Trade costs

• The “take-away” for this lecture– 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, trade barriers, and transaction costs.

Gravity model origins: Newton’s Apple• In 1687, Newton proposed the “Law of Universal

Gravitation.” It held that the attractive force between two objects i and j is given by

Fij = G [Mi Mj]/ Dij2

where notation is defined as follows– Fij is the attractive force– Mi and Mj are the masses– Dij is the distance between the two objects.– G is a gravitational constant

• Economists have used this specification to explain trade between countries i and j where GDPs are used as measures of mass.

Graphing the relation

• Divide by Mi

– Fij/Mi = G*Mj/Dij2

• Take logs– ln(Fij/Mi)= ln(G*Mj) – 2 ln(Dij)

• Note that if we focus on the imports of a single country, say Britain or Canada, log(G*Mj) is a constant.

Canadian business service imports

Gravity model of trade

• A fuller specification commonly used by economists isln Fij = ln G + lnMi + lnMj - lnDij + φ lnLij + ij– where Fij is trade from i to j– ln G is a constant– Mi , Mj are i and j’s GDPs– Dij is distance from i to j– Lij measure linkages between i and j such as shared language,

colony history, shared legal environment, etc.– and ij is an error term

• The results indicate that is roughly equal to one, indicating that a 10% increase in distance reduces trade by 10%.

Why Distance Matters

• Freight costs (moving goods)– 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

Why Distance Matters

• Freight costs (moving goods)– 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

Capital costs of transport

Trade costs and the INCO Terms

Inco terms

• EXW (ex works): factory door price• FAS (free alongside ship): adds costs of transport

to port• FOB (free on board): adds cost of loading on ship• CIF (cost, insurance, and freight): adds shipping

and marine insurance costs• DEQ (delivered ex quay): adds customs

clearance, unloading costs• DDP (delivered duty paid): adds land transport to

buyer’s location

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)

Fabulous Fashion

• What is Zara’s business model?– Why does this model require a very fast

supply chain?

• Where does Zara source merchandise its for its European stores? Why?

Stock-outs and distance

• Critique the following statement: Manufacturing in far off locations does not lead to stock-outs since firms can either (1) ship goods with sufficient lead time and/or (2) hold inventories near to consumers.

• What conditions make this statement false?

The Border Effect on Canada-US Trade in 1995

Calculating border effects• The border effect is defined as the actual

domestic-foreign trade ratio divided by the predicted trade ratio (according to the gravity model). – Fij = G [Mi Mj]/ Dij

• Consider Ontario’s trade with BC and Washington State. If distance is the same, the gravity model predicts: – Fon,bc/Fon,wa = Mbc/Mwa= .6

– Since actual trade ratio is 11.75, border effect is 11.75/.6=19.6

Try this one

• Minas Tirith and Osgiliath are two cities in the country of Gondor. Edoras is in Rohan. Osgiliath’s exports to Minas Tirith are $500 and its exports to Edoras are $250. Minas Tirith is twice as far from Osgiliath as Edoras and Minas Tirith and Edoras both have GDPs equal to 10,000.

• What is the implied border effect?

Why do national borders matter for exporters?

• Trade barriers – Tariffs (duties): Not big enough in 1995 to

explain CA-US BE– Non-tariff barriers: customs clearance,

product standards and certification

• Exchange rates

• High transactions costs

Duty rate is determined by two factors:

Classification and Tariff Treatment

What the goods are or Country of origin/manufacture,what the goods are made of. and point of direct shipment

Duty rates may be specific (3.21/kg) or ad valorem (6.5%).

Structure of the Classification number

Chapters, headings, subheadings, tariff #, and classification #:

95 ......chapter

95.06 ......heading International

9506.11 ......subheading component

9506.11.10 ......tariff number Canadian

9506.11.10.00 ...... classification number component

}}

Tariff Treatments

• (MFN) Most-Favoured Nation• (AUT) Australia• (NZT) New Zealand

• (GPT) General Preferential• (LDCT) Least Developed Countries • (CCCT) Commonwealth Caribbean Countries • (GT) General Tariff -- 35%

Free Trade Agreement Tariff Treatments

• (UST) United States Tariff

• (MT) Mexico Tariff

• (MUST) Mexico-United States Tariff

• (CT) Chile Tariff

• (CRT) Costa Rica Tariff

• (CIAT) Israel Tariff

CUSTOMS TARIFF - SCHEDULE• LIST OF COUNTRIES AND APPLICABLE TARIFF

TREATMENTS

The following countries and territories are designated beneficiary countries of the Most-Favoured-Nation tariff treatment. Countries and territories that have been designated as beneficiary countries of the General Preferential Tariff treatment are denoted by a single dagger symbol (t). Countries and territories that have been designated as beneficiaries of the Least Developed Country tariff treatment are denoted by a double dagger symbol (tt). Countries and territories which are designated beneficiary countries of the Commonwealth Caribbean Countries tariff treatment are denoted by an asterisk (*).

Afghanistan t tt Denmark Luxembourg Algeria t Djibouti t tt Macao t Andorra Dominica t * Macedonia, Former Yugoslav Angola t tt Dominican Republic t Republic of t Anguilla t * Ecuador t Madagascar t tt Antigua and Barbuda t * Egypt t Malawi t tt Antilles, Netherlands t El Salvador t Malaysia t Argentina t Emirates, United Arab t Maldives t tt Armenia, Republic of t Equatorial Guinea t tt Mali t tt Ascension t Eritrea t tt Malta t Australia Estonia, Republic of t Mariana Islands t

CUSTOMS TARIFF-SCHEDULE 95-5

Tariff Item SS Description of Goods Unit of MFN Applicable

Meas. Tariff Preferential Tariffs95.06

Articles and equipment for general physical exercise, gymnastics, athletics, other sports (including table tennis) or outdoor games, not specified or included elsewhere in this chapter; swimming pools and paddling pools.

- Snow -skis and other snow ski equipment:-- Skis

--- Downhill PAR Free UST, CCCT, LDCT, GPT, MUST, CIAT,

CT:Free

--- Other 7.5% UST, CCCT, LDCT,MT, MUST, CIAT,

----- Cross Country............PAR CT: Free GPT:5%----- Snowboards..……….NMB----- Other ...........................PAR

9506.119506.11.10 00

9506.11.90

10 20

90

Tariffs by HS category, 2002

Agriculture• Price support programs exist for dairy products sector,

eggs, chicken, and turkey. These commodities account for 25% of total farm receipts.

• Price supports are complemented by supply management and import restrictions.– Import quotas apply to supply-managed commodities

subject to small “in-quota” tariffs. These import quotas often amount to less than 5% of domestic consumption. High (often prohibitive) tariffs apply to imports beyond quota levels. For example, the tariff rate for chicken within the quota is 5% but 238% outside quota.

– Free trade partners are granted preferential access

Tariffs by tariff treatment, 2002

Least Developed Counties

• As of 2003, Least Developed Countries goods can enter Canada duty free.

Proof of Origin - General Preferential Tariff (GPT), Least Developed Country Tariff (LDCT), and the Commonwealth Caribbean Countries Tariff Treatment (CCCT)

• Form A Certificate of Origin;

or

• Exporter’s Statement of Origin

EXPORTER’S STATEMENT OF ORIGIN

I certify that the goods described in this invoice or in the attached invoice #__________ were produced in the beneficiary country of _____________ and that

at least ____ per cent of the ex-factory price of the goods originates in the beneficiary country/countries

of ________________ .

Name and title_____________________________

Corporation Name and Address _______________

Telephone and fax numbers __________________

Signature and date (day/month/year)___________

NAFTA Tariff Treatment

• NAFTA certificate of origin

• Statement of origin for goods valued under $1600 Cdn.

Rules of origin (ROOs)

• ROOs are tariff-treatment and product specific and can be extremely complicated.

• For non-RTA treatments, a certain percentage of the ex-factory price of the good must originate in beneficiary countries. Additionally, the good must be directly shipped from a beneficiary country. The critical value content varies by treatment: 50% for MFN treatment, 60% for GPT, and 40% for the LDCT.

ROOs for RTAs: TVs in the NAFTA• Article 401 of the NAFTA sets out four possible criteria

that can be used to establish North American origin• The main criterion used for products incorporating

non-North American inputs (``non-originating materials") states– Each of the non-originating materials used in the production

of the good undergoes an applicable change in tariff classification set out in Annex 401 as a result of production occurring entirely in the territory of one or more of the Parties, or the good otherwise satisfies the applicable requirements of that Annex where no change in tariff classification is required, and the good satisfies all other applicable requirements of this Chapter

Example (cont.)• Annex 401 is a 243 page document that specifies

for every tariff item (8-digit classifications) what inputs must be sourced from within North America in order for the final good to be deemed of North American origin. For most TVs (8528.12.bb)– A change to tariff item 8528.12.bb from any

other heading, except from tariff item 8529.90.dd or 8540.11.aa or more than one of the following: tariff item 7011.20.aa, tariff item 8540.91.aa.• 8540.11.aa is the most important part of the

TV, the cathode ray tube.

The Tariff Mismatch

• What are average US tariffs?• What are tariffs on sweaters? On footwear? How much

savings would occur for a $202 basket of goods at Wal-Mart if tariffs were eliminated?– How much of tariff reductions would be passed on the

consumers?

• What explains variation in tariff rates across products?• Why hasn’t shoe production moved to NAFTA-country

Mexico?

Transaction Costs

• Definition: costs incurred during the process of buying or selling

• Transaction costs arise because the buyer and seller are different entities with – different incentives– different private information

• Transaction costs exclude costs of production, transportation, and taxation.

Buyer and seller must

- find each other (matching)

- agree on physical product specifications (quality), price (including INCO term), and quantity

- safeguard and enforce the contract

Why are transaction costs higher for international trade?

• Relational separation– Lack of “contacts” (fewer leads, less trust)

• Cultural separation – affect negotiation

• Political separation– unfamiliar, perhaps unfriendly courts, need to

use trade intermediaries to ensure payment

Mattel Recalls 19m. Toys Sent From China

• Why the recall of toys?• What other problems have occurred regarding

Chinese-produced goods?• Why have these problems emerged?• What steps are being taken to remedy the

problem?

Intermediaries that guarantee payment

• For domestic transactions, how are payments made?– Cash in advance– Open account– Cash of delivery

• Because of cutlural and political separation that reduces trust and increases risks to either the buyer or the seller, international transactions do not usually rely on open accounts.

Banks as intermediaries: The letter of credit

• The buyer goes to his bank a obtains a “letter” in which the bank promises to pay for goods upon delivery of certain documents

• The seller receives the letter and ships the goods• The shipper (or carrier) completes the trip and

presents the stipulated documents to the bank. The most important of these is the “bill of lading” which will turn over ownership of the goods to the buyer.

• The bank pays the seller (often thru a second bank)

Insure against risk

• Government insurance– Export credit agencies (ECAs) will insure against payment

default– Export Development Canada insures provides insurance for

accounts receivable as well as• refusal to accept the goods; • bankruptcy or insolvency; • cancellation of import or export permits;• currency transfer; • war, revolution, or insurrection; and • contract cancellation

– www.edc.ca/english/insurance_accounts_receivable.htm

• Private insurance (banks)

Legal recourse: Litigation

• Which country’s laws apply?– The parties should specify that their contract will

be governed by the law of a particular country.

– If no country is specified, the courts must determine which laws apply (based on location and other factors).

• Which country’s courts will hear the case?– This should also be specified.

– A court may apply the laws of another country.

Litigation

• Will the courts of one country recognize and enforce a decision made in another country?– The purpose of the lawsuit is to obtain damages. Thus,

it is best to initiate lawsuits in a country where the defendant has assets.

– If the judgment is made in a country where the defendant has no assets, then the plaintiff must get another country to enforce the judgment. There are no international agreements automatically recognizing the judgments of another country.

Trade costs for services

• Distance effects– These can be prohibitively high for cross-

border trade (e.g., masseuse services, retail banking services) but technological advance is facilitating more of it.

– Setting up overseas branches circumvents high distance costs.

• Border effects– Governments may restrict movements of

people and inward foreign direct investment.

Can the US Bring Jobs Back from China?

• What factors are encourage US companies to source locally?– What has changed since the article was written in

June, 2008?• What makes the US unattractive relative to China.

– What is the “China Price”?• Production of what types of goods are unlikely to return

to the US? Why? What nascent industries may locate in the US?

• How is China maintaining its edge relative to countries like Vietnam and Mexico?

Distance Still Matters

• Consider the country portfolio analysis diagrams on page 46– How do we decide what a good market is based on

the diagrams?– Why do the diagrams differ?

Engel curve: superior good

Per capita wineconsumption

Minerva

Income per capita

Athena

Hellica

Engel Curve: inferior good

Per capita fast-foodconsumption

Minerva

Income per capita

Athena

Hellica