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Chapter 4: Trade Costs

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 border-related components.

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Chapter 4: Trade Costs

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  1. Chapter 4: Trade Costs Keith Head Sauder School of Business

  2. 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 border-related components. • Trade costs include transportation costs, travel costs, communication costs, customs costs (trade policy barriers), currency conversion costs, and transaction costs.

  3. 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.”

  4. 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.

  5. A “gravity” law for Canadian exports

  6. France’s Exports

  7. France’s Imports

  8. France’s Exports (w/ legend)

  9. France’s Imports (w/ legend)

  10. 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)

  11. Capital costs of transport

  12. Trade costs and the INCO Terms

  13. Why Distance Matters • Transport costs (goods) • Freight carrier costs • Marine insurance costs • Time costs • Travel costs (people) • Communication costs (info)

  14. 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

  15. 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 stock-outs, bottlenecks—at a cost. • Holding costs • Loss of “option value”

  16. Reefers

  17. Zara keeps up with shifting fashions

  18. 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)

  19. Trade costs for services • Travel costs • Customer travels to Provider’s base • Provider travels to Customer’s base • Communication costs: remote-provision of information-based (“impersonal”) services • Futuristic trade in services: haptics • Remote piloting • Remote surgery

  20. France’s imports of “other commercial services”

  21. Canada’s imports of “other commercial services”

  22. 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

  23. 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]

  24. 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

  25. What are the actual trade flows between states & provs?

  26. What does gravity predict?Economy sizes (M)

  27. What does gravity predict?Distances (flying, in km)

  28. Example calculations 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.

  29. 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

  30. 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.

  31. The Transaction process: a timeline • Buyer demands, seller offers Search phase • Potential Buyer/Seller pair forms Engagement phase • Decision to sign contract Negotiation phase • Contract signed Safeguard phase • Completion dates (payment & delivery) Enforcement phase

  32. 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

  33. 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)

  34. Negotiate Agree on terms, for example: • Physical product specifications • Price (including INCO term) • Quantity • Place & Time of delivery • Form ($, £, ¥…) and time of payment

  35. Safeguard Precautions (pre-breach), for example: • Exporter posts performance bonds • Exporter insures against non-payment • Guarantors of payment • Importer obtains L/C

  36. Enforce Remedies (post-breach), for example: • Collection agencies • Mediation • Courts • Insurance claims

  37. 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

  38. 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 …

  39. 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

  40. Letter of Credit(L/C)

  41. L/C flow diagram

  42. 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.

  43. 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…

  44. Bill of Lading(B/L)

  45. 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

  46. Trade Costs Customs costs (trade policy) Transport Costs Transaction Costs Currency Conversion Costs Communication costs Travel Costs Distance Effects Border Effects

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