European Union: Competitiveness

Last Updated: 11 January 2013
Article by Steve Stivala

Enhancing productivity is ever more crucial in today's world. But how easy is it, especially when all factors are pointing in the reverse direction?

It would seem that in the midst of the ongoing economic turmoil, competitiveness takes on the form of a double edged sword. Unfortunately, the world is still experiencing the effects of the knock-out blow landed at the height of the financial and economic crisis in mid-2008, with further exacerbations brought about by a sovereign debt problem which presents a Euro-wide systemic risk. Against this backdrop, there is a glimmering hope of recovery, but subdued economic growth and conservative fiscal response are set to characterise the European economy in the near future. In this regard, enhancing competitiveness is probably one of the key factors to herald and encourage future economic and sustainable growth. On the flip side, this requires investment, both at the firm level and at the national government level, which is difficult to achieve in times of muted demand, credit squeezing, high government borrowing costs, and limits on government spending.

Competitiveness has therefore become an even more relevant area which is now embedded, more than ever, in European (and world-wide) policy-making. It is thus crucial to understand the underlying economic fundamentals of the concept and how it is measured, in order to be able to have an intelligent discussion about the subject. Unfortunately, many commentators and politicians alike still fail to grasp the basic idea of external competitiveness. We often hear statements like "Cheap labour from the Far East is destroying Western jobs", or "We need to focus on high-value added exports to create more jobs". At best, this is only half the story. At worst, this is a misguided mercantilist approach which adopts a narrow focus. Paul Krugman (1996) succinctly captures this concept in his seminal paper on competitiveness:

"While influential people have used the word 'competitiveness' to mean that countries compete just like companies, professional economists know very well that this is a poor metaphor"

Krugman, P. (1996), "Making sense of the Competitiveness Debate", Oxford Review of Economic Policy, Vol. 12, No.3.

Understanding why external competitiveness is not a zero-sum game

It is often understood that competitiveness is a mere reflection of unit labour costs and labour productivity, and that it is imperative to improve on these two indices in order to gain a competitive advantage over other countries and export our value-added abroad, thus contributing to the generation of jobs. Whilst this view is intuitively appealing (and indeed has some truth in it as most competitive indicators focus on such indices), at the heart of this concept lies a general understanding that countries compete in the same way as businesses do. By implication, this would mean that failure to have high labour productivity and low wage costs could result in less generated exports and less jobs. In essence, this is a mercantilist approach which adopts the view that international trade is solely concerned with being more 'competitive' than other countries in order to generate exports and generate jobs within the home economy. Consequently, jobs generated, say, in the Far East due to lower wage costs would displace jobs in high-wage countries. This is diametrically opposite to what basic international trade theory dictates.

First, international trade thrives on the concept of comparative advantage. Even if a country has an absolute disadvantage, relative to another country, in the production of all goods, it still pays off to trade internationally (See Box 1). The key is to look at the opportunity costs of each country in producing one good over another. In this regard, every country has a comparative advantage and every country stands to gain from trading internationally. This may seem confusing and counter-intuitive, but it is indeed the reason why countries export goods to other countries which are clearly more efficient in producing the good themselves.

Secondly, one must keep in mind that the purpose of international trade (and being competitive in the process) is not to generate as much exports as possible to foster jobs. On the contrary, the purpose is to be able to import goods and services which would have been otherwise too costly (in relative terms) to produce locally.

Lastly it is also pertinent to note that international trade is a dynamic subject with many interdependencies among the different variables. In other words, prices, wages, size of the world market and specialisation are all simultaneously determined, and therefore not static. This means that growth in productivity in one country does not necessarily translate to less jobs in another country. Even though a particular industry may not remain competitive (and jobs would be lost), the economy as a whole can still gain from trade by specialising in the good where comparative advantage exists, provided that there is flexibility in the economy to shift resources from one activity to another.

At the heart of this argument is the economic theory of stages of development, which is outlined in detail in the Global Competitiveness Report issued by the World Economic Forum. In short, this theory states that countries in the initial stages of development compete on the basis of unskilled labour and natural resource endowments. At this stage, it is important to have a business environment with all basic necessities (institutions, infrastructure, stable macro-economic environment and so on). As the country progresses and wages and productivity increase, the economy would need to adjust and focus more on enhancing the quality of products and improving the efficiency of production. In this case, competitiveness is more likely to be improved if there is an emphasis on higher education and training, better financial markets, well functioning labour markets and so on. In the third stage of development, the emphasis should fall on creating new and innovate products using the most sophisticated production processes. This is the innovation-driven stage. There is some parallelism between the theory of stages of development and the 'three-sector hypothesis' in the sense that as the economy advances, there is a movement away from manufacturing and towards the services sector. However, this may not always hold (see section on additive manufacturing and the 3rd Industrial Revolution). It is pertinent to note that according to the Global Competitiveness Index, Malta is classified as an 'Innovation-driven' economy, as shown on the following page.

Competitiveness – more than just labour costs and productivity?

Although many publications focus on labour productivity and compensation per employee to compute a statistical measure of competitiveness (such as the ULC – Unit Labour Cost), the subject of competitiveness is clearly a richer concept than what statistics imply.

In our previous issue we briefly discussed competitiveness with respect to the Maltese economy. Since the situation would not have drastically changed, below we re-produce a few salient points which emerge from the previous publication:

  • Following Malta's accession in the European Union, we argued that 'competitiveness' would need to be addressed and restored through the real channels of the economy due to the relinquishment of monetary and exchange rate policy. This means that, although local businesses and employees would be exposed to the realities of international competition, this still presents an avenue for greater market efficiency and innovation.
  • We also argued that competitive pressures tend to impact most the manufacturing sector (although the services sector is not immune to such exposure). However, this represents a migration towards economic 'tertiarisation' which is an expected and natural economic progression.
  • When considering statistical measures, we pointed out that compensation per employee was rising faster than labour productivity, which signals a deterioration of competitiveness. However, Malta still has a competitive edge relative to the EU27 since Maltese hourly labour costs are significantly below the EU27 average, whilst Maltese labour productivity levels are slightly below the EU27 levels.
  • We also noted that exchange rate fluctuations play an important part in Malta's competitiveness, particularly since around two thirds of Maltese exports are directed towards countries outside the Euro Area. Indeed, the appreciation of the Euro between 2006 and 2008 played an important part in the erosion of competitiveness whilst the opposite was experienced post 2008.
  • Lastly, we argued that the amelioration of competitiveness should be a shared objective between all social partners (although some variables are outside the control of any of the local social partners), and that enhancing competitiveness should not be solely constrained to curbing cost increases but should also encompass supply side factors such as incentivising investment. We further expound on this point below.

According to the Global Competitiveness Report, competitiveness is defined as "the set of institutions, policies, and factors that determine the level of productivity of a country". In turn, productivity is said to determine the rates of return obtained by investments, which is a key driver of economic growth. Put simply, greater productivity enhances both the level and the potential for economic growth, thus increasing the level of prosperity which can be earned by the economy.

The GCR lists no less than twelve pillars which are in some way determinants of competitiveness. These pillars, although not mutually inclusive, are important to differing degrees depending on the stage of economic development of a particular country. For instance factor-driven economies would find it worthwhile to focus on basic requirements such as the development of institutions and ensuring macro-economic stability, whilst innovation-drive economies, having already a framework of basic necessities would find it more beneficial to focus on business sophistication and research and development.

Third Industrial Revolution?

Competitiveness is a dynamic concept and the rules of the game are sometimes overhauled to such an extent that factories, processes and jobs become obsolete overnight. The first and second Industrial Revolutions saw a radical departure from traditional types of manufacturing at the time. In particular, the coal fired steam engine and proliferation of printed matter heralded the first industrial revolution, whilst the electrification of factories and the creation of the assembly line, as perfected by Henry Ford, gave rise to the second industrial revolution characterised by mass production. It is for this reason that, as wages increased in the developed world, mass production (being intrinsically labour intensive) moved to countries such as China, India and Mexico. Even today, this process of finding the most efficient method of production continues, as firms are now moving to India, Indonesia and Vietnam, since Chinese labourers demand higher pay and shorter working hours.

Some economic commentators believe that the Third Industrial Revolution is on its way. More specifically, this revolution, which is endorsed by the EU and backed by EU-wide initiatives, will once again redefine the boundaries of competitiveness. The main drivers are expected to be a revolutionary way in which renewable energy is created, transported and distributed along an "energy internet" framework. At the heart of this, it is expected that a major characteristic of the Third Industrial Revolution would be mass customisation (as opposed to mass production) which would be possible due to the convergence of different technologies, ranging from smarter production processes, more efficient automation and robotisation. This novel concept of additive manufacturing (think of 3D printers where three dimensional products are produced from a digital blue-print file) would re-invent economies of scale and alter the capital to labour ratio of many production processes. As the labour component decreases, it might induce companies to re-locate factories back to the West with a view to be closer to market and to benefit from synergies of having the designers and producers of goods in the same place. The competitiveness landscape would be changed forever.

This article was originally published in Insight 2012. Please click here to view the original document.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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