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International Competitiveness
What is international competitiveness? International competitiveness is the ability of firms
in an economy to match the price and quality of other nation’s output.
List the main factors affecting international competitiveness. International competitiveness
is largely determined the relative price and quality of domestic goods and services relative to
foreign products.
Identify factors which influence the relative price of imports and exports.
Relative costs of production eg wage between different countries
Relative productivity of labour. A rise in productivity reduces labour costs and so
improves competitiveness
Exchange rates impact on the price of imports and exports. A depreciation lowers the
price of exports in terms of foreign currency and increase the price of imports
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How can quality factors affect competitiveness? Price is just one factor affecting demand.
The relative design, appearance and functionality of a product affect competitiveness.
What is a competitiveness pyramid?
The competitiveness pyramid is a model
that shows sustainable growth as an
outcome of competitiveness.
At the base of the pyramid are policy
inputs that impact on the essential
conditions for competitiveness, hence
sustainable growth.
State action to make it easier to do
business (deregulation) or improve
education and training eventually
provides the conditions necessary for
sustainable growth.
Note the link between this model, developed by Ireland’s Competitiveness Council, and the
Treasury’s productivity drivers. Supply side policies require state funding and are long term
Trade and integration
Distinguish between open and closed economies. A closed economy is self-sufficient and
there is no intentional trade. An open economy engages in international trade.
Define trade. Trade is the exchange of goods and services.
Why do regions and countries trade? Different countries trade because they have different
factor endowments eg climate, skilled labour force, and natural resources vary between nations.
This means some countries are better placed in the production of certain products than others.
Explain specialisation. Specialisation is when individuals, firms, regions or countries
concentrate in the production of particular good and services.
What are the benefits of specialisation? Concentrating on a particular product or task means:
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Increased total output so that more wants can be satisfied
A greater variety of products ie more choice
An increase the size of the market offering opportunities for economies of scale
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International Competitiveness |
What are the risks of specialisation? Specialisation makes individuals, firms, regions or
countries interconnected and interdependent, relying on others to supply key products
Explain interdependence. Trading partners become mutually dependent on one another.
How are specialisation, trade and interdependence linked? Specialisation creates
surpluses. These surpluses are traded. Each party in exchange becomes dependent on the other.
specialisation
surpluses
trade
interdependence
Absolute and comparative advantage
Define international trade. International trade is the exchange of goods and services across
national borders.
Define absolute advantage. Absolute advantage occurs when a country can make more of a
given product using fewer resources than another nation. Unit cost of production is lower.
Define comparative advantage. Comparative advantage occurs when a country can make a
product at relatively lower opportunity cost than another nation.
How do countries acquire a comparative advantage? Different factor endowments mean
countries have different opportunity costs. Countries with abundant supplies of low wage
workers have a comparative advantage in labour intensive industries.
How is absolute advantage identified? Productivity is an indicator of absolute advantage.
Give a worked example 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.
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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,
on average, produces 20 pcs while labour in nation A make only make 4 pcs.
Give a worked example of comparative advantage. Using the data in the previous question:
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Computers In Country A one worker makes either 4 pcs or 10 bikes so the opportunity
cost of one extra pc is 10/4=2.5 bikes. In Country B the opportunity cost = 4 bikes lost
for 20 extra pcs ie only 4/20 = 0.2 bikes for one more computer.
Bicycles 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
of one extra bike is just 0.4 pcs
Construct a worked example to demonstrate the benefits of specialisation and trade
Assume a simple two country, two product world
with no trade. Using the data in the previous two
questions, if each nation allocates half its resources
to the production of both goods, the production
possibilities are as shown in the table opposite.
World output is 120 pcs and 70 bicycles.
Position Pre Specialisation
Country
Computers
Bicycles
A
20
50
B
100
20
Total
120
70
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
Now assume complete specialisation, where each
country specialises in the products in which it has
the comparative advantage. Total output of both
products increases representing a potential gain in
economic welfare. The two countries must now
trade to acquire products they are relatively
inefficient at making
If County’s A & B trade half the surpluses created
through specialisation both nations are better off
than when they were self-sufficient and produced all
products, themselves. This assumes an appropriate
exchange rate that lies between the opportunity cost
ratios.
Country
Computers
Bicycles
A
0
100
B
200
0
Total
200
100
Gain
80
30
Position Post trade
Country
Computers
Bicycles
A
60
65
B
140
35
Total
200
100
Good Y
Use production possibility curves to show the potential gains from international trade
K: after
40
30
20
J: before
PPC for
Country B
PPC for
Country A
10
Good X
0
20
40
60
80
The diagram shows production possibility
curves (PPCs) for two countries, A and B,
mapping combinations of good X and good
Y that can be produced when all resources
are used. The slope at each PPC reflects the
pattern of opportunity cost for each
country.
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
output moves to point K. Both countries can benefit from specialisation and trade.
List factors that might limit specialisation and trade

The benefits 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.
Interdependence: countries become reliant on imports of essentials from other
countries. Eg a strike in the French electricity industry can mean power cuts for the UK.
Structural change: trade increases competition Declining industries may need protection
from overseas competitors to give them time to restructure and regain competitiveness
Infant industry argument. An infant industry has a potential comparative advantage
which is currently underdeveloped. Infant industries need protection from overseas
competitors to allow them time to acquire that competitive advantage
Trade Restrictions such as tariffs and quotas restrict trade
Acceptable term of trade The ToT must lie within the relative opportunity cost ratio of
the trading nations
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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
exporting products that make use of abundant labour and low tech capital eg toys and shoes
Is comparative advantage a static concept? Comparative advantage can be acquired. Eg,
investing in latest technologies improves the productivity of labour, reducing opportunity cost.
How can comparative advantage change over time? 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
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Human investment 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
Lower inflation rates than competitors
Explain dynamic efficiencies Dynamic efficiencies are improvements in productivity causing
lower unit costs that occur over time as a result of eg investment trade or knowledge transfers
The effects of international trade
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
developing economies such as China where unit labour costs are lower.
Explain the gains from international trade in general terms. Trade allows
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Specialisation that increases total output thereby increasing economic welfare.
Firms have greater scope for economies of scale. Trade opens up foreign markets and
allows firms to increase production. Resultant lower unit costs reduce prices
Improves consumer choice. Domestic consumers have access to overseas goods
Increased competition reduces the power of domestic monopolies and encourages firms
to become world-class and adopt best practice product and process innovations to
reduce unit costs.
FDI, licensing and outsourcing result in technology and knowledge transfers.
| 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 export prices to import
prices expressed as an index value. The ToT show the volume of imports one unit of export buys.
How are the terms of trade measured? The ToT is measured using the formula: Terms of
trade = index of export prices/ index of import prices x 100
What is an improvement in the terms of trade? 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
a country has to give up fewer exports for the imports it receives.
Why are the terms of trade important? 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
given amount of imports
What is the Presbisch-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, bananas and metals.
Explain the development trap. The Presbisch-Singer hypothesis suggests that by specialising
in primary commodities, deteriorating terms of trade mean that more and more exports are
required to pay for the same volume of imports
What are the implications of the Presbisch-Singer hypothesis? To avoid the development
trap, developing economies must change the structure of the economy and acquire a
comparative advantage introduction of non-primary products eg textiles
Outline limitations of the terms of trade. Movements in the terms of trade reflect relative
price changes but give no information about import and export volumes. The impact on the
current account depends on the price elasticity of demand for imports and exports.
Pattern of global trade
What is a bloc? A bloc is a group of countries in alliance eg the EU
Distinguish between intra and inter regional trade. Intra-regional trade is the exchange of
products between nations in the same geographical area eg the UK and France. Inter-regional
trade is the exchange of products between nations in different geographical areas eg UK and USA
Distinguish between intra and inter industry trade. Intra-industry trade is the exchange of
products made by the same industry. Inter-industry trade is the exchange of products made by
different industries
Identify the main features of global trade:
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Developed economies dominate international trade.
International trade typically takes place within regional trading blocs such as the EU so
as to minimise transport costs.
Inter industry rather than intra industry trade.

Does the theory of comparative advantage explain the pattern of global trade? The
potential benefits of comparative advantage are negated by:
Regional trade blocs which establish trade barriers such as tariffs and quotas which
restrict specialisation and trade
Transport costs which encourage intra-regional trade between nations in the same
geographical area
Intra industry trade where nations trade the same type of product eg the car industry
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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
another eg $2/£
What is the value of sterling? The pound is also known as sterling. The value of the pound is
measured in terms of the amount of foreign currency it can buy.
Give an example of exchange rates. There are many exchange rates eg the £ against the US$,
euro, yen, etc. For the UK, the dollar exchange rate means the number of dollars ($) one pound
(£) can buy and is determined by the supply and demand for sterling (pounds). If the exchange
rate is, say, $2 then one £ buys two $ - the buyer must give up $2 for every £1 required.
What is an exchange rate system? An exchange rate system is the method selected by
government for determining the value of the currency against another currency.
What does the term effective exchange rate mean? The effective exchange rate is the
weighted average of a currency’s exchange rates with its major trading partners' currencies. The
weightings reflect the proportion trade with each trading partner.
Explain a strong pound. A strong pound suggests a historically high exchange rates eg $2:£1.
Sterling is appreciating relative to other currencies.
How are exchange rates determined? The value of a nation’s currencies against other
currencies can be set by the government or market forces.
What is purchasing power parity (PPP)? Purchasing power parity occurs when the price of
identical products sold in different countries are the same, when expressed in terms of a
common currency eg the $. This assumes no transaction costs or trade barriers.
What is the purchasing power parity exchange rate? 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
chocolate in the UK and USA.
What happens if the market and PPP exchange rates diverge? If the market and PPP
exchange rates diverge, the $ price of products is different in the two countries. Economic
agents can make a profit by buying products one country and reselling them in another.
Define arbitrage. Arbitrage is the practice of exploiting price differences in different markets. A
profit is made by buying cheap and selling dear – assuming low transaction and transport costs.
What is the law of one price? The impact of arbitrage and international trade results in one
common $ price’ for products in different nations. Assumes floating exchange rates
$/£
What is a freely floating exchange rate? The value of the currency is determined in markets
called Foreign Exchange Market (Forex), without any government intervention
S£
FXM for £:$
$2
D£
£Bn
Draw a diagram to illustrate a market set exchange
rate. The exchange rate for eg the pound against the dollar
is determined by the interaction of the forces of supply and
demand
Demand for £s: the demand curve for sterling D£ shows the
amount of pounds demanded at each and every exchange
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
equals the number pounds demanded.
Why do exchange rates fluctuate? The price of a currency is determined in Forex markets. A
change in any factor affecting supply and demand for a currency affects the clearing price
What factors determine the demand and supply of a currency?
International trade in goods and services ie imports and exports ie the relative
competitiveness in terms of price and quality of UK products
Long term Capital flows from the purchase of assets eg FDI and shares ie the relative the
merits of inward investment or loans in to the UK (capital account)
Short-term capital flows in and out of bank accounts ie hot money largely affected by
relative interest rates and expected movements in future exchange rates
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Explain an appreciation of sterling 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
price competitiveness deteriorates as the price of UK imports fall whilst UK export prices rise.
What is a depreciation of sterling? 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
competitiveness improves as the price of UK imports rises & UK export prices fall.
What are the effects of a fall in exchange rate? 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.
Net exports eventually rise stimulating aggregate demand and improving the BoP
Structural change occurs as UK firms respond to price changes brought about by the
depreciation.
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Is a stable exchange rate desirable? Frequent and significant changes in the exchange rate are
destabilising. Uncertainty and increased risk reduces confidence, investment and stability
How are exchange rates and the balance of payments linked? When Forex markets are in
equilibrium, the demand for pounds to pay for UK products and assets exactly matches the
supply of pounds to pay for overseas products and assets. The balance of payments is in balance
Explain how balance of payments problems are automatically corrected by floating
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
competitiveness helps move the balance of payments, back into balance.
Identify the merits of a floating exchange rate system.
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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
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30
Floating exchange rates |
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Reduces the ability of speculators to bet against government inability to maintain fixed
exchange rates
Reduces the need for governments to hold reserves of foreign currency
Identify the limitations of a floating exchange rate system. The J curve effect means that
exchange rate changes initially worsen any balance of payments problem
Fixed exchange rates
What is a fixed exchange rate system? In a fixed exchange rate system the value of one
currency against other currencies is held constant.
How can governments intervene to fix an exchange rate? Maintaining an official exchange
rate requires government action to
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$/£
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Restrict currency flows through exchange controls that limit the amount of the domestic
currency that can be taken out of the country. The UK stopped exchange controls in
1979.
Use reserves of gold and foreign currencies to buy and sell foreign currencies for sterling
to maintain the fixed rate. Forex interventions are carried out by the central bank
Use interest rates to encourage the purchase or sale of the currency
S£
FXM for £:$
$2.2
In the diagram opposite, the Forex price of sterling is two
dollars to the pound.
$2.0
D£
Q1
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Draw a graph to illustrate government intervention
to maintain the value of sterling at a fixed rate.
Q2
£Bn
If the government wants to maintain the exchange rate at
$2.20 to the pound then it must buy up excess supply of
[Q2 -Q1] pounds using its reserves of US$s.
Outline the benefits of a fixed exchange 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
international competitiveness
Outline the drawbacks of a fixed exchange rate system. A fixed exchange rate system:
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Requires the government to hold adequate reserves of foreign currency. The
opportunity cost of foreign reserves is foregone interest
Linking domestic monetary policy 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
fixed exchange rate. Read up on the UK’s Black Wednesday in 1992 for an example
Identify other exchange-rate systems
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Managed float whether central bank intervenes to buy and sell foreign currency to
maintain the value of sterling at some target rate
Adjustable peg where the official exchange rate is fixed in the short term but can be
revalued periodically in the long-term
Exchange rate band 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 changes in the supply and demand for currency on the Forex markets
In the short term exchange rate changes are mainly caused by speculators who buy and
sell a currency having to make a capital gain
In the longer run, exchange rates are determined by economic fundamentals
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What are economic fundamentals? Economic fundamentals are the underlying key
characteristics of an economy including productivity and international competitiveness and
Interest rates, growth rates and inflation rates
How can depreciation affect net exports [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
imports falls only if the demand for imports is relatively price elastic
What is the Marshall-Lerner condition? This predicts that depreciation improves the current
account only if the combined elasticities of demand for imports & exports are greater than one.
Does a fall in 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
providing there is spare capacity in the economy to increase output to meet extra demand.
Explain the J curve effect. Following a fall in the value of a currency:
Prices tend to adjust quickly. UK consumers face higher prices for imports while UK firms
selling overseas can reduce prices.
Quantities adjust slowly often after a time lag of up to 12 months. Consumers may be
slow to notice relative price changes while firms may have fixed price contracts in place.
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X-M
This means the price elasticity of demand of imports
and exports is likely to be inelastic in the short run,
but become more elastic over time
Surplu
s
J Curve Effect
0
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, the current account begins to improve.
Define the J curve effect. The J curve is the path followed by the current account following
exchange rate depreciation where the trade balance initially worsens before it improves.
What is the inverted J curve effect? The current account initially improves following an
appreciation of a currency where the trade balance initially improves before it worsens.
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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 trade bloc reduces the risk and
uncertainty associated with volatile exchange rates and so encourages international trade and
associated benefits
Balance of payments problems
What is external balance? External balance is when the balance of payments is in equilibrium
Explain ‘a balance of payments problem’. A balance of payments problem arises when there
is an imbalance between the two main sections: the current account and the capital account.
Give an example of a balance of payments imbalance. China is running a $ 426,100,000,000
surplus on its current account while the USA is operating a $ -673,300,000,000 deficit (CIA)
Identify the likely causes of a current account deficit:
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Excessive household 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
An overvalued currency resulting in high priced exports and low-priced imports
How is a current account deficit financed? The current account deficit is financed by a capital
account surplus. For example the USA attracts large capital inflows from China
Is a current account deficit sustainable? The USA can continue to finance its current-account
deficit because overseas investors have confidence in the American economy. The economic
fundamentals and future prospects of the American economy are viewed with confidence.
How can a balance of payments imbalance be corrected? Where the imbalances are caused
by the current account, there are two main options:


Expenditure reducing policies cut GDP and so lower the demand for imports
Expenditure switching policies that increase the price of imports and/or lower the price
of exports so reducing net exports
Identify potential expenditure reducing policies. Expenditure reducing policies reduce the
level of aggregate demand eg increasing taxes or reducing cover spending and increasing
interest rates.
What are the drawbacks of expenditure reducing policies? Expenditure reducing policies to
improve the current account reduce the level of GDP causing cyclical unemployment and
threatening economic stability.
What is free trade? Free trade occurs when a county abolishes any controls or restrictions on
international trade such as tariffs or quotas.
How can government restrict international trade? Methods of limiting imports and exports


Tariffs: imposing a tax on imports
Non-tariff barriers: impose trade restrictions other than tariffs eg foreign exchange controls
Identify potential expenditure switching policies. Government action to cut exchange rate
reduces the price of exports in foreign currency and increases the price of imports. A tariff also
increases the price of imports while exports subsidies lower the price of exports.
What are the drawbacks of expenditure switching policies? 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