Global Value Added: Costs of trade

© Professor Daniel F. Spulber

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The Global Value ConnectionStrategies to maximize net gains from trade

Homecountry

Suppliercountries

Partnercountries

Customercountries

Internationalbusiness

Internationalbusiness

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Globalization: Growth of world tradeindicates 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

Suppliercountry X

Customer Country YHigh P 200High T 140

Customer Country ALow P 100Low T 25

Maximize net gains from trade

Target customer countries that are easier to serve –May choose customer countries near supplier countries

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Costs of trade: strategic effects

Supplier country XLow P 50High T 80

Supplier country BHigh P 75Low T 25

Customercountry A

Minimize total costs of sourcing

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

Freight (Seattle-Tokyo)1,500

Insurance 500

CIF price 22,000

(cost, insurance, freight)

Administrative cost to buyer 750Import tariff (15% cif) 3,300Local port costs 350Document preparation 230Custom broker fee 750Freight forwarder fees (1% of cif) 220Bank costs (2% of ex works price) 400Total landing charges

6,000Total 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:

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 equivalentJ. Anderson and E. van Wincoop, 2004, Trade Costs, Journal of Economic Literature

%.170

BB

BA

P

T

P

PP

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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

Example: [Price in Yen] = [Yen/Dollar exchange rate] times

[Price in Dollars]

10,000 ¥ = 125 * $80

Pi = X * Pi*

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Do arbitrage opportunities exist?

Yes. Evidence is that Purchasing Power Parity (PPP) does not holdPi is the domestic consumer price index

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

Pi = X * Pi*

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Purchasing Power Parity

Burger price: Japan 280 ¥ US $2.80Tall latte price: Japan 320 ¥ US $2.80Yen to Dollar exchange rate = 125Market basket is a burger and a latte:280 ¥ + 320 ¥ = 600 ¥125 * ( $2.80 + $2.80 ) = 700 ¥PPP does not holdExchange rate would have to be about 107 Yen to

Dollar (about right)

Pi = X * Pi*

Example

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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 priceversus averages overmultiple goods -- PPP

Starbucks latte differsFrom McDonald’s

Big Mac

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1. Transaction costsGreater in international business!

• 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

• 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

The four Ts

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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

The four Ts

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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

The four Ts

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TariffsAbout 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

15.27 25.22 693,764 105,942

Australia, New Zealand, Japan

2.30 3.07 413,295 9,525

EU & Scandinavia 3.52 3.83 2,019,146 71,107

Eastern Europe & former USSR

10.11 7.56 295,953 29,919

US, Canada, Caribbean

3.10 9.32 1,102,816 34,201

South & Central America

12.77 9.85 291,164 37,186

Worldwide 6.10 13.55 4,879,113 297,456

The four Ts

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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.

The four Ts

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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%.

The four Ts

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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

The four Ts

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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

The four Ts

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3. TransportationAbout 5.6% of world trade -- geography matters

Imports Freight Other Total % of transp. Transp. imports

World total 5386700 206784 97682 304466 5.6Ind. Countries 3477000 111273 69948 181221 5.2Dev. Countries 1909700 95511 27735 123246 6.45 Africa 100747 9009 1846 10855 10.8 Asia 1019377 52469 15722 68191 6.7 Europe 318409 8653 3899 12552 3.9 Middle East 161097 10737 2110 12847 7.9 Western Hem. 310081 14643 4158 18801 6.1

Table 1 World transport costs in million $US. Source of data: IMF. Balance of Payments Statistics

Yearbook, 1998

The four Ts

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Air freight versus ocean shipments

Ratio

Greater efficiencies in transport. Also,

outsourcing increases demand

for JIT transportation services

The four Ts

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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

The four Ts

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4. TimeExample: Regulation -- time to start a business in days

Australia 2Canada 3Denmark 4US 5France 8Singapore 8Turkey 9Hong Kong 11Netherlands 11

Venezuela 116Azerbaijan 123Angola 146Indonesia 151Brazil 152Mozambique 153Congo 155Haiti 203

Doing Business in 2005, World Bank.

The four Ts

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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

The four Ts

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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

OPTIONALMATERIAL

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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 intrabloc

OPTIONALMATERIAL

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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) OPTIONALMATERIAL

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LatinAmerica

OPTIONALMATERIAL

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Latin America Growth Rate

http://tendencias.infoamericas.com/article_archive/2003/037/037_economic_outlook.htm

OPTIONALMATERIAL

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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

OPTIONALMATERIAL

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• 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

Mercosur

OPTIONALMATERIAL

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• 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

Mercosur

OPTIONALMATERIAL

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North American Free Trade AgreementNAFTA

• Founded 1994

• Membership

– Canada, Mexico and the United States

• Population

– 380 Million

• Foreign Trade about 40%

intrabloc

OPTIONALMATERIAL

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North American Free Trade AgreementNAFTA

• 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