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 is 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

Frances Exports

Frances Imports

Frances Exports (w/ legend)

Frances 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 spoilageat 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, bottlenecksat a cost.
Holding costs
Loss of option value

Reefers

Zara keeps up with shifting fashions

Zaras 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 Providers base
Provider travels to Customers base

Communication costs: remoteprovision of information-based

(impersonal) services
Futuristic trade in services: haptics
Remote piloting
Remote surgery

Frances imports of
other commercial services

Canadas 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 2s exports to
region 1 (same country) and region 3
(different countrycross-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)

12

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)
Destination j
Origin i

BC

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 sellers samples
Visit sellers factory
Request references from other
(satisfied) customers, learn about
reputations
Check buyers 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
Carriers 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