With continuing uncertainty of the terms of the UK’s exit from the EU, I’ve been looking at how Brexit might affect UK manufacturing. I recently looked at the importance of this sector for the UK economy and what impact Brexit has already had on employment and turnover within the manufacturing sector. In this article, I’ll look at the importance of regulatory alignment, in particular how this might affect trade and how important it is to manufacturing.
Some Fundamental Economics
It is generally accepted that everyone gets richer if they specialize and trade with others rather than trying to produce everything themselves. The fundamental theory that explains this is called comparative advantage. It applies at any level to individuals, companies and countries.
It seems to be common sense that if you can produce something more cheaply than anyone else, then you should produce more than you need and sell some of them for a profit. It also seems to be common sense that if someone else can produce something more cheaply than you can, then you’re better off buying it than producing it yourself. This is called absolute advantage. Comparative advantage is a bit more subtle. It shows that even if you could produce something more cheaply than you can buy it, you still might be better off buying it if it allows you to dedicate more of your resources to producing something else where you can make more profit.
These ideas can be understood most clearly using a simple example. Consider trade in only two goods between two countries. Let’s assume that Germany has an absolute advantage over the UK in producing both cars and industrial robots. For a given unit of production resource, referred to within economics as thefactors of production, Germany could produce either 10 cars or five robots. Given the same factors of production, the UK could produce eight cars or one robot.
Units produced by each country if all factors of production are dedicated to producing a single product. Germany has the absolute advantage for both cars and robots.
Now let’s consider comparative advantage. In order to produce one car, Germany must give up producing 0.5 robots (5/10). Because the UK is less efficient at producing robots, they would only be giving up 0.125 robots to produce a car (1/8). Similarly, to produce a robot, Germany would be giving up two cars while the UK would be giving up eight cars. Considering the production cost in terms of what alternative production is being sacrificed is known as the opportunity cost. The theory of comparative advantage states that whichever country has the lowest opportunity cost should produce the product, and that will result in everyone being better off than if they had only considered their absolute advantage.
The per unit opportunity costs for each country shows that the UK has a comparative advantage for the production of cars while Germany has a comparative advantage for the production of robots.
Barriers to Trade
In the real world, when considering where you have a comparative advantage, it is not only the production costs that must be considered. The cost of getting the product into the market must also be taken into account. For example, it might be much cheaper to build a house in Vietnam than it is in Switzerland. However, if you were to transport the house from Vietnam to Switzerland, the transportation costs would be extremely high. The building standards are also likely to be very different. Training construction workers and obtaining special materials to build to the Swiss building standards would be very difficult within Vietnam. Clearly, in this case it would probably not make sense for Switzerland to import houses.
In the above example, distance is used as an example of a natural barrier to trade. The further apart two countries are, the more that the advantage gained by trading may be consumed by transportation costs. As well as natural barriers to trade, such as distance, other barriers include tariffs and non-tariff barriers. When countries have different regulations or standards, it is a non-tariff barrier. It can mean that different versions of a product may have to be produced for different markets, reducing economies of scale, or it can mean that multiple sets of certification testing may be required, directly increasing costs.
The Challenge of Regulatory Alignment in Brexit
Brexit has in part been driven by the idea that in leaving the EU, the UK will have greater control over regulations and will. Therefore, it will be able to reduce the costs associated with bureaucracy. In reality, those ideas are, in general, mutually exclusive. If the UK wishes to exercise its independence by creating regulations that are less demanding than those used within the EU, it may reduce the cost of goods produced for domestic consumption. However, any goods exported to the EU will require separate certification and testing processes, which will greatly increase costs. In high-value manufacturing, such as aerospace, inspection and other certification-related costs can be more significant than the costs involved in actually producing parts. This is likely to rapidly make the UK become uncompetitive within these tightly integrated supply chains. This point has been made repeatedly by industry representatives. For example, last month Paul Everitt, the chief executive of the aerospace and defense trade body ADS wrote to the UK government stating that, “Regulatory divergence would pose a serious risk to our sectors and will result in huge new costs and disruptions to many of our members.”
If, on the other hand, the UK goes down the route of maintaining close regulatory alignment, then there will be little impact on existing manufacturing operations. However, ADS has also warned that an “inability to shape safety rule making… will make it much more difficult to bring UK technology to market.”Ironically, this would also mean that the UK has lost the ability to shape the regulations that it follows.
Regulation within the highly integrated European aerospace industry is currently handled by the European Union Aviation Safety Agency (EASA). This body carries out certification, regulation and standardization, including new types of certificates and other airworthiness approvals for aircraft. The UK currently contributes between £1m and £4m to fund EASA. The aerospace industry has estimated that creating a UK authority able to perform these functions will take at least 10 years and cost £30m to £40m a year. Without membership in EASA, this is a cost that will be incurred even if regulatory alignment is maintained.
The aerospace industry is just one example in which regulatory alignment is critical to maintaining competitive supply chains. The chemicals and automotive industries are also highly dependent on close alignment.Brexit means that the UK must now choose between two highly compromised options: give up control over regulations or increase the cost of regulatory compliance.
Read part 1 of this story here.