# Macroeconomics: Theory through Applications, v. 1.0

by Russell Cooper and A. Andrew John

## 5.6 Globalization and Competitiveness Revisited

### Learning Objectives

After you have read this section, you should be able to answer the following questions:

1. How is competitiveness measured?
2. What are some of the policies governments use to influence their competitiveness?

At the beginning of this chapter, we noted that both President George W. Bush and President Obama have emphasized policies to improve the competitiveness of the United States. Such interest in national competitiveness is not restricted to the United States.It is perhaps more pronounced in the United States than in other countries. A Google search on October 17, 2011 reveals that the string “Keep America Competitive” has almost twice as many hits as the string “Keep Canada Competitive” and more than three times as many hits as “Keep Britain Competitive.” In their “Lisbon Agenda” of 2000, the heads of European countries stated an aim of making the European Union “the most competitive and dynamic knowledge-driven economy by 2010.”See “Lisbon Agenda,” EurActive, May 21, 2007, accessed July 27, 2011, http://www.euractiv.com/en/future-eu/lisbon-agenda/article-117510.

Various organizations produce rankings of the competitiveness of countries. For example, IMD, a business school in Switzerland, produces a World Competitiveness Yearbook (WCY) every year.See “World Competitiveness Center,” IMD, accessed August 22, 2011, http://www.imd.org/research/centers/wcc/index.cfm. The World Economic Forum (WEF) produces an annual Global Competitiveness Report.See “Global Competitiveness Report,” World Economic Forum, accessed June 29, 2011, http://www.weforum.org/s?s=global+competitiveness. In 2010, the WEF judged Switzerland to be the most competitive economy in the world, followed by the United States and Singapore. According to IMD, the top three were Hong Kong, the United States, and Singapore. These rankings are covered extensively in the business press, and there is also a market for them—WCY resources cost over $1,000. Business and governments purchase these reports each year. National competitiveness is big business. In their bid to measure competitiveness, the WEF and the WCY look at a combination of “hard” economic data and surveys of businesspeople. Each looks at hundreds of measures in their respective attempts to measure national competitiveness. If these two institutions are to be believed, national competitiveness is a very complicated animal indeed. Although we do not want to go through their measures in detail, a few themes emerge. • Both the WEF and the WCY look at measures of human capital, such as the number of people enrolled in tertiary education. • Technology and technological infrastructure feature prominently in both lists of data. The WEF and the WCY look at measures such as the penetration of computers, the Internet, and mobile phones and the granting of patents. • The quality of public institutions and the prevalence of corruption feature prominently in both lists. Here, the WEF relies on survey data on corruption, bribes, and the extent to which the legal system is fair and transparent. The WCY includes survey information on management practices and “attitudes and values.” Thus the items that we have identified as components of social infrastructure and human capital are included as key determinants of competitiveness. (Technological infrastructure is difficult to classify and measure. In part, it is captured by measures of capital stock because knowledge can be embodied in the capital stock.) Countries that do better in terms of these rankings will tend to have higher levels of output because these are all inputs into the aggregate production function. The competitiveness of a country is not a matter of how much output it produces, however; we already have a perfectly good measure of that, called real gross domestic product (real GDP). Instead, competitiveness is the ability to attract foreign capital. If countries do not have enough domestic savings to fund investment, then they need to obtain capital from other countries. The amount of capital in the world is limited, so countries compete for this capital by trying to make their economies attractive places to invest. More human capital, better knowledge, or superior social infrastructure all serve to increase the return on investment. If workers are more skilled, then extra capital will generate more output. If firms have better processes in place, then extra capital will generate more output. If a country is free of corruption, then extra capital will generate more output. This suggests that one good yet simple indicator of national competitiveness is the marginal product of capital. Country A is more competitive than country B if capital investment in country A is more productive than in country B. More exactly, a country is more competitive if it has a higher marginal product of capital. ## Globalization: Another Look Whenever a good or service is produced and sold, economic value is created. The amount of value is given by the difference between the value to the buyer and the value to the seller. For example, suppose a toy car is produced in a factory in Kansas at a cost of$5. Imagine that a potential buyer in California values the car at $20—that is, she is willing to pay up to this amount for the toy. Then the value created if the buyer and seller trade is$20 − $5 =$15.

In a globalized world, toy cars can be transported around the world. This means two things. First, goods can go to where buyers value them the most. There might be a buyer in Germany who values the car at $25. If he buys the car, then the trade creates$20 worth of value (= $25 −$5). Second, goods can be manufactured where production costs are lowest. Perhaps the toy car can be manufactured in China for $2. If the toy is produced in China and sold in Germany, then the total value created by the trade increases to$23 (= $25 −$2). Globalization thus contributes to a more efficient global economy because goods—and many services—can be shipped around the world to create more value. They can be produced where it is most efficient to produce them and sold where they are valued the most.

We have also seen that capital (and to a lesser extent labor) moves around the world. Capital moves to competitive economies—that is, to the places where its marginal product is highest. This again contributes to economic efficiency because it means that we (that is, the world as a whole) get more output from a given amount of capital input.

This brief description paints a rosy picture of globalization as a force that makes the world a more productive place. Yet globalization has vehement critics. Protesters have taken to the streets around the world to complain about it. And the recent era of globalization has seen mixed results in terms of economic success. Some economies—particularly in East Asia—have exploited the opportunities of globalization to their advantage. But other countries—most notably in sub-Saharan Africa—remain stuck in poverty.

So what is our story missing? What is wrong with the idea that the free movement of goods and capital can encourage prosperity everywhere? There are some reasons why we should temper our optimism about the process of globalization, including the following:

• There are winners and losers. There is a strong presumption from economic theory that globalization will increase overall economic efficiency, but there is no guarantee that everyone will gain. Investors are winners from globalization because they can send their funds to wherever capital earns the highest return. Workers in countries that attract capital will, in general, be winners because they will obtain higher real wages. However, workers in countries that lose capital lose from globalization: they see their real wages decrease. In our example, the buyers of toys in California and Germany benefit from the fact that toys are cheaper and available in greater variety. But the toy manufacturer in Kansas loses out because it cannot compete with the cheaper product from China. The factory may close, and its workers may be forced to look for other—perhaps less attractive—jobs.
• The playing field is not level. In an introductory economics book, we do not have room to review the details of trade agreements throughout the world. But one trenchant criticism of globalization is that developed countries have maintained high tariffs and subsidies even as they have encouraged poorer countries to eliminate such measures. As a result, the benefits of globalization have been almost entirely absent for some of the poorest countries in the world. Moreover, rich countries have disproportionate control over some of the key international institutions: the managing director of the International Monetary Fund (IMF) is traditionally a European; the president of the World Bank is appointed by the United States.
• One size may not fit all. International institutions such as the IMF and the World Bank typically advocate similar policies for all countries. In fact, different policies might be appropriate for different countries. For example, these organizations argued that countries should allow free movement of capital across their borders. We have seen that there is a strong argument for allowing capital to go in search of the highest return. But not all capital flows take the form of building new factories. Sometimes, the movement of capital consists of only very fast transfers of money in and out of countries, based on guesses about movements in interest rates and exchange rates. These flows of money can be a source of instability in a country. There is increasing recognition that, sometimes at least, it is better to place some limits on such speculative capital movements.

Most economists are convinced that the benefits of globalization are enough to outweigh these concerns. Many—perhaps most—are also convinced that, if globalization is to live up to its promise for the world, it needs to be managed better than it has been in the past.

## Policies to Increase Competitiveness and Real Wages

We know that if an economy increases its labor input, other things being equal, the marginal product of labor (and hence the real wage) decreases. If an economy increases its physical capital stock, meanwhile, then the marginal product of capital (and hence the economy’s competitiveness) decreases.

There is a critical tension between competitiveness and real wages. Suppose for a moment that human capital and technology are unchanging. Then an economy in which real wages are increasing must also be an economy that is becoming less competitive. Conversely, the only way in which an economy can become more competitive is by seeing its real wages decrease.

High real wages make a country less attractive for businesses—after all, firms choose where to locate in an attempt to make as much profit as possible, so, other things being equal, they prefer to be in low-wage economies. Indeed, the WEF and the WCY both use labor costs as one of their indicators of competitiveness. Our article about Compal locating in Vietnam likewise cited low wages as an attraction of the country.

But we must not be misled by this. High real wages signal prosperity in a country. Low real wages, even if they make an economy competitive and help to attract capital, are not in themselves desirable. After all, the point of attracting capital in the first place is to increase economic well-being. As an example, China has been quite successful at attracting capital, in large part because of low real wages. As the country has become more prosperous, real wages have risen. A BusinessWeek article, commenting on the increasing wages in the country, observed the following: “The wage issue has started to affect how companies operate in China. U.S. corporations and their suppliers are starting to rethink where to locate facilities, whether deeper into the interior (where salaries and land values are smaller), or even farther afield, to lower-cost countries such as Vietnam or Indonesia. Already, higher labor costs are beginning to price some manufacturers out of more developed Chinese cities such as Shanghai and Suzhou.”“How Rising Wages Are Changing the Game in China,” Bloomberg BusinessWeek, March 27, 2006, accessed June 29, 2011, http://www.businessweek.com/magazine/content/06_13/b3977049.htm. In other words, increasing real wages are making China less competitive. But this tells us that China is getting richer, and workers in China are able to enjoy improvements in their standard of living. This is a good thing, not a problem.

What we really want are policies that will increase both competitiveness and real wages at the same time. The only way to do this is by increasing the stocks of human capital, knowledge, and social infrastructure (there is little a country can do to increase its stock of natural resources). There are no easy or quick ways to increase any of these. Still, important policy options include the following:

• Invest in education and training. Overall economic performance depends to a great degree on the education and skills of the workforce. This is one reason why countries throughout the world recognize the need to provide basic education to their citizens. It is worthwhile for countries to build up their stock of human capital just as it is worthwhile for them to build up their stocks of physical capital.
• Invest in research and development (R&D). The overall knowledge in an economy is advanced by new inventions and innovations. The romantic vision of invention is that some brilliant person comes up with a completely new idea. There are celebrated examples of this throughout human history, starting perhaps with the cave dweller who had the idea of cracking a nut with a stone and including the individual insights of scientists like Louis Pasteur, Marie Curie, and Albert Einstein. But the reality of invention in the modern economy is more mundane. Inventions and innovations today almost always originate from teams of researchers—sometimes in universities or think tanks or sometimes in the R&D departments of firms. Governments often judge it worthwhile to subsidize such research to help increase the stock of knowledge. R&D expenditures in the United States and other rich countries are substantial; in the United States they amount to about 2 percent of GDP.
• Encourage technology transfer. Firms in developed countries tend to have access to state-of-the-art knowledge and techniques. To increase their stock of knowledge, such countries must advance the overall knowledge of the world. For poorer countries in the world, however, there is another possibility. Factories in poor countries typically do not use the most advanced production techniques or have the most modern machinery. These countries can improve their stock of knowledge by importing the latest techniques from other countries. In practice, governments often do this by encouraging multinational firms from rich countries to build factories in their countries. Technology transfer within a country is also important. Researchers have found that, even with a country, there can be big differences in the productivity of different factories within an industry.See Chang-Tai Hsieh and Peter Klenow, “Misallocation and Manufacturing TFP in China and India,” The Quarterly Journal of Economics CXXIV, no. 4, November 2009, accessed June 28, 2011, http://klenow.com/MMTFP.pdf. So countries may be able to increase real GDP by providing incentives for knowledge sharing across plants.
• Invest in social infrastructure. Improvements in social infrastructure are hard to implement. A government, no matter how well intentioned, cannot eliminate corruption overnight. Nor can it instantly establish a reliable legal system that will uphold contracts and protect property rights. (Even if a country could do so, it would still take considerable time for international investors to gain confidence in the system.) Improving social infrastructure is, for most countries, a struggle for the long haul.

We should ask whether government needs to play a role in any of this. After all, individuals have an incentive to invest in their own education. Many people find it worthwhile to pay for undergraduate or graduate degrees because they know they will get better, higher paying jobs afterward. Similarly, firms have a lot of incentive to carry out R&D because a successful invention will allow them to earn higher profits.

There is no doubt that these private incentives play a big role in encouraging the advancement of knowledge. Still, most economists agree that private incentives are not sufficient. Particularly in poor countries, people may not be able to afford to pay for their own education or be able to borrow for that purpose, even if it would eventually pay off for them to do so.

Because knowledge is nonrival and frequently nonexcludable, not all the benefits from R&D flow to the firms that make the investment. For example, suppose a firm comes up with some new software. Other firms may be able to imitate the idea and capture some of the benefits of the invention. (Although the United States and other countries have patent and copyright laws to help ensure that people and firms can enjoy the benefits of their own inventions, such laws are imperfect, and firms sometimes find that their ideas are copied or stolen.) Private markets will do a poor job of providing nonrival and nonexcludable goods, so there is a potential role for the government.

Similar arguments apply to much social infrastructure. The provision of roads is a classic function of government because they are again (most of the time, at least) nonrival and nonexcludable. And the establishment of a reliable legal system is one of the most basic functions of government.

### Key Takeaways

• In some leading studies, the items that we have identified as components of social infrastructure and human capital are included as key determinants of competitiveness. Overall, the marginal product of capital is a good indicator of the competitiveness of a country.
• Governments take actions to increase their competitiveness and the real wages of their workers by encouraging the accumulation of human capital, knowledge, and the transfer of technology.