Trade Creation and Trade Diversion in the North American Free Trade Agreement: The Case of the Agricultural Sector

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This paper examines the effect of the U.S.-Mexico trade agreement under the North American Free Trade Agreement (NAFTA). The results suggest that U.S. agricultural imports from Mexico have been responsive to tariff rate reductions applied to Mexican products. A one percentage point decrease in tariff rates is associated with an increase in U.S. agricultural imports from Mexico by 5.31% in the first 6 years of NAFTA and by 2.62% in the last 6 years of NAFTA. U.S. imports from Mexico have also been attributable to the pre-NAFTA tariff rates. Overall, the results indicate that the U.S-Mexico trade agreement under NAFTA has been trade creating rather than trade diverting.

Key Words: agricultural sector, NAFTA, panel data, tariffs, trade creation, trade diversion

JEL Classifications: F10, F15, Q17, Q18, C31, C33

The surge of free trade agreements (FTAs) has raised the question of their effect on the countries included in the FTA and on the rest of the world (Bhagwati and Krueger; Krueger 1997). It is an issue that economists have long debated. The debate has divided economists between those who support FTAs and those who oppose them. The former group emphasizes trade-creating effects. By reducing (eliminating) trade barriers among members, FTA can improve resource allocation within a region and improve income for member countries. Production shifts toward the most efficient producers of specific commodities within the FTA and consumers are better off because they can purchase goods at lower prices. The latter group argues that FTAs are by definition discriminatory because they lower/eliminate barriers on internal trade while retaining barriers to trade with nonmembers and are, therefore, trade diverting. Even if an FTA results in internal trade creation, these proponents believe that such gains are likely to be outweighed by their trade-diverting effects. In general, one would expect an FTA to result in some amount of both trade creation and trade diversion (Krueger 1997; Venables). If the trade diversion is sufficiently large relative to the trade creation, the agreement could conceivably end up being harmful to the member countries.

The North American Free Trade Agreement (NAFTA) is one of the most comprehensive agreements in history. Like many other FTAs, the creation of NAFTA has been a subject of bitter discussions and division among politicians and economists, focusing on the effect that NAFTA might have on trade and economic welfare (Fukao, Okuba, and Stern). When NAFTA was being negotiated in the early 1990s, for example, many countries voiced concern that their exports to the United States (and, to a lesser extent, to Canada and Mexico) would be displaced by NAFTA exports, even though in many products and industries those countries could be more competitive than NAFTA producers (Lederman, Maloney, and Serven). From the viewpoint of Mexico, this trade diversion is also important because it would entail a loss of fiscal revenues from replacing imports from third countries subject to tariffs with duty-free imports from the United States or Canada.

Despite the growing concern of the debate, NAFTA was expected to create new trade among the member countries. Through progressive elimination of tariff and nontariff barriers, bilateral trade flows among the United States, Canada, and Mexico were expected to increase. A number of reports have shown evidence of increased trade flows. The Congressional Budget Office (CBO), for example, analyzed that by 2001, NAFTA had increased U.S. exports to Mexico by 11.3% and had increased U.S. imports from Mexico by 7.7% (CBO). On the other hand, the report also pointed out that the agreement had almost no effect on the U.S. trade balance with Mexico and little effect on the change in U.S. gross domestic product (GDP).

Considerable concern is also expressed about the welfare implications of increased trade among the NAFTA member countries. Agriculture is one of the sectors in which there is considerable concern about the potential effects of free trade agreements on domestic producers and consumers (Miljkovic and Paul). …