15 _Central America and NAFTA_ _55._ In general, we observe only mild trade diversion when the Mexican supply is very elastic, otherwise trade diversion is negligible. This is shown by cases (1) and (2) where trade diversion does not exceed 1 percent of total imports. If the Mexican export supplies were very elastic, then we would observe some trade diversion, but still in the moderate range. If the Spanish elasticities<sup>2</sup> were a good approximation to the Mexican ones, then apparel would exhibit the highest trade diversion which, nonetheless, would be almost insignificant at less than 0.5 percent of total imports.

56. These trade diversion estimates may look promising for Central America, but they have to be taken cautiously because they do not reflect the full burden of NAFTA. Specifically, they do not take into account the likely case of Mexican producers exporting a much larger share of output to the U.S. to take advantage of higher prices, while importing cheaper products for Mexican consumption, a possibility to which we now turn.

# Estimates **Allowing for the Redirection of Mexican Output**

57. Tables E.7 report some simulation exercises regarding the trade diversion effects of NAFTA allowing for the complete diversion of Mexican supply to the U.S. market. Four log-linear functions determine the equilibrium: U.S. import demand, ROW export supply, Mexican supply and Mexican demand. There are two possible post-NAFTA equilibria. In the **first,** ROW continues to export to the U.S. market, but Mexican supply is diverted to the high-priced protected market in the U.S. In the second, ROW exporters are driven from the U.S. market and the tariff is no longer applicable. A bifurcated equilibrium occurs with the difference between prices in the U.S. and prices in ROW no longer determined by the U.S. tariff level. The effective tariff is the difference between the U.S. price and the ROW price, which under this second condition is less than the nominal U.S. tariff level. A **third** equilibrium could be selected if this effective tariff level became negative. Then the U.S. tariff level would be rendered totally ineffective, and the free trade equilibrium would occur with a single world-wide price level. The calculations presuppose knowledge of both the supply and demand functions which comes partly from estimated elasticities taken from the academic literature, and partly by calibration to make the initial equilibrium conform well with the 1985 facts. We took from Stern et al. (1974)5 the U.S. import demand elasticities for each ISIC category that we analyzed. We also employed actual data on the Mexican net-exports to production ratio and the Mexican production to U.S. imports ratio as a matching reference. The ROW supply was assumed to be very elastic to represent a marginal supplier that predominantly determines the international price. The constant in front of this ROW supply function is arbitrarily a function of the units in which the commodity is measured. We have set it equal to one in all cases.

> 2 The data on the Spanish supply elasticities was taken from: Donges, Juergen "The Spanish Industry in Face of its Integration into the European Community." Economia Internazionale, Vol. 33, pp. 271-81, 1980.

5 Stern, R.M., J. Francis, and B. Schumacher. Price Elasticities in International Trade. Macmillan, 1974.