About the C.D. Howe Institute

The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.

Get the App

Hsieh, Li, Ossa, Yang - Free Trade is More Complex Than You Thought

Share

-A A +A

From: Chang-Tai Hsieh, Nicholas Li, Ralph Ossa, Mu-Jeung Yang

To: Concerned Canadians

Date: October 19, 2017

Re: Free Trade is More Complex Than You Thought

Most trade economists have come to believe that the gains from trade liberalization go beyond lower prices for imported goods. Inspired by the ‘new’ trade models of Paul Krugman and Marc Melitz, they now usually add that there are also new import variety and domestic productivity gains.

The basic idea is that consumers benefit from having access to a wider range of imported products and average productivity grows as competition forces the weakest firms to shut down. For example, trade liberalization allows consumers to enjoy an increasing variety of imported food items while at the same time shaking out unproductive domestic food firms.

These ideas gave rise to an empirical trade literature that generally concludes there are large new gains from trade.

In recent research, we reconsidered the Canada-US free trade agreement (CUSFTA) to carefully account for the new gains from trade. Our accounting is based on an exact decomposition of the gains from trade in a generalized model, which we can link to confidential microdata from Canada and the US. Our decomposition reveals that the prior empirical literature has only provided an incomplete and selective account of the new gains from trade. Our top line result is that the new gains from trade reaped by Canada were actually negative since Canadian consumers lost strongly from the exit of Canadian firms.

To understand this, it is instructive to consider the effects of CUSFTA on the set of firms serving the Canadian market. On the one hand, additional US firms entered into exporting that tend to be less productive than incumbent US exporters since it became easier to export to Canada. On the other hand, some Canadian firms exit from production that tends to be less productive than surviving Canadian firms since they now face tougher import competition. Intuitively, selection into production and exporting follows the Darwinian principle of survival of the fittest.

This means that to accurately measure the new gains from trade, we must account for both variety and productivity effects for both domestic firms and foreign firms. We must measure domestic variety losses and not just import variety gains.

We estimate that in the eight years following CUSFTA, Canadian consumers experienced a welfare loss equivalent to 2.1 percent of real income due to the reduction of domestic varieties available to consumers. The increase in choice due to entry of new foreign varieties was only worth a 0.4 percent increase in Canadian real income. The fact that exiting domestic firms tended to be smaller and less valuable to consumers raised average productivity among domestic firms, but this was only worth 0.3 percent of real income during this period. Likewise, the new foreign entrants were less productive, which lowered their contribution to Canadian welfare by 0.2 percent. Combining all of these effects, the new welfare effects of CUSFTA amounted to a 1.5 percent reduction in Canada’s real income eight years after CUSFTA came into effect.

The fact that the reduction in domestic variety far outweighed the increase in foreign variety does not mean that Canada lost from CUSFTA overall. On the contrary, we find that Canada’s welfare actually rose substantially as a result of this trade liberalization with the overall gains amounting to 4.4 percent of real income. That means that the traditional effect of trade – cheaper imports due to tariff cuts – far outweighed the negative net variety and net productivity effects we document, largely because tariffs on manufacturing imports from the US fell from over 8 percent to below 2 percent. 

Our findings do not challenge the common belief among economists that trade liberalization brings about welfare gains. However, they do challenge the notion that these gains arise because of an increase in the variety of available products or the average productivity of firms.

Chang-Tai Hsieh in a professor of economics at the University of Chicago Booth School of Business and the National Bureau of Economic Research, Nicholas Li is an assistant professor of economics at the University of Toronto, Ralph Ossa is Professor of Economics at the University of Zurich and NBER, and Mu-Jeung Yang is an assistant professor of economics at the University of Washington, Seattle.

To send a comment or leave feedback, email us at blog@cdhowe.org.

Connect with Us

© 2014 C.D. Howe Institute. All Rights Reserved.

Connect with Us

© 2014 C.D. Howe Institute. All Rights Reserved.