Modelling Competitiveness

Biswajit NagIndian Institute of Foreign TradeNew Delhibiswajit@iift.ac.inbiswajit.nag@gmail.com

Content

Theoretical Models to asses International Competitiveness

Empirical Issues in Measuring and Modeling Competitiveness

International Competitiveness

•The concept of international competitiveness is often used in analyzing countries' macroeconomic performance.

•It compares, for a country and its trading partners, a number ofsalient economic features that can help explain international trade trends.

• International competitiveness is said to occur whenever the economic welfare of a nation is advanced through an increase in the flow of trade or through an alteration in the conditions of trade starting from a presumed initial equilibrium.

Theoretical Models to asses International Competitiveness

• In order to describe the processes involved in securing and maintaining international competitiveness, the conventional models of international trade theory are used, namely the Ricardian, Heckscher‐Ohlin, contemporary standard trade, and industrial organization models. The major identifier of international competitiveness in these models are trade balance and Terms of Trade (ToT)

• International competitiveness is also influenced by capital flows. TOT is function of exchange rates, which are affected by both short‐ and long‐term international capital flows. This  impact directly on the international flow of goods. 

Classical and Early Neo‐classical Models

• Ricardian or factor (labor) productivity Model:– comparative advantage– the factor of the Ricardian theory can be construed as either an optimal combination of a number of resources or literally as a single factor.

– the factor productivity theory is theoretically deficient, insofar as no explanation is given as to the source of the differences  in  productivity  among  nations.

Classical and Early Neo‐classical Models

• Heckscher‐Ohlin or factor proportions model:– nations tend to export goods whose production requires relatively more of the inputs for which there is a domestic abundance

– In the Heckscher‐Ohlin model, international competitiveness is enhanced through either export‐ or  import‐biased  growth.

Infant Industry Model

• The infant industry model depicts a domestic competitive industry that is subject to external economies of scale but which is too small (perhaps, nonexistent) to be internationally competitive.

• If the domestic industry could somehow grow to some critical size or greater, it would be internationally competitive or even domestically or internationally dominant. 

Standard Trade and Industrial  OrgannisationModels

• Introduces, process innovation (dissimilar technologies or technological change) in production or business administration in general (production, marketing, management, finance, and the like) are introduced. 

• As a follow up of process innovation, product innovation is alsointroduced in the structure. 

• H‐O theory assumes perfect competition only. Once we consider above issues, it becomes necessary to twist the models towards monopolistic competition and oligopoly. .

Imperfect Competition

The Chamberlinian Model• In this kind of models, the products are differentiated, entry is 

free, equilibrium profits are zero, and the number of firms is relatively small.

• It describes the welfare effects (and competitiveness) on variety and price (and quantity) of the ability to exploit internal economies of scale because of expanded markets provided by free international trade.

The Conjectural Variation Model• In this kind of models, oligopolies may be homogeneous or 

differentiated, and free market‐type barriers to entry and positive economic profits are common.

• It describes the entrepreneurial nature of the profit‐seeking behavior of international homogeneous and differentiated oligopolies, with and without internal economies.

• But neither type deals explicitly with the effects of the multinational enterprise (MNE) on international trade and the consequences of these effects on economic welfare,

Imperfect Competition

Industrial Organisation Models

• MNEs have been described as exporters of the services of firm‐specific assets or of knowledge capital. Their existence and growth depend on increasing returns to scale in the production of goods as the notion of internal economies is conventionally understood.

• Most models look into firms’ enterprenurial ability  (process and production efficiency and managerial skill) as the core strength of competitiveness. 

• Literature identifies  that the  complementarity which exist between the important variables can be attributed to profit‐seeking innovative entrepreneurship that was made possible by technological progress with regard to communication and transportation and by an increasingly favorable political environment.

• The result was that the levels of MNE activity and intra‐industry and international trade increased concurrently.

Other issues

• Exchange Rate and Capital flows : Having Price effect

• Tariffs and Trade barriers  

So, Modeling competitiveness is based on 

Productivity • Due to resource endowment• Due to technological superiority 

Entrepreneurial Ability• (Process and product innovation, managerial skill) • Efficiency in the process through intra‐industry trade

Non‐Entrepreneurial Issues• Exchange rate• Capital Flows• Tariffs and trade barriers• RTAs and geographical effect

Empirical Issues in Measuring and Modeling Competitiveness

Competitiveness IndexCompetitiveness in trade is broadly defined as the capacity of an industry to increase its share in international markets at the expense of its rivals. The competitiveness index is an indirect measure of international market power, evaluated through a country’s share of world markets in selected export categories.

The index is the share of total exports of a given product from the region under study in total world exports of the same product.

Where s is the country of interest, d and w are the set of all countries in theworld, i is the sector of interest, and x is the commodity export flow. Inwords, it is the share of country s’s exports of good i in the total world exportsof good i.

Revealed Comparative Advantage (RCA)Comparative advantage underlies economists’ explanations for the observed pattern of inter-industry trade. In theoretical models, comparative advantage isexpressed in terms of relative prices evaluated in the absence of trade. Since these are not observed, in practice we measure comparative advantage indirectly. Revealed comparative advantage indices (RCA) use the trade pattern to identify the sectors in which an economy has a comparative advantage, by comparing the country of interests’ trade profile with the world average.

Definition: The RCA index is defined as the ratio of two shares. The numerator is the share of a country’s total exports of the commodity of interest in its total exports. The denominator is share of world exports of the same commodity in total world exports. RCA takes a value between 0 and +∞. A country is said to have a revealed comparative advantage if the value exceeds unity.

RCA and RCDA

The RCA index of country i for product j is often measured by the product’s share in the country’s exports in relation to its share in world trade: 

RCAij = (xij/Xit) / (xwj/Xwt)

Where xij and xwj are the values of country i’s exports of product j and world exports of product j and where Xit and Xwt refer to the country’s total exports and world total exports. 

A value of less than unity implies that the country has a revealed comparative disadvantage (RCDA) in the product. 

Similarly, if the index exceeds unity, the country is said to have a revealed comparative advantage in the product.

RCA – RCDA Analysis• Measures of revealed comparative advantage (RCA) have 

been used to help assess a country’s export potential. The RCA indicates whether a country is in the process of extending the products in which it has a trade potential.

• Country A’s  potentiality of exporting products falling on the upper side of the diagonal is quite high as Country B is having comparative disadvantage in those products. 

• But we are not sure whether demand in Country B is sufficiently high from the RCA Analysis. RCA only provides supply side story.  

RCA – RCDA Analysis

RCDA: 1-RCA, when 0<RCA<1

Constant Share Market Analysis

• The intrinsic norm of this analysis is that a country's export share in a given market should remain unchanged over time. 

• Keeping the market share constant, the model expresses the competitiveness term as negative or positive to adjust the actual change in market share.

Constant Share Market Analysis

• The difference between the actual export growth from a member country into a given market and the unchanging export share implied by the ‘constant‐market share norm’ is attributed to the following three factors:1. The effects of a general increase in demand for imports in the given  market2. Commodity composition, and3. Changes in competitiveness

Constant Share Market Analysis

• The three effects can be explained by the following equation. 

X(t)‐X(0) = m X(0) + Σ {(mi ‐m) Xi(0)} + Σ {Xi(t) – Xi(0) – mi Xi(0)}

• X: exports of country A to country B• Xi: commodity i exports of country A to country B• m: Percentage increase in country B's total imports from period 0 to period t• mi: Percentage increase in country B's imports of commodity i between 

period 0 to period t.• and X=∑Xi 

Constant Share Market Analysis• The right hand side can be divided into three components 

1. The general rise in country B's total imports 2. The commodity composition of country A's exports to B in period 0, and 3. An unexplained residual indicating the difference between country A’s 

actual exports increase to country B and the hypothetical increase if country A maintained its share of exports of each commodity group in country B.

• If a country fails to maintain its market share in a given market, the competitiveness term will be negative. This indicates that the relative price increase for that country is greater than its competitors. 

Constant Share Market Analysis

Note: The table is calculated for the year 1999-02

Constant Share Market AnalysisIndia’s Increase in Exports to China: Segregation of Various Effects

(2002-04)

84.59160.94‐145.53Paper

98.32‐10.9312.61Lather

41.91‐25.2683.35Rubber

42.5620.9336.51Plastic

45.55‐17.5171.95Pharmaceutical

59.59‐51.8892.29Organic

‐13.0442.2370.81Inorganic

25.903.9670.14Chemical

‐108.01‐39.20247.21Agriculture

Increased competitiveness

Commodity composition

General increase in imports in 

ChinaGroup

(No of commodities)

Shift Share Market Analysis

• The gains or losses of world market shares by individual countries are often considered as an index of their trade competitiveness.

• Given changes in demand, the relative medium‐term inertia of geographical and sectoral specializations partly affects such outcomes.

• For a given period, the model distinguishes the impact of a country’s initial position in different markets relative to its capacity to adapt and to its competitiveness.

Shift Share Market Analysis

• The export growth of a given country is divided into:1. Global demand effect

2. Sectoral composition effect

3. Geographical composition effect

4. Competitiveness effect, captured by the residual term

Shift Share Market Analysis

• The change in country i’s exports from time 0 to t is expressed as follows:

Xti... – X0i.. = r X0i.. + Σk (rk – r) X0i.k + Σk Σj (rjk – rk) X0ijk + Σk Σj {Xtijk – X0ijk(1+ rjk)}

Shift Share Market Analysis

Source: World Trade Competitiveness: A Disaggregated View by Shift-Share Analysis, by Angela Cheptea, Guillaume Gaulier and Soledad Zignago

OECD MethodThe OECD model produces indicators of relative competitiveness based on the export unit values of manufactures, unit labour costs in anufacturing and consumer price indices. The OECD also produces indices of effective exchange rates.

This is defined by a particular characterization of the links between foreign trade variables (export and import volumes) and the measures of price-competition influencing them.

In breaking down tradeable goods by place of production and product category (food, manufactures, etc), the model draws up for each type of tradeable good, an equation of market share for each exporting country. This is a function only of the differential between the export and the market price,

By explaining the change in total demand for this good on a market as the outcome of an income effect and a product-substitution effect, it is possible to derive equations for the demand for these goods.

By aggregating these equations of bilateral flows for a given product for all markets or producers, global export and import equations may be derived foreach country

OECD Method• The competitiveness variables that appear in such equations are 

explicitly defined price (or cost) differentials based on a weighted average whose weighting pattern is imposed by the model. It is these weights that underlies the construction of the OECD's indicators.

• The OECD calculates indicators of overall competitiveness which provide  an average measure of countries' competitive position on their home markets as well as on their export markets.

• In the overall model, two factors effectively go to explain changes in exports: growth of export markets and changes in export market shares as a result of changes in countries' price‐competitiveness.

Gravity Model

The gravity model is perhaps the most widely used econometric model of international trade patterns. An econometric model uses historical data to try to estimate (and test the robustness of) a hypothesized economicrelationship. Once estimated, an econometric model may also be used to try and extrapolate to cases outside of what has been experienced, i.e., as a predictive policy device.

The model is very easy to set up with simple econometric tools.

Earlier, gravity model was accused of lack of theoretical foundation. However, views are changing. The development of the ‘new’ trade theory helped to provide stronger theoretical foundations for the specification, and it is now recognized that a reduced form gravity equation can be derived from most models of international trade that incorporate transportation costs

Gravity ModelIn order to estimate the gravity model a double logarithmic specification is usually used, relating the bilateral trade flows of each country pair (the dependent variable) to the product of their GDPs and the distance between them (the independent variables), plus an error term to capture the random component in the data. In most applications, additional independent variables are also often included in the model to improve the fit. These may include measures of openness, remoteness, common language or currency, acommon border, and of course the presence or absence of a regional trading agreement. The variables may be continuous (e.g., some measures ofopenness) or qualitative measures represented by dummy variables (e.g., a country pair is assigned a 1 if they share a common language, a 0 otherwise)

As a single equation linear model, the gravity model can be estimated easily using ordinary least squares (OLS), although other methods (e.g., generalized least squares) may be helpful if the data exhibits heteroscedasticity. If the data from which the model is estimated is a panel (i.e., is composed of both time series and cross-sectional elements) then pooled OLS, fixed effects or random effects models may also be used.

Example (Nag and Nandi, 2006)• Model on India’s major trade partners and SAARC countries • Panel Data Model• Period of study 1990‐2000• Multiplicative interactive forms for GDP and per capita GDP have 

been used to consider continuous cross influence by sample countries.

• The model was estimated by fixed‐effect panel data estimation technique.

• Egger (2000) has justified the use of fixed effect model. 

The Model continued…

• The model below, is inspired from Frankel et al. (1995), Ghosh (2002), and Matyas (1997).

Log (Xind j t) = αind + γj + λt + a1 log (GDPind ∗ GDPj) + a2log (per capita GDPind ∗ per capita GDPj) + a3 log (distance indj)+ a4 log (nom‐exchange rateind / nom‐exchange ratej) + a5 log (exp price indexind / world exp price index) + a6 log (consumer price indexj / consumer price indexind) + uind jt

• ind = India; j = 1, 2…16; (India’s top 10 export destinations and six SAARC countries); t = 1, 2…11; (1990–2000); Xind = India’s total export

Example