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Global Value Added: Costs of trade

Professor Daniel F. Spulber

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The Global Value Connection

Strategies to maximize net gains from trade

Home

country

Supplier

countries

Partner

countries

Customer

countriesInternational

business

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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

Supplier

country X

Customer Country Y

High P 200

High T 14

0

Customer Country ALow P 100

Low T 25

Maximize net gains

from trade

Target customer countriesthat are easier to serve

May choose customer

countries near supplier

countries

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Costs of trade: strategic effects

Supplier country X

Low P 50

High T 80

Supplier country B

High P 75

Low T 25

Customer

country 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 toolto 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 750

Import tariff (15% cif) 3,300

Local port costs 350

Document preparation 230

Custom broker fee 750

Freight forwarder fees (1% of cif) 220

Bank costs (2% of ex works price) 400

Total 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 thedisadvantage

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Costs ofTrade

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 abasis forinternational trade and arbitrage

PA PB T

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Costs ofTrade

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 tradeMarkup:

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 doesnot 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 inYen] = [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 hold

7Pi is the domestic consumer price index

7Pi* 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 acommon currency

This relationship should be observed if the law of one priceholds because aggregate price levels would be correlated

The long term speed of convergence of currencies to PPP is veryslow only about 15% per year! never converges

7Pi = X * 7Pi*

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Purchasing Power Parity

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 107Yen to Dollar

(about right)

7Pi = X * 7Pi*

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-powerparity, the notion that a dollar should buy the same amountin all countries. Thus in the long run, the exchange ratebetween two countries should move towards the rate thatequalises the prices of an identical basket of goods and

services in each country. Our "basket" is a McDonald's BigMac, which is produced in about 120 countries. The Big Mac

PPP is the exchange rate that would mean hamburgers costthe same in America as abroad. Comparing actual exchangerates 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 McDonalds

Big Mac

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1. Transaction costs

Greater 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 andregulatory jurisdictions

Search for trading partners

Marketing and sales costs

Contracting:

Negotiating contractterms

Monitoring performance

Purchasing, Financing

Human resourcemanagement:

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 choiceof 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 sitesaimed 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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Tariffs

About 6% of world trade

Import-wtd.Average

SimpleAverage

Total Merch.Imports, in Millions

of US $

ImputedTariff

Revenues,in Millions of

US $

Afri 9 9 9 9

Asi lK i

9 9

Austr liZ l J

9 9

E & i i 9

E ster Eur e &for er USSR

10.11 7.56 295,953 29,919

US, Canada,

Cari ean3.10 9.32 1,102,816 34,201

South & CentralAmeri a

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 = $100Mark 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 contentrequirements

Domestic subsides

Technical barriers andstandards: 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 freetradesource 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-tariffclassification

Source and serve within the same country or trade block

The four Ts

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3. Transportation

About 5.6% of world trade -- geography matters

Imports Freight Other Total % of

transp. Transp. imports

World total 5386700 206784 97682 304466 5.6

Ind. 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 7.9Western Hem. 310081 14643 4158 18801 6.1

Table 1 World transport costs in million $US.

Source of data: IMF. Balance of Payments StatisticsYearbook, 1 8

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 shippingcosts

Trade off speed and flexibility versus shipping costs Outsource to logistics specialists

The four Ts

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4. Time

Example: Regulation -- time to start a business in days

Australia 2

Canada 3

Denmark 4

US 5

France 8

Singapore 8

Turkey

Hong ong 11

Netherlands 11

Venezuela 116

Azerbaijan 123

Angola 146

Indonesia 151

Brazil 152

Mozambique 153

Congo 155

Haiti 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 andcommunication

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

OPTIONAL

MATERIAL

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Founded 1 8 Membership

Australia, Brunei, Canada, Chile, China, Taiwan, Hongong, Indonesia, Japan, orea, Malaysia, Mexico, New

ealand, Papua New Guinea, Peru, Philippines, Russia,Singapore, Thailand, United States, and Vietnam

Population : over 2 billion Output

$14,46 billion at market exchange rates $16,578 billion at PPP rates

Foreign Trade (exports plus imports)

Approx $4 trillion, of which 74% was

intrabloc

OPTIONAL

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) OPTIONALMATERIAL

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Latin America Growth Rate

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

OPTIONAL

MATERIAL

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Mercosur

Founded 1 1

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

MATER

IAL

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Brazil and Argentina account for over 5% 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

OPTIONAL

MATERIAL

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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

OPTIONAL

MATERIAL

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North American Free Trade Agreement

NAF

TA

Founded 1 4

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

NAF

TA

Free Trade Area not Customs Union

Legally binding agreement enforced through penalties and

sanctions

Dispute resolution mechanism through FTC

Supplemental agreements on environmental cooperation andlabor 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 toreduce 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 gaincompetitive advantage by reducing its costs of trade