Empirical Estimates of Trade Costs

Empirical assessments of trade costs are most frequently derived through estimation of a gravity equation, and an excellent survey of estimating trade costs can be found in Anderson and van Wincoop (2004). They estimated that the tax equivalent of representative international trade costs is as high as 74% for industrialized countries, including 21% transportation costs and 44% border-related costs.² Costs for developing countries can be much higher.

De (2008) estimates a modified gravity equation for eight sectors in 10 Asian countries, controlling for distance, to examine the effects of both policy and non-policy barriers to trade. Infrastructure quality and transport costs, along with tariffs, are found to be the main determinants for cross-country variations in Asia's trade flows. Infrastructure interventions that reduce the costs of international transport and trade are therefore seen to be crucial for the region to fully realize the gains from recent and prospective trade policy liberalization reforms.

There is often skepticism as to whether the benefits of trade-related infrastructure investment in developing countries accrue proportionately to the poor. Large scale infrastructure projects are frequently viewed as mainly benefiting large firms, whether those are domestically or foreign owned. The poor, who are often also the most deprived of infrastructure services, are often considered to be secondary beneficiaries, if indeed any benefits extend to them at all.

Menon and Warr (2008) examine the impacts of road improvement in Lao People's Democratic Republic (Lao PDR), a poor, land-locked country. Lao PDR has a rugged, mountainous terrain and generally low quality roads. The poorest people often reside far from urban centers and are the most disadvantaged by the high transport costs that result from bad roads. Over the past two decades Lao PDR has made substantial progress in reforming legal and administrative obstacles to market-based development and in opening to trade with the outside world, but these reforms in soft infrastructure may be of limited value for producers facing very high transport costs arising from inadequate market access due to physical infrastructure constraints. Inadequate or substandard roads remain a stubborn obstacle to realizing the potential benefits from international trade for rural residents.

In this context, Menon and Warr use a general equilibrium modeling approach to assess the impact of rural road improvement on the incidence of poverty. Differentiating rural villages into three categories according to the quality of road access available: (i) no vehicular access, (ii) dry season only access, and (iii) all weather access, they find that although improvement in roads in all three categories reduces poverty, the type of road improvement is critical in determining the magnitude of the impact. For instance, when areas with no vehicle access are provided with dry season access roads, the reduction in poverty incidence is about 17 times that which occurs when upgrading from roads suitable only for dry season access to all weather access roads. And the effect on Gross Domestic Product (GDP) is about six times as great. In this context, enabling transport of traded goods for households without initial road access is highly pro-poor compared with road improvement for households already having dry season road access to markets. Extending the access from this land-locked economy further to overseas markets depends on the cooperative efforts in the GMS.

Edmonds and Fujimura (2008) investigate the impacts of infrastructure development on trade and Foreign Direct Investment (FDI) in the GMS, focusing on both domestic and crossborder infrastructure. The way in which road infrastructure, whether domestic or cross border, affects trade directly is clear and operates mainly through reductions in transport costs. These same reductions in transport costs also underlie the impacts on poverty. Furthermore, reductions in transport costs have an indirect positive effect on FDI inflows by reducing transaction costs in intra-firm vertical integration across countries designed to exploit comparative cost advantages. Increases in FDI, in turn, can further increase regional trade, and add to the direct effect of reduced transport costs achieved through improvements in road infrastructure near border areas. When such gains are present, this reduces tendencies towards production agglomeration. If the advantages of production integration across economies outweigh those from agglomeration, then reductions in transport costs make FDI complementary to trade. This defines a virtuous cycle of trade and investment to lower trade costs that fosters increased trade and economic growth.

To explore this, Edmonds and Fujimura estimate gravity models using panel data from 1981 to 2003 for trade and FDI flows between each pair of the six GMS countries. The results show that the quality of road infrastructure in border areas between economies has a positive and statistically significant relationship with trade flows between them, and that this relationship is particularly strong when both cross-border and domestic road infrastructure are included in the estimates. They also find that cross-border road infrastructure has effects distinct from domestic roads, suggesting that investments in cross-border infrastructure have an independent and important role to play in the promotion of regional trade.

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