Last November's U.S. presidential election brought to the fore the issue of whether free trade with Mexico is a good or bad "deal" for the U.S. Here, S&P Global Ratings delves into the economics of regional free trade and concludes that the net gains from North American Free Trade Agreement (NAFTA) are significant for both countries, not just for Mexico.
The canonical understanding of the net gains from trade (NGT) is that even if countries don't grow faster as a result of increased international trade, the (static) economic benefits are higher than the costs. In addition, there might be dynamic gains, although these are more difficult to pin down (note 1).
Removal of trade restrictions (import tariffs and quotas) helps small economies that take foreign prices of tradable goods as given to allocate their resources (labor, capital, and land) more efficiently using comparative advantage, resource abundance, and economies of scale in their favor. This conclusion varies slightly when the economy is large, but the idea that more international trade is better than less is not invalidated by it (note 2).
Net Gains From Trade: The Standard Measuring Formula
When an economy opens up to trade with other countries, the prices of importable goods and services decrease relative to nontradables, and those of exportables increase, causing the economy to export and import more. Exports increase because there's more production and less consumption of exportables, and imports increase because the opposite is true for importables. As long as there's balance between domestic saving and investment, exports and imports are equal.
The standard textbook formula to "guesstimate" the annual static gains from trade is to multiply the value of imports (or exports if the two are equal) by the percentage reduction in the domestic price of importables relative to exportables associated with a hypothetical move from autarky to free trade and divide the result by two (note 3).
The standard formula assumes perfect competition among domestic producers and free labor mobility. In contrast, capital is sector specific, namely, it's "stuck" in the sectors where investments were made in the past. Under these conditions, trade liberalization improves the return on capital in export-oriented activities, because relative prices are higher, and reduces it in import-competing activities. Labor moves from the importable to the exportable sectors, contributing to widening the gap between capital returns given that the marginal productivity of capital increases in the first sector and decreases in the other.
The winners and losers of increased external competition according to this model are capitalists and consumers, but not workers. Producers of exportables and consumers of importables win, while producers of importables and consumers of exportables lose. Workers neither win nor lose because there's full employment and nominal wages are equalized across sectors. Moreover, because labor is a nontradable, real wages (i.e., nominal wages in terms of nontradables) are constant.
We can apply the standard formula as a rough approximation of the annual NGTs due to NAFTA in the U.S. and Mexico. For this, we may use the increase in the average of imports and exports, because the two are not equal, between 1993, the year when NAFTA was enacted, and 2015.
During this period, Mexican exports to the U.S. grew from $40 billion to $296 billion, while U.S. exports to Mexico increased from $42 billion to $236 billion. Compared with China, Mexican exports to the U.S. are 40% lower and imports are twice as large, resulting in a lower bilateral surplus, one sixth the size of China's.
Dividing the increase in the average of exports and imports ($225 billion) by two yields $113 billion, which represents 10% of Mexico's GDP and 0.6% of U.S. GDP. Thus, regardless of what number we use as an estimate of the reduction in the relative price of importables vis-à-vis exportables due to NAFTA, the resulting NGT is miniscule for the U.S. compared with Mexico. For example, if the relative price drop is 10% in the U.S. and 20% in Mexico (protectionist barriers were higher in Mexico than in the U.S. before NAFTA), the NGT would be 2% of GDP in Mexico versus 0.06% of GDP in the U.S.
However, these results are misleading because the standard formula is not designed to capture the costs and benefits associated with offshoring as opposed to conventional trade. To wit, the standard formula assumes that U.S. exporters compete in Mexican markets with Mexican producers, and vice versa. While this may be true for some products (e.g., avocados), it's not true for others (e.g., cars or computers).
At least half of the trade that takes place across the U.S.-Mexico border involves the offshoring of U.S. manufacturing activities to Mexico to produce final goods sold primarily in the U.S. The objective of U.S manufacturers is, naturally, to take advantage of Mexico's lower labor costs and its geographical proximity to the U.S.
According to the standard model, the NGT is the difference between the increase in the "consumer surplus"—the satisfaction domestic consumers obtain from being able to buy more importable goods at lower prices—and the decrease in the "producer surplus"—the loss in capital returns domestic manufacturers and their investors have to absorb as a result of higher import competition (note 4). Because the former always exceeds the latter, provided the price-elasticities of supply and demand have the "right" signs, the NGT is positive. The standard model also tells us that the income redistribution needed to generate a dollar of net efficiency gain can be a big number. In other words, the aggregate loss in the producer surplus of importables can be a large fraction of the aggregate gain in the consumer surplus.
However, when there's offshoring, there's no loss in producer surplus. As an example, consider the assembly in Mexico of Ford vehicles using U.S.-made components (note 5). Given that Ford is an American company and offshoring reduces production costs, there's not a decrease but actually an increase in U.S. producer surplus. Assuming that the latter is passed on to the consumer via a reduction in the price of the vehicle, the NGT is the entire increase in the U.S. consumer surplus, which—as mentioned before—can be quite large.
To see how large, suppose that NAFTA accounts for 10 percentage points of the reduction in the relative price of motor vehicles and parts in the U.S. since 1993, which was 32% compared with the CPI, and probably more in terms of U.S. exportables (note 6). Applying the 10% relative price drop to the 12 million vehicles sold annually in the U.S. yields an increase in consumer surplus of 1.2 million units, which is also the net gain for the U.S from offshoring car manufacturing to Mexico. In contrast, the prediction of the standard model is 75,000 units, the result of multiplying the 10% price reduction by the 1.5-million-unit increase in Mexican exports since 1993 and dividing by two.
We can extend this analysis to all the goods (except oil) consumed in the U.S. that can be imported from Mexico, assuming that half of the bilateral trade involves offshoring and the other half is conventional. Because most Mexican exports to the U.S. are consumer durables, including motor vehicles and parts, and textiles, a 10% relative price reduction since 1993 seems reasonable.
For the half of trade that's conventional, the NGT accruing to the U.S. is very small: 0.03% of GDP (0.06% divided by two). However, for the unconventional part, the NGT is significant, as follows from multiplying 10% by total U.S. consumption of consumer durables and textiles, which represents 12% of GDP. The result (1.2% of GDP) is a gross estimate of the increase in U.S. consumer surplus due to offshoring manufacturing production to Mexico.
Just as the U.S. doesn't experience a significant loss in producer surplus as a result of offshoring, neither does Mexico given that there is little competition among U.S and Mexican companies in offshored manufacturing activities. On the contrary, Mexico benefits because these activities create high-productivity employment for thousands of domestic workers. For example, the increase in Mexican employment in the motor vehicles and parts sector alone since 2007 was 300,000 workers. At $8,000 per year per worker, this represents 2% of Mexican GDP, which added to the 2% we had before, and the creation of employment in other industries implies a total NGT for Mexico of around 5% of GDP per year.
NAFTA's Effect On U.S. Employment
As we mentioned earlier, the standard trade model assumes that labor is perfectly mobile and capital is immobile. This is supposed to be a realistic assumption in the short run, but in fact it isn't. Labor mobility is imperfect in the short run and even in the medium and long term, although it is expected to increase over time, the same as capital mobility does.
Imperfect labor mobility can lead to involuntary unemployment, a decline in labor force participation, and lower real wages in industries and locations that are hit hard by import competition. In fact, recent empirical research has shown that a large number of U.S. manufacturing workers who were displaced by Chinese import penetration in the last 20 years has remained unemployed or out of the labor force for long periods, while others had to accept lower-paying jobs because they couldn't find suitable occupations that matched their skills (note 7).
According to one study, the cumulative net loss of U.S. employment due to China is between 2.0 and 2.4 million workers (note 8). At $50,000 per worker (average annual earning), this represents a potential GDP loss of between 0.55% and 0.66% of actual GDP for the U.S.
However, when it comes to NAFTA, there is no evidence of a similar reduction in U.S. employment. Notwithstanding the fact that the U.S. trades with Mexico almost as much as it trades with China, the net loss of U.S. jobs attributed to NAFTA is estimated at around 15,000 workers per year, the difference between 200,000 jobs created and 185,000 destroyed each year (note 9).
A likely reason why Mexico accounts for lower net U.S. job losses than China is that, as we indicated before, its bilateral trade surplus is much lower. In 2015, U.S. trade (exports plus imports) with Mexico was $535 billion compared with $596 billion with China. But, while the U.S imported $296 billion from Mexico, it imported $483 billion from China.
NAFTA's Effect On U.S. Wages
Capital mobility across sectors limits the persistence of producer surplus losses, allowing investors to shift capital to sectors where the expected returns are higher. As with nominal wages, competition among capitalists ensures that capital returns are equalized across sectors.
Economic theory tells us, by way of the Stolper-Samuelson theorem, that when all production factors including capital are mobile (the textbook definition of the "long run"), trade liberalization redistributes income from workers to capitalists, and vice versa, regardless of the sectors in which the latter are employed.
Specifically, if importables are labor-intensive and exportables are capital-intensive, real wages must fall and the real rental price of capital must rise. "Real" in this case means that wages fall and capital returns increase not only in terms of nontradables, but also in terms of exportables and importables.
This analysis can be extended to allow for differences in labor skills. Suppose that U.S. exports are intensive in high-skill labor, and U.S. imports from Mexico are intensive in low-skill labor. A direct application of the Stolper-Samuelson theorem predicts that increased trade between the U.S. and Mexico will reduce the real wage of non-skilled U.S. workers and increase that of skilled ones, while the opposite will happen in Mexico.
Thus, capital mobility introduces a new dimension to the analysis of trade-induced income redistribution that helps to explain why import penetration from China and other emerging markets including Mexico has been blamed for the increase in income inequality in the U.S. along with other factors such as skill-biased technological change and immigration. In a nutsell, all of these factors have the potential of increasing the real income of U.S. capitalists and skilled workers at the expense of that of non-skilled U.S. workers. However, the empirical evidence is that, compared with China, NAFTA's effect on low-skill wages in the U.S has been modest (note 10).
In this article, we have estimated, albeit roughly, the net gains from NAFTA and found that they are not only significant for Mexico, but also for the U.S. despite the latter being a much larger and less open economy than Mexico.
What makes NAFTA a particularly good deal for the U.S. is offshoring. Unlike classic import competition where the competitor is a foreign producer, offshoring of U.S. manufacturing activities to Mexico does not result in a loss of producer surplus for, if this was the case, there would be no offshoring in the first place. As a result, the net gains from trade are higher and the redistribution costs are lower.
Finally, while trade with Mexico may be responsible for some of the employment loss and real wage stagnation observed in the U.S. in the last two decades, particularly in manufacturing, Mexico's share of responsibility appear to be considerably small compared to increased trade between the U.S. and China.