrictions on internationalHow can governmenttrade such restrict as tariffs international or quotas. trade?  Tariffs Methods of limiting imports and exports  Non- barriers : imposing a tax on imports Identify potential expenditure: impose trade switchingrestrictions policies. other than tariffs eg foreign exchange controls Government action to cut exchange rate reduces the price of exports in foreign currency and increases the price of imports. A tariff also increasesWhat are thethe price drawbacks of imports of expenditure while exports switching subsidies policieslower the price of exports. ? Engineering a fall in the value of currency simply invites retaliation from overseas governments leading to a damaging series of competitive devaluations. Similarly increasing tariffs or subsidising exports invites retaliation and breaks the rules of trading blocs such as the EU, and the World Trade Organisation

| Balance of payments problems 33