Does NAFTA Matter: Trade or No Trade

Edited Photo. Source: Flickr - Simon Gray

By all accounts NAFTA is a huge trade agreement which has significantly changed the economies of the countries involved: Canada, the U.S.A., and Mexico. But has this change been for the better, or has it made the countries involved worse off than before?

Concepts of Free Trade

The concept of free trade goes back thousands of years. Basically, economic theory largely accepts that increased trade brings about increased prosperity. This boils down to the economic concept of comparative advantage.

Comparative advantage is complex in a world where millions of items are produced by hundreds of different countries with different sized markets and various unique skills. Each individual country, or company, should produce the goods or services that it is able to provide at the lowest relative opportunity cost – or highest comparative advantage. Then – through trade – they can obtain other required goods and services from another country and everyone should be better off. Let's simplify this theory.

I can pick 80 apples in one hour and I can cut 50 steaks in one hour. You can pick 100 apples an hour and you can cut 100 steaks an hour. You therefore have an absolute advantage in both picking apples and cutting steaks. However, does this mean you should pick all your own apples and cut your own steaks, or are you better off trading with me?

Let's look at a typical 8 hour workday. In 8 hours, you can cut 800 steaks. Or you can pick 800 apples. Or any combination of steaks and apples at your productivity rates. In 8 hours I can cut 400 steaks, or pick 640 apples. Or any combination of the two at my productivity rates.

How can we arrange this to maximum the total amount of steaks and apples produced per day in a manner that makes us both best off? For simplicity, let's say for dietary needs we must each have a minimum of 200 steaks and 200 apples.

Well, it's clear I'm a better apple picker than steak cutter, so I let's say I focus all my time on apples as it's my comparative advantage. I produce 640 apples per day.

You're better than me at both, but relative to me you are more efficient as a steak cutter because you can cut 2x as many steaks but pick only 1.25x as many apples. So you spend your time cutting 800 steaks per day.

Our aggregate production is 800 steaks and 640 apples, so now it's time to trade. To you, 100 steaks is worth 100 apples, but to me 100 steaks is worth 160 apples. Therefore, we will trade at some number in between these two; let's say we agree to trade 130 apples per 100 steaks and I need 200 steaks for my consumption. After our trade, I will have 200 steaks and remaining 380 apples. You will have 600 remaining steaks and 260 of my apples.

On the other hand, if I cut 200 steaks it would take me 4 hours. In the remaining 4 hours, I would only be able to pick 320 apples. Likewise, if you cut 600 steaks for yourself in 6 hours and used the remaining 2 hours to pick apples, you would only have 200 apples. Through trade and focusing our production on our comparative advantages, we both have more steaks and apples than we would be able to produce on our own. This is pure free trade as there are no barriers to our trading situation. We can freely decide on the price of the trade and there is nothing to prevent us from trading.

However, let's say my leader really values steak cutting and decides to tax imported steaks so heavily that it takes 200 apples to pay for 100 steaks. If I spend my time cutting steaks (400 per day) because it's so valued by my leader, I have no time to pick apples. We do like apples for our diet, so I still have to trade a bit. If I need 200 apples per day, it would cost me your relative price of 200 or more steaks (remember you can produce either 100 steaks per hour or 100 apples per hour). Even if we trade at your opportunity cost, I would be left with just 200 steaks and 200 apples. To produce this myself, I would need 4 hours of steak cutting for 200 steaks and have the remaining 4 hours to pick 320 apples. Basically my leader just shut down the market because it no longer makes sense for me to trade even though I'm worse than you at picking apples and cutting steaks.

Let's say your leader values your apple picking skills and taxes imported apples. He makes the tax heavy to incentivize you to spend your time picking apples instead of cutting steak, so it costs 100 steaks cost you 150 apples. So you spend your day picking 800 apples. You need 200 steaks for your diet. If you trade with me to get steak, I will provide your 200 steaks for 300 apples. This leaves you with 200 steaks and 500 apples. You can produce your own 200 steaks and pick 600 apples the rest of the day without trade. Therefore, by enacting the import tax to make apples more valuable, your leader effectively killed your incentive to trade. If you still wanted to trade, I would need to produce steak all day to have enough for import and personal consumption even though I'm not great at steak cutting. This would leave me with 200 steaks and your 300 apples. Still worse off than with free trade.

This is the foundation of free trade and why most economists believe free trade makes us better off. In this simple model, you can see that tariffs hurt everyone because it makes markets either inefficient or non-existent.

Impact of NAFTA

Free trade agreements by their nature increase the volume of trade. By eliminating tariffs on the vast majority of products, the market will determine where things should be produced based on their comparative advantage.

As you could see, this is consistent with the steak and apples scenario and economic theory. It's important to know that it worked this way in real life as well. In 1988 bilateral trade was about US$155 billion; by 2016 trade was about US$600 billion! The U.S. is by far Canada's largest trading partner. We send approximately 76% of our total exports down south; more than half our imports are from the U.S.

However, increased trade doesn't always mean that everyone is better off. Tariffs were long designed by politicians to protect industries perceived to be important to our country. While political will is far from efficient at the best of times, it is great for securing votes.

Our Advantages and Lack Thereof

Canada arguably has great advantages in grains production, hydroelectric production, oil and gas production, timber and wood products, and many minerals. We don't have much advantages producing many fruits, clothing, and other consumer goods.

But what happens when our government has long subsidized or protected the production of consumer goods? We end up having thousands employed in sectors where we have no advantages. It's difficult for the companies who employ thousands of people making simple machine parts, clothing, cigarettes, and other products to compete with companies in Mexico or the southern U.S. who can produce these goods for much cheaper.

NAFTA actually facilitated an erosion of largely unskilled factory work in Canada and the northern U.S. states which were previously protected by tariffs. These jobs poured into the lower cost southern states and Mexico where wages and benefits are significantly lower.

Meanwhile wealthier business owners and investors – largely based in the northern U.S. – realized larger profits as these goods were produced for less and still sold in the entire trade bloc.

Free trade has also turned Canada into even more of a primary resource economy. It's simply not advantageous to process raw resources in our country compared to processing costs in some U.S. states, Mexico, or other countries (China).

Since processing, or manufacturing, historically consumes a lot of person hours – most of them lower skill occupations – workers in these sectors have suffered immensely with no tariffs in place to protect their comparative inefficiency.

In order to somewhat stem the loss of jobs, it has taken public money to subsidize factory refurbishment and other tailor-made help. Despite this, the jobs keep disappearing along with the taxpayer money.

Should We Accept Free Trade?

I believe Canadians need to make a decision on our stance on free trade in general. This doesn't mean allowing prominent political parties – who are largely funded by those who benefit the most from trade – to simply push free trade forward. It's easy to promote trade to help your fundraising friends while using taxpayer's money to deal with the fallout.

I'm talking careful examination while realizing the general benefits and drawbacks of each approach. Then moving forward with that in mind.

Canada With Free Trade

If we accept free trade, we should try promote completely free trade across all industries (dairy & chickens included) with as many countries as possible. We can expect lower consumer prices, higher exports, higher imports, and more service sector jobs of various skill levels. Low-skill jobs will not pay very well and high-skill occupations will pay better.

We should also expect that consumption will increase, so sales taxes are likely to be a very effective form of tax collection. Taxes should then be used to subsidize education and re-training, not specific industries or companies. Basically, no one is protected whatsoever, but we'll let you gain skills in occupations that are in better demand.

In this scenario, it is likely that we would trend towards a minimum income of basic guaranteed income tax system. Low-skill employees in low wage jobs will have their wages subsidized by monthly grants through the tax system (sort of like EI cheques for working people). To pay for this, higher income individuals would be taxed more as they disproportionately benefit from free trade.

Canada Without Free Trade

If we don't accept free trade, we should not pursue free trade agreements or low-tariff arrangements with any individual country. Instead, we should establish tariffs at prices that ensure the products can be manufactured competitively in Canada. These tariff rates should be broad-based and trade agreements should be focused on promoting ease of trade and uniform tariffs with countries whose advantages complement our import requirements.

We can expect higher consumer prices, less exports, less imports, and more manufacturing and similar secondary industry jobs. Since lower skill positions will be in higher demand, wages for all individuals at the low end of the occupation scale will go up. The selection of internationally produced products would be diminished, or expensive compared to locally produced goods.

It is likely that jobs which are highly skilled will pay less. There will be less opportunity for overseas services work and selling, servicing, and financing high-tech imported goods. Our higher tech manufactured goods will also be in less demand overseas.

Tax-wise, conceivably a lot of revenue can be generated by tariffs on all imports. This means it would probably be best to lower taxes on corporations to help them compete better with companies producing comparable goods abroad. (Our exported products would be subject to tariffs by the countries importing those products.)

One example of how our country would look with tariffs is to see our dairy industry, arguably our largest high tariff, highly protected industry today. Aside from relatively small access grants given under some free trade agreements, tariffs on imported dairy products range from 200% to more than 300%.

Dairy producers in our country are well-off. Most hold assets worth millions and they are arguably the most successful farmers across the entire agriculture industry. Barns are new, equipment is shiny, paycheques are steady, and profits are guaranteed. This has also spawned a successful dairy service industry around them; typically equipment is more expensive and service fees higher than in other countries of similar size.

However, we have very expensive dairy product prices compared to other industrialized dairy producing countries. This means lower dairy consumption and outsized hardship on low income individuals consuming dairy. We also have a limited variety of dairy products and many would argue our best cheeses are imported from other countries or are locally made in non-protected dairy sectors (goat and sheep dairy for example).

It's nearly impossible to start a new dairy as the startup costs related to production permits in particular are extremely expensive. It's also difficult to expand rapidly, so efficiencies are hard to realize. Also, dairy employees are normally not much better off than employees in non-protected industries such as pigs or cattle. The benefits go largely to the owners and holders of production permits.

Free Trade or Not

I personally don't have a very strong opinion either way. I believe we are generally more prosperous as a whole with free trade. However, this doesn't mean we are necessarily happier. Many arguments could be made each way.

There are winners and losers in every scenario, it's just a matter of properly supporting the losers with smart policy. This means supporting individuals affected, not giving grants and managing complex favour situations to corporations.

I also think we should commit to taking one path or the other. It's hard to advocate free trade and write good trade agreements which benefit our country while we willingly protect certain "special industries". If we're in the business of protecting, let's equally protect everything.

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