Archived — Perspectives on North American Free Trade: Paper Number 1: Can Small-Country Manufacturing Survive Trade Liberalization? Evidence from the Canada-U.S. Free Trade Agreement

by Keith Head and John Ries, University of British Columbia, April 1999

Executive Summary

The effects of the Canada-United States Free Trade Agreement (FTA) on Canadian manufacturing are of interest to both policymakers and academics. From a policy perspective, the Canadian experience will serve as a lesson for other small countries considering liberalizing trade with a larger trading partner. On the academic side, there are conflicting theories on whether liberalization will benefit or harm small country manufacturing. In this paper, we develop two theoretical models that offer opposing predictions about the effects of market size and tariff reductions on a country's share of production. We expand these models to include standard comparative advantage effects of trade liberalization. We evaluate the models using matched Canadian and U.S. manufacturing data at the 3-digit SIC level over the period 1990–1995.

Our first empirical exercise is to estimate the "border effect" — the observed and unobserved barriers to trade that impede consumption of imported goods. We decompose this border effect into a portion attributable to tariffs and a portion resulting from non-tariff barriers. We find that non-tariff barriers have steadily fallen but remain high (exceeding 50 percent in tariff equivalent terms) for particular industries. These high non-tariff barriers dampen the effects of negotiated tariff reductions.

Our second empirical exercise tests the theoretical predictions of our two models. We examine the relationship between a Canadian industry's share of North American demand for that industry's goods and Canada's share of the output of that industry. In addition, we evaluate how tariffs influence this relationship. Our investigation reveals some evidence that trade liberalization favours industries with relatively low demand, a result consistent with one of our models. We also find that Canadian industries that are natural resource intensive and had large tariff reductions experienced the largest change in output shares over the 1990–1995 period. Overall, we see the FTA as part of a long-term trend towards increased economic integration between the United States and Canada. While differences in changes in output share across industries were small, our results suggest that trade liberalization favoured Canadian industries with a low demand share and high natural resource intensity.

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