Global Value Added: Costs of trade
© Professor Daniel F. Spulber
The Global Value Connection
Strategies to maximize net gains from trade
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Globalization: Growth of world trade
indicates decreasing costs of trade
Since WWII:
• World trade/World output
Growth at 2.9% per year
• Manufactured goods trade/Manufactured output
Growth of 3.7% per year
• FDI/world output
Growth at 3% per year
Hummels, Ishii and Yi, J. International Economics
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Further evidence of decreasing costs of trade
• Technological improvements in transportation and
communications
• Decrease in trade barriers
• Acceptance of market system in more countries
• Convergence of international business practices
Creates need for extreme advantage
… Still a long way to go in reducing costs of trade
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Costs of trade: strategic effects
Maximize net gains
from trade
Customer Country Y
High P
200
High T
140
Supplier
country X
Target customer countries
that are easier to serve –
May choose customer
countries near supplier
countries
Customer Country A
Low P
100
Low T
25
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Costs of trade: strategic effects
Supplier country X
Low P 50
High T 80
Minimize
total costs of
sourcing
Customer
country A
Supplier country B
High P 75
Low T 25
Choose supplier countries
based on trade costs – may
choose those that are close
to customer countries
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Costs of trade: Example
• World Tools, based in Seattle, plans to export a machine tool
to a customer based in Tokyo
• The ex works price, that is the price at the factory with the
buyer responsible for all export arrangements, is $ 20,000
• A Japanese competitor offers a comparable product for
$ 25,000
Is the price offered by World Tools competitive?
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Costs of trade: Example (continued)
Ex works price
20,000 Administrative cost to buyer
750
Freight (Seattle-Tokyo) 1,500 Import tariff (15% cif)
3,300
Insurance
500 Local port costs
350
Document preparation
230
CIF price
22,000 Custom broker fee
750
(cost, insurance, freight)
Freight forwarder fees (1% of cif) 220
Bank costs (2% of ex works price) 400
Total landing charges
6,000
Total
28,000
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Costs of trade: Example (continued)
• Competitive disadvantage: $ 3,000
($28,000 versus $25,000)
• Even with transportation cost, World Tools had a
competitive advantage of about $3,000 ($22,000 versus
$25,000) – This is hidden cost of trade.
• NOTE: If transaction go through a distributor who marks
up by 35%: Competitive disadvantage is $ 4,050
($37,800 versus $ 33,750)
Taxes and other proportional mark-ups widen the
disadvantage
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Costs of Trade
PA : Price in customer country – ask price
PB : Price in supplier country – bid price
PA − PB : International bid-ask spread
T:
Cost of trade
If the spread is less than T, there is no trade: autarky
PA − PB < T
If the spread is greater than or equal to T, there is a
basis for international trade and arbitrage
PA − PB ≥ T
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Costs of Trade
Trade flows from lower-priced countries to higher-priced countries.
Competitive market equilibrium with trade: price differences tend
toward the cost of trade
No-arbitrage condition:
PA -
PB = T
• Direct costs of trade: The four Ts
• Hidden costs of trade are very high: They are the foregone
opportunities for international business
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How big is T is practice?
Estimate of average costs of trade
Markup:
PA
 PB
PB

T
PB
 170%.
Breakdown of the effects as tariff equivalents:
21% Transportation
44% Border-related trade barriers
55% Retail and wholesale trade
1.21 * 1.44 * 1.55 = 2.7 = 1 + 1.7
An estimate of time costs is 9% tariff equivalent
J. Anderson and E. van Wincoop, 2004, Trade Costs, Journal of Economic Literature
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Do arbitrage opportunities exist?
YES. Evidence is that the Law of One Price (LOP) generally does
not hold internationally
Pi Domestic Currency Price of a particular good i
Pi* Foreign Currency Price of a particular good i
X Nominal Exchange Rate
Pi = X * Pi*
Example:
[Price in Yen] = [Yen/Dollar exchange rate] times [Price in Dollars]
10,000 ¥ = 125 * $80
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Do arbitrage opportunities exist?
Yes. Evidence is that Purchasing Power Parity
(PPP) does not hold
Pi is the domestic consumer price index
Pi = X * Pi*
Pi* is the foreign consumer price index
X is the exchange rate
• Absence of PPP likely due to trade costs
• National price levels should be equal when converted to a
common currency
• This relationship should be observed if the law of one price
holds because aggregate price levels would be correlated
• The long term speed of convergence of currencies to PPP is
very slow – only about 15% per year! – never converges
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Purchasing Power Parity
Example
Pi = X * Pi*
Burger price: Japan 280 ¥
US $2.80
Tall latte price: Japan 320 ¥
US $2.80
Yen to Dollar exchange rate = 125
Market basket is a burger and a latte:
280 ¥ + 320 ¥ = 600 ¥
125 * ( $2.80 + $2.80 ) = 700 ¥
PPP does not hold
Exchange rate would have to be about 107 Yen to Dollar
(about right)
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The PPP Puzzle: Evidence from
Germany and the US
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The Big Mac Index
“Burgernomics is based on the theory of purchasing-power
parity, the notion that a dollar should buy the same amount
in all countries. Thus in the long run, the exchange rate
between two countries should move towards the rate that
equalises the prices of an identical basket of goods and
services in each country. Our "basket" is a McDonald's Big
Mac, which is produced in about 120 countries. The Big Mac
PPP is the exchange rate that would mean hamburgers cost
the same in America as abroad. Comparing actual exchange
rates with PPPs indicates whether a currency is under- or
overvalued.”
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The Big Mac Index
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Law of one price
versus averages over
multiple goods -- PPP
Starbucks latte differs
From McDonald’s
Big Mac
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The four Ts
1. Transaction costs
Greater in international business!
• Search for trading partners
• Marketing and sales costs
• Contracting:
– Negotiating contract
terms
– Monitoring performance
• Purchasing, Financing
• Human resource
management:
• Logistics and inventory
• Backoffice: Accounting, Tax,
Orders, Bills, Payments
• Currency conversions
• International finance costs
• International communication
– Differences in languages,
cultures, social customs
– Time zones
– Distance
• Different business practices
• Handling multiple legal and
regulatory jurisdictions
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The four Ts
Business strategies to reduce transaction costs
• International sourcing and serving expertise and careful choice
of customer and supplier countries
• Economies of scale and scope in transactions
• Information technology and communications technology
• Outsourcing to specialized intermediaries
• Innovative types of transactions Example: Dell has web sites
aimed at 85 countries, employs a common technology platform
for consistent ordering and product information
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The four Ts
2. Tariff and nontariff barriers
T (per unit of output) is a “specific” tariff.
An “ad valorem” tariff t is a percentage of the international
price. These are equivalent:
T = tPW.
With international competition, price falls to
PW + T or (1 + t)PW
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The four Ts
Tariffs
About 6% of world trade
Import-wtd.
Average
Simple
Average
Total Merch.
Imports, in Millions
of US $
Imputed
Tariff
Revenues,
in Millions of
US $
Africa
15.10
19.88
62,189
9,392
Asia (excl. Hong
Kong and Taiwan
Australia, New
Zealand, Japan
EU & Scandinavia
15.27
25.22
693,764
105,942
2.30
3.07
413,295
9,525
3.52
3.83
2,019,146
71,107
Eastern Europe &
former USSR
US, Canada,
Caribbean
South & Central
America
Worldwide
10.11
7.56
295,953
29,919
3.10
9.32
1,102,816
34,201
12.77
9.85
291,164
37,186
6.10
13.55
4,879,113
297,456
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The four Ts
Tariffs and effective rate of tariff protection
Effective trade protection: Compare tariff with economic activity
Example: Ad valorem tariff on imported computers: 25% of
price
World price: PW = $800.
Domestic price of computer after tariff is (1 + .25) PW = $1000
Unit costs (components domestic or imported): $700
Price of computer minus cost of components is value added by
assembly business: $800 - $700 = $100
Mark up from tariff tPW = $200
Effective rate of trade protection is equal to double the returns to
assembly: 200% !!! Entry barrier to assembly exporter.
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The four Ts
Tariffs and effective rate of tariff protection
Tariff on imported components
• Benefits domestic components producers
• Harms domestic assembly industry
• Benefits assembly exporter entering country by subsidizing
entry of assembled products
Example: 10% tariff on components of $700 = $70
Harm to domestic assembly industry of 70%.
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The four Ts
Non-Tariff Barriers
• Anti-dumping duties
• Import quotas
• Voluntary export restraints
(VERs)
• Licensing by governments
• Domestic content
requirements
• Domestic subsides
• Technical barriers and
standards: compatibility,
quality, health, safety,
packaging, labeling
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The four Ts
Business strategies to reduce tariff costs
• Take advantage of regional trade agreements: e.g. Canada,
Mexico and the US do not have a common external tariff
so import through lowest tariff country
• Use bilateral agreements with trade blocks: e.g. EU has
agreements with 70 LDCs for duty-free or quota free
trade—source from these countries when serving EU
• Choose among classifications to lower tariffs: changing
one or two product components can change classification
of the whole product, which may put it into a lower-tariff
classification
• Source and serve within the same country or trade block
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The four Ts
3. Transportation
About 5.6% of world trade -- geography matters
World total
Ind. Countries
Dev. Countries
Africa
Asia
Europe
Middle East
Western Hem.
Table 1
Imports
Freight Other Total
transp. Transp.
5386700
3477000
1909700
100747
1019377
318409
161097
310081
206784
111273
95511
9009
52469
8653
10737
14643
97682 304466
69948 181221
27735 123246
1846 10855
15722 68191
3899 12552
2110 12847
4158 18801
% of
imports
5.6
5.2
6.45
10.8
6.7
3.9
7.9
6.1
World transport costs in million $US.
Source of data: IMF. Balance of Payments Statistics Yearbook, 1998
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The four Ts
Ratio
Air freight versus ocean shipments
Greater efficiencies in transport. Also,
outsourcing increases demand
for JIT transportation services
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The four Ts
Business strategies to reduce transport costs
•
•
•
•
•
•
Coordinate locations for sourcing and serving
Use economies of scale in transport (containers)
Source groups of components from same region
Predictability of demand influences modal choice (Recall Acer)
Weigh inventory costs against shipping costs
Weigh economies of scale in manufacturing against shipping
costs
• Trade off speed and flexibility versus shipping costs
• Outsource to logistics specialists
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The four Ts
4. Time
Example: Regulation -- time to start a business in days
Australia
Canada
Denmark
US
France
Singapore
Turkey
Hong Kong
Netherlands
2
3
4
5
8
8
9
11
11
Venezuela
Azerbaijan
Angola
Indonesia
Brazil
Mozambique
Congo
Haiti
116
123
146
151
152
153
155
203
Doing Business in 2005,
World Bank.
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The four Ts
Business strategies to reduce time costs of trade
•
•
•
•
Establish local or regional distribution or manufacturing
Learn local market conditions
Train local and transferred employees
Delays associated with international transportation and
communication
• Speed of government regulations and legal system
• Time to negotiate, monitor and enforce contracts
Time costs are business foregone and time costs of money
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Trade-Blocks
• WTO:
148 member countries as of 2005
• European Union EU:
25 countries
• ASEAN: (Brunei, Indonesia, Laos, Malaysia, Myanmar,
the Philippines, Singapore, Thailand, and Vietnam)
• Lome convention: EU members and 70 African,
Caribbean, and Pacific countries
OPTIONAL
MATERIAL
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• Founded 1989
• Membership
– Australia, Brunei, Canada, Chile, China, Taiwan, Hong
Kong, Indonesia, Japan, Korea, Malaysia, Mexico, New
Zealand, Papua New Guinea, Peru, Philippines, Russia,
Singapore, Thailand, United States, and Vietnam
• Population : over 2 billion
• Output
– $14,469 billion at market exchange rates
– $16,578 billion at PPP rates
• Foreign Trade (exports plus imports)
– Approx $4 trillion, of which 74% was OPTIONAL
intrabloc
MATERIAL
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APEC agenda
• Trade and investment
liberalization
• Technical and economic cooperation to promote economic
development
• Regional development
(Voluntary unilateral tariff reduction, No formal dispute
resolution mechanism)
OPTIONAL
MATERIAL
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Latin
America
OPTIONAL
MATERIAL
36
Latin America Growth Rate
OPTIONAL
MATERIAL
http://tendencias.infoamericas.com/article_archive/2003/037/037_economic_outlook.htm
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Mercosur
• Founded 1991
• Membership:
– Argentina, Brazil, Paraguay, Uruguay,
and now Chile (Bolivia associate
member)
• Population: 220 million
• Total GDP $ 1,100 billion
• GDP per capita over $5,000
OPTIONAL
MATERIAL
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Mercosur
• Brazil and Argentina account for over 95% of the GDP
• Decisions are made by consensus
• Imperfect customs union
• Relies on Rules of Origin as well as Common External
Tariffs
• Has a dispute resolution mechanism, but occasionally relies
on the WTO for dispute resolution
OPTIONAL
MATERIAL
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Mercosur
• Largest trade group after EU and Nafta
• Working on convergence in Common External Tariffs
• Major effort is need toward harmonization of
macroeconomic policy
• Integration with FTAA an important issue
OPTIONAL
MATERIAL
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North American Free Trade Agreement
NAFTA
• Founded 1994
• Membership
– Canada, Mexico and the United States
• Population
– 380 Million
• Foreign Trade about 40%
intrabloc
OPTIONAL
MATERIAL
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North American Free Trade Agreement
NAFTA
• Free Trade Area not Customs Union
• Legally binding agreement enforced through penalties and
sanctions
• Dispute resolution mechanism through FTC
• Supplemental agreements on environmental cooperation and
labor laws
• Import restriction through non-tariff barriers is prohibited
• Sensitive issues are energy, agriculture and transportation
OPTIONAL
MATERIAL
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Summary and take-away points
• Coordinate choice of customer and supplier countries to
reduce trade costs
• Costs of trade offset gains from product variety and scale
• Costs of trade favor domestic competitors
• The international businesses in global competition can gain
competitive advantage by reducing its costs of trade
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