External Finance in Small and Medium-Sized Enterprises - Essay Example

Independent study of the of the Number Introduction Small and medium sized enterprises (SMEs) are a growing and dynamic sector in the UK economy and are likely to greatly contribute to its future economic growth. SMEs have a significant role in productivity growth of the UK economy as it stimulates fierce competition and innovation in the market. In the beginning of 2011, the number of SMEs was about 4.5 million representing about 99.9 per cent of the businesses. It also accounted for almost 50 per cent of the private sector turnover and 60 per cent of the employment generated by the private sector (HSBC, “SMEs continue important drive to international shores”). Studies advocate that it is in the best interest of the SMEs in the UK if they are able to trade internationally as it will improve their market share as well as have a positive impact on position of the balance of payments of the UK. International Trade The exchange of goods, services and capital across international borders in order to expand the market and facilitate trade is known as international trade. A significant portion of a country’s Gross Domestic Product (GDP) comes from international trade. However, in order to carry out the trading operations in a structured manner, there needs to be a certain level of peace and stability prevailing in between the two countries involved. The international trade can be explained by the help of three models. Adam Smith’s Model - Adam Smith, who is considered as the founder of modern economics, had argued in favor of free trade. Stressing on the advantages associated with division of labor and absolute advantage, he proposed free trade and developed his theory of international trade. According to Smith (4), “The greatest improvement in the productive powers of labor, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labor”. Considerable amounts of quantitative and qualitative improvements are possible by dint of division of labor. Hence, there is increase in output, enhanced workers’ skills, rise in productivity and stimulation of technological development. Consequently, economic growth is facilitated along with considerable rise in the national wealth. Absolute Advantage A country should produce only those goods that involve using the abundant factor as the production is cost efficient and import those commodities whose efficiency levels are not at par with the former. A country in that case is said to have an absolute advantage in the production of that commodity. In such situations, trade takes place between two countries having absolute advantage in two different products and the gains from trade is realized by both (Smith 63-77). Ricardian Model – Well-known economist, David Ricardo, had based his theory of international trade on the law of comparative advantage. Also, the theory stands on grounds of four assumptions: There is perfect competition There are two countries that engage in trade There are two sectors There is just one factor of production implying labor (Desmet and Riera, “Hecksher-Ohlin Trade Theory”) The theory states that a country should specialize in production of those goods in which they have a comparative advantage as specialization and free trade benefits all trading partners. Opportunity Cost: The loss of potential gain from other alternatives taking place due to choosing one particular alternative is known as opportunity cost. It is a concept used in microeconomics so as to discuss the relationship between scarcity and choice. Comparative Advantage – The ability of a country or firm to produce a good or service at a lower marginal cost or opportunity cost compared to a competing country or firm is termed as comparative advantage. Given that trade is taking place between two entities, even if one has the absolute advantage in production of all goods, it is still beneficial to produce the good with a comparative advantage and realize the trading gains (Dornbusch, et al. 823-839). The Ricardian model is, thus, an improvement over Adam Smith’s model as it takes into account the comparative advantage in the process of production and not absolute advantage. Hecksher Ohlin Model – Developed in the early 1900s by Eli Hecksher and Bertil Ohlin, the H-O model states that a country should import those goods that require using the factor less in supply and export those goods that are produced using the abundant resource. A country’s comparative advantage is determined by relative endowments of the factors of production like, land, labor and capital, as profitability of goods is calculated by the input costs. Hence, a country would be better off if it produces goods that require intensive use of the factors that are abundant therein. In the Ricardian model, only labor as a factor was considered, but H-O model introduces variable capital endowments. However, even though a country may be endowed with a larger share of factors than another country, the absence of returns to scale guarantees that only the relative factor endowments matter. For example, a country is regarded as labor abundant if the labor to capital endowment ratio exceeds the corresponding proportion of another country. The H-O model is based on the following assumptions; There is free flow of factors like, labor and capital, between sectors There is difference in the factor endowments between two countries The level of technology between the two countries is the same Tastes and preferences are the same (Ronald, “Hecksher-Ohlin Trade Theory”) External Finance in SMEs It is important for the SMEs to be able to access finance for funding their business ventures. Lack of finance can hamper the businesses’ survival prospects by constraining the cash flow. In this respect, external finance is an important aspect of the market mechanism so as to allocate resources within the economy. It facilitates replacement of the old non-profitable business ventures with new ones that offer more innovative products and efficient production process. As a result, economic productivity improves and optimum utilization of the available and underutilized resources is facilitated. It has been seen that more than half of the SMEs do not use any formal source of external finance and rely more on informal ways such as, trade credit from suppliers and retained earnings (BIS, “SME Access to External Finance”). Reasons for SMEs to export SMEs should export because regardless of the fact that there is a large domestic market in the UK, there is an even larger market to expand if they target the markets in Europe (Crick, Chaudhry IV and Batstone 49-67). Consequently, this step enlarges their scope of growth as SMEs are able to tap the opportunities abroad. There might be countries that are less competitive than the UK and the SMEs will be able to realize higher profit margins on penetrating the same. In addition, the developing countries have a high rate of growth potential in most products. So, it would be profitable for the SMEs to capture such markets. Also, over dependence on the UK market is dangerous for the SMEs as there remains a high probability of stalling of the domestic markets. If they set bases in different markets worldwide, then decline in market share in the domestic market can be offset to a great extent. SMEs should test their own products at an international level in order to realize quality offered by the international competitors. They can offer their products at a competitive price and try to capture the markets. SMEs should also compare their products with those that are superior so that they can subsequently incorporate those ideas in the production process and improve the products produced. The UK’s membership in the EU, the NATO and the Commonwealth prove to be highly beneficial on a worldwide level (Baxter, “5 Reasons why exporting is the business for British SMEs”). The SMEs should take advantage of the same so as to expand market share internationally. There are different funding schemes that are directed at development of this sector and the SMEs can employ those to their advantage. Furthermore, the British have a good market reputation for delivering quality products and offer fair deals. Hence, it is easier for the SMEs to expand their markets abroad. SME Industry: Tourism Tourism is the world’s largest industry and has immense economic contributions in both the developing and developed economies. It is increasingly being used as a vehicle for economic development at a local, regional and national level. In the UK, there are a growing number of local authorities that are seeking to capture economic benefits offered by the tourism industry. Nonetheless, sustainability of the tourism sector depends on the destination competitiveness, implying the ability of a nation to meet international standards in production of its goods and services under a free market regime. A tourism destination can be made competitive if there is an increase in the tourism expenditure and the nation is able to provide the tourists with a valuable experience while preserving the natural resources therein for the future generations without compromising on the residents’ welfare. Such measures will in future attract more tourists, which will increase revenue of the industry, create employment opportunities and increase real income of the individuals living there. In order to be internationally competitive, the tourism sector should be made a leading sector by strengthening the distribution channels and allowing private sector investment, which will enhance the industry conditions and induce competitiveness. Apart from making the industry competitive, there is also a need to pay attention towards other sectors such as, Service Quality Management and Marketing or Imaging of the industry. It is necessary for the tourists to have a good and memorable experience at a particular destination in order for them to revisit or recommend others to do so. Word-of-mouth is a very important aspect of this industry. SMEs have an ability to generate more employment opportunities, create flexible and diversified industrial bases, encourage competition and innovation, improve industrial relations and establish enterprising cultures. Even though some SMEs lack good business and management skills, yet there are others who exploit the available resources for facilitating business growth in a very effective manner (Khan and Lin, “International Trade and Tourism: Evidence from Cointegration and Causality Tests by using Singapore Data”). The theories of international are appropriately applied to this industry. The theory of comparative advantage is based on the differences in relative factor endowments. Hence, a country with an abundance of unutilized or underutilized labor and a good natural resource base is likely to have a comparative advantage in export of tourism services. The UK neither has a large natural resource base nor does it have cheap labor. Yet, The UK is a very popular tourist destination (Khan and Lin, “International Trade and Tourism: Evidence from Cointegration and Causality Tests by using Singapore Data”). Trade and tourism are highly related as several opportunities are generated from business trips made across the world. Successful business trips will in turn motivate business men to take holiday or pleasure trips to those destinations if the experience was good. Other visitors like, people visiting friends and family, those studying overseas and those requiring medical treatments, also contribute to the overall development of the UK tourism industry (UNCTAD, “International Trade In Tourism-Related Services: Issues And Options For Developing Countries”). Additionally, variations in the tourists’ tastes and preferences in consumption may give rise to import requirements for the country, thereby facilitating international trade. Conclusion It is quite evident that for supporting greater prosperity of the UK economy, presence of SMEs are essential and it will be beneficial to both the UK economy and the SMEs if they begin exporting and penetrating global markets. The UK is a very famous tourist location and thus, the tourism industry is a very flourishing industry for the SMEs. Consequently, it has to be made internationally competitive so as to constitute greater share of the country’s GDP. The scope of international trade is ample in this sector and must be appropriately exploited. Works cited Baxter, Ian. “5 Reasons why exporting is the business for British SMEs.” Real Business. Real Business, March 2014. Web. 21 July 2014. BIS. “SME Access to External Finance.” BIS. BIS, January 2012. Web. 21 July 2014. Crick, Dave, Shiv Chaudhry IV, and Stephen Batstone. "Revisiting the concentration versus spreading debate as a successful export growth strategy: the case of UK SMEs exporting agricultural-related products." Entrepreneurship & Regional Development 12.1 (2000): 49-67. Print. Desmet, Klaus and José Riera. “Ricardian Model.” eco.uc3m. Klaus Desmet and José Riera. No Date. Web. 21 July 2014. Dornbusch, Stanley Fischer, et al. "Comparative advantage, trade, and payments in a Ricardian model with a continuum of goods." The American Economic Review 67.5 (1977): 823-839. Print HSBC. “SMEs continue important drive to international shores.” HSBC.HSBC. 2012. Web. 21 July 2014. Khan, Habibullah and Chua Chun Lin. “International Trade and Tourism: Evidence from Cointegration and Causality Tests by using Singapore Data.” Fama. No Publisher. No date. Web. 21 July 2014. Ronald, Jones W. “Hecksher-Ohlin Trade Theory”. econ.rochester. No Publisher. No Date. Web. 21 July 2014. Smith, Adam. "An Inquiry into the Nature and Causes of the Wealth of Nations." London: Methuen & Co., Ltd. 1776. Print UNCTAD. “International Trade In Tourism-Related Services: Issues And Options For Developing Countries”. United Nations. United Nations. 1998. Web. 21 July 2014. Read More