Chapter 4: Trade Costs
Keith Head
Sauder School of
Business
Overview
• To realize the gains from trade, buyers
and sellers must incur a variety of costs
other than production costs; these are
known as “trade costs.”
• Trade costs have distance- and borderrelated components.
• Trade costs include transportation costs,
travel costs, communication costs,
customs costs (trade policy barriers),
currency conversion costs, and
transaction costs.
The Gravity Equation of
Bilateral Trade
• Fij = G Mi Mj / Dij
• Fij is the Flow of goods from country i
to country j.
• Mi and Mj are the sizes (or “masses”)
of economies i and j.
• Dij is the distance between i and j.
• G represents “everything else”; call it
the “gravitational constant.”
Gravity as a market share
benchmark
• Country i’s share of market j is Fij/Mj.
• Fij/Mj = G Mi / Dij
• ln (Fij/Mj) = ln (G Mi) - ln Dij
• When drawn on a log scale, this is a
linear equation with slope of -1.
• The intercept is proportional to
exporter country size.
• It usually fits the data very well.
A “gravity” law for Canadian exports
France’s Exports
France’s Imports
France’s Exports (w/ legend)
France’s Imports (w/ legend)
Why Distance Matters
• Transport Costs: (moving goods)
– Freight carrier costs
• Fuel & crew costs (increasing in distance)
• Capital costs:
– Vessels (op. cost increases with trip length)
– Port infrastructure (usually not related to distance)
– Marine Insurance: Risks accumulate over
longer trips
– Time costs
• Travel costs (moving people)
• Communication costs (moving ideas)
Capital costs of transport
Trade costs and the INCO Terms
Why Distance Matters
• Transport costs (goods)
– Freight carrier costs
– Marine insurance costs
– Time costs
• Travel costs (people)
• Communication costs (info)
Why delays are costly
• Opportunity cost of “floating
inventory”
– Annual interest rate * (transit
days/365)*value of good
– Small (<1%) in practice.
• Spoilage
• Loss of Sale (stock-outs)
• Synchronization: Supply chain
bottlenecks
Mitigating Time Costs
• “Preservation” technology
reduced spoilage—at a cost.
• Planning: if shipping takes weeks,
then ship the goods weeks before
they are needed.
Problem: uncertainty (2 kinds)
• Inventories reduce risk of stockouts, bottlenecks—at a cost.
– Holding costs
– Loss of “option value”
Reefers
Zara keeps up with shifting fashions
Zara’s just-in-time system
“Shipments were made out of the distribution
Center [in Spain] twice a week, by truck to
Europe [357 stores] and by airfreight to
stores outside Europe, [92 stores] so that
stores received goods within 24-36 hours
of shipment in Europe and within 1-2 days
outside Europe. No inventory was held
centrally, and there was almost no
inventory at the stores that was not on the
selling floor.” (Columbia B. School “Zara”
case)
Trade costs for services
• Travel costs
– Customer travels to Provider’s base
– Provider travels to Customer’s base
• Communication costs: remoteprovision of information-based
(“impersonal”) services
• Futuristic trade in services: haptics
– Remote piloting
– Remote surgery
France’s imports of
“other commercial services”
Canada’s imports of
“other commercial services”
Distance & Border effects
• The data show a regular pattern:
after taking into account partner
size, trade is inversely proportionate
to geographic distance.
• “Cultural distance” also matters:
language, colonial history, legal sys.
• For a given distance, crossing
national borders is a surprisingly
large impediment to trade
Calculating Border Effects
• Border effect: compare trade within borders
(2 regions in same country) to trade across
borders (2 regions in different countries)
• Compare actual trade to trade predicted by
the gravity equation
• For example: compare region 2’s exports to
region 1 (same country) and region 3
(different countrycross-border trade)
• Actual Trade Ratio (ATR): F21 / F23
• Gravity-Predicted Trade Ratio (GPTR):
[GM2M1/D21]/[GM2M3/D23]=[M1/D21]/[M3/D23]
=[M1/M3]/[D21/D23]
How “wide” is the Canada-US Border?
•
•
•
•
•
•
ATR over GPTR
B2: = (F21 / F23)/ [(M1/ D21)/(M3/ D23)]
B2: = [(F21/F23)/(M1/M3)] *(D21 / D23)
D21 & D23 almost same, so say D21 / D23 = 1
Hence B2: = (F21 / F23)/(M1/M3)=???
Many other border effects could be calculated
What are the actual trade
flows between states & provs?
Flows (2004, bn
CAD)
Origin i
Destination j
BC
ON
WA
OH
53.39
2.75
5.40
0.33
Ontario (ON)
6.48
201.97
0.97
9.56
Wash. (WA)
3.40
0.61
158.86
1.56
Ohio (OH)
0.39
17.60
4.03
219.83
Brit. Col. (BC)
What does gravity predict?
Economy sizes (M)
Economy
Size
(2004)
1:BC
2:ON
3:WA
4:OH
Popn (mn)
4
12
6
12
Income p.c.
(th CAD)
M: (GDP in
bn CAD)
$
39
157
$
43
517
$
55
328
$
46
552
What does gravity predict?
Distances (flying, in km)
Origin i
BC
Destination j
ON
WA
Brit. Col. (BC)
Ontario (ON)
Wash. (WA)
Ohio (OH)
3366
189
3336
3311
308
3264
OH
Example calculations
Rel
Rel
Orig: ON [2]
Dest:
Dist GDP
BC[1],WA[3] D21/D23 M1/M3
ON:(BC,WA)
1.01
0.48
Rel
Trade
F21 / F23
6.68
GPTR: Rel GDP / Rel Dist = .48/1.01= 0.475
ATR: Rel Trade = 6.68
Border Effect: ATR / GPTR = 6.68/0.48 = 14
Ontario exports 14 times more to BC than it would
in a borderless world.
Why do national borders
matter for exporters?
• Customs costs (trade policy: duties, etc.)
– Consider in Chapter 5 (Trade Rules)
– Unimportant (?) for the 2004 CA-US BE
• Currency conversion costs
– Conversion fees
– Exchange rate volatility payment risks
– Lack of relative price transparency
• National Business Networks: sparse
cross-border linkages higher
transaction costs
Transaction Costs
• Definition: costs incurred during the
process of buying or selling
• Transaction costs arise because the
buyer and seller are different entities
– Different incentives (v-p,p-c)
– Different private information
• Transaction costs exclude costs of
production, transportation, and
taxation.
The Transaction process:
a timeline
1. Buyer demands, seller offers
Search phase
2. Potential Buyer/Seller pair forms
Engagement phase
3. Decision to sign contract
Negotiation phase
4. Contract signed
Safeguard phase
5. Completion dates (payment & delivery)
Enforcement phase
Search
Multilateral learning, for example:
–Seller advertises in trade journals
–Buyer conducts internet search
–Buyer sends letters of inquiry
–Seller queries contacts for potential
clients
–Buyer queries contacts for
potential suppliers
Engage
Bilateral learning, for example:
–Inspect seller’s samples
–Visit seller’s factory
–Request references from other
(satisfied) customers, learn about
reputations
–Check buyer’s credit rating
–Develop personal relationships
(guan xi)
Negotiate
Agree on terms, for example:
–Physical product specifications
–Price (including INCO term)
–Quantity
–Place & Time of delivery
–Form ($, £, ¥…) and time of
payment
Safeguard
Precautions (pre-breach), for example:
–Exporter posts performance bonds
–Exporter insures against nonpayment
–Guarantors of payment
–Importer obtains L/C
Enforce
Remedies (post-breach), for example:
–Collection agencies
–Mediation
–Courts
–Insurance claims
Why are transaction costs
higher for international trade?
• Lack of “contacts” (fewer leads, less trust)
• Linguistic differences slow or impede the
search, engagement, and negotiation
phases.
• Cultural differences affect negotiation
• Use of different currencies
• Long distances
• Issues with foreign credit agencies and
banks
• Issues with foreign courts
Payment problem
• Seller does not want to incur
production and transport costs to
serve a buyer who does not pay.
• Buyer does not want to pay for
goods that are never delivered or
delivered late or defective.
• Needed: trust or …
Payment Options
• Open Account
– exporter bills customer, who is expected
to pay under agreed terms at a future
date.
• Documentary Draft (D/P, D/A)
– similar to “cash on delivery”, buyer gets
goods when he pays (with a bank draft)
• Letter of Credit (L/C), “documentary
credit”
• Payment in advance
Letter of Credit
(L/C)
L/C flow diagram
L/C vs D/P
• With a documentary draft (D/P), the
seller sends the goods without a
guarantee that the buyer will be willing
or able to pay when goods arrive, in
which case, seller retains goods but
must find another buyer.
• With L/C, Seller assured of payment if
the stipulated documents are presented
to issuing bank on time.
• Buyer does not pay until documents
received.
The “Documents”
• Invoice
– who sold what to whom for how much
• Bill of Lading
– Carrier’s statement to shipper that goods
were loaded
– “key that unlocks the door to the floating
warehouse”  gives the holder title to the
goods.
• Certificate of Origin
• Certificates of
Inspection/Quality/Weight…
Bill of Lading
(B/L)
Advantages and limitations of
the L/C
• Replaces situation of mutual distrust
(between buyer and seller) with mutual
trust in the intermediaries (the banks)
• Certain Problem: must pay the banks
for this service. (who will pay?)
• Rare Problem: what if you cannot trust
the banks?
• Occasional Problem: false or misleading
documents
Trade Costs
Customs costs
(trade policy)
Transport
Costs
Transaction
Costs
Travel Costs
Distance Effects
Currency
Conversion
Costs
Communication
costs
Border Effects
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International Business - University of British Columbia