Canada-U.S. Free Trade and Price Convergence in North America

1. Introduction The debate over the 1989 Canada-U.S. Free Trade Agreement (CUSTA) and the 1994 North American Free Trade Agreement (NAFTA) included much discussion of the possible positive and negative effects of convergence in North America. Economists pointed to the potential benefits of scale economies and gains from trade associated with different relative prices. Market integration would be associated with a convergence of productivity, wages, and costs on both sides of the border as mutually beneficial trade established a single market price. Free trade opponents of various types predicted that cultural convergence would rob Canada of its distinct identity (as elusive as this identity might be to define) and also argued that any changes in wages and prices would tend to raise prices but lower wages in Canada. This paper looks at wages and prices in Canada and the U.S. and attempts to identify the extent and nature of any convergence attributable to the formal trade liberalization agreements of 1989 and 1994. The paper begins by explaining why economic theory holds that trade liberalization should lead to price convergence. Next, it examines the impact of the 1965 Canada-U.S. Auto Pact on convergence of wages, prices, and returns to capital. The existing literature on the post-CUSTA experience is then reviewed, and new evidence updating this work is presented. We find fairly consistent evidence that divergence, rather than convergence, followed CUSTA's introduction. We consider three general explanations for the result: 1) the size of tariff reductions; 2) the failure to reduce non-tariff trade impediments; and 3) the combination of limited exchange rate pass-through combined with exchange rate volatility. The evidence seems to point to the second and third of these potential explanations. 2. The Link between Economic Integration and Convergence The convergence of prices for outputs and inputs has long been viewed as a measure of economic integration. As barriers to the movement of inputs and final outputs between members of a regional trading arrangement are reduced or eliminated, there should be an intensification of trade among member countries. In the neoclassical economic model, an intensification of trade should lead to an equalization of prices net of transport costs and taxes (Hine, 1994). Furthermore, since trade is a substitute for factor movements in the neoclassical model, increased trade should also lead to a convergence of wages and returns to capital within the region. To the extent that direct factor movements are stimulated by differences in wage rates and rates-of-return to capital, increased cross-border flows of capital and labor, perhaps facilitated by formal trade agreements, should further contribute to a convergence of returns to factors of production within the integrating region. Most empirical studies focus on trade and foreign direct investment as measures of closer economic integration; however, there are compelling reasons to focus on price-based measures of economic integration rather than these more traditional measures based on trade flows. The theory of contestable markets provides the fundamental insight that the threat of substantial new entry into domestic industries can cause monopoly prices to decline to competitive levels without actual entry taking place. Moreover, the threat of new entry can lead to reductions in X-inefficiency (higher than necessary costs that, in turn, are encouraged by the protection from more efficient competitors enjoyed by incumbent producers). In the extreme, the threat of new competition from imports can promote significantly lower prices in domestic markets without any significant increases in import volumes. This means that examining convergence of prices and cost contributes not only directly to the debate over the consequences of trade liberalization but also indirectly to the literature on economic integration. …