Between a Rock and a Hard Place: The Economics of Canada-US Freer Trade

Abstract

The prospects for successfully negotiating a Canada-US free trade agreement have shifted from very optimistic (in March, 1987) to very pessimistic (in July, 1987). The focus of press reporting on the pro-free-trade position has also been subject to some movement, between those who take a 'defensive' position and those who espouse an 'offensive' position in arguing for free trade. The 'offensive' position is that the gains to Canada from Canada-U.S free trade are very large, relative to the status quo, and that Canada would be very wise to grab the opportunity for it. There is significant economic analysis to support this position.' The 'defensive' position is that the alternative to a free trade arrangement is US protectionism.2 In other words, the choices facing us are to negotiate a free trade agreement, or, given the political attitude in the US, to find ourselves embroiled in a serious trade dispute with the US. It is widely believed that the latter alternative is a very unattractive one for Canada. This latter proposition has not been analysed in as much detail by economists, although some general predictions from standard trade theory are obviously applicable. One premise holds that trade wars between a small country and a large country will tend to be won by the large country, due to terms of trade effects. For example, we would expect a given tariff on US goods entering Canada to have a negligible effect on the prices received by US producers, and a significant effect on the prices paid by Canadian consumers of those products. In simple terms, US exports to Canada are a small part of total US production, and restricted access to the small Canadian market will primarily affect Canadian consumer prices. By contrast, if the US were to impose the same tariff on imports from Canada, Canadian producers would have to absorb most of the tariff. The price for competing US products is unlikely to change as a result of the tariff because Canadian imports supply a very small share of the US market. At the same time, since Canadian exports to the US constitute a large share of Canadian production, diverting those exports from the US to the Canadian market would cause