Dennis Novy's research illustrates why costs of international trade are important, but so are relationships between trading countries
As this list from recent World Trade organization disputes suggests, the primary concern in trade impasses stems from costs and the degree to which they impede trade. The concerns about costs are particularly resonant now, as the world recovers from an unprecedented fall in world trade. The Great Trade Collapse in the wake of the 2008 recession represented the largest drop in world trade in the last 150 years outside of wartime. The experiences of this unprecedented period in world trade have brought increased scrutiny to the trade situation, and they have underscored a classic economic question: How much do trade costs impede international trade? Findings from my recent research suggest the answer: It depends.
Though standard economic theory has long taken a ‘one-size-fits-all’ approach to analysing the effects of trade costs, my research shows that trade costs impact countries in very uneven ways. of course, transportation costs and tariffs do reduce international trade. But my research shows that the same change in costs can have widely varying impacts. It demonstrates that the relationship between trading partners – not just the costs themselves – matter, and matter a great deal. My theoretical research provides the underpinnings of a new way of thinking about the forces at work in trade’s ebb and flow.
This theoretical work and evidence from OECD countries’ trade show that trade costs have differential effects, depending on the trade intensity of the countries involved.
When they already trade a lot, country pairs hardly benefit when transportation costs or duties fall. But bilateral trade grows faster when the initial trade relationship was thin. As a result, trade liberalization often leads to relatively larger trade creation among country pairs that previously traded very little. In the standard international trade literate, the link between trade costs – such as tariffs, transportation costs and bureaucratic hurdles - and trade is typically very simple: if trade costs go up by a certain extent, then the ‘trade cost elasticity’ tells us by how much trade is affected. For example, if trade costs fall by 1 per cent and the trade cost elasticity is 5, then trade is expected to go up by 5 per cent.
But so far the literature has only allowed for a ‘one-size-fits-all’ scenario: for a given change in trade costs, trade was expected to react by the same percentage for all bilateral trading pairs. It made no difference whether two large countries like the US and Germany were trading with each other, or whether a large country like the US was trading with a small country like Iceland. Neither did it make a difference whether two countries had fairly low bilateral trade barriers (think US and Canada), or whether bilateral trade barriers and transportation costs were higher (think US and Italy). But in practice, data show that the effect of trade frictions on trade flows varies widely.
My new research challenges this ‘one-size-fitsall’ feature. I develop a relationship that allows trade costs to have a heterogeneous impact across country pairs. This means that a given trade cost change, say, a 1 per cent drop, can lead to different effects for different trading partners. This new approach is arguably fundamental to understanding the trade cost elasticity, and indeed, evidence from OECD trade flows shows that similar trade barriers may have widely different effects.
The results indicate that trade costs’ effects vary, depending on how intensely two countries trade with each other. Specifically, the more the destination country imports from a particular exporting country, the less sensitive are its bilateral imports to trade costs. one reason for this may be that large exporters tend to enjoy a relatively powerful market position in the destination country. Demand for the exporter’s goods is often buoyant, and consumers might not react strongly to price changes induced by changes in trade costs. On the contrary, small exporters might only face weak demand for their goods, and consumers may be sensitive to price changes. As a result, small exporters are hit harder by rising trade costs and find it more difficult to defend their market share.
This framework has the potential to shed new light on the effect of institutional arrangements such as free trade agreements; currency unions that seek to reduce the costs of trade, such as the Eurozone; or World Trade organization (WTo) membership on international trade. For example, some have suggested that the WTo has strongly promoted trade but unevenly. Some countries and industries have benefited more than others, and the variable effects of trade costs may be a previously hidden factor in the uneven effects.
About the author
Dennis Novy is an associate professor in the Department of Economics at the University of Warwick and a research affiliate at the Centre for Economic Policy Research. He is an expert on international trade and international economics.
This article is based on “International Trade without CED: Estimating Translog Gravity,” forthcoming in the Journal of International Economics. The full paper is available at here.