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  EUROPEAN ECONOMY Economic Papers 467 | November 2012 Measuring quality and non-cost competitiveness at a country-product level Francesco Di Comite Economic and Financial A ff  airs ISSN 1725-3187    Economic Papers are written by the Staff of the Directorate-General for Economic and Financial Affairs, or by experts working in association with them. The Papers are intended to increase awareness of the technical work being done by staff and to seek comments and suggestions for further analysis. The views expressed are the author’s alone and do not necessarily correspond to those of the European Commission. Comments and enquiries should be addressed to: European Commission Directorate-General for Economic and Financial Affairs Publications B-1049 Brussels Belgium E-mail: Ecfin-Info@ec.europa.eu This paper exists in English only and can be downloaded from the website ec.europa.eu/economy_finance/publications A great deal of additional information is available on the Internet. It can be accessed through the Europa server (ec.europa.eu)  KC-AI-12-467-EN-N ISBN 978-92-79-22988-6 doi: 10.2765/27416 © European Union, 2012  European Commission Directorate-General for Economic and Financial Affairs Measuring quality and non-cost competitiveness at a country-product level By Francesco Di Comite * Abstract This paper contributes to the ongoing debate on macroeconomic imbalances and external competitiveness by developing a set of indicators of export capability at a country-product level which can be used to complement the existing toolkit of instruments based mostly on unit labour costs and relative price levels. A micro-based methodology is proposed here to extract information on the capacity of a country's exporters to compete abroad by combining trade and macroeconomic data. In particular, light is shed on two independent components of demand for a particular variety (country-product combination): markup-shifting quality and sales-boosting non-cost competitiveness . Together with cost efficiency and information on foreign prices and consumption, these additional indicators may enhance our understanding of the determinants of a country's external position, thus providing better guidance for policymaking.  ________________________________  JEL codes:  F12; F41; L11 Keywords: external competitiveness; quality; non-cost competitiveness; international trade.  ________________________________ * European Commission, DG Economic and Financial Affairs, B-1049 Brussels, Belgium, francesco.di-comite@ec.europa.eu EUROPEAN ECONOMY Economic Papers 467    1 1.   Introduction A key factor in assessing the sustainability of a country’s external position is its capacity to finance the purchase of external goods and services through its exports. This is why an increasing amount of attention and effort is being given to the definition of suitable indicators of external competitiveness, which may be used to identify potential imbalances or dangerous long-term trends. The external position of a country may be affected by several factors, stemming from both the demand and the supply side of the economy, the latter being typically associated with export  performance and the former with import growth. This paper focuses on the supply side of the economy, and specifically on the ability of countries to compete in export markets through the development of better products, in terms of consumers' willingness to pay and their selling capacity. There are currently very few alternatives available to researchers for identifying the drivers of external competitiveness and they are mostly based on productive efficiency and relative price levels, thus drawing all the attention towards these two dimensions of competitiveness. In contrast, a methodology is proposed here to extract from trade and macroeconomic data information on the evolution of what will be referred to as the quality and non-cost competitiveness of EU Member States' exports. A formal definition of these concepts will be presented in Section 3, but as a first approximation it can be said that the term “quality” captures the characteristics of an exported  product that affect markups and sales positively, whereas “non-cost competitiveness” captures the characteristics of an exported product that affect sales but not equilibrium markups or prices. In order to identify these two elements, a particular demand structure is assumed, which has the advantage of being flexible, tractable and fully identifiable. The choice of the modelling framework is motivated in the next section, where a concise literature review of alternative models in trade theory is presented. Section 3 then presents the specific model used and the procedure to be followed when identifying its parameters. Section 4 turns to the empirical implementation of the estimation procedure and addresses the issues related to data requirements and availability, showing how to use the model to build indices of quality and non-cost competitiveness. An illustrative example of the use of these indices for policy purposes is  presented in Section 5, with a particular focus on the Latvian experience. Section 6 then turns to the issue of how to use the indicators to undertake policy analysis, showing some comparisons across products and countries. Finally, Section 7 concludes. 2.   Quality and taste in the trade literature There are many alternative models of international trade currently available to researchers, but only few of them can actually be used to identify asymmetric product characteristics. In general terms, the issue of how to account for differences across product characteristics such as quality can  be meaningfully dealt with only in specific theoretical frameworks allowing for product differentiation and for consumers appreciating variety. 1  This requirement restricts the menu of available models to the so-called New Trade Theory, pioneered by Krugman (1980, 1979) on the 1   These two conditions are needed In order to avoid corner solutions in which all the consumers buy the same amount of all the available varieties (in the case of lack of differentiation) or they all consume only one particular variety and ignore the others (in the case of lack of love for variety).
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