Why is external competitiveness important in compensation?
External competitiveness refers to an organization's pay as compared to its competitors. This pay is the compensation employees receive including the base pay, bonuses, perks, options, etc. and may also be known as CTC (cost to company) in some countries.
Compensation is actually decided by (among other factors) how competitive an organization wishes to be with respect to its competitors. In other words, an organization will need to pay market average or higher than market average compensation to attract talent and retain it. A better compensation package will help an organization employ brighter talent who would be less willing to leave and would be more productive than the talent willing to work at lower compensation package (and may be more amenable to turnover). The compensation is also affected by forces of demand and supply, among other factors. In some case, perks like work-life balance may be used to attract the talent, such perks are part of the compensation package.
Note that a higher compensation package will increase the labor cost and that has to be factored in, by the managers, while deciding compensation levels to stay competitive. So an organization may decide on lag (less than market), match (equal to market i.e., competitors) or lead (more than market average) type of compensation.