Thinking about Trade and Trade Costs

One of the big issues facing policymakers around the world is the evolution of the pattern and volume of international trade flows. I recently participated in a very useful conference that included a number of papers that shed light on this important question. The conference, “Trade Costs and International Trade Integration — Past, Present and Future,” organized by Dennis Novy (Warwick University), David Jacks (Simon Fraser University), and Christopher Meissner (University of California, Davis), and sponsored by the UK’s ESRC, and the University of Warwick’s CAGE.


Figure 2a, estimated trade costs, from Jacks, Meissner, Novy, “The role of trade costs in the great trade collapse,” in R. Baldwin The Great Trade Collapse (VoxEU/CEPR, Nov. 2009).

The links to the papers are here. The program is below:

Session 1: Trade Costs in Emerging Economies

  • Caroline Freund (World Bank), “What Constrains Africa’s Exports?” (with Nadia Rocha). Abstract:This paper examines the effects of transit, documentation, and ports and customs delays on Africa’s exports. The authors find that transit delays have the most economically and statically significant effect on exports. A one-day reduction in inland travel times leads to a 7 percent increase in exports. Put another way, a one day reduction in inland travel times translates to a 1.5 percentage point decrease in all importing-country tariffs. By contrast, longer delays in the other areas have a far smaller impact on trade. The analysis controls for the possibility that greater trade leads to shorter delays in three ways. First, it examines the effect of trade times on exports of new products. Second, it evaluates the effect of delays in a transit country on the exports of landlocked countries. Third, it examines whether delays affect time sensitive goods relatively more. The authors show that large transit delays are relatively more harmful because of high within-country variation.
  • Keith Head (University of British Columbia), “The Erosion of Colonial Trade Linkages after Independence” (with Thierry Mayer and John Ries). Abstract: Most independent nations today were part of empires in 1945. Using bilateral trade data from 1948 to 2006, we examine the effect of independence on post-colonial trade. While there is little short-run effect on trade, after four decades trade with the metropole (colonizer) has contracted by about 65%. Hostile separations lead to large, immediate reductions in trade. We also find that trade between former colonies of the same empire erodes as much as trade with the metropole, whereas trade with third countries decreases about 20%. The gradual trade deterioration following independence suggests the depreciation of some form of trading capital.
  • John Brown (Clark University), “A Ricardian Factor Content Characterization of the Welfare Effects from Trade: Evidence from Japan’s Opening Up” (with Daniel Bernhofen and Tanimoto Masayuki). Abstract: Following Samuelson’s seminal 1939 contribution, existing measures of the gains from trade are rooted in the theory of consumer demand. Their empirical implementation requires either aggregate consumption data, which are hardly available, or are based on specific functional forms on consumer utility. We suggest a factor content characterization of the gains from trade which is based on production theory and requires no assumptions on the demand side of the economy. We show that our measure can be viewed as a generalization of David Ricardo’s 1817 labour value formulation of the gains from trade. An attractive feature of our characterization is that the gains from trade become empirically refutable. In addition, our measure allows inference about the sources of the benefits and costs from trade. We apply our measure to Japan’s 19th century opening up to world commerce where we are able to observe a market economy under autarky and trade. Our analysis applies Japan’s 19th century autarky technology matrix to Japan’s early commodity trade flows. We provide causal evidence on positive gains from trade and show that Japan’s early gains arose from its ability to import relatively scarce factors as well as Ricardian augmentation of labour.

Session 2: New Empirical Methods

  • Michael Waugh (NYU Stern School of Business), “The Elasticity of Trade: Estimates and Evidence” (with Ina Simonovska). Abstract: Quantitative results from a large class of structural gravity models of international trade depend critically on a single parameter governing the elasticity of trade with respect to trade frictions. We provide a newmethod to estimate this elasticity and illustrate themerits of our approach relative to the estimation strategy of Eaton and Kortum (2002). We employ this method on data for 123 developed and developing countries for the year 2004 using new disaggregate price and trade flowdata. Our benchmark estimate for all countries is approximately 4.5, nearly 50 percent lower than the alternative estimation strategy would suggest. This difference implies a doubling of the measured welfare costs of autarky across a large class of widely used trade models.
  • Volodymyr Lugovskyy (Georgia Institute of Technology), “Transportation Cost and Endogenous Quality Choice” (with Alexandre Skiba). Abstract: This paper examines how the quality of exports depends on relative country size and its remoteness. Specific transportation cost is the key variable in our analysis as it gives rise to the Alchian-Allen effect. In the model, we allow for endogenous quality choice by a producer serving many international locations. Higher quality comes at higher marginal cost of production, but can be delivered at the same absolute, and thus proportionally lower, transportation cost to a given destination. Our model complements the well documented demand side response to the distribution of transportation costs (known as the Alchian-Allen effect) by the supply side response. We show that, ceteris paribus, equilibrium quality decreases in the domestic country size and increases in remoteness from foreign markets. This happens because a larger portion of the demand is affected by the Alchian-Allen effect for smaller countries’ producers, and the Alchian-Allen effect is stronger for remote countries. We confirm our predictions empirically on a detailed product level dataset of all exporters worldwide into a sample of Latin American importers.
  • Ivan Cherkashin (Pennsylvania State University) “Firm Heterogeneity and Costly Trade: A New Estimation Strategy and Policy Experiments” (with Svetlana Demidova, Hiao Looi Kee, Kala Krishna). Abstract: This paper models and estimates the responses of firms (who differ in their productivity and face firm and market specific demand shocks) to trade policies in different product and export destinations. The paper does three things. First, it builds a tractable partial equilibrium model in the spirit of Melitz (2003), which incorporates both of these dimensions of heterogeneity and is well-suited for empirical work. Second, it shows how to use this model to estimate the structural parameters of interest using only cross-sectional data. Third, it uses the model to perform counterfactual experiments regarding the effects of reducing costs, both fixed and marginal, or of trade preferences (with distortionary Rules of Origin) offered by an importing country. We find both have a catalytic effect which greatly increases exports to all markets. Our counterfactuals make a case for “trade as aid,” as such polices can create a win-win scenario for all parties concerned and are less subject to the usual worries regarding the efficacy of direct foreign aid.

Session 3: The Dynamics of International Trade and Trade Costs

  • Menzie Chinn (University of Wisconsin) “Supply Capacity, Vertical Specialization and Tariff Rates: The Implications for Aggregate U.S. Trade Flow Equations “Abstract: This paper re-examines aggregate and disaggregate import and export demand functions for the United States over the 1975q1-2010q1 period. This re-examination is warranted because (1) income elasticities are too high to be warranted by standard theories, and (2) remain high even when it is assumed that supply factors are important. These findings suggest that the standard models omit important factors. An empirical investigation indicates that the rising importance of vertical specialization combined with changing tariff rates and transportation costs explains some of results. Accounting for these factors yields more plausible estimates of income elasticities.
  • Beata Javorcik (University of Oxford), “Roll out the Red Carpet and They Will Come: Investment Promotion, Information Asymmetries and FDI Inflows” (with Torfinn Harding). Abtract: As information asymmetries between host countries and potential foreign investors constitute a significant obstacle to investment flows across international borders, an important policy question is: what can aspiring FDI destinations do to reduce such barriers? This study uses newly collected data on 124 countries to examine the effects of investment promotion on FDI inflows. We test whether sectors explicitly targeted by investment promotion agencies in their efforts to attract FDI receive more investment in the post-targeting period, relative to the pre-targeting period and nontargeted sectors. The results of our analysis are consistent with investment promotion leading to higher FDI flows to countries in which information asymmetries are likely to be severe. Investment promotion efforts appear to be reasonably cost effective. A dollar spent on investment promotion is found to increase FDI inflows by 189 dollars. An additional job created by a foreign affiliate requires 78 dollars in investment promotion spending.
  • Paul Bergin (University of California, Davis) “The Dynamic Effects of Currency Union on Trade” (with Ching-Yi Lin). Abstract: A currency union’s ability to increase international trade is one of the most debated questions in international macroeconomics. This paper studies the dynamics of these trade effects over time. First, empirical work with data from the European Monetary Union finds that the extensive margin of trade (entry of new firms or goods) responds several years ahead of overall trade volume and actual implementation of the monetary union. This implies a fall at the intensive margin (previously traded goods) in the run-up to EMU. A dynamic stochastic general equilibrium model of trade studies the announcement of a future monetary union as a news shock lowering future trade costs, and finds that the early entry of new firms in anticipation is explainable as a rational forward-looking response under certain conditions. Required elements are sunk costs of exporting and ex-ante heterogeneity among firms. The findings help identify which types of trading frictions are reduced by adopting a currency union. Findings also indicate that a significant fraction of the welfare gains from a monetary union are based upon expectations for the future, so that continued gains depend upon long-term credibility of the union.

Session 4: Trade Policy

  • James Anderson (Boston College) “Specialization: Pro- and Anti-Globalizing, 1990-2002” (with Yoto Yotov). Abstract: Specialization alters the incidence of trade costs to buyers and sellers, with pro-and anti-globalizing effects on 76 countries from 1990-2002. The structural gravity model yields measures of Constructed Home Bias and the Total Factor Productivity effect of changing incidence. A bit more than half the world’s countries experience declining constructed home bias and rising real output while the remainder of countries experience rising home bias and falling real output. The effects are big for the outliers. A novel test of the structural gravity model restrictions shows it comes very close in an economic sense.
  • Marcelo Olarreaga (University of Geneva) “Weak Governments and Trade Agreements” (with Jean-Louis Arcand and Laura Zoratto). Abstract: The recent theoretical literature on the determinants of trade agreements has stressed the importance of political gains, such as credibility, as a rationale for trade agreements. The empirical literature, however, has lagged behind in the estimation of the economic gains or losses associated with these politically motivated trade agreements. This paper fills that gap by providing estimates of the economic impact of politically and economically motivated trade agreements. We find that credibility gains play a role in increasing the probability of two countries signing an agreement. Moreover, agreements with a stronger political motivation are more trade creating than agreements that are signed for pure market access / economic reasons.
  • Jeffrey Bergstrand (University of Notre Dame) “The Growth of Bilateralism” (with Scott Baier and Ronald Mariutto). From the Conclusion: One of the most notable international economic events of the past 20 years has been the proliferation of bilateral FTAs, argued by some to be attributable to governments having pursued a policy of “competitive liberalization.” We have employed new comparative statics from a simplified version of the numerical general equilibrium model of FTA economic determinants in Baier and Bergstrand (2004) to suggest how the net welfare gains of an FTA between country I and country j would be influenced by other FTAs — both those of i (or j) with other countries — due to tariiff complementarity” — as well as those among other countries (say, k with l) — due to competitive liberalization. Guided by these general equilibrium comparative statics, we specified a simple logit (and probit) model to estimate the influence on the likelihood of a bilateral FTA between i and j of indexes for each country of “multilateral FTAs” and “ROW FTAs” — in the spirit of Anderson and van Wincoop’s (2003) “multilateral resistance” terms. We found that the marginal response probabilities of these indexes of “own-FTA” and “third-country-pair-FTA” competitive liberalization effects were both statistically and economically significant — and on the order of magnitude of the effects of country-pairs’ GDP sizes on the likelihood of two countries forming an FTA. Moreover, using a “Sensitivity-Specificity” analysis, we determined the optimum cutoff probability for predicting FTAs and the results indicated that we could predict correctly an FTA (“No-FTA”) when one existed (none existed) 91 percent of the time. The results provide economically and statistically significant evidence that “tariff complementarity” is at least as important as “competitive liberalization” as a source of the growth of bilateralism.

I won’t discuss each of the papers, but they’re all very interesting, and helped me catch up on the trade literature. Instead I’ll focus on the macro implications. As I discussed in this post, I’ve been thinking about how trade costs, vertical specialization and supply side effects can be incorporated into macroeconomic models of trade flows. Some of those econometrically oriented thoughts have been traced out in this paper, presented at the conference.

Several of the papers presented were directly related to this issue. The Simonovska-Waugh paper provided a potential reconciliation for the finding of low aggregate price elasticities derived from aggregate data-based regressions such as in Chinn (2010), and the high rates of substitutability (which are consistent with high price elasticiities), such as in the Eaton-Kortum model.

In addition, James Anderson pointed out that changing measured income elasticities are consistent with constant trade costs, but changing home bias as some countries experience faster productivity growth than others. In other words, the multilateral resistance indices change over time. In fact, according to the Anderson-Yotov estimates, the decline in the US inward multilateral resistance index is the third highest of all countries in their sample.

While not relevant to the issue of trade elasticities, I thought Keith Head’s estimated impact of the separation between metropole and colony of interest — particularly the divergent impacts of amicable versus hostile breakups.


Excerpt from Figure 6 from Keith Head (2010).

The most interesting finding in my mind is that about 60 years after gaining independence, a colony has about the same trade with its former colonizer (as a proportion of trade at independence) regardless of whether the breakup is amicable or not.

1 thought on “Thinking about Trade and Trade Costs

  1. ReformerRay

    Each of us has views as to what trade issues are important. I see the U.S. trade deficit as the most important issue. The deficit is important because it probably diminished U.S. GDP.
    All of the trade models described above ignore the issue of what a trade deficit does to domestic output – so far as I can tell.
    Enquiring minds want to know whether the large U.S. trade deficit from 1998 – 2008 reduced U.S. employemnt and domestic output (large meaning 5 trillion dollars sent overseas to pay for 10 years of trade deficits).
    If this issue is ignored by the most sophisticated writers on foreign trade, U.S. trade policy will continue to be guided by those who have a vested interest in the outcome rather than by peer reviewed analysis.

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