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In the last Learn-It the case for free trade was explained. The theory behind the proposition that free trade is a 'good' thing is that of comparative advantage. Some countries are relatively better at making some goods than others, even if they are absolutely worse at making all goods.
This begs the question, 'why do countries have a comparative advantage in some goods and services but not in others?'. This, in turn, leads on to the question of competitiveness. For a country to be competitive internationally, it obviously has to have a comparative advantage in a reasonable number of goods and services. Is the UK competitive internationally? These are some of the questions that we shall be answering in this Learn-It.
First and foremost, a country's available resources will determine where it has a comparative advantage. Saudi Arabia would not have a comparative advantage in the production of oil if it did not have so much oil under the worthless sandy deserts! The discovery of North Sea Oil turned the UK into a net exporter of oil rather than a net importer. Remember that we are not just talking about physical resources here. The quantity and quality of the human resources available is also crucial.
This leads to the second important point. Private and public sector investment in human capital (through education and training) and in research and development (to develop new products or improve existing ones) can help create a comparative advantage in an area where a country is traditionally weak.
It should be noted that the areas in which a country has a comparative advantage can change over time, partly through the actions of the country in question, but also due to the improved efficiency (or discovery of new resources) in a competing country.
Although the UK used to have a comparative advantage in the production of many manufactured goods (we were, after all, one of the first countries to industrialise), nowadays our strength lies in areas such as chemicals, distribution and financial services (like banking and insurance). Unfortunately, most of these areas are not those that are successful in terms of international trade. Basically, the UK is quite good in the service sector, only around 20% of which is tradeable (how do you export a haircut?), but declining in manufacturing, which makes up most of a countries exports and imports. Later in this Learn-It you will see why the UK has become less competitive in terms of the manufacturing sector.
This is a similar question to the previous one. Some would say it is, effectively, the same question. If something happens that makes an industry within a country less competitive, then that country may cease to have a comparative advantage in that industry.
In this section, though, we will move away from basic questions about whether the country in question has the right resources. We shall look at 'price' and 'non-price' factors that continually affect the competitiveness of UK industry (N.B. mainly manufacturing industry).
- The exchange rate. This is the factor that one continually hears on the news in terms of the "strong pound causes problems for industry" type headline. If a country's currency is relatively strong, its exports will be relatively more expensive in other countries. Also, imports into the domestic markets will be relatively cheaper. Exporters and firms that concentrate on the domestic market will suffer.
- Relative inflation rates. Prices tend to rise in all countries, but if prices rise faster in one particular country then, for a given exchange rate, the effect will be very similar to a rise in the value of the currency. If the inflation rate in the UK is 10% over a given year, and the inflation rate in Germany is 8% over the same year (assume the exchange rate remains constant), then UK exports in Germany will be 2% more expensive relative to German home-produced goods. Equally, German imports into the UK will appear 2% cheaper than UK home-produced goods. Can you remember the link between inflation rates and exchange rates? If not, go to the topic called 'Exchange rates'.
- Unit labour costs. This is defined as the labour cost (to the firm) per unit of output produced. Higher costs can affect the price that a firm charges, leading to the problems outlined above. Of course, firms may decide to stay competitive and not raise their prices following a rise in unit labour costs, but their profit margin will be cut which is not good for their competitiveness in the long run given the likely cut in essential investment. Changes in labour productivity are extremely important here. If the output per worker is rising then rises in labour costs (through higher wages) will not necessarily raise unit labour costs because the increased wages have been earned through increased output.
In the topic called 'Market structure - monopolistic competition and oligopoly' we found that non-price competition was often the most important method of competition in oligopoly given the fact that these type of markets tend to have the characteristic of price stability.
The growth of multinationals has seen the global marketplace turn into lots of huge oligopolies. Price competition is often far less important when competing internationally than non-price competition. Remember that when we discuss the international competitiveness of a particular country, we are effectively looking at the competitiveness of the firms within that country.
- Income elasticities. Increases in the size of an economy (through real growth in GDP) will increase, on average, the incomes of its inhabitants. Some of this income will be spent. Some of it will be spent on imports. The question is, what is the income elasticity of demand for foreign imports? Equally, it would be useful to know the income elasticity of demand for our exports. When foreign countries grow, how does the demand for UK exports change with changes in foreign income?
- Quality of the product. This can be a huge factor. Mercedes cars compete well in the car market even though their price is relatively high. Why is this? Because of the quality of the cars. It is difficult to quantify 'quality' but one way of doing it is to measure value per ton of exports. For a given weight of, say, cars, if the quality of the exported cars is high then the 'value' (i.e. price times quantity) will be high relative to the weight of the exports.
- Design. This is similar to the factor above. Better design leads to better quality and increased sales. Both quality and design depend on the level of research and development at which a firm is prepared to invest.
- Marketing. Ask any firm in an oligopolistic market and they will tell you the importance of marketing. This includes doing the right market research before the launch of a product as well as the obvious advertising required during and after the product launch.
- Prompt delivery and after-sales service. These are often forgotten but very important aspects of non-price competition. In particular, firms can earn a reputation for good after-sales service, which will have a very positive effect on future sales.
The best way to assess this is to look at all the factors one by one and see how well the UK 'scores', as it were.
- The exchange rate. Many manufacturers in the UK think that this is one of the key factors that affect their competitiveness. When the pound fell in value after falling out of the ERM, the improved competitiveness of British industry helped the economy come out of recession. The relatively high value of the pound since the summer of 1996 has caused problems for British industry. Other economists argue that, whilst the strong pound is an inconvenience to manufacturers, it does reflect the strength of the UK economy and it also bears down on inflation. It is a sign of success and exporters should learn to live with it. After all, the value of the German Mark rose against the pound during its success after the war and they never seemed to complain about their exchange rate. They just keep making better products!
- Relative inflation rates. Although the inflation rate of the UK now compares very favourably with countries in the EU and around the world, post war history (especially the 70s and 80s) shows that the UK tended to have higher inflation relative to its competitors. This was a problem that caused successive devaluations in the pound. This, in turn, made the problem worse by increasing the price of imports. The UK is definitely in a better position than it has been on this score, but will it stay there indefinitely?
- Unit labour costs. As we said above, the two key factors here are labour costs and labour productivity. The UK as a whole tends to have a lower productivity in terms of output per worker than most other developed economies. The UK is roughly 20% behind France and Germany and 40% behind the USA. To compensate for this, labour costs tend to be lower in the UK. Basically, the UK is a low skill low wage economy whereas Germany, for example, tends to invest in high technology machinery, which is more productive, needs better skilled workers who, therefore, receive higher wages.
So, to sum up, the UK doesn't do too well on the exchange rate, but at least that is a sign of strength, and it keeps inflation down.
On inflation, the UK is much improved in recent years.
On unit labour costs, the UK's record on productivity is poor, but the lower wages make up for this. Is that a good situation to be in, though?
- Income elasticites. Unfortunately, the UK's income elasticity for foreign imports has always been quite high. Also, the income elasticity of demand for UK exports tends to be relatively low. Hence, as world incomes rise (which, over the long term, tends to happen) UK consumers buy relatively more foreign imports (at the expense of home-produced goods) and foreign consumers do buy more UK exports, but in relative terms the increase is small.
- Quality of the product. Unfortunately, the UK performs poorly on this measure. Figures for value per ton show that there are few developed countries that produce poorer quality goods than the UK. Perhaps part of the reason for this is that the UK tends to export products that use lower technology. But this is hardly a good thing in itself. This simply highlights the fact that the UK invests a relatively small amount of money in research and development.
- Design. Again, whilst some industries in the UK can be quite innovative and understand the importance of design as an investment, the overall picture is not promising. It seems as though the huge up front costs of research and development put off many firms from improvements in this area.
- Marketing. Another black spot for UK industry. There is evidence that foreign firms invest more money into their sales departments abroad and undertake more market research. Only about half of UK firms undertake any analysis of the foreign markets into which they plan to export. Some economists believe that this is the most important reason for the UK's poor performance internationally.
- Prompt delivery and after-sales service. Again, the UK is near the bottom of the league table. The time between an order and the delivery of the product is relatively long in the UK and the after-sales service offered by UK firms is generally considered to be relatively poor as well.
As you can see, the UK is not very competitive on the 'non-price' side. Although the UK is improving on some of the 'price' factors, this will count for very little unless firms start to devote more time on some of the factors listed above.
In the topic called 'The balance of payments', you can see that the uncompetitiveness of UK industry is one of the main reasons why the UK tends to have a deficit on the 'trade in goods' section of the balance of payments. You will also find a discussion on whether the UK's failure in this field actually matters given the expanding service sector.
The Global Competitiveness Report
Every July the World Economic Forum releases the Global Competitiveness Report. The results are based on a poll of multinational businessmen and various pieces of economic data. The UK tends to find itself in the top ten out of over 50 countries assessed. Of course, the majority of the countries are not developed, but the UK does tend to be above most European countries.
This might seem surprising given the analysis above. But many economists think the report is flawed. The fact that businessmen are polled means the results are highly subjective. The results also reflect the 'free market' view of the authors. The UK does well because of a thriving financial sector and the fact that its labour market is more flexible than most of those in Europe. One of the areas where the UK scores less well is the quality of education for its workforce. Some would say this is the most important category. Finally, it tries to measure the competitiveness of economies as countries when, as discussed above, it is the companies within countries that compete, not the countries themselves. Inevitably, therefore, the report does not allow for the UK companies' poor record on non-price competition.