Thursday, December 15, 2016

The Role of Direct Flights in Trade Costs

One sentence summary: The direct flights in line with bilateral air services agreements reduce trade costs.

The corresponding paper by Demet Yilmazkuday and Hakan Yilmazkuday has been published at Review of World Economics.

Effects of direct flights on trade costs are investigated using micro price data at the city level. After controlling for local retail/distribution costs, traded input prices are obtained to be further used in the measurement of trade costs across cities through arbitrage conditions. The existence of a direct flight enters trade costs regressions negatively and significantly. The results are shown to be robust to the consideration of many control variables, nonlinearities in the effects of distance on trade costs, possible endogeneity of having direct flights between cities and alternative definitions of the data. The direct flights that are shown to be determined by bilateral air services agreements are further shown to reduce trade costs through an endogeneity analysis; the main policy implications are twofold: (i) international trade policies through aviation services, such as Open Skies Agreements of the U.S., are alternative trade policy tools to reduce international trade barriers; (ii) direct flights facilitate the integration of internal markets as in the case of European Union.

Non-technical Summary
The increase in air transportation/travel due to the technological development in jet aircraft engines has led to the improvement of global market integration significantly since World War II. This improvement has been partly achieved by the increase in air shipment due to lower air transportation costs, and partly due to the face-to-face business meetings that overcome informational asymmetries in international trade, because the reduction in informal trade barriers through business and social networks is one of the key factors facilitating trade. Therefore, there is no doubt that air transportation/travel has significantly contributed to welfare-improving globalization.

Within this picture, direct flights have gained more importance, because, compared to the inconvenience of transferring flights and the additional flying time, direct flights provide the cheapest/fastest air travel and air transportation. Regarding the role of direct flights in air travel, a direct flight facilitates a business travel by considerably reducing the journey costs, including the opportunity cost of time. By reducing the travel time, direct flights also allow business people to have face-to-face meetings, expand the knowledge of alternative markets, augment their reciprocal trust and thus increase the likelihood of trade.

Considering the discussion so far, this paper attempts to measure the effects of direct flights on trade costs between cities by introducing and using a micro price data set on 22 traded goods at the retail level across 433 cities covering 114 countries. 

Such a rich data set allows us to consider the effects of direct flights on trade costs for both international and intranational city pairs. Trade costs are defined as the arbitrage costs measured by the maximum price difference between traded input prices across cities in order to control for local retail/distribution costs. We also work with time-averaged (long-run) data to eliminate the transitory variations in prices, such as those due to exchange rates.

The results show that the existence of direct flights between cities negatively and significantly reduces trade costs. The following figure shows the distribution of trade costs for city pairs with and without any direct flight, where the horizontal axis represents trade costs.

This result is robust to the consideration of many control variables and nonlinearities in the effects of distance on trade costs.

One policy implication of this paper is that tariff rates and/or duties are not the only trade policy tools that can be used to lower trade costs in order to facilitate welfare increasing economic interaction between countries; other international trade policies through aviation services, such as Open Skies Agreements of the U.S. or A Common Aviation Area Agreement and Euro-Mediterranean Aviation Agreement of the E.U., are also effective in reducing international trade costs.

Another policy implication is that direct flights facilitate the integration of internal markets. In particular, trade costs can be reduced through direct flights even within the same internal market; e.g., Multilateral Agreement on the Establishment of a European Common Aviation Area signed by many European countries among themselves to facilitate the integration of their internal markets is a perfect example to this case.


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