TUNIT - Tavares: Transaction Costs and Regional Trade

Trade and Integration

The Trade Section of the DTT supports the efforts of Member States to promote economic diversification and integration, trade liberalization, and market access that can lead, through expanded market and investment opportunities, to enhanced economic development, job creation, and poverty reduction.

Transaction Costs and Regional Trade
José Tavares de Araujo Jr. (1)

OAS Trade Section, May 1997

Index

	Abstract
1.	Introduction
2.	Corporate refocusing: origins and consequences
3.	Computer prices and economic integration
4.	Conclusion
	Appendix: Intra-industry trade indexes
	References

Abstract

This paper uses the transaction cost theory to discuss the economic foundations of the contemporary trend toward regional integration. It reviews the evolution of bilateral trade flows in five regional blocs and shows that the decline of information costs is a key variable for explaining the generalized growth of intra-industry trade during the last 15 years. Technical progress in the computer industry has generated new forms of international competition wherein the regional supply of intermediate inputs plays a strategic role. Regionalization trends are likely to be even stronger in the near future, but they do not imply any threat to the multilateral trading system.

1. Introduction

Since the early eighties, regional trade has been growing faster than world trade, despite the outstanding performance of the latter, and this has engendered an intense debate on regionalism versus multilateralism. Curiously, the debate has been centered on the behavior of governments, not on the economic foundations of such phenomenon. As Paul Krugman noted, "in some sense, the question of whether regional trading arrangements are good or bad is a moot point. There is nobody who is in a position to decree regional blocs either into or out of existence. So we need to ask why such blocs are in fact emerging (1993, p.73)."

This paper answers this question as follows: A cluster of technological innovations — which included personal computers, new generations of software, fax machines, modems and better telecommunication systems — has allowed a sharp decline of transaction costs worldwide and, consequently, created new forms of competition. To face the new economic environment, firms had to refocus their strategies, by reducing the scope of their production lines in order to keep only those activities they could perform according to the best international practice. This restructuring process opened new markets for intermediate products and services at home and abroad. Due to the time constraints of contemporary production processes, firms prefer suppliers from neighbor countries when subcontracting services abroad or importing inputs. Thus, the trend toward regional integration strengthens the multilateral trading system. At each economy, firms establish their domestic and regional networks in order to face global competition. When signing preferential trading agreements, governments are just sanctioning the institutional framework dictated by market forces. They may commit mistakes, but their attitude is essentially coherent with the idea of free trade.

Besides reconciling regionalism with multilateralism, the argument presented here has two merits. First, it provides a theoretical foundation to the gravity model. The distance between countries and their respective sizes are important variables for explaining bilateral trade flows, not because of Newton’s law, but due to the peculiarities of the competition process. Second, it introduces an additional element to the list of factors that justify intra-industry trade. Even in the absence of product differentiation and increasing returns, every industry generates a certain amount of regional trade flows which depend upon the ratio of transaction costs to production costs borne by incumbent firms, adjusted by the difference between domestic and foreign prices.

Section 2 shows how the interplay between transaction costs and production costs creates regional trade, and illustrates the process of corporate refocusing with some examples from the American economy. Section 3 reviews the evolution of intra-industry trade in five regional blocs: Andean Pact, Australia-New Zealand, European Union, the Southern Common Market (MERCOSUR) and the North American Free Trade Agreement (NAFTA). These trade flows are treated as dependent variables that follow the behavior of transaction costs. Finally, some concluding remarks are made in section 4.

2. Corporate refocusing: origins and consequences

As Ronald Coase pointed out some 60 years ago, firms exist because there are transaction costs in the economic system. Every contract between economic agents presupposes a set of activities for its implementation, such as information gathering, bargaining, monitoring and enforcing. All these activities generate transaction costs. Whenever production costs were lower than transaction costs, firms will find opportunities to circumvent market operations through the expansion of in-house activities. Conversely, an eventual decline of transaction costs will reduce the scope of production vectors and firms will be compelled to refocus their capabilities on those production lines that remained profitable. In other words, the relationship between transaction costs and production costs indicates the convenient degrees of output diversification and vertical integration of the existing firms, i.e. their input/output ratios.

It should be noted that this approach to transaction costs is rather different from the conventional view presented in the international trade literature, which does not distinguish such costs from transportation costs. According to Jeffrey Frankel et al., for instance, the "notion of transportation costs should probably be understood as transaction costs, encompassing not just physical transportation of goods but also costs of communications and the idea that countries tend to have a better understanding of their neighbors and their institutions (1995, p.76)." In contrast, my definition includes only one type of transaction cost: expenditures provoked by imperfect knowledge. As Carl Dahlman (1979) well explained, information gathering is needed because there is insufficient data about the profile of trading opportunities, bargaining costs result from the lack of information on the preferences of economic agents, monitoring and enforcing costs exist because contracts are always incomplete. Therefore, all transaction costs are, in fact, information costs.

Moreover, transportation costs should not be treated as transaction costs for two additional reasons. First, while the former costs are proportional to the amount of foreign trade, the later vary according to the scope of activities carried out by domestic firms, but independently from the levels of production and trade. Second, the same logic underlying the relationship between transaction costs and production costs can be applied in regard to transportation costs, as the following discussion indicates.

Figure 1: Transaction Costs, Average Costs and Output Vectors

Transaction costs can be raised by several factors such as interventionist economic policies, cumbersome judicial systems, inefficient public services or lack of human capital. Likewise, they can be reduced by factors such as deregulation, trade liberalization, transparent public procedures and technical progress, which is, by far, the most important. While the former reducing factors normally yield once for all effects, technical progress continually reshapes the interplay between transaction costs and production costs, as figure 1 shows. Curves Ac and Tc describe the levels of average costs and transaction costs for different ranges of output vectors. Each output vector includes all firms activities, from in-house produced inputs to final goods sold in the market. Imagine one firm producing v1 goods at level a of average costs. If a new technology shifts the transaction costs curve from Tc to Tc’, the firm will concentrate its activities on a narrower range of products, v2, at level b of average costs. Now, the output vector [v1 – v2] will be carried out by other firms which have cost structures more fitted to the new market conditions.

New technologies may shift the transaction costs curve by generating three types of effects: [a] the decline of information costs; [b] more flexible production processes, with a greater number of "technologically separable interfaces", which, as Williamson (1989) has argued, expand the opportunities for new market transactions; [c] a lower degree of interdependence among the different stages of the production process, which reduces the need for in-house coordinating efforts and creates the conditions for corporate refocusing. The movement from vector v1 to v2 corresponds to a restructuring process whereby the firm redefines its intrinsic core, i.e., those elements "that are idiosyncratically synergistic, inimitable, and noncontestable (Langlois and Robertson, 1995, p.7)", and selects the ancillary capabilities that should be transferred to other producers.

In a free trade environment, the market created by the new ratio Tc’¤Ac will be served by three main groups of firms:

domestic firms that can produce those goods at competitive prices;

foreign exporters offering final goods included in vector [v1 – v2];

exporters from neighbor countries selling inputs to the firm that has refocused its production lines.

Evidently, all types of goods can be imported from everywhere, but, when outsourcing, firms are very concerned with delivery times and inventory costs. These constraints benefit neighboring suppliers. Thus, lower transaction costs stimulate trade, but specially intra-industry trade among countries in the same region. Indeed, the greater the difference between the declining rates of transaction costs and transportation costs, the stronger the trend toward regional integration, as section 3 will describe.

If, instead of free trade, all countries apply a uniform tariff on imports, the exporters of intermediate goods and their clients would favor any trading arrangement which eliminates that tariff. In fact, the higher the levels of intra-industry trade, the greater the support governments will get from the private sector for signing regional integration agreements. These agreements increase the international competitiveness of domestic firms and, therefore, may lead to further trade liberalization at the multilateral level.

The performance of the American economy in the eighties well illustrates the facts described in figure 1. As Constantinos Markides pointed out: "More firms were refocusing in the 1980s than in the 1960s. For example, in the 1960s only 1 percent of the top American companies were refocusing, while fully 25 percent were diversifying. By contrast, in the 1980s more than 20 percent of these firms were refocusing, while only 8 percent were diversifying. As a result the trend toward diversification that began more than fifty years ago is now reversing itself. In particular, there was a significant increase in the single-business firms, and a decrease in the unrelated-business firms within the population of Fortune 500 firms. This represents a major evolutionary change for the American corporation (1995, p.8)."

His interpretation follows the logic described by figure 1: "... we will argue that over the past twenty years, changes in the real and financial markets have reduced the optimal level of diversification for most firms. Thus even firms that were optimally diversified a few years ago are now in a state of disequilibrium. A reduction in the optimal level of diversification will occur either because the costs of diversification have increased or because the benefits of diversification have decreased ( ibidem, p.23)."

Not by chance, since the eighties the American government became more committed to regional integration!

3. Computer prices and economic integration

Table 1 summarizes the data to be discussed in this section. It shows the evolution of world exports, transportation costs, computer prices and the bilateral economic relations of six pairs of countries from 1980 to 1995. Four aspects of the bilateral relations have been included:

the intra-industry trade index, measured as a weighted average of 25 industries listed in the appendix; (2)
the bilateral trade flows;
the rhythm of economic integration, measured as the product of the two preceding variables; and
the correlation between the performance of computer prices and the progress of economic integration, measured by two coefficients, one for the entire period (listed on the 1980 column) and another for a shorter period (1983-1995).

Transportation costs are described by the "Liner index" compiled by the Ministry of Transport of Germany, which is based on monthly weighted assessments of freight rates on cargoes loaded or discharged by liners of all flags at ports in the Antwerp/Hamburg range. This index shows that intercontinental transportation costs did not change very much during the last 15 years. Despite the declining trend since 1985, in 1995, freight rates were still approaching the 1980 level. Therefore, we may ignore this variable and focus our attention on information costs only.

Within the limits of the analytical framework presented in section 2, a convenient indicator for information costs is the hedonic price index for personal computers compiled by the U.S. Bureau of Economic Analysis (BEA). This is a quality-adjusted index that captures innovations introduced in PC models regarding memory size, speed and hard disk capacity. For the period 1982-1995, the figures listed in table 1 are based on the comprehensive revision made by BEA in 1996. For 1980-1982, I used a previous estimate released in 1985 (see Cartwright, 1986). (3)

Table 1: Trade, economic integration and transaction costs (1980 - 1995)

	1980	1981	1982	1983	1984	1985	1986	1987	1988	1989	1990	1991	1992	1993	1994	1995
World exports	110	108	100	98	104	105	116	140	160	172	197	203	218	216	244	289
Freight rates	84	98	100	99	127	134	112	103	102	105	94	99	97	95	92	88
PC's prices	117	107	100	70	60	57	42	38	34	32	27	23	17	14	12	9

Argentina/ Brazil	*-0.60*			*-0.78*
Economic integration	51	49	24	21	36	27	22	37	49	63	66	101	169	224	295	402
Bilateral trade	158	122	100	83	102	84	104	98	120	150	174	259	392	521	640	787
IIT index	0.32	0.40	0.24	0.25	0.35	0.32	0.21	0.38	0.41	0.42	0.38	0.39	0.43	0.43	0.46	0.51

Australia/ New Zealand	*-0.83*			*-0.91*
Economic integration	47	53	50	50	63	70	69	87	112	124	138	143	156	163	213	244
Bilateral trade	104	110	100	98	124	113	110	148	187	214	234	239	252	254	323	375
IIT index	0.45	0.48	0.50	0.51	0.51	0.62	0.63	0.59	0.60	0.58	0.59	0.60	0.62	0.64	0.66	0.65

Canada/ United States	*-0.88*			*-0.90*
Economic integration	61	69	66	77	97	101	102	110	131	134	146	145	154	171	204	233
Bilateral trade	96	107	100	114	138	143	142	154	181	189	202	202	217	241	279	311
IIT index	0.64	0.64	0.66	0.68	0.70	0.71	0.72	0.71	0.72	0.71	0.72	0.72	0.71	0.71	0.73	0.75

Colombia/ Venezuela	*-0.60*			*-0.78*
Economic integration	18	15	17	11	13	12	11	14	19	18	34	38	65	83	99	151
Bilateral trade	66	105	100	71	67	51	37	47	55	54	73	107	142	231	238	326
IIT index	0.27	0.14	0.17	0.15	0.20	0.23	0.31	0.29	0.35	0.34	0.47	0.36	0.46	0.36	0.42	0.47

France/ Germany	*-0.81*			*-0.94*
Economic integration	99	86	80	79	76	80	109	134	147	161	203	200	216	180	206	253
Bilateral trade	119	104	100	97	92	98	133	166	185	195	240	240	253	211	239	299
IIT index	0.83	0.83	0.80	0.82	0.83	0.81	0.82	0.81	0.80	0.82	0.84	0.83	0.85	0.85	0.86	0.85

Mexico/ United States	*-0.71*			*-0.83*
Economic integration	33	43	26	32	50	60	78	51	87	97	140	153	411	431	422	445
Bilateral trade	141	176	100	82	109	123	114	90	142	169	216	285	498	526	596	598
IIT index	0.23	0.25	0.26	0.39	0.45	0.49	0.69	0.57	0.61	0.57	0.65	0.54	0.83	0.82	0.71	0.74
Sources:	IMF - Direction of Trade Statistics; UN COMTRADE Data Base; US Bureau of Economic Analysis; UNCTAD - Review of Maritime Transport.

Transaction Costs and Regional Trade José Tavares de Araujo Jr. (1)

Transaction Costs and Regional Trade
José Tavares de Araujo Jr. (1)