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Views from the Prairie

October 09

Economics of Trade

Over the last decade, there have been a couple of best selling books purporting to show that trade has significantly changed. Both of these books, the "Long Tail" and the "World is Flat", mistake changes in the costs of trade for a fundamental change in trade practices.

Don't get me wrong. There are very important things to learn about these two books, but not necessarily what the authors propose.

To understand both phenomena, we have to go back to the basic nature of trade. Trade happens when one person exchanges something of value with another person. That trade consists of two parts: identifying what and how highly each person values something, and the actual transfer. Trade is a combination of information transfers and transfers of value between two (or more) entities.

What made the "Long Tail" and the "World is Flat" ideas possible were dramatic cuts in the cost of energy, information, and capital flow. The Internet has cut the cost of information by standardizing the presentation of information. It used to be difficult and expensive to move money around the world. Now, the costs of moving money have been cut by the central banks of nearly every country. This reduction in the cost of capital flow has been happening behind the scenes, but has been critical to the expansion of trade. But central to both the "Long Tail" and "The World is Flat" ideas was the cut in the costs of energy. When oil was at $10 a barrel, it was very cost effective to have a central warehouse and overnight all shipments to anywhere in the country. With cheap oil, we could easily move items around the world and provide overnight satisfaction to a customer.

Edward E Leamer analyzed trade practices for the Journal of Economic Literature. In his research, he found that no matter how people thought things were changing, the ratios were still the same. People purchased goods and services from places far away in the same proportion as they had before. What changed was that more goods and services were being purchased. As foreign trade partners became more prosperous, the amount of trade between us and them went up, but in proportion to the GDP. In places that had been very marginal before, now the new prosperity was noticeable. In places that had been very active before, there was even more trade and the same proportions of trade was going out to the margins.

In other words, things were mostly the same except that more trade was happening. Yes, there have been sectors that were impacted by outside trade. Yes, worker salaries were affected by the threat of "off shoring". But, the general economy was operating the same as it had been before - just more of it.

Likewise a recent research paper from the Wharton School of Business analyzed the rental patterns at NetFlix. They had hoped to show the "Long Tail" effect when the incremental cost was nothing for offering more movies. Their data showed simply that the same ratios of rental occurred no matter how many movies were offered.

The cost of energy is crucial to these phenomena. The cost of transporting goods is a huge part of their cost to the final consumer. The transportation costs due to high oil prices have not fully hit everything yet, but will. Voices are being raised about the energy costs of the Internet - that we can't continue to grow the internet with how much it costs to have data centers. Currently, internet data centers are using about 1.5% of the electricity of this country and that percentage is growing. The expansion of trade that has happened with these lower costs will change as the costs start rising again.

Grant Wickes talked about how his company went through the process of expecting the Long Tail to support it. His conclusion was that it was a mistake to expect a business to live on the Long Tail. The Long Tail eventually curls back into normal business practices and there will be three possible outcomes: most companies will die, some will be acquired, and a lucky few will establish a new brand.

Low Cost

What do these phenomena "Long Tail" and the "World is Flat", really mean? What they mean is that low cost will continue to have a market. If the cost of finding us as a supplier is low, then more people will do business with us. If the cost of delivery is low, we will be able to sell more of it. As energy costs go up, the information and delivery costs will be affected and the next idea will be about intelligent control of costs, not the World is Flat".

Quote: The Long Tail curled. In the process, hundreds of companies died. - Grant Wickes


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Prior Years

  1. 2008