Is the Iceberg Melting Less Quickly? International Trade Costs after World War II

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1 Is the Iceberg Melting Less Quickly? International Trade Costs after World War II Dennis Novy y University of Warwick 7 May 2007 Abstract International trade costs determine trade patterns and therefore economic performance. This paper develops a micro-founded measure of these international trade costs. It is derived by incorporating bilateral iceberg trade costs into a multi-country general equilibrium model of trade and solving for the implied gravity equation. The innovation of this micro-founded gravity equation is to express multilateral resistance in the form of observable variables. As a result, it becomes possible to compute trade costs directly from this gravity equation and also to track the changes in trade costs over time. It is found that since World War II trade costs amongst OECD countries have declined markedly. The decline in trade costs has been particularly dramatic for nearby trading partners, consistent with the promotion of regional economic integration through NAFTA and the European Common Market. JEL classi cation: F, F4 Keywords: Trade Costs, Gravity, Distance, Economic Integration I am grateful to Petra Geraats, David Jacks, Chris Meissner, Francesco Caselli, Jakob de Haan and Stephen Redding for valuable comments. I would also like to thank conference/seminar participants at the Annual Congress of the European Economic Association (EEA) in Amsterdam, the University of Groningen, the University of Cambridge, the Federal Reserve Bank of St. Louis, the University of Birmingham, the University of Oxford and the University of Warwick. Any remaining errors are mine. y Department of Economics, University of Warwick, Coventry CV4 7AL, United Kingdom. d.novy@warwick.ac.uk and /faculty/novy/

2 Introduction Barriers to international trade are large and since they impede trade ows, they have a strong impact on countries overall economic performance. Some barriers, like tari s and transportation costs, are directly observable but numerous other barriers are notoriously di cult to measure, for example administrative and communication costs. The aim of this paper is to derive a comprehensive measure of trade costs that can capture all barriers to international trade. This comprehensive measure of trade barriers is derived by incorporating bilateral iceberg trade costs into a multi-country general equilibrium model of trade. Iceberg trade costs mean that for each good that is exported a certain fraction melts away during the trading process as if an iceberg were shipped across the ocean. The model yields a micro-founded gravity equation that relates trade ows to iceberg trade costs and output in a simple and intuitive way. It is therefore possible to compute trade costs directly from this micro-founded gravity equation. The recent literature, most notably the important contribution by James Anderson and Eric van Wincoop (2003), has given considerable attention to the measurement of trade costs. The contribution of the current paper is to greatly simplify the measurement of trade costs. This is achieved by nding a convenient solution to the problem of capturing the unobservable multilateral resistance variables highlighted by Anderson and van Wincoop (2003). In particular, the micro-founded gravity equation includes terms for countries total exports and these total export terms indirectly incorporate countries trade barriers with the rest of the world. Intuitively, the bigger a country s total exports are, the lower are its trade barriers with other countries. This convenient form of expressing multilateral resistance implies that it is easy to measure changes in trade costs over time because they explicitly depend on observable variables. Empirical bilateral trade costs are thus obtained for OECD countries during the post- World War II period. For the G7 subsample trade costs fell by 26:5 percent between 960 and Similarly, for European Union countries trade costs fell by 7:7 percent between 977 and For both subsamples the 2002 tari equivalent of trade costs stands at about 40 percent. In general, trade costs have fallen most dramatically for nearby trading partners, implying an increase in regional economic integration that is consistent with the emergence of regional free trade agreements such as NAFTA and the European Common Market. As opposed to a comprehensive measure of trade barriers, the literature has produced many estimates of certain trade cost components. Two well-known examples are John Mc- Callum s (995) and Andrew Rose s (2000) papers. McCallum (995) examines the e ect of the U.S.-Canadian border as a very general form of trade costs, whereas Rose (2000) focuses on common currencies. David Hummels (2007) measures the costs of transportation

3 with a focus on ocean and air freight rates. But by their very nature, such measures focus on single trade cost components and therefore only convey a partial picture. In contrast, this paper presents a comprehensive measure of trade costs that captures all barriers to trade. In their in-depth survey of trade costs, Anderson and van Wincoop (2004) combine various trade cost components such as transportation costs, tari s and language barriers. They argue that based on data from recent years, the tari equivalent of representative international trade costs is around 74 percent, a number that is consistent with the range found in this paper. But the advantage of the comprehensive trade cost measure in this paper is to produce trade costs that vary over time and that are country-pair speci c. Trade costs in fact exhibit a high degree of heterogeneity across country pairs, a nding which is masked by any one- ts-all measure. Apart from providing snapshots of trade costs over time, the paper also seeks to explain the dispersion of trade costs across country pairs. The trade cost regressions reveal how trade cost components have changed over time. For example, they show that language barriers have declined substantially. In 970 using the same o cial language was associated with a tari equivalent of trade costs that was lower by 5 percentage points on average, but in 2000 the language barrier is no longer signi cantly di erent from zero. Likewise, the advantage of sharing a common colonial history was substantial in 970 but has washed out over time and can no longer be associated with lower trade costs in Head and Ries (200) derive a measure for the U.S.-Canadian border e ect. since their two-country framework does not consider trade with other countries, by construction it cannot account for multilateral resistance. The gravity equations developed by Je rey Bergstrand (985), Scott Baier and Je rey Bergstrand (200) and Anderson and van Wincoop (2003) include multilateral resistance terms, but they are unobservable because they are highly non-linear theoretical constructs. But The micro-founded gravity equation derived in this paper is more practical since it captures multilateral resistance with observable variables and therefore provides an easy and intuitive way of computing trade costs. Another advantage of this gravity equation is that in order to compute trade costs, there is no need to impose any structure on the underlying trade cost components. In particular, no assumptions are needed as to which variables are actually important as trade cost determinants and what functional form they take. Baier and Bergstrand (200) only consider transportation costs and tari s, whereas Anderson and van Wincoop (2003) focus on distance and border barriers. The paper is organized as follows. Section 2 develops the general equilibrium model with iceberg trade costs, resulting in the essential gravity equation and the micro-founded Novy (2007) derives explicit solutions for the multilateral resistance variables on the basis of Anderson and van Wincoop (2003) s model and subsequently uses them to derive a measure of international trade costs. 2

4 trade cost measure. Section 3 illustrates how trade costs have changed over the past few decades with special emphasis on the G7 and European Union countries, showing that economic integration has progressed fastest on a regional level. Section 4 explains the variation of trade costs across country pairs and provides a discussion of the results. Section 5 concludes. 2 A Model with Iceberg Trade Costs This section develops a micro-founded general equilibrium model that is similar to the framework typically encountered in the New Open Economy Macroeconomics literature, as for example in Obstfeld and Rogo (995), with the exception that the model abstracts from price stickiness as it does not focus on the short run. The model augments the standard framework in three distinct ways. First, it extends to multiple countries. Second, it adds nontradable goods and third, as its central building block the model incorporates iceberg trade costs of the kind introduced by Samuelson (954) and rst included in a monopolistic competition model by Krugman (980). Optimizing consumers and rms inhabit J countries with = ; 2;:::; J and J 2. The range of all consumers and of all goods produced in the world is the continuum [0; ]. Country comprises the consumer range [n ; n ], and country- monopolistic rms each produce one di erentiated good on the same range, where n 0 = 0 and n J =. It is assumed that the fraction s of goods is tradable so that [n ; n + s (n n )] is the range of all tradable goods produced by country (0 < s ). 2 These can be purchased by all consumers in the world. The remaining range [n +s (n n ); n ] represents country s nontradable goods. The latter are available for purchase to country- consumers only. Exogenous bilateral iceberg trade costs ;k are incurred when goods are shipped from country to country k where ;k ( 0 for 6= k = 0 for = k Iceberg trade costs mean that for each unit of goods that is shipped from to k the fraction ;k melts away as if an iceberg were shipped across the ocean ( ;k < for 6= k). It is assumed that bilateral trade costs are symmetric ( ;k = k; ). The assumption of zero intranational trade costs is a normalization which can also be found in Baier and Bergstrand (200). 3 2 For an empirical motivation of this assumption see Section Suppose that trade costs of shipping from to k can be decomposed into the costs up to the border of k times the costs of intranational shipping within k (the latter the same for all origins of shipment). The normalization of intranational trade costs to zero then implies that ;k should be interpreted exclusively as the costs of shipping up to the border of k. 3

5 2. Consumers All consumers within one country are identical. They like consumption and dislike work such that their utility can be described as U = ln C + ln ( L ) () where C and L denote per-capita consumption and labor supply of the representative country- consumer. The parameter is assumed to be identical across countries. C is a CES Dixit-Stiglitz composite consumption index de ned as C " JX k= Z nk +s k (n k n k ) Z # (c i ) n d i + (c i ) d i n k n +s (n n ) (2) where c i denotes the per-capita consumption of good i in country. The country- consumption index (2) is de ned over all tradable goods produced in the world, which is the rst term within the brackets of (2), plus all nontradable goods produced by country, which are given by the second term within the brackets. > is the elasticity of substitution and it is assumed to be identical across countries. The consumption-based price index, de ned as the minimum expenditure for one unit of C, can be derived from (2) as P = " JX k= Z nk +s k (n k n k ) n k ( i ) d i + Z n n +s (n n ) ( i ) d i # (3) where i denotes the prices of the individual goods as follows p T ki i = ( k; p T ki for n k i n k + s k (n k n k ) 8 ; k (4) p NT i for n + s (n n ) i n denotes the f.o.b. (free on board) price of the tradable good produced by country-k rm i and p T ki =( k;) is the c.i.f. (cost, insurance, freight) price of the same good when traded with country. p NT i is the price of the nontradable good produced by country- rm i. All prices are denominated in one world currency. The c.i.f. price is =( k; ) times the f.o.b. price because when one unit of a tradable good produced by a country-k rm is shipped to country, only the fraction ( k; ) arrives at the destination. The tari equivalent k; of iceberg trade costs can therefore be expressed as k; = k; = k; k; (5) Maximizing consumption (2) subect to the minimum expenditure (3) yields the stan- 4

6 dard individual demand function c i = i The per-capita budget constraint in country is given by P C (6) P C = W L + (7) where W is the nominal wage and denotes per-capita nominal pro ts made by country- rms, which are fully redistributed to country- consumers. 2.2 Firms There is monopolistic competition such that each rm as the single producer of one differentiated good sets the pro t-maximizing price. Not all rms within one country are symmetric since in country the fraction s of rms produces tradable goods, whereas the fraction ( s ) produces nontradable goods. Let yi T denote the output produced by country- tradable rm i and yi NT the output produced by country- nontradable rm i. In addition, let yi;k T be the tradable output of rm i produced for country k so that y T i JX yi;k T (8) k= All rms face a linear production function that has constant returns to scale and that operates with labor as the only input y T i;k = A L T i;k (9) y NT i = A L NT i (0) where A is an exogenous and country-speci c technology level that is assumed to be the same across the tradable and nontradable sectors. L T i;k labor used to produce yi;k T and ynt i with L T i and LNT i denote the amount of JX L T i;k () k= As all consumers within one country are identical, they each spread their labor over all domestic rms according to how much labor input each rm needs. Since labor is assumed to be internationally immobile, domestic consumers do not work for foreign rms. in Obstfeld and Rogo (995), production does not exhibit increasing returns to scale. Since the number of rms in country is given by the range [n 5 As ; n ], their pro ts are

7 determined endogenously. This framework is therefore consistent with the approach taken by, for instance, Anderson (979) and Anderson and van Wincoop (2003) who assume that each region is specialized in the production of only one good. Using demand function (6) market clearing for the tradable good produced by country rm i requires ( ;k ) yi;k T = ;k p T! i (n k n k )C k (2) P k The right-hand side of (2) represents the amount of the tradable good i that the (n k n k ) consumers in country k demand. The left-hand side is the amount of the good that arrives in country k after being shipped there from country. Accordingly, market clearing for a country- nontradable good requires yi NT = pnt i P! (n n )C (3) The pro t function for tradable rm i in country is T i = JX k= p T iy T i;k W L T i;k (4) where W is the nominal wage that is the same across tradable and nontradable rms because workers are assumed to be mobile within countries. Plugging the production function (9) and the market-clearing condition (2) into pro ts (4) and maximizing with respect to p T i yields the standard markup p T i = For nontradable rms the same procedure leads to W (5) A p NT i = W (6) A so that p T i = p NT i p (7) Thus, all country- rms set the same price p, irrespective of whether they produce tradable or nontradable goods. Appendix A. shows that the model outlined in Sections 2. and 2.2 has a unique equilibrium solution. As one might expect, in equilibrium trade costs reduce the real wage, consumption and real pro ts. 4 4 See equations (30)-(32) and (36). 6

8 2.3 A Gravity Equation with Trade Costs Given the equilibrium solution to the model, one can now derive the equilibrium trade ows between countries and k. Since all country- rms producing tradable goods are symmetric and since s (n n ) is the overall number of these rms, all goods that leave country for destination country k are given by EXP ;k = s (n n )y T i;k (8) where EXP ;k denotes real exports from to k. Likewise, all goods that leave country k for export to country are given by EXP k; = s k (n k n k )y T ki; (9) As we are ultimately interested in bilateral trade costs and as these bilateral trade costs in uence trade ows in both directions, we need to combine (8) and (9) in order to take all available information on trade ows into account. The standard way of combining unidirectional trade ows is to multiply them by each other. 5 This yields EXP ;k EXP k; = s (n n )y T i;k s k(n k n k )y T ki; (20) Appendix A.2 shows that one can derive a micro-founded gravity equation for EXP ;k EXP k;. As Appendix A.2 explains in detail, this is achieved by substituting the market-clearing conditions for yi;k T and yt ki; and their equilibrium solutions. After various steps of algebra one obtains a micro-founded gravity equation that explicitly includes trade costs EXP ;k EXP k; = s (GDP EXP ) s k (GDP k EXP k ) ( ;k ) 2 2 (2) where GDP is the real output of country and EXP P k6= EXP ;k are real total exports from. Of course, bilateral trade EXP ;k EXP k; decreases if bilateral trade costs ;k go up. Conversely, bilateral trade increases if there are more rms that produce tradable goods, i.e. if the shares s and s k go up, or if GDP and GDP k go up. But a crucial feature of gravity equation (2) is that bilateral trade is not solely determined by GDP and GDP k as in traditional gravity equations, but also by total exports EXP and EXP k. For example, if total exports EXP increase, then bilateral trade will fall. The intuition is as follows. For an increase in EXP to occur, trade costs with third countries must have dropped, for instance ;l with l 6= k. This means that for any given level of ;k, bilateral trade between and k has become more costly relative to other country pairs. It therefore 5 See Baldwin and Taglioni (2006) for a discussion, in particular why it is problematic to take the sum of unidirectional trade ows as opposed to their product. 7

9 falls. Gravity equation (2) thus takes into account the fact that in order to determine bilateral trade ows between and k, it is not enough to solely focus on bilateral trade costs between and k. Instead, one also needs to consider bilateral trade costs with third countries. These third-party trade costs indirectly enter (2) because they are embodied in EXP and EXP k. Gravity equation (2) therefore captures what Anderson and van Wincoop (2003) call multilateral resistance, i.e. the idea that trade between two countries is determined by their bilateral trade barrier ;k relative to their barriers with all other countries. The total export terms EXP and EXP k embody these barriers with all other countries and therefore control for multilateral resistance. Whereas the multilateral resistance variables in Anderson and van Wincoop (2003) are unobservable because they are highly nonlinear functions of unknown bilateral barriers, gravity equation (2) solves this problem by relating multilateral resistance to the observable total export terms. An alternative way of thinking about multilateral resistance is along the lines of trade destruction and trade diversion. For example, if bilateral trade barriers go up everywhere in the world except between countries and k (i.e. only ;k is constant), then total trade ows in the world are diminished so that there is trade destruction. But and k will redirect some of the destroyed trade towards each other because their relative bilateral trade barrier has dropped. Therefore, to a smaller extent there is also trade diversion. Apart from conveniently controlling for multilateral resistance, a maor advantage of gravity equation (2) is that it allows for an easy computation of bilateral trade costs ;k. For simplicity it is assumed that the fraction of rms producing tradable goods is the same across countries (s = s k = s). 6 trade costs as ;k = Gravity equation (2) can then be solved for EXP ;k EXP k; (GDP EXP ) (GDP k EXP k ) s Intuitively, if bilateral trade ows between and k rise all else being equal, then trade between these two countries must have become less di cult and trade costs must have gone down. Conversely, if output in either country increases without simultaneously leading to an increase in bilateral trade, then the implied trade costs must have gone up. 7 Expression (22) implies that it is straightforward to measure the change in bilateral trade costs over time because they explicitly depend on observable variables. Appendix A.3 shows that expression (22) also holds in the more general case when countries run trade de cits or surpluses. 6 See Section 3. for a discussion of s. 7 Head and Ries (200) compute a U.S.-Canadian border e ect based on relative expenditure ratios, but their two-country framework does not consider trade with partners outside North America and thus does not capture multilateral resistance. Neither does their framework allow for nontradable goods. (22) 8

10 3 Trade Costs over Time This section examines how bilateral trade costs have evolved over time. Its guiding question is By how much have trade costs fallen for which country pairs? Using annual data for , I compute iceberg trade costs on the basis of equation (22) and convert them into tari equivalents through the relationship given in (5). 3. Data and Parameter Assumptions The export data, denominated in U.S. dollars, are taken from the IMF Direction of Trade Statistics (DOTS), and the GDP data come from the IMF International Financial Statistics (IFS). The data appendix gives the exact sources. The data are annual for a sample of 3 countries, consisting of 26 OECD countries plus ve important South American and Asian countries (Argentina, Brazil, Chile, India and Indonesia). 8 For most countries data are reported from 960 until 2002, but for some only more recent data are available. Computing bilateral trade costs on the basis of (22) requires two parameter assumptions. The rst is the elasticity of substitution. It is set to =, which via the optimal prices (5) and (6) corresponds to a markup of 0 percent. The elasticity of substitution is often estimated to lie near 8 but many studies using aggregate data nd higher values. 9 For example, Eaton and Kortum (2002) estimate to be 9:28, and under the assumption of homogeneity across industries Head and Ries (200) obtain an estimate of :4 for. In line with the gravity literature, I assume that is constant over time. Broda and Weinstein (2006) estimate elasticities of substitution based on demand and supply relationships for disaggregated U.S. imports. When comparing the period with , they only nd a marginal decline in the median elasticity that is not always signi cant depending on the level of disaggregation. It is well known that lower elasticities lead to higher trade cost estimates (see Anderson and van Wincoop, 2004). Intuitively, a lower means that consumers are less sensitive to prices and trade costs and should therefore consume a larger amount of foreign goods. Given the actual level of trade ows, a lower thus implies higher trade costs. For example, under = the tari equivalent of U.S.-Canadian trade costs in 960 is 40:8 percent, whereas under = 8 it is 63: percent. The main focus of this paper, however, is not the level of trade costs but rather the percentage change of trade costs over time. It turns out that the percentage change is hardly dependent on. For example, under = the tari equivalent of U.S.-Canadian trade costs between 960 and 2002 declined by 39:2 percent (from 40:8 to 24:8 percent). Cutting the elasticity of substitution to = 8 would result in 8 The OECD countries include all current 30 OECD members except for Belgium/Luxembourg and the Czech Republic/Slovak Republic, who only report ointly. 9 See the survey given in Anderson and van Wincoop (2004, Section 3.6). 9

11 a very similar decline of 40:7 percent (from 63: to 37:4 percent). 0 The second parameter assumption that is needed to compute trade costs is the fraction s of rms that produce tradable goods. Stockman and Tesar (990) say that this fraction is di cult to estimate directly from the data but report evidence that the expenditure on nontradable goods as a share of private nal consumption ranges from 8:9 to 44:3 percent for ve large OECD countries (France, Italy, Japan, United Kingdom and United States) between 960 and 988. As my sample includes many smaller countries, the appropriate share of nontradable goods is likely to be closer to the lower end of this range. I therefore choose s = 0:8, implying that 20 percent of all goods are nontradable. Given the general decrease in trade costs over the last decades, one might expect that more goods have become tradable, as suggested in the literature on endogenous tradability, for instance by Bergin and Glick (2006). However, in a recent empirical analysis of globalization the IMF nds that based on sectoral input-output tables unlike in many emerging market countries, the tradables sector share output in most industrial countries has actually fallen slightly in recent years because of the rapid expansion of service sectors (IMF 2005, p. 3). Since my sample includes both industrial countries and some emerging market economies, the overall e ect on s is unclear. But even if there has been a slight downward trend in s, the resulting additional decrease in trade costs would be small. For example, cutting s from 0:8 to 0:75 would merely reduce the 2002 tari equivalent of U.S.-Canadian trade costs from 24:8 to 24: percent. 3.2 Bilateral Trade Costs in the U.S. and UK I now report bilateral trade costs for the United States and for the United Kingdom as two eminent examples. The UK is picked as the second biggest European economy after Germany whose data show a structural break in the wake of reuni cation. Table gives a snapshot of U.S. bilateral trade costs for the years 960 and U.S. bilateral trade costs have fallen with almost all trading partners in the sample except for slight increases with Chile and Iceland. The decline in trade costs has been particularly dramatic for the two neighbors Canada and Mexico, but also for Ireland and Korea which both experienced strong economic growth relative to other countries in the sample. The tari equivalents vary substantially across countries, with levels ranging from 24:8 percent for Canada up to 7 percent for Greece in The average magnitude is consistent with values typically put forward in the literature. For example, Anderson and van Wincoop (2004) nd that the representative tari equivalent of international trade costs is 74 percent. Table 2 is the UK counterpart to Table. Unlike the United States, the UK exhibits 0 The regression results in Section 4 are not qualitatively a ected when trade costs are computed with = 8 instead of = (see the discussion in Section 4.3 and Table A in the appendix). 0

12 Table : U.S. Bilateral Trade Costs Tari equivalent Partner country Percentage change Argentina 77:9 Australia 77:0 66: 4:2 Austria 76:7 Brazil 59:7 Canada 40:8 24:8 39:2 Chile 67:8 68:4 +0:9 Denmark 80:5 Finland 92:3 76:7 6:9 France 73:6 6:0 7: Germany 62:9 53:4 5: Greece 7:0 Hungary 85:9 Iceland 92:3 96:5 +4:6 India 75:4 73:6 2:4 Indonesia 69:2 Ireland 88:7 46:8 47:2 Italy 69:8 65:6 6:0 Japan 57:7 50:6 2:3 Korea 03:3 49:9 5:7 Mexico 58:5 30:9 47:2 Netherlands 6:3 53:6 2:6 New Zealand 78:9 74:8 5:2 Norway 78:9 Poland 0:6 Portugal 92:3 Spain 83:8 79:5 5: Sweden 75: 68:6 8:7 Switzerland 70:9 6:0 4:0 Turkey 79:9 UK 60:3 54: 0:3 All numbers are percentage values. Blank cells: Data not available. Computations based on (22) and (5).

13 Table 2: UK Bilateral Trade Costs Tari equivalent Partner country Percentage change Argentina 98:0 Australia 44:5 66:9 +50:3 Austria 6:8 Brazil 79:9 Canada 47:5 67:8 +42:7 Chile 70:4 87:6 +24:4 Denmark 52:4 Finland 52:9 56:7 +7:2 France 64:7 4:6 35:7 Germany 57:7 38:9 32:6 Greece 79:9 37:5 +72: Hungary 6:3 Iceland 75: 73:6 2:0 India 57:0 72:7 +27:5 Indonesia 8:8 Ireland 36:4 23:0 36:8 Italy 64:2 50:8 20:9 Japan 8:8 70:9 3:3 Korea 24:2 68:4 44:9 Mexico 95:3 94:6 0:7 Netherlands 45:3 32:6 28:0 New Zealand 39:3 79:2 +0:5 Norway 50:2 Poland 67:2 Portugal 6:0 Spain 68:9 49:4 28:3 Sweden 49:0 5: +4:2 Switzerland 62:3 55:3 :2 Turkey 66:7 United States 60:3 54: 0:3 All numbers are percentage values. Blank cells: Data not available. Computations based on (22) and (5). 2

14 a number of remarkable increases in trade costs between 960 and 2002, mostly with former colonies that are far away such as Australia, Canada, India and New Zealand. The increases seem less staggering if one takes into account that the initial 960 tari equivalents for these countries are comparatively low. What the U.S. and the UK have in common is that with the exception of Korea, the most dramatic declines in trade costs have occurred with nearby countries. In the case of the UK these are France, Germany, Ireland, the Netherlands and Spain. These countries also exhibit the lowest levels of trade costs in The G7 and European Union Countries I now compute bilateral trade costs amongst the G7 countries between 960 and Figure plots each country s average bilateral tari equivalent with the other G7 countries, weighted by each trading partner s share of combined G7 exports. All seven countries have experienced a steady decline in their average tari equivalents. The decline is strongest for Canada, resulting in the lowest 2002 tari equivalent (26:6 percent), and the decline is weakest for Japan, resulting in the highest 2002 tari equivalent (55:3 percent). It is not surprising that Japan has the highest trade costs, given that it is far away from the other G7 countries. In addition, Japan does not have a free trade agreement with any other G7 country. The top graph in Figure 2 depicts the average of the graphs in Figure, weighted by each country s share of total exports amongst G7 countries. The values of the top graph can be interpreted as the representative intra-g7 tari equivalent. Between 960 and 2002 it fell by 26:5 percent from 55 to 40:5 percent, consistent with the 74 percent tari equivalent of international trade costs that Anderson and van Wincoop (2004) suggest for a broader sample of countries. As a comparison, the bottom graph plots the tari equivalent based on the world c.i.f./f.o.b. ratio that is reported by the IMF as a measure of transportation costs. It dropped from 7:6 percent in 960 to 3:3 percent in Anderson and van Wincoop suggest a higher value for transportation costs (0:7 percent) but in either case, transportation costs constitute only a fraction of overall trade costs. 2 Section 4 discusses other factors such as language barriers that can be identi ed as maor trade cost components. As for the G7 subsample, I compute trade-weighted averages of trade costs for a subsample of 3 European Union (EU) countries between 977 and The 2002 The G7 countries are Canada, France, Germany, Italy, Japan, the UK and the U.S. 2 See Anderson and van Wincoop (2004, Section 2.2) for a discussion of transportation costs. The c.i.f./f.o.b. tari equivalent is computed from the world import and export series reported in the IMF Direction of Trade Statistics. These data should be treated with caution though since their quality is questionable, see Hummels and Lugovskyy (2006) for a discussion. 3 The 3 EU countries are the 5 EU member countries prior to the 2004 Eastern enlargement exclusive of Belgium/Luxembourg who only report ointly. Some data prior to 977 are missing. 3

15 Tariff equivalent θ Canada Tariff equivalent θ France Tariff equivalent θ Germany Tariff equivalent θ Italy Tariff equivalent θ Japan Tariff equivalent θ UK Tariff equivalent θ U.S Figure : Trade-weighted averages of bilateral trade costs amongst G7 countries (measured as tari equivalents). 4

16 G7 tariff equivalent θ implied by trade costs τ World tariff equivalent based on IMF c.i.f./f.o.b. ratio Figure 2: G7 trade costs and the IMF world c.i.f./f.o.b. ratio (both measured as tari equivalents). tari equivalent is highest for Greece with 22 percent and lowest for the Netherlands with 33 percent. Between 977 and 2002 the trade-weighted intra-eu tari equivalent fell by 7:7 percent from 47:5 to 39: percent. The corresponding representative G7 values are 45: and 40:5 percent so that in comparison, EU trade costs were higher in 977 but slightly lower in Over the past 30 years trade costs have therefore fallen more rapidly within the European Union than amongst G7 countries. This nding is consistent with the previous observation that the most dramatic declines in trade costs have occurred amongst nearby countries. 3.4 An Increase in Regional Economic Integration Tables and 2 exhibit the pattern that U.S. and UK bilateral trade costs have fallen most dramatically for nearby trading partners. In fact, this pattern applies more generally, suggesting that over the past few decades there has been an increase in regional economic integration. Table 3 formally demonstrates for a panel of 273 country pairs that between 970 and 2000 trade costs have dropped most rapidly for nearby countries. 4 In a regression of the percentage decline in tari equivalents, the coe cient of the logarithm 4 The panel includes these countries: Australia, Austria, Brazil, Canada, Chile, Denmark, Finland, France, Germany, Greece, Hong Kong, Iceland, Indonesia, Ireland, Italy, Japan, Korea, Mexico, the Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, the UK and the U.S. 5

17 Table 3: Distance and the Decline in Tari Equivalents ln(distance) Constant Percentage decline in k, :048 ( 3:98) 0:38 (2:67) 0:062 ( 2:00) :228 (4:8) Country xed e ects yes yes Intra-European pairs included yes no Number of observations R The dependent variable is the percentage decline in k, de ned as ( k;970 k;2000 )= k;970. Robust OLS estimation, t-statistics given in parentheses. ** and * indicate signi cance at the and 5 percent levels. of distance is negative and signi cant. This result holds up even if intra-european trade relations are not included in the sample. In essence, absolute trade ows have increased for virtually all country pairs but they have increased more quickly amongst nearby countries. Relative trade has therefore increased with nearby trading partners and decreased with distant ones. Coughlin (2004) comes to the same conclusion from the perspective of individual U.S. states in an analysis of merchandise exports. Frankel, Stein and Wei (997) identify the Americas, Europe and Paci c Asia as continental trading blocs that have a high degree of internal integration. Bayoumi and Eichengreen (997) nd evidence of relative trade diversion in that the formation of the European Community lowered the growth rate of trade with other industrial countries by :7 percentage points. But the results in Table 3 suggest that the relative increase in trade with nearby countries did not only take place amongst European nations. As free trade agreements have typically been concluded with nearby countries, they have certainly contributed to the increase in regional economic integration, see Venables (200) for a discussion. Another reason could be evidence reported by Hummels (2007) that over recent years the cost of overland transport has declined relative to ocean transport, which might have disproportionately favored shorter distances. 4 The Determinants of Trade Costs Trade costs vary substantially across country pairs. For instance, why is the G7 average tari equivalent so much lower for Canada (26:6 percent) than for Japan (55:3 percent)? In order to explain this variation across country pairs, I regress bilateral trade costs on a number of potential trade cost determinants such as distance and common language use that are typically found in the gravity literature, for example in Rose (2000) and 6

18 Fitzgerald (2007). These regressions are run for a balanced panel of 273 country pairs for the years 970, 980, 990 and Methodology In the gravity literature, variables such as distance and a common language dummy are ex ante regarded as trade cost components. But as Anderson and van Wincoop (2003) demonstrate, simply adding such trade cost proxies to a standard gravity regression without controlling for multilateral resistance leads to unfounded comparative statics and biased trade cost estimates. This problem is particularly severe if observations are pooled across years and if multilateral resistance changes over time. In contrast, the methodology adopted here is a two-step procedure. First, bilateral trade costs are computed on the basis of (22) to obtain a micro-founded trade cost measure that takes time-varying multilateral resistance into account. Second, the variation of trade costs across country pairs is explained ex post (i.e. after accounting for multilateral resistance) by regressing them on potential determinants. Apart from having a solid theoretical foundation, another advantage of this procedure is that the dummy variable coe cients in those regressions (such as the coe cient on the common language dummy) represent tari equivalents and can therefore be easily interpreted and compared to each other. The regressions are set up as follows. The tari equivalent kt is linked to potential trade cost determinants by kt = + k + t + ln(distance k ) + 2 Common Border k + 3 ln(area k ) + 4 Landlocked k + 5 Island k + 6 Common Language k + 7 Colonial k (23) + 8 T ariffs kt + 9 F T A kt + 0 ERV olatility kt + " kt where and k denote country xed e ects that capture unobservable country-speci c characteristics, t is a time dummy and " kt is the error term. The remaining righthand side variables can be divided into three rough groups. The rst group consists of geographical factors ( - 5 ), the second group is formed by historical factors ( 6-7 ) and the third group consists of institutional factors ( 8-0 ). ln(distance k ) denotes the natural logarithm of distance in km between countries and k. Common Border k is a contiguity dummy which takes on the value if the two trading partners share a common border. Both regressors can be seen as proxies for transportation and information costs, which tend to be lower for nearby trading partners. ln(area k ) is the logarithm of the product of the two trading partners surface areas. Landlocked k and Island k take on the value if one of the trading partners is landlocked or an island, the value 2 if both partners are and 0 otherwise. Colonial k is a dummy indicating a past colonial relationship between and k, for example between the UK and 7

19 Australia. The Common Language k dummy indicates whether the two countries have the same o cial language. None of these geographical and historical regressors change over time. But the institutional regressors are time-varying. T ariffs kt is a oint measure of tari s for countries and k that is based on country ratings of tari regimes published by the Fraser Institute in the Freedom of the World Report. The oint measure is constructed by multiplying the two single-country ratings for each pair. F T A kt is a dummy variable for free trade agreements such as NAFTA and the European Common Market. ERV olatility kt measures the volatility of the nominal exchange rate between and k over the ve years preceding t as the standard deviation of the rst di erences of the monthly logarithmic nominal exchange rates. The data appendix explains the variables in more detail and gives the exact data sources. 4.2 Regression Results Table 4 reports the results of estimating (23), both for individual years and data pooled across years. The regressions explain percent of the trade cost variation. The yearspeci c dummies in the pooled regression are negative and re ect the general drop in trade costs over time. Greater distance between trading partners, larger surface area and being landlocked are the geographical factors that are associated with higher trade costs at the percent con dence level. A large surface area often indicates large internal distances that need to be overcome to engage in international trade. But trading partners that share a common border or that are islands do not face signi cantly di erent trade costs. The common language and colonial dummies have the expected negative coe cients. In the pooled regression, two countries with a previous colonial relationship have a bilateral tari equivalent that is 5:9 percentage points lower compared to two countries without a common colonial past ( 7 = 0:59). Similarly, using the same o cial language reduces the tari equivalent by 9:2 percentage points ( 6 = 0:092). This nding is in line with Hummels (200) language barrier estimate and Eaton and Kortum s (2002) estimate for 2002 data. It is interesting to see from the single-year regressions that the bene ts of a common colonial past and using the same language have washed out over time. The nding that the language coe cient has subsided possibly re ects the fact that an increasing number of people across the world have started to learn foreign languages. 5 Turning to the institutional factors, a free trade agreement reduces trade costs by 5:5 percentage points ( 8 = 0:055). The fact that this coe cient is not negative in the single-year regression for 980 can be explained by the sharp increase in the number of 5 For example, see the British Council s report on the English language made available at britishcouncil.org/english/pdf/future.pdf. 8

20 Table 4: The Determinants of Trade Costs Regression Regressors Pooled Geographical factors ln(distance) 0:62 (24:20) Common Border 0:005 (0:25) ln(area) Landlocked 0:027 (2:4) 0:273 (4:49) Island 0:008 ( 0:29) Historical factors Common Language Colonial 0:092 ( 5:49) 0:59 ( 6:2) Institutional factors Tari s 0:006 ( :4) Free Trade Agreement 0:055 ( 3:76) Exchange Rate Volatility 0:000 (0:4) 980 dummy 0:067 ( 5:00) 990 dummy 0:09 ( 6:7) 2000 dummy 0:5 0:60 (:0) 0:039 (0:88) 0:020 (3:55) 0:06 (2:39) 0:080 (0:90) 0:48 ( 4:28) 0:248 ( 5:59) 0:08 ( :3) 0:32 ( 3:68) 0:07 (0:86) 0:9 (3:93) 0:007 (0:7) 0:08 (4:84) 0:32 (4:06) 0:00 ( 0:0) 0:06 ( 2:74) 0:86 ( 5:39) 0:03 ( 2:25) 0:036 (:5) 0:00 ( 0:59) 0:6 (9:8) 0:00 (0:02) 0:029 (3:47) 0:236 (6:39) 0:50 ( :24) 0:068 ( 2:06) 0:27 ( 3:66) 0:284 (:37) 0:066 ( 2:7) 0:005 ( 0:50) 0:43 (0:70) 0:024 ( 0:62) 0:06 (0:79) 0:242 (3:6) 0:704 ( :85) 0:044 ( :52) 0:065 ( 2:4) 0:865 (0:70) 0:02 ( 0:83) 0:04 (2:33) ( 0:44) Country xed e ects yes yes yes yes yes Number of observations R The dependent variable is the tari equivalent kt. Robust OLS estimation, t-statistics given in parentheses. ** indicates signi cance at the percent level. 9

21 free trade agreements since 970. The number of country pairs that were part of a mutual free trade agreement more than doubled from 26 in 970 to 55 in 980. In fact, using the 970 free trade agreement dummy in the regression for 980 yields the expected negative and signi cant coe cient. The number of country pairs with a free trade agreement kept rising to 83 in 990 and 95 in Perhaps more surprisingly, tari s and exchange rate volatility are not associated with signi cantly higher trade costs, neither in the pooled nor in the single-year regressions. This result is consistent with the relatively small role that policy related barriers play in determining total trade costs. Anderson and van Wincoop (2004) calculate that policy related barriers including tari s and trade agreements make up only eight out of the 44 percentage points associated with border related barriers. Overall, it therefore seems that institutional factors are less important than geographical and historical factors in explaining the variation of trade costs across country pairs. Distance is the only explanatory variable that is signi cant in all single years, a nding which highlights the importance of transportation costs. Speaking the same language and having a common colonial past used to be associated with substantially lower trade costs but those initial advantages have faded over time. 4.3 Discussion In addition to the results reported in Table 4, the country xed e ects included in regression (23) also carry important information. 6 In the pooled regression they are positive and signi cant at the percent level for Austria, Greece, Iceland, Ireland and Mexico. They are negative and signi cant for Chile, Hong Kong, France, Germany, Italy, Japan, Korea, the Netherlands, Sweden and the U.S. There is no obvious explanation for these xed e ects because by construction they capture unobserved characteristics. But it is striking that a number of countries with negative xed e ects and thus systematically lower trade costs have a reputation as strong exporting nations such as Hong Kong, Germany and Korea. A number of robustness checks have been performed for the results in Table 4. Computing trade costs based on an elasticity of substitution = 8 instead of = leaves the signi cance unchanged for all coe cients (see Table A in the appendix). The results reported in Table 4 are not sensitive to the exclusion of particular countries like the U.S. or UK from the sample, and neither to the exclusion of all intra-european trade relations. The results also hold up when the sample is restricted to intra-european trade relations or to trade relations between rich countries (see Table A2 in the appendix). 7 Finally, 6 It is not possible to include country random e ects instead of country xed e ects because each observation is associated with two countries. 7 Rich countries are de ned as those with per-capita income of over US$ 20,000 in 2002 according to UN data. This threshold excludes the South American countries as well as Greece, Indonesia, Mexico, New 20

22 the residuals of the trade cost regressions might be spatially correlated. For instance, if a certain country is hit by a shock, its neighbors are more likely a ected than remote countries. To check for this possibility, I regress the residuals from the single-year regressions on continental dummies but nd no spatial correlation at all. 8 Furthermore, allowing for cluster e ects associated with individual countries or continents produces results very similar to those in Table 4. The period after World War II is not unprecedented as a time of enormous trade expansion. The rst era of globalization is generally considered to be the trade boom that started in the late 9th century and continued until the beginning of World War I. Using the model developed in the current paper, Jacks, Meissner and Novy (2006) nd that the median tari equivalent of trade costs stood at 90 percent in 870 and at 76 percent in 93, implying a drop of 6 percent over four decades. In comparison, the average G7 tari equivalent declined more rapidly from 55 percent in 960 to 40:5 percent in 2002, a drop of 26:5 percent over four decades. Apart from distance, important determinants of 9th century trade costs were tari s, railroad infrastructure, exchange rate regime coordination through the Gold Standard and, similar to the post-world War II period, a common colonial history as well as the use of a common language. 5 Conclusion This paper develops a micro-founded measure of international trade costs. It is based on a multi-country general equilibrium model of trade with bilateral iceberg trade costs as its central ingredient. The model yields a micro-founded gravity equation that includes trade costs and that captures multilateral resistance in the form of total export terms. Since all variables in the gravity equation are observable, it is possible to compute trade costs directly from the gravity equation without the need to make any assumptions about underlying trade cost components such as distance and tari s or their functional form. The empirical results obtained with the trade cost measure are economically sensible and consistent with the literature. Since World War II trade costs have declined markedly. For the G7 countries they fell by 26:5 percent between 960 and 2002, and for European Union countries trade costs decreased by 7:7 percent between 977 and For both subsamples the 2002 tari equivalent of trade costs stands at roughly 40 percent. addition, the paper nds clear evidence that over the past few decades economic integration has progressed most on a regional level, as trade costs dropped more quickly between nearby trading partners than between distant ones. The dispersion of trade costs across country pairs can best be explained by geographical Zealand, Korea and Spain. 8 The dummies are de ned as intracontinental binary variables for Europe, North America and Asia, i.e. they only take on the value if both countries in a pair are on the same continent. In 2

23 factors like distance and being landlocked. Sharing a common colonial history and sharing the same o cial language were associated with signi cantly lower trade costs in 970, but in 2000 these factors are no longer important. After controlling for geographical and historical variables, trade costs still vary considerably across countries, indicating a high degree of heterogeneity. Trade costs tend be high for Austria, Greece, Iceland, Ireland and Mexico. They tend to be low for Chile, Hong Kong, France, Germany, Italy, Japan, Korea, the Netherlands, Sweden and the U.S. 22

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