International_Economics_Tenth_Edition (1)

Transportation Costs and

Comparative Advantage

Besides embodying production costs, the principle of comparative advantage recognizes the costs of moving goods from one nation to another. Transportation costs refer to the costs of moving goods, including freight charges, packing and handling expenses, and insurance premiums. These costs can modify international trade patterns.

Trade Effects

The trade effectsof transportation costs can be illustrated with a conventional supply and demand model based on increasing cost conditions. Figure 3.5(a) illustrates the supply and demand curves of autos for the United States and Canada. Reflecting the assumption that the United States has the comparative advantage in auto production, the u.s. and

~FIGURE 3.5

Free Trade Under lncreasinq-Cost Conditions

Canadian equilibrium locations are at points E and F, respectively. In the absence of trade, the u.s. auto price, $4,000, is lower than that of Canada, $8,000.

When trade is allowed, the United States will move toward greater specialization in auto production, whereas Canada will produce fewer autos. Under increasing-cost conditions, the U.S. cost and price levels rise, and Canada's price falls. The basis for further growth of trade is eliminated when the two countries' prices are equal, at $6,000. At this price, the United States produces 6 autos, consumes 2 autos, and exports 4 autos; Canada produces 2 autos, consumes 6 autos, and imports 4 autos. Thus, $6,000 becomes the equilibrium price for both countries because the excess auto supply of the United States just matches the excess auto demand in Canada.

The introduction of transportation costs into the analysis modifies the conclusions of this example. Suppose the per-unit cost of transporting an

(b) With Transportation Costs of $2,000 per Auto

s

90 Sources of Comparative Advantage

auto from the United States to Canada is $2,000, as shown in Figure 3.5(b). The United States would find it advantageous to produce autos and export them to Canada until its relative price advantage is eliminated. But when transportation costs are included in the analysis, the U.S. export price reflects domestic production costs plus the cost of transporting autos to Canada. The basis for trade thus ceases to exist when the U.S. auto price plus the transportation cost rises to equal Canada's auto price. This equalization occurs when the U.S. auto price rises to $5,000 and Canada's auto price falls to $7,000, the difference between them being the $2,000 per-unit transportation cost. Instead of a single price ruling in both countries, there will be two domestic auto prices, differing by the cost of transportation.

Compared with free trade in the absence of transportation costs, when transportation costs are included the high-cost importing country will produce more, consume less, and import less. The low-cost exporting country will produce less, consume more, and export less.

Transportation costs, therefore, tend to reduce the volume of trade, the degree of specialization in production among the nations concerned, and thus the gains from trade.

The inclusion of transportation costs in the analysis modifies our trade-model conclusions. A product will be traded internationally as long as the pretrade price differential between the trading partners is greater than the cost of transporting the product between them. When trade is in equilibrium, the price of the traded product in the exporting nation is less than the price in the importing country by the amount of the transportation cost.

Transportation costs also have implications for the factor-price-equalization theory presented earlier in this chapter. Recall that this theory suggests that free trade tends to equalize commodity prices and factor prices so that all workers will earn the same wage rate and all units of capital will earn the same interest income in both nations. Free trade permits factor-price equalization to occur because factor inputs that cannot move to another country are implicitly being shipped in the form of commodities. Looking at the real world, however, we

see U.S. autoworkers earning more than South Korean autoworkers. One possible reason for this differential is transportation costs. By making lowcost South Korean autos more expensive for U.S. consumers, transportation costs reduce the volume of autos shipped from South Korea to the United States. This reduced trade volume stops the process of commodityand factor-price equalization before it is complete. In other words, the prices of U.S. autos and the wages of U.S. autoworkers do not fall to the levelsof those in South Korea. Transportation costs thus provide some relief to high-cost domestic workers who are producing goods subject to import competition.

The cost of shipping a product from one point to another is determined by a number of factors, including distance, weight, size, value, and the volume of trade between the two points in question. Table 3.12 shows the averageimportance of transportation costs for imports of the United States and other countries. Since the 1960s, the cost of international transportation has decreasedsignificantly relativeto the value of U.S. imports. From 1965 to 2000, transportation

The Size of Transportation Costs for

Selected Countries in 2002

I I 111111111 II

*The freight and insurance factor is calculated by dividing the value of a country's imports. including freight and insurance costs (the cost-insurance-freight value), by the value of its imports excluding freight and insurance costs (the free-an-board value).

Source: International Monetary Fund, International Financial Statistics, January 2004. See also International Monetary Fund, International Financial Statistics Yearbook, 1996, pp. 122-125.

costs as a percentage of the value of all u.s. imports decreased from 10 percentto less than 4 percent.This decline in the relative cost of internationaltransportation has made imports more competitive in U.S. markets and contributed to a higher volume of trade for the United States. Falling transportation costs have been due largely to technological improvements, including the development of large dry-bulk containers, large-scale tankers, containerization, and widebodied jets. Moreover, technological advances in telecommunications have reduced the economic distances among nations.

Falling Transportation

Costs Foster Trade Boom

If merchants everywhere appear to be selling imports, there is a reason. International trade has been growing at a startling pace. What underlies the expansion of international commerce? The worldwide decrease in trade barriers, such as tariffs and quotas, is certainly one reason. The economic opening of nations that have traditionally been minor players, such as Mexico and China, is another. But one factor behind the trade boom has largely been unnoticed: the declining costs of getting goods to the market. 8

Today, transportation costs are a less severe obstacle than they used to be. One reason is that the global economy has become much less transport intensive than it once was. In the early 1900s, for example, manufacturing and agriculture were the two most important industries in most nations. International trade thus emphasized raw materials, such as iron ore and wheat, or processed goods such as steel. These sorts of goods are heavy and bulky, resulting in a relatively high cost of transporting them compared with the value of the goods themselves. As a result, transportation costs had much to do with the volume of trade. Over time, however, world output has shifted into goods whose value is unrelated to their size and weight. Finished manufactured goods, not raw commodities, dominate the flow of trade. Therefore, less transportation is required for every dollar's worth of exports or imports.

'Drawn from "Delivering the Goods," The Economist, November 15,

1997, pp. 85-86.

containers that could be separated from the truck's trailer. With the trailer left at dockside, the containers could be stacked several high aboard the ship. As time passed, a container crane was invented, which made it possible to load and unload containers without capsizing a vessel. Moreover, the adoption of standard container sizes permitted almost any box to be transported on any vessel.

Although the shipping container transformed ocean shipping into a highly productive business, getting the cargo to and from the dock was another problem. National governments generally regulated the prices and shipping practices of domestic freight companies. New firms could enter the freight business only with great difficulty and were subject to tight restrictions. This situation started changing during the 1970s, when the United States began to deregulate its transportation industry. First airlines, then road shippers and railroads, were freed from regulations on what they could carry, where they could haul it, and what price they could charge. Trucks were no longer forced to run empty because they were licensed to ship goods on only one leg of a round-trip journey. Railways were no longer forced to maintain unprofitable branch lines, but could emphasize the shipping of freight in large volumes over long distances. Deregulation of the transportation industry resulted in increased efficiency and lower costs.

The freight revolution intensified during the 1980s, as deregulation and new technology eliminated the boundaries between different modes of transportation. For example, an electronics manufacturer in, say, Taiwan could request an ocean freight company to deliver its exports to the American Midwest. The ocean freighter might negotiate a deal with a railroad to ship the container from Oakland to Kansas City; hire a trucking firm to haul it from Kansas City to Topeka; assume responsibility for fulfilling delivery schedulesat each stage of the journey; and send a singleinvoicefor the entire shipment. Such intermodalism has resulted in freight companies such as United Parcel Service and Federal Express, which specialize in using a combination of aircraft and trucks to deliver freight quickly. It has also resulted in railroads' building tracks at dockside, so containers can be shipped directlyfrom ships onto trains.

Terrorist Attacks Result in Added Costs and Slowdowns for u.S. Freight System: A New Kind of Trade Barrier?

Once in a great while, an event occurs that is so horrific that it sears its way into the national psyche. Such an event occurred on September 11, 2001, when terrorists launched an assault on the very symbols of American economic and military might-the twin towers of New York's World Trade Center and the Pentagon complex in Washington, DC.

Immediately following the terrorist attacks, Quality Carriers, Inc., the country's biggest liquidbulk trucker, rehired the $5,000-a-month nightshift security guard it had previously let go at its tanker-truck terminal in Newark, New Jersey. The company also paid two drivers a total of $1,200 to re-park any vehicles loaded with chemicals in plain view and under security lights. To get in at night, the terminal's 52 drivers now must wait for supervisors to open the gate with new electronic gadgets. For Quality Carriers, extra security measures added to the firm's costs. Company officials noted that the carrier would try to pass along most of the added costs to its customers.

Also at risk were the nation's 361 public seaports, which handle more than 95 percent of overseas trade. Following the attacks, President George W. Bush instructed the U.S. Coast Guard to take additional measures to guard bridges in U.S. harbors and sites such as the Statue of Liberty. For example, Coast Guard personnel board each inbound cargo ship some 11 miles outside the harbor and inspect the ship's cargo. Once inside the harbor, ships must travel at slow speeds, flanked on each side by a tugboat, to prevent ships from ramming into bridge supports. Shipping companies are charged up to $1,500 for each tugboat escort. Once ships are at their berths, random containers are opened and their contents removed and inspected by government officials. Such tightened security measures add about two hours to each ship's arrival process. Table 3.13 summarizes some security measures taken to protect the U.S. freight system from terrorist attacks.

Before the terrorist attacks on the World Trade Center and Pentagon, U.S. border enforcement overwhelming focused on limiting the inflow of illegal drugs and immigrants, However, the terrorist attack complicated business as usual along u.s. borders. This is because the cross-bor- der transportation and communications networks used by terrorists are also the arteries of a highly integrated and interdependent economy. Analysts note that u.s. prosperity relies on its ready access to global networks of transport, energy, information, finance, and labor. It would be self-defeating for the United States to embrace security measures that isolate it from these networks.

The U.S. border securitymeasures adopted since 2001 have consisted of taking the old drug and immigration enforcement infrastructure and adapting it to counterterrorism efforts. As understandable as these measures may be, a sustained crackdown at U.S. ports of entry risks a considerable impact on legitimate travel and trade. For example, the United States and Canada conduct more than $1.3 billion worth of two-way trade a day, most of which is transported by truck. Analysts estimate that a truck crosses this border every 2.5 seconds, amounting to 45,000 trucks and 40,000 commercial shipments every day. Immediately following the terrorist attacks of 2001 and the subsequent clampdown, the

result was a drastic slowing of cross-border traffic. Delays for trucks hauling cargo across the u.S.-Canadian border rose from 1 to 2 minutes to 10 to 15 hours, stranding shipments of perishable goods and parts. Automobile firms, many of which produce parts in Ontario and ship them to U.S. assemblyplants on a cost-efficient, just-in-timebasis, were especially vulnerable. Ford closed an engine plant in Windsor and a vehicle plant in Michigan because of parts shortages. Extensive traffic jams and long delays also plagued the U.S.-Mexican border, where some 300 million people, 90 million cars, and 4.3 million trucks cross the border annually.

Although border delays are now not as long as immediately following the terrorist attacks, heightened security concerns can have an adverse effect on cross-border trade. Simply put, security can become a new kind of trade barrier. The U.S. response immediately following September 11, 2001, was the equivalent of imposing a trade embargo on itself. While the long-term process of North American integration has not been reversed, it has been complicated by the squeeze on the cross-border transportation arteries that provide its lifeblood.'

'Peter Andreas, "Border Security in the Age of Globalization," Regional Review, Federal Reserve Bank of Boston, Third Quarter, 2003. pp. 3-7.

1.The immediate basis for trade stems from relative commodity price differences among nations. Because relative prices are determined by supply and demand conditions, such factors as resource endowments, technology, and national income are important determinants of the basis for trade.

2.The Heckscher-Ohlin theory suggests that differences in relative factor endowments among nations underlie the basis for trade. The theory asserts that a nation will export that commodity in the production of which a relatively large amount of its abundant and cheap resource is used. Conversely, it will import commodities in the production of which a relatively scarce and expensive resource is used. The theory also states that with trade, the relative differences in resource prices between nations tend to be eliminated.

3.Contrary to the predictions of the HeckscherOhlin model, the empirical tests of Wassily Leontief demonstrated that for the United States exports are labor-intensive and import-competing goods are capital-inten- sive. His findings became known as the Leontief paradox.

4.By widening the size of the domestic market, international trade permits firms to take advantage of longer production runs and increasing efficiencies (such as mass production). Such economies of large-scale production can be translated into lower product prices, which improve a firm's competitiveness.

5.Staffan Linder offers two explanations of world trade patterns. Trade in primary products and agricultural goods conforms well to the factor-endowment theory. But trade in manufactured goods is best explained by overlapping demand structures among nations. For manufactured goods, the basis for trade is stronger when the structure of demand in the two nations is more similarthat is, when the nations' per capita incomes are similar.

6.Besides interindustry trade, the exchange of goods among nations includes intraindustry trade-two-way trade in a similar product. Intraindustry trade occurs in homogeneous goods as well as in differentiated products.

7.One dynamic theory of international trade is the product life cycletheory. This theory views a variety of manufactured goods as going through a trade cycle, during which a nation initially is an exporter, then loses its export markets, and finally becomes an importer of the product. Empirical studies have demonstrated that trade cycles do exist for manufactured goods at some times.

8.Dynamic comparative advantage refers to the creation of comparative advantage through the mobilization of skilled labor, technology, and capital; it can be initiated by either the private or public sector. When government attempts to create comparative advantage, the term industrial policy applies. Industrial policy seeks to encourage the development of emerging, sunrise industries through such measures as tax incentives and R&D subsidies.

9.The environmental laws of national governments can affect the competitive position of their industries. These laws often result in cost-increasing compliance measures, such as the installation of pollution-control equipment, which can detract from the competitiveness of domestic industries.

10.International trade includes the flow of services between countries as well as the exchange of manufactured goods. As with trade in manufactured goods, the principle of comparative advantage applies to trade in services.

11.Transportation costs tend to reduce the volume of international trade by increasing the prices of traded goods. A product will be traded only if the cost of transporting it between nations is less than the pretrade difference between their relative commodity prices.

•Business services (page 87)

•Capital/labor ratio (page

64)

•Distribution of income

(page 66)

•Dynamic comparative advantage (page 82)

•Economies of scale (page 74)

•Factor-endowment theory

(page 63)

•Factor-price equalization

(page 65)

•Heckscher-Ohlin theory

(page 63)

•Home market effect

(page 75)

•Increasing returns to scale

(page 74)

•Industrial policy (page 82)

•Interindustry specialization

(page 77)

•Interindustry trade (page 76)

•Intraindustry specialization

(page 77)

•Intraindustry trade (page 77)

•Leontief paradox (page 71)

•Product life cycle theory

(page 80)

•Specific-factors theory

(page 98)

•Theory of overlapping demands (page 76)

•Transportation costs

(page 89)

1.What are the effects of transportation costs on international trade patterns?

2.Explain how the international movement of products and of factor inputs promotes an equalization of the factor prices among nations.

3.How does the Heckscher-Ohlin theory differ from Ricardian theory in explaining international trade patterns?

4.The Heckscher-Ohlin theory demonstrates how trade affects the distribution of income within trading partners. Explain.

S.How does the Leontief paradox challenge the overall applicability of the factor-endowment model?

6.According to Staffan Linder, there are two explanations of international trade pat- terns-one for manufactures and another for primary (agricultural) goods. Explain.

7.Do recent world-trade statistics support or refute the notion of a product life cycle for manufactured goods?

8.How can economies of large-scale production affect world trade patterns?

9.Distinguish between intraindustry trade and interindustry trade. What are some major determinants of intraindustry trade?

10. What is meant by the term industrial policy? How do governments attempt to create comparative advantage in sunrise sectors of the economy? What are some problems encountered when attempting to implement industrial policy?

11. How can governmental regulatory policies affect an industry's international competitiveness?

12. International trade in services is determined

by what factors?

13. Xtra! For a tutorial of this questi~n, go to

.....H"!iiI. http://carbaughxtra.swlearnmg.com

Table 3.14 on page 96 illustrates the supply and demand schedules for calculators in Sweden and Norway. On graph paper, draw the supply and demand schedules of each country.

a.In the absence of trade, what are the equilibrium price and quantity of calculators produced in Sweden and Norway? Which country has the comparative advantage in calculators?

b.Assume there are no transportation costs. With trade, what price brings about balance in exports and imports? How many calculators are traded at this price? How many calculators are produced and consumed in each country with trade?

c.Suppose the cost of transporting each calculator from Sweden to Norway is $5. With trade, what is the impact of the transportation cost on the price of calculators in Sweden and Norway? How many calculators will each country produce, consume, and trade?

d.In general, what can be concluded about the impact of transportation costs on the price of the traded product in each trading nation? The extent of specialization? The volume of trade?

3.1 The Penn World Dataset provides statistks on 28 key economic variables for the world'smajor economies from 1950 to 1992, including GDP per capita adjusted for changes in terms of trade. Visit

http://www.bized.ac.uk/dataserv/

penndata/pennhome.htm

3.2 The home page of the Office of Trade and Economic Analysis of the U.S. Department of Commerce/International Trade Administration provides a variety

of trade statistics for the United States by world, region, or country. Go to

http://www.ita.doc.gov/td/industry/otea

3.3 The U.S. Department of Labor/ Bureau of Labor Statistics maintains a home page that shows how the hourly compensation of U.S. workers in manufacturing compares to that of workers in other countries. Visit the site at

http://www.bls.gov/data/home.htm

The factor-price-equalization theory assumes that factor inputs are completely mobile among industries within a nation and completely immobile among nations. However, although factor mobility among industries may occur in the long run, many factors are immobile in the short run. Physical capital (such as factories and machinery), for example, is generally used for specific purposes; a machine designed for computer production cannot suddenly be used to manufacture jet aircraft. Similarly, workers often acquire certain skills suited to specific occupations and cannot immediately be assigned to other occupations. The so-called specific-factors theory analyzes the income-distribution effects of trade in the when factor inputs are immobile among industries-in effect, a short-run version of the factor-price- equalization theory.

Referring to Figure 3.6, suppose the United States produces steel and computers using labor and capital. Assume that labor is perfectly mobile between the steel and computer industries, but capital is industry-spe- cific: Steel capital cannot be used in computer production, and computer capital cannot be used in steel production. Also assume that the total U.S. labor forceequals 30 workers.

In each industry, labor is combined with a fixed quantity of the other factor (steel capital or computer capital) to produce the good.

Labor is thus subject to diminishing marginal productivity, and the labor demand schedule in each industry is downward-slopinq." The computer industry'slabor demand schedule is denoted by DL{c), while DL{s) denotes the labor demand schedule in the steel industry. Because labor is assumed to be the mobile factor, it will move from the low-wage industry to the high-wage industry until wages are equalized. Let the equilibrium wage rate equal $15 per hour, seen at the intersection point A of the two labor demand schedules. At this wage, 14 workers are hired for computer production (reading from left to right) and 16 are used in steel production (reading from right to left).

Suppose the United States has a comparative advantage in computer production. With free trade and expanded output, the domestic price of computers increases, say, from $2,000 to $4,000 per unit, a 100 percent increase; the demand for labor in computer production increases by the same proportion as the computer price increase and is denot-

"The value of marginal product (VMP) refers to the price of a product (P) times the marginal product of labor (MP). The VMP schedule is the labor demand schedule. This is because a business hiring under competitive conditions finds it most profitable to hire labor up to the point at which the price of labor (wage rate) equals its VMP. The VMP schedule is downward sloping because of the law of diminishing returns: As extra units of labor are added to capital. beyond some point the marginal product attributable to each additional unit of labor will decrease. Because VMP; P X MP, falling MP means that VMP decreases as more units of labor are hired.