Trade costs

1. 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.

2. 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.

3. 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.

5. Canadian business service imports

6. Gravity model of trade • A fuller specification commonly used by economists is ln Fij = ln G +  lnMi +  lnMj -  lnDij + φlnLij + 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%.

8. 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

9. 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

10. Capital costs of transport

11. Trade costs and the INCO Terms

12. 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

13. 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)

14. 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?

15. 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?

16. The Border Effect on Canada-US Trade in 1995

17. 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

18. 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?

19. 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

20. Duty rate is determined by two factors: ClassificationandTariff 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%).

21. Structure of the Classification numberChapters, 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 } }

22. 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%

23. 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

24. CUSTOMS TARIFF - SCHEDULE • LIST OF COUNTRIES AND APPLICABLE TARIFF TREATMENTS

25. CUSTOMS TARIFF-SCHEDULE 95-5 Tariff Item SS Description of Goods Unit of MFN Applicable Meas. Tariff Preferential Tariffs 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 --- DownhillPAR Free UST, CCCT, LDCT, GPT, MUST, CIAT, CT:Free --- Other 7.5% UST, CCCT, LDCT, MT, MUST, CIAT, ----- Cross Country............PARCT: Free GPT:5% ----- Snowboards..……….NMB ----- Other ...........................PAR 95.06 9506.11 9506.11.10 00 9506.11.90 10 20 90

26. Tariffs by HS category, 2002

27. 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

28. Tariffs by tariff treatment, 2002

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

30. 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

31. 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)___________

32. NAFTA Tariff Treatment • NAFTA certificate of origin • Statement of origin for goods valued under $1600 Cdn.

33. 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.

34. 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

35. 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.

36. 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?

37. 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.

38. Buyer and seller must - find each other (matching) - agree onphysical product specifications (quality), price (including INCO term), and quantity - safeguard and enforce the contract

39. 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

40. 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?

41. 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.

42. 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)

43. 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)

44. 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.

45. 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.

46. 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.

47. 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?

48. 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?

50. Hellica Per capita wine consumption Athena Minerva Income per capita Engel curve: superior good