Eu 15 And Ireland

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 country's 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.

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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 country's 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

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