Class Notes 4

Takeaways

Momo Deretic
Sauder School of Business
 Gravity model of trade
Fij = G [Mi Mj]/ Dij
where Fij is trade from i to j, or in some cases, both from I to j and j to i
ln G is a constant (unless we have cultural, colonial or language ties)
Mi , Mj are i and js GDPs
Dij is distance from i to j
Economists have collected data on trade flows to
estimate the logged version of this equation:
log Fij = log G + alog Mi + blog Mj - qlog Dij +
- (eij is an error term)
The results indicate that qis roughly equal to one,
indicating that a 10% increase in distance reduces trade
by 10%. aand bare also usually one.
 Why Distance Matters
Freight carrier 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
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 buyers location
Time costs: 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)
 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.
 Why do national borders
matter for exporters?
Trade barriers (customs duties, etc.)

Exchange rates
Volatility risks?
Conversion fees
Higher transaction costs
 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
 Trade costs for services
Four modes of service trade (WTO)
(1) Cross-border service trade;
(2) Consumption of service abroad;
(3) Commercial presence in the
consuming country;
(4) Individuals travelling abroad to provide
services (presence of natural persons)
 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.