The purpose of this study is to illustrate, with a simple two-country, two-good, two-factor model, how a technological/regulational improvement in one country's distribution sector can affect firms'' location decisions and the nature of the trading equilibrium. It is shown that, through improvements in distribution sector, one country might divert high-tech industries to another country.

Toru Kikuchi

English

Research Papers in Economics

Distribution Costs, International Trade and Industrial
Location 
Toru Kikuchi
Kobe University
Abstract
The purpose of this study is to illustrate, with a simple two-country, two-good, two-factor
model, how a technological/regulational improvement in one country's distribution sector can
affect firms' location decisions and the nature of the trading equilibrium. It is shown that,
through improvements in distribution sector, one country might divert high-tech industries to
another country.
Citation: Kikuchi, Toru, (2008) "Distribution Costs, International Trade and Industrial Location." Economics Bulletin, Vol. 6,
No. 24 pp. 1-5
Submitted: June 5, 2008.  Accepted: June 25, 2008.
URL: http://economicsbulletin.vanderbilt.edu/2008/volume6/EB-08F10014A.pdf1 Introduction
In the last decade the role of distribution sector in the global economy such as
wholesale and retailing networks and storage has been widely discussed.1 It is
increasingly recognized that trade and transport services within the borders
of trading countries impose international trade barriers.2 According to this
point, Rousslang and To (1993) point out that costs of domestic wholesaling
and retailing services can act as natural trade barriers in the same manner as
international transportation costs and estimate the barriers that such costs
impose against U. S. imports.
Related to this, several studies emphasize the role of distribution costs as
a determinant of trade patterns. Based on Ricardian trade setting, Bandy-
opadhay (1998) analyzes the eect of the distribution sector's technological
progress on trade patterns. Also, based on Ricardian framework, Yano and
Dei (2003) focus on the vertical production chain in which tradable middle
products produced upstream and transformed into nontradable nal con-
sumption goods downstream: they show how the suppression of competi-
tion in one country's downstream sector aect trade patterns. Furthermore,
based on \new economic geography" trade model, Martin and Rogers (1995)
study the impact of improvement of the quality of local infrastructure. How-
ever, previous studies do note distinguish between \distribution costs for
imported products" and \distribution costs for domestically produced prod-
ucts": an improvement in distribution's sector implies a symmetric reduction
in transaction costs for both imports and domestically produced products.
This assumption is justied for simplication. However, distribution sector's
improvement often cause asymmetric reductions in transaction costs. These
cases imply that imports require more domestic distribution services than lo-
cally produced products.3 In other worlds, domestic distribution sector play
a much greater role in insulating domestic producers from import competi-
tion than was previously recognized. This seems to suggest that the focus on
an improvement in the quality of distribution sector should be accompanied
by a focus on its \international trade barrier" nature.
1See, for example, Limao and Venables (2001) and World Bank (2004).
2See, for example, Wakasugi (2002).
3For example, since it take time to transport products from one country to another,
wholesalers and retailers may have to maintain high inventory levels to ensure uninter-
rupted supply in the domestic market. Bandyopadhyay (1998) notes these possibilities.
1To take this into consideration, in this study, we focus on the eect of an
improvement in the distribution sector which is in favor of importing activ-
ities. The purpose of this study is to illustrate, with a simple two-country,
two-good (homogeneous good/dierentiated high-tech products), two-factor
(labor/capital) model, how a technological/regulational improvement in one
country's distribution sector can aect rms' location decisions and the na-
ture of the trading equilibrium.
Section 2 presents the model. Section 3 analyzes the impact of an im-
provement in the quality of distribution sector on industrial location.
2 The Model
Suppose that there are two country (Country 1 and Country 2), each with
two factors (capital, K and labor, L) and two types of goods (a homogeneous
good and a large variety of dierentiated high-tech products).4 Assume that
the countries are identical in regard to tastes, size, and technology, but dier
with respect distribution costs on dierentiated high-tech products, to which
we assume those costs as directly related to the quality of their distribution
sectors.
Consumers have Cobb-Douglas preferences over both categories and spend
fraction  of their income on high-tech products. Country i's price index for
high-tech products is represented by the Dixit-Stiglitz form:
Pi =
h
ni(pi)
1  + nj(tItipj)
1 i1=(1 )
;  > 1 (1)
where  is the degree of substitution among all products, pi is the producer
prices of high-tech products produced in Country i, and ni is the number
of varieties produced in Country i, respectively. Trade costs consists of two
parts: tI (tI > 1) represents the \iceberg" international trade costs, which
is common for two countries. Domestic distribution costs ti (ti > 1) for
the imported high-tech products are also in the form of \iceberg costs" and
country-specic. Note that, for simplicity, we assume that the distribution
costs for domestically produced products are zero. This assumption intends
to capture the situation that more of distribution services are needed when
4The model is a variant of Kikuchi (2005).
2the producer and consumer are not in the same country.5 We assume these
domestic distribution costs ti as directly related to the quality of Country i's
distribution sector: changes in these costs represent changes in its quality.
Importing one unit of high-tech product variety for Country 1, tIt1 units
of products must be shipped from Country 2. Thus, the demands of con-
sumers in Country i for a Country i (i.e., local) variety and a Country j (i.e.,
imported) variety are
cii = p
 
i P
 1
i Ei; (2)
cij = (tItipi)
 P
 1
i Ei; (3)
where Ei is the total income in Country i.
The homogeneous good is produced with constant returns, using only
labor as an input. Units are chosen so that one unit of labor produces one
unit of output. As usual in new geography models, no transport costs exist for
the homogeneous good, which serves to tie down the wage rate. Also assume
that the parameters of the model are such that both countries produce the
homogeneous good; thus, constant, identical wages for labor hold (hereafter
set to unity).
The production of each variety of high-tech product requires one unit of
capital to develop the product and  units of labor per unit of output. As
in Martin and Rogers (1995) and Martin and Ottaviano (1999), one of the
central assumptions is that the capital is rm specic, but it moves freely
between countries: if a variety developed by Country 1's capital is produced
in Country 2, the operating prots are repatriated to Country 1. Given a
Dixit-Stiglitz specication with constant elasticity , each rm sets its price
as p1 = p2 = ()=(   1). By choice of units, one can set  = (   1)= to
have
p1 = p2 = 1: (4)
Given that one unit of capital is required to develop a variety, the payment
for each unit of capital employed in Country i, ri, must satisfy,
ri = pixi   xi = xi=; (5)
where xi is the output of a representative rm in Country i. When capital
mobility is unrestricted, the payment for capital will be equalized between
5Rousslang and To (1993) point this out.
3countries, which implies that r1 = r2 and thus
x1 = x2: (6)
3 Distribution Costs and Industrial Location
Now consider the rms' location decisions. The product market equilibrium
in Country i requires that supply equals demand for each variety: xi =
cii + tItjcji. Substituting (2), (3), and (4) into this condition and setting
Ei = (rK + L) = 1 yields the following equilibrium condition:
x1 =
1
n1 + I1n2
+
I2
I2n1 + n2
; (7)
x2 =
I1
n1 + I1n2
+
1
I2n1 + n2
; (8)
where i  t
1 
i (i  1) measures the freeness of domestic distribution for
imports, which directly related to the quality of Country i's distribution
sector. Also, I  t
1 
I (I  1) measures the freedom of international trade.
Using (5), (6) and (7), the equilibrium share of Country 1 rms, s1 can
be obtained:
s1 
n1
n1 + n2
=
1
2
"
1  
I(1   2)
(1   I1)(1   I2)
#
; (@s1=@1) < 0: (9)
Equation (9) implies the surprising feature of distribution costs.
Proposition: An improvement in the quality of distribution sector in a coun-
try will induce a diversion of high-tech products away from that country.
Now, let us explain the impact of the improvement in the quality of
Country 1's distribution sector (i.e., 1 increases) more precisely. This change
induces two eects. First, it shifts demand curves for Country 1's varieties
downward: a lower distribution costs implies an increase in the eective
number of imported variety, I1n2, which leads to a fall in local demand for
locally produced varieties in Country 1 (see equation (7)). Second, it shifts
demand curves for Country 2's varieties upward: an easier access to Country
1 market increases the advantage of locating in Country 2 (see equation (8)).
4The above two eects reinforce each other and induce high-tech rms (i.e.,
capital) to ow out of Country 1. It is also important to note that the lower
international trade costs (i.e., a higher I) becomes, the bigger the magnitude
of this outward ow becomes.
This result has important policy implications for national economies. Im-
provements in one country's distribution sector can divert rms in high-tech
industries over to another country. This lowers the incentive to improve the
quality of distribution sector. Although a higher quality of distribution sec-
tor reduces import transaction costs, it also induces industrial diversion and
might raises the transaction costs of receiving products from those indus-
tries that relocate elsewhere. The possibility that industries will be diverted
provides some theoritical grounds for the coordination of investment for dis-
tribution sectors among national economies. Further research should focus
on these policy implications.
References
[1] Bandyopadhyay, U. (1998) "Distribution Costs and International Trade:
A Ricardian Model," Review of International Economics, Vol. 6, pp.
164{178.
[2] Dixit, A. K., and J. Stiglitz (1977) \Monopolistic Competition and Op-
timum Product Diversity," American Economic Review, Vol. 67, pp.
297{308.
[3] Limao, N., and A. J. Venables (2001) \Infrastructure, Geographical Dis-
advantage, Transport Costs, and Trade," World Bank Economic Review,
Vol. 15, pp. 451{479.
[4] Kikuchi, T. (2005) \Interconnected Communications Networks and
Home Market Eects," Canadian Journal of Economics, Vol. 38, pp.
870{882.
[5] Martin, P., and G. Ottaviano (1999) \Growing Locations: Industry Lo-
cation in a Model of Endogenous Growth," European Economic Review,
Vol. 43, pp. 281{302.
5[6] Martin, P., and C. A. Rogers (1995) \Industrial Location and Public
Infrastructure," Journal of International Economics, Vol. 39, pp. 335{
351.
[7] Rousslang, D. J. and T. To (1993) \Domestic Trade and Transportation
Costs as Barriers to International Trade," Canadian Journal of Eco-
nomics, Vol. 26, pp. 208{221.
[8] Wakasugi, R. (2002) \Distribution of Improted Products: The Case of
Automobiles," in Miwa, Y., K. G. Nishimura and J. M. Ramseyer (eds.)
Distribution in Japan, Oxford University Press.
[9] Yano, M. and F. Dei (2003) \Trade, Vertical Production Chain, and
Competition Policy," Review of International Economics, Vol. 11, pp.
237{252.
[10] The World Bank (2004) Reforming Infrastructure: Privatization, Reg-
ulzation, and Competition, Springer.
6

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