Can international trade help solve the UK’s productivity puzzle?
Published 2 October 2023
The UK has been grappling for some time with a productivity problem. As policymakers and researchers search for solutions, one question emerges: can international trade offer part of the solution to this productivity puzzle?
Productivity, the amount of output generated per unit of input, is an important determinant of economic growth and living standards. The UK’s productivity puzzle is in fact a series of related questions that include:
1) why its productivity lags behind its major competitors such as France, Germany and the US – (ONS estimates suggest 27%, 28% and 31% lower respectively;
2) why its recent productivity growth has slowed – for much of the 20th century productivity growth hovered around 2.2% per year. From the mid-200s this fell to around 0.5% per year; and
3) why is the productivity of the different regions of the UK so different? – the gap between the most productive region, London, and the least, Wales, is 63%.
While there is no one-size-fits-all solution to these problems, international trade holds the potential to be a significant piece in any policy jigsaw. One potentially useful way to consider the effects that international trade might have is to first identify what contributes to productivity change. Broadly, this can be separated into what happens within an industry and what happens between industries. Within an industry this can be further separated as to whether trade encourages businesses to increase their productivity, or whether it allows more productive firms to grow more quickly than less productive ones, who may then exit the market / cease trading. Between industries this is about whether the more productive industries in a country are getting bigger.
It turns out that the ‘within the industry’ factors are by far the most important and can explain over 80% of the change in UK productivity1. The ‘between industry’ effects matter, but they change only very slowly.
Research evidence2 suggests that international trade helps to improve productivity within industries in the following ways:
- Access to global markets: engaging in international trade opens doors to larger markets, in particular for firms that are already more productive. This expanded market reach can increase demand for UK products and services, prompting companies to invest in efficiency improvements and innovation.
- Competition breeds innovation: exposure to international trade can act as a catalyst for innovation. The need to stay competitive can motivate businesses to adopt more efficient production processes, such changes are easier to implement the more productive the firm is already.
- Knowledge transfer and learning: trade can help knowledge transfer and learning both because firms can bring back the information and ideas of what works elsewhere, but also because knowledge and technologies are embodied within products, and so firms import new and higher quality inputs.
- Economies of scale: the scale of international trade enables firms to achieve economies of scale.
- Specialisation: while the process of encouraging the UK to focus on industries in which the UK has a comparative advantage works only very slowly, this same idea works more strongly and more quickly within businesses. They give up producing the goods and services they are less productive in and focus their attention on the core competencies that they have
Some businesses are better placed to take advantage of the productivity-boosting channels from international trade, which inevitably implies that others, and the workers and managers within those businesses, are not.
Businesses within an industry can be categorised into three types, as shown below. There are typically few of these big ‘superstars’, somewhat more ‘national champions’ and a majority of ‘standard’ firms, which are often small and medium-sized businesses (SMEs). The benefits to trade largely accrue to the ‘superstars’ and ‘national champions’, whereas the ‘standard’ businesses face more competition, lose sales and generally find business life harder. The ‘superstar’ and ‘national champion’ businesses both become more productive and they grow more quickly than the ‘standard’ ones, which raises aggregate productivity.
There can also be industry and regional dimensions to this productivity change. Industries have different proportions of these three types of business, and hence the costs and benefits of international trade fall differently. This is part of the ‘between industry’ productivity change that occurs. Similarly, there are regional differences, in part because firms in industries tend to cluster together. All regions have some of these three types of firms, but the higher productivity regions have more of the ‘superstars’ and fewer of the ‘standard’ firms. This will bring about a local dimension to the adjustments that follow when there is greater trade.
In conclusion, international trade and trade policy can be part of the solution to the UK’s productivity problem, but it is not a standalone fix. While in the aggregate there is evidence it helps improve productivity it does not benefit all firms, industries and regions evenly and there may need to be policies that help these affected employees and entrepreneurs move into these better-performing firms/industries/regions. Supportive policies that promote innovation, education, research and development and infrastructure would also help here.
- Coyle, D. and Mei, J-C. (2023) ‘Diagnosing the UK productivity slowdown: which sectors matter and why?’ Economica, Vol. 90, pp. 813-850.
- Syverson, C., (2011). What determines productivity? Journal of Economic literature, 49(2), pp.326-365.