Essay About Good Case And Labor Costs

Eu 15 And Ireland
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I. Introduction
With the reduction of international transaction costs, globalization is dominating the
economic discussion more and more in recent times. Markets that were, measured in
economic distance, far apart only a few years ago are moving together and competition
seems to be tightening. A good case in point is the European Union (EU) with its policy
of creating a common market in Europe.
While the traditionally strong economies such as Germany are facing the competition
mentioned above, the EU has also produced an “infant prodigious”. With major investment
and subsidies in infrastructure, development, and education, Ireland and its economy
are performing very well, producing 5.1% real economic growth in 2004, compared
to only 1.7% in Germany.
Of course, the question arises as to how Ireland is able to do that. Somehow the Irish
island seems to be more attractive to economic investment and growth than continental
Europe, or in other words, seems to be more competitive.
This paper introduces the most common instruments to measure a countrys competitive
position, discusses their shortcomings, and introduces an extended approach. The findings
are then applied to Ireland.
II. Measuring Competitiveness
The traditional measure for many economies to assess competitiveness, also used in the
EU, is the Real Exchange Rate (RER). The RER measures any given price index at
home against its counterpart abroad and expresses the result in common currency terms.
When deciding on a price index, a commonly used index is unit labor costs (ULC) in
the traded-goods sector of a country. The rationale of this index is simple: since traded
products basically share the same market, comparing the underlying (labor) costs is an
indicator for profitability and, as a consequence, also for the attractiveness of either of
the two economies to produce tradable goods there. In other words, RERULC is a first
indicator for competitiveness of a country.
However, this measurement has some considerable shortcomings. These can be shown
rather intuitively when analyzing various scenarios. In the first scenario, a depreciation
of the domestic currency (given a pricing-to-market strategy of the domestic producers
of tradable goods) increases the profit margin in this sector and hence improves attractiveness
to produce in this sector and country. This is in line with the above findings
since the RER is lowering, indicating an improved competitive position.
– 2 –
The above discussion can be extended in a first step by introducing the possibility of
price differentiation. After a depreciation of the domestic currency, producers in the
home country will increase their output and lower their prices to sell the increased output.
Hence, value added prices for traded-goods are changing. With RERPVT being the
relation of value added prices of traded-goods of the home country and abroad (in common
currency terms), this ratio is falling. Improved competitiveness now stems from the
fact that the relative profitability in the home countrys traded-goods sector, expressed
by RERULC/RERPVT has improved.
When introducing intermediate products, the analysis of the above is extended further.
With a depreciated domestic currency, the country can not only redeem higher margins
on the world markets, but also has to pay higher prices (in domestic currency terms) for
the required inputs of intermediate products. If wages remain unchanged, profits in that
country would dwindle, hence lowering the competitiveness of this country. It is therefore
sensible to extend the discussion by a profit-based RER (RERPRF) that also takes
the cost functions of producing the output in the traded-goods sector into account.
Another extending scenario is the introduction of differences in technological progress
or capital productivity. In a static scenario, larger short-run supply elasticity leads to a
higher share of increased competitiveness being translated into higher production. If this
is the case, an analysis only based on RERPRF will lead to inconclusive results. While
the ratio of RERULC/RERPVT will look better for a country with lower short-run supply
elasticity, the total profits for a country with a larger elasticity will have increased more
ex-post. The lower RERPRF for the former therefore does not indicate a competitive advantage
over the latter.
Introducing a dynamic perspective into the above scenario, a similar analysis can be
conducted over time. The depreciation in t0 will lead to an increased position in
RERULC/RERPVT since input of labor and capital are unchangeable. When in t1 the input
of labor becomes variable, RERULC and RERPRF will rise again. Inferring a loss of competitiveness