Ekeme Ekere Afia. 301308330. ECON 443.

Fall 2019

Dissolving NAFTA: Who Gets What and Why ?

Introduction

Among the numerous shocking outcomes of the Trump reign in the United States is one

that puzzles economists and advocates of free trade – the dissolution of the North American

Free Trade Agreement (NAFTA). NAFTA is an Economic Integration Agreement (EIA) between

Canada, the United States and Mexico that dates back to 1994. Like most free trade

agreements, NAFTA was signed to eliminate trade barriers between the three countries and

ensure freer mobility within the region. Trade agreements are usually known to increase the

welfare of member countries due to the reduction of trade costs. However, President Donald

Trump has called for the US exit from NAFTA. This will be replaced by a more restrictive trade

agreement between the three countries called the United States Mexico Canada Agreement

(USMCA).

The consensus on the welfare effects of the removal of EIA’s is that it reduces the

welfare of member countries to varying degrees. Researchers have modelled different

scenarios of dissolution of NAFTA and often end at the same result – all parties will be worse off

after the exit. Furthermore, a similar case in Europe is the famous British-Exit out of the EU,

commonly referred to as “BREXIT”. Research on Brexit also show the negative effects of some

member countries of the EU.

The outcome of pulling out of NAFTA is predicted to be negative for the three countries

involved (Baier, Bergstrand, & Bruno, 2019). To prepare for potential welfare effects of
dissolving NAFTA, it is important to consider the factors that may affect the extent of its

adverse effects on member countries. In my paper, I focus on how changes in price and wage

will affect welfare through the proportion of trade diversion post-dissolution. I focus on a case

where NAFTA ceases to exist to illustrate these effects. I conclude that the relative level of

intranational costs and nature of the domestic market in each country determines how badly

they will be affected after eliminating NAFTA.

Welfare Effects of NAFTA

Reports show that NAFTA has been overall successful in increasing international trade

within the region and increasing economic welfare in member countries. The agreement called

for a removal for regional barriers to trade such as tariffs on most imports between the US and

Mexico, removal of export subsidies, etc. A study by Parro and Caliendo estimates that the pact

increased the volume of intra-bloc trade and real wages increased for all member countries as a

result (Caliendo & Parro, 2015).

The movement from an overall positive EIA like NAFTA to a more restrictive one is

USMCA may seem counterintuitive. However, given the current political climate, the dissolution

of NAFTA seems inevitable. The rest of my paper will focus on the welfare effects of a total

dissolution of NAFTA and the factors that will determine who will be affected and to what

extent.

Welfare Effects of No-NAFTA

Various iterations of what is to be expected with changes to NAFTA mostly present

negative outcomes for all three members. A specific no-NAFTA case is studied by Baier et al in

their paper titled Putting Canada in the Penalty Box: trade and welfare effects of eliminating
NAFTA. Their estimates show that the standard of living falls in all three countries (Baier,

Bergstrand, & Bruno, 2019). Canada, however, is affected the most with its fall in real GDP per

capita twice as large as Mexico and eight times as much as the US (Baier, Bergstrand, & Bruno,

2019).

Who Gets What?

Baier et al study the effects of the no-NAFTA case and their results are summarized as

follows and are also presented numerically in figure 1 and 2:

• Trade with countries outside the FTA increases for all countries with Canada increasing

foreign trade the most

• Intranational trade within each country increases with Canada increasing within-country

trade the most

• Nominal wage decreases and price increases for all three countries with Canada facing the

largest welfare loss of 2.11%

Eliminating NAFTA will lead to diverting trade both internationally and domestically as

seen in the estimates presented by Baier et al. The ratio of how much trade is diverted

domestically, given the reduction in real wage, explains why each member country is affected

the way the study predicts. Specifically, in the domestic market, the nature of industries in the

market and the ease with which countries can divert trade domestically will determine welfare

effects, especially for Canada.

Nature of Domestic Industries

A no-NAFTA situation will create loss in multilateral trade flows within the region. The countries

that trade the most with other members will potentially face the greatest welfare loss due to

imposition of tariffs within the region. Furthermore, domestic industries are highly dependent

on exports to other member countries will further intensify these welfare losses. Canada and

Mexico trade more with the US than vice versa (Baier, Bergstrand, & Bruno, 2019). Therefore,

in a no-NAFTA case, Canada and Mexico may face higher potential welfare losses.

Intranational Trade

When goods are produced in a country, a proportion of output remains in the domestic

and is traded between cities and states in the country. Intranational trade refers to the level of

in-country movement of goods. The volume of trade within the domestic market is then

determined by intranational trade costs such as distance between regions, transport costs,

state regulations etc.

Intranational trade costs refer to the barriers to trade that exist within the domestic

market. Such trade barriers could be due to physical distance, high intra-city shipping cost,

industry regulation, road transport corruption, etc. A popular measure of intranational trade

costs is the price gaps that exist for a good as it moves from its source to other regions in the

country. Higher price variation as the good travels from a remote location to its destination

implies high intranational trade costs.

Another way to think of intranational trade costs is the level of dispersion of economic

activity relative to the size of the economy. The free movement of goods across the country will
promote the dispersion of trade from a central hub where it is being produced to being more

spread across cities within the country. The concentration of trade in a central location could be

an indicator of high intranational costs. For example, Mexico would have low intranational

trade costs because it is a small country and trade is dispersed among major and heavily

populated metropolitan areas (Baier, Bergstrand, & Bruno, 2019). On the other hand, a country

like Canada is likely to have relatively higher intranational trade costs because its economic

activity is geographically concentrated in nearby provinces like Ontario and Quebec (Baier,

Bergstrand, & Bruno, 2019).

A third measure of intranational trade costs are province regulations for trade of goods.

Some countries have little or no regulation or restrictions that prohibit trade of certain goods in

some states or cities. A country that has little or no regulation will have lower intranational

costs. Therefore, lost bilateral flows can easily be diverted to the domestic market. Canada has

been known to have provincial regulation that prevents sale of goods in certain provinces and

as such, will have high intranational trade costs.

The relationship between economic integration and welfare effects of member

countries lies in the level of intranational trade costs that exist in member countries. Upon

withdrawal from an FTA, some trade is deflected to the domestic markets within each country.

This substitution to domestic markets will then be affected if there are high intranational costs

that exist in that region or country. If it is easy to transmit goods within the country, deflecting

trade to domestic markets will not be difficult. The study by Baier et al already points out that a

no-NAFTA case will increase intranational trade in each country (Baier, Bergstrand, & Bruno,
2019). Therefore, eliminating NAFTA will result in lower welfare if there are significant trade

barriers that exist between states or provinces in the country.

The link between intranational trade costs and welfare effects explains the results Baier

et al present in their paper. Mexico has low intranational costs when compared to regions

within the US and Canada. Therefore, it seems logical that Mexico will suffer a lower relative

reduction in economic welfare. Canada, on the other hand, suffers the most in terms of

economic welfare as a result of having the highest relative intranational trade costs.

Welfare effects of No-NAFTA in Canada

Canada suffers the most welfare loss post-dissolution. This can be explained by its high

intranational trade costs and share of industries that will be affected post dissolution. These

costs are influenced by stringent inter-provincial regulation on trade in goods between

provinces.

Canada has the highest relative intranational trade costs. These costs are influenced by

relative dispersion of trade compared to the other members and institutional barriers between

markets in different provinces. For example, Canadian brewers who suffer from higher tariffs

from other member countries after dissolving NAFTA, will be subject to high intranational trade

costs due to different provincial regulations that may prohibit sale of alcohol in certain cities in

some provinces (Find Law Canada, n.d.). Such tight inter-provincial regulations exist on sale of

other goods in Canada and contribute to high domestic trade costs. Other institutional barriers

may be licensing requirements or burden on proof when transporting goods between

provinces. This follows that relatively high intranational costs that exist in Canada contribute to

the large reduction in welfare in Canada.

Furthermore, domestic industries in Canada that are dependent on NAFTA trade flows

will suffer the most. An example is the automobile industry. NAFTA has created freer trade in

automobile parts and an integrated supply chain for the industry. Trump has threatened to

impose tariffs on automobile imports post dissolution. A report by the Canadian Conference

board anticipates that the Canadian automobile industry stands to lose suffer sharp declines

upon imposition of tariffs if NAFTA declines (Zivitz, 2018 ). This could lead to job losses of up to

100,000 and reduction in welfare for the Canadian economy (Zivitz, 2018 ).

Putting it all together:

Dissolving NAFTA entirely without replacement is the worst-case outcome of the threats made

by President Trump. This brings welfare loss to all countries most especially Canada. Varying

scenarios can be depicted such as only the US pulling out, replacement FTA’s between Canada-

Mexico and countries like China or the EU. However, important factors in determining how

welfare changes between member countries are a country’s level of exposure to the world

market and the level of integration of its domestic market.

Conclusion

The interaction between changes in intranational-international trade ratio and consequent

changes in price and wages will determine who wins and who loses with adjustments to NAFTA.

In negotiating trade agreements, countries should consider these factors when assessing how

EIA exits will affect their home economies.

Works Cited
Agnosteva, D., Anderson, J., & Yotov, Y. (2014, January). Intranational Trade Costs:
Measurement and Aggregation. Retrieved from NBER.
Baier, S., Bergstrand, J., & Bruno, J. (2019). Putting Canada in the penalty box: trade and welfare
effects of eliminating NAFTA. Cesifo.
Caliendo, L., & Parro, F. (2015). Estimates of the Trade and Welfare Effects of NAFTA. Review of
Economic Studies , 1-44.
Cuiriak, D., Dadkhah, A., & Xiao, J. (2019). Quantifying CUSMA: The Economic Consequences o
the New North American Trade Regime. Retrieved from HOWE Institute.
Find Law Canada. (n.d.). How much alcohol can I bring from another province? Retrieved from
Find Law Canada: https://constitutional.findlaw.ca/article/how-much-alcohol-can-i-
bring-from-another-province/
Mayer, A. (2011, May 13). Canada's weird liquor laws. Retrieved from CBC News.
Zivitz, N. (2018 , March 9). Canada would lose 91,000 jobs if NAFTA ends: Conference Board.
Retrieved from BNN Bloomberg.
Figure 1:

Summary of Results from Baier et al: “Putting Canada in the Penalty Box: trade and welfare

effects of eliminating NAFTA”