Why are trade costs important?
Differences in economic size and endowments are not the only reason why some countries trade more than others, or trade with a wider range of partners. Trade intensity also depends on many other factors capturing the degree of separation between countries. One way of thinking about these factors is as the ‘friction’ associated with trade, or the set of economic forces that tends to reduce trade. Paul Samuelson’s famous image sees trade flows being reduced by frictions in the same way that an iceberg melts while moving through the sea.
An effective way of capturing this effect is through trade costs between partner countries. Most international trade theories include trade costs as the set of factors driving a wedge between export and import prices. Trade costs are the price equivalent of the reduction of international trade compared with the potential implied by domestic production and consumption in the origin and destination markets. Higher bilateral trade costs result in smaller bilateral trade flows.
In an increasingly globalised and networked world, trade costs matter as a determinant of the pattern of bilateral trade and investment, as well as of the geographical distribution of production. Although tariffs in many countries are now at historical lows, overall trade costs remain high. One estimate based on an exhaustive literature review suggests that representative rich country trade costs might be as high as 170% ad valorem – far in excess of the 5% or so accounted for by tariffs (Anderson and Van Wincoop 2004). Their number breaks down into 55% domestic distribution costs, and 74% international trade costs.
What are the sources of trade costs?
Trade costs have two main categories of sources:
- The first encompasses entirely bilateral factors of separation between the exporter and the importer, which are more dependent on exogenous factors than particular policy choices. Examples include:
- Geographical distance, as a rough proxy for international transportation costs;
- Common features between trading partners such as language, common history, or sharing a common border.
- The second category includes endogenous trade costs, which in a sense represent the ‘thickness’ of the two countries’ borders. Examples include:
- Logistics performance – cost, delay, and reliability – and trade facilitation bottlenecks – such as border control, and transit systems with third countries;
- International connectivity, such as the existence of regular maritime, air, or terrestrial services;
- Non-tariff measures.
Given the all-inclusive nature of this classification, trade costs in the developing world should be significantly higher than those for rich economies. Tariffs and non-tariff barriers remain substantial in developing countries. Other sources of trade costs also represent significant obstacles to greater export and import volumes, particularly in areas such as poor infrastructure and dysfunctional transport and logistics services markets.
Unsurprisingly, physical separation has a major trade reducing effect, as evidenced by Figure 1 which shows the relative impact of different factors on trade costs, based on our recent work (Arvis et al. 2013). However, policies also have a significant influence on trade costs. Maritime-transport connectivity and logistics performance are very important determinants of bilateral trade costs: in some specifications, their combined effect is comparable to that of geographical distance. Generally, traditional and non-traditional trade policies, including market entry barriers and regional integration agreements, play a significant role in shaping the trade costs landscape.
Figure 1. Relative impact of different sources of trade costs; normalised regression coefficients (‘betas’) against the indicator measuring the cost component
Source: Arvis et al. 2013.
Measuring trade costs: Inverse gravity
Applied international trade literature has traditionally focused on using the standard gravity model to identify particular factors as sources of trade costs, using a direct econometric approach where trade costs are proxied by a series of available indicators such as distance. This approach has two drawbacks: the first is that it does not produce an overall estimate of the level of trade costs between countries; second, inclusion of some variables but not others immediately gives rise to concerns about omitted variables bias, to the extent that omitted trade costs are correlated with variables included in the model.
In Arvis et al. (2013), we take a different approach. We use the inverse form of the gravity model developed by Novy (2013) to infer trade costs from the observed pattern of trade and production across countries. Intuitively, when a country sells relatively more goods to its own residents than to foreigners, it must be because international trade costs have increased relative to domestic trade costs, holding other factors constant. Similarly, if a country sells relatively more of its production to foreigners than to residents, it must be because international trade costs have fallen relative to domestic trade costs, again holding other factors constant.
Trade costs measured in this way are highly informative for policy purposes, and this is the first case in which the inverse gravity approach to trade costs has been used to derive bilateral trade costs for a wide range of developing countries.
To measure trade costs over the 1995-2010 period, UNESCAP and the World Bank embarked on a joint data-collection exercise. In addition to data on export and import flows, calculation of trade costs using the inverse gravity methodology also requires information on domestic production in each country. Usage can then be calculated as domestic production less total exports.
Trade data are easily available in harmonised format. Obtaining data on domestic production is more challenging, and requires recourse to a combination of UN national accounts data and GDP data from the World Development Indicators, scaled up using an approximate conversion factor from value added to gross shipments terms. The end result is a database covering up to 178 countries, two sectors, and the 1995-2010 period. Based on the available data, we calculate trade costs for as many bilateral pairs as possible, and use interpolation to fill in missing country-year combinations, where feasible.
Recent trends in trade costs
To provide a point of comparison across countries, we calculate trade costs between each country for which we have data and the ten largest importers. Averaging results by income group shows that, as expected, poorer countries tend to exhibit higher levels of trade costs than do richer ones (Figure 2).
Figure 2. Trade costs’ inverse dependence on per capita income
Note: Figure shows average trade costs for manufactured goods with respect to the 10 largest importing countries, by World Bank income groups, 1996 and 2009, percent ad valorem equivalent.
Source: Arvis et al. 2013.
Converting ad valorem equivalents to index numbers makes it possible to see the rate at which trade costs have evolved over time in different country groups, taking into account that each group started from a different baseline in 1996. Figure 3 shows that for manufacturing, trade costs have fallen most quickly in the high-income countries. They have fallen considerably more slowly in the lower income groups. This dynamic needs to be addressed by developing country policymakers if they want to deepen their countries’ integration into the global economy, both in an absolute and a relative sense. In agriculture, by contrast, trade costs have remained relatively flat across the board, which is consistent with the continued existence of major policy barriers.
Figure 3. Trade costs are falling more slowly in low-income countries
Note: Figure shows average trade costs for manufactured goods with respect to the 10 largest importing countries, by World Bank income groups, 1996-2009, 1996=100.
Source: Arvis et al. 2013.
Trade costs are an important policy issue for all countries, but particularly for developing countries. They partly determine a country’s ability to position itself in global networks of trade and production. Our research uses a new database and a recently developed methodology, and shows that trade costs are higher in lower income countries, and that they are falling more slowly. Policymakers need to address this dynamic if they want to improve the absolute and relative position of lower income countries in global trade. The ESCAP-World Bank trade cost database provides a unique way for governments to assess progress of their countries in reducing their trade costs with key partners. For researchers, it may also provide an alternative to standard gravity modeling in identifying the impact of various factors on trade, as done in a recent OECD paper (Moise et al. 2013).
Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.
Anderson, J, and E Van Wincoop (2004), “Trade Costs”, Journal of Economic Literature, 42(3), 691-751.
Arvis, J-F, Y Duval, B Shepherd, and C Utoktham (2013), “Trade Costs in the Developing World: 1995-2010”, Policy Research Working Paper 6309, World Bank.
Moise, E, S Sorescu, D Hummels, and P Minor (2013), “Trade Facilitation Indicators: The Potential Impact of Trade Facilitation on Developing Countries’ Trade”, Trade Policy Paper 144, OECD.
Novy, D (2013), “Gravity Redux: Measuring International Trade Costs with Panel Data”, Economic Inquiry, 51(1), 101-121.
Please note that the trade costs database is available at: http://data.worldbank.org/data-catalog/trade-cost