International Competitiveness and Terms of Trade

The international competitiveness of an economy is a central goal of economic policy. But how can this competitiveness be measured? One important indicator is the “Terms of Trade.” (TOT)

#1 The concept of international competitiveness

In the study of economics, there is no consensus on what is meant by “international competitiveness.” One of the best-known definitions comes from Bela Balassa, who describes competitiveness as the “ability to sell.”

However, the ability to sell one’s products in the market does not fully describe competitiveness. If a company lowers its prices far enough, it can always sell its products. However, it will not earn any profit and may even suffer losses. Competitiveness, therefore, also includes the “ability to earn.”

#2 What is the goal of international competitiveness?

One goal of high competitiveness is to increase the volume of goods and services available to the economy for consumption and investment purposes. However, this goal should not be pursued “at any price.”

If a country pursues the goal of inclusive and ecologically sustainable economic growth, low labor costs, low environmental costs, etc., these, unfortunately, are not appropriate instruments for increasing competitiveness.

However, the aim can be to offer high-quality products that meet high demand on the world market. Increased demand leads to rising prices. Then, by selling one’s own products to the rest of the world, the quantity of imported goods exchanged for them becomes greater over time. “Terms of Trade can express this real exchange ratio.

#3 International Competitiveness and Terms of Trade

The Terms of Trade indicate how many units of an import good (or units of a bundle of import goods) the country receives for one unit of its export good (or one unit of a bundle of export goods).

An improvement in the Terms of Trade means that the country can sell its products on the world market, receiving more import good units for one unit of its export good. Domestic products are thus deemed so attractive – and thus competitive – by consumers abroad that they are willing to pay an increasing price.

Therefore, an economy can be considered internationally competitive if it succeeds in selling its products on the world market without the Terms of Trade deteriorating. And when the Terms of Trade improve, the competitiveness of the economy increases.

The level of a country’s Terms of Trade depends essentially on two prices:

• Price of export goods: If the prices of a country’s export goods rise, this means an improvement in the country’s international competitiveness as measured by the Terms of Trade. At first glance, this sounds paradoxical because low prices are actually an expression of low production costs. In turn, low production costs are an indicator of high competitiveness in the sense of “ability to sell.”
• Price of imported goods: If the prices of a country’s imported goods fall, this means an improvement in the domestic Terms of Trade. At first glance, this also seems counterintuitive because falling prices for foreign products are a competitive advantage for the foreign country.

These contradictory assessments can be resolved if a distinction is made between the perspective of companies and the perspective of private households or consumers.

#4 Competitiveness from the perspective of producers and consumers

For producers (i.e., companies), high competitiveness is when the prices of their own products are relatively low (then the company can sell a lot) and the prices of other companies are relatively high (because then these competitors can sell little.)

For a consumer, the situation is different: He earns his income by selling his labor. To earn a high income, the private household (consumer) is interested in high wages, i.e., getting a high price for his product (service). However, the consumer prefers the prices of the products he buys from companies to be as low as possible, so the household’s income, has a high purchasing power.

An improvement in a country’s Terms of Trade has two key benefits for the country concerned. First, with rising Terms of Trade, domestic industry products are considered attractive products in the rest of the world (competitive effect). This safeguards domestic production, employment, and income. Second, for a given quantity of its export goods, the domestic market receives an increasing quantity of import goods. This improves consumption and investment opportunities at home because the quantity of available goods increases (wealth effect).

#5 Economic policy implications

Various measures are available to increase the Terms of Trade. Measures to increase the prices of domestic products include labor productivity, technological progress, and innovation. The domestic market has no direct influence on the prices of products imported from abroad. Nevertheless, these prices can be lowered by reducing tariffs and other trade barriers, and the development of substitutes can reduce dependence on import prices.