metadata: authors: 0: author: Levy, Santiago
1: author: van Wijnbergen, Sweder
count: Mexico,United States
docna: 0: docna: Transition problems in economic reform :
            agriculture in the Mexico - U.S. free trade agreement
docty: Policy Research Working Paper
subtopic: Rural Settlements,Labor Markets,International Trade and Trade Rules,Food Security,Agricultural Growth and Rural Development,Inequality,Rural Labor Markets
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The authors use Mexican agriculture as a
            case study to analyze the transition problems that arise in
            most major economic reforms. They focus on the implications
            for policy design of the absence of efficient capital
            markets; on the welfare costs of reforming only gradually;
            on incentive problems created by trade adjustment policies;
            and on the redistribution aspects of policy reform in the
            presence of realistic limits on available intervention
            instruments. They emphasize that adjustment should focus on
            increasing the value of assets owned by the groups affected,
            and not on direct income transfers of programs targeted to
            output or other characteristics controlled by the
            beneficiaries. That is, they contend that adjustment should
            be targeted to improving what people have, as opposed to
            what people do.
geo_reg_key: 119228,517191
repnme: repnme: Transition problems in economic reform :
            agriculture in the Mexico - U.S. free trade agreement
display_title: Transition problems in economic
            reform : agriculture in the Mexico - U.S. free trade agreement
listing_relative_url: /research/1992/08/699639/transition-problems-economic-reform-agriculture-mexico-free-trade-agreement
topicv3: Agriculture and Food Security m1326205 435,Labor Markets m1326488 855,Poverty m1326687 695,Trade m1326924 698,Rural Development m1504505 2667
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Policy, Research & Ect Affairs
no_of_pages: 59
model_extractions: <!-- Start of picture text --> Policy Rroh |h<br>Country Opwetions<br><!-- End of picture text -->

WPS 967 This paper- a product of theCountry Operations Division 1, Country Department II, Latin America and the Caribbean- was partialy financed by the OECD Development Center as part oftheir research project on Developing Country Agriculture and International Economic Trends, and by the World Bank under grant no. BB676-65M. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Margaret Stroude, room 18-159, extension 38831 (August 1992, 34 pages plus 19 pages of appendix).

Levy and van Wijnbergen use Mexican agriculture as a case study to analyze the transition problems that arise in most major economic reforms. They focus on the implications for policy design of the absence of efficient capital marcets; on the welfare costs of reforming only gradually; on incentive problems crated by trade adjustment policies; and on the redistributive aspects of policy reform in the presence of realistic limits on available intervention instruments.

They emphasize that adjustment should focus on incrrasing the value of assets owned by the groups affected, and not on direct income transfers or programs targeted to output or other characteristics controlled by the beneficiaries. That is, they contend that adjustment should be targeted to improving what people have, as opposed to what people do.

ThePolicy ResearchWorking PaperSeriesdisseminates thefidingsofworkunderwayintheBank Anobjectiveoftheseries is to get these findings out quickly, even if presentations are less than fully polished. The fmdings, interpretations, and conclusions in these papess do not necessarily represent official Bank policy.

Produced by the Policy Research Dissemination Center
Transition Problems in Economic Reform: Agriculture in the Mexico-U.S. Free Trade Agreement* by Santiago Levy Boston University and Sweder van Wijnbergen World Bank and CEPR

# Table of Contents

|1.|Introduction|1|
|---|---|---|
|2.|Model Structure|3|
||2.1<br>Static Relationships<br>2.2<br>Intertemporal<br>Relationships<br>2.3<br>The Transition Path and the Steady-State<br>2.4<br>Budget Constraints<br>and Welfare Measures|3<br>7<br>8<br>9|
|3.|The Impact of Free Trade in Maize|11|
|4.|What Type of Trade Adjustment?|17|
|5.|On the Pace of Adjustment|24|
|6.|Conclusions|30|
|Refe|rences|33|
|Appe|ndix|34|

* This paper was partially financed by the OECD Development Centre as part of their research project on "Developing Country Agriculture and International Economic Trends." The authors thank Ian Goldin and Hans Binswanger for helpful comments and discussions. An appendix with detailed equations and a discussion of data and calibration is available on request from Sweder van Wijnbergen.
# 1. Introduction

Agriculture contributes less than 8X of Mexico's GDP.<sup>Nevertheless,</sup> when in June 1990 Presidents Salinas and Bush announced<sup>negotiations on a Free</sup> Trade Agreement (FTA) between Mexico and the US, it<sup>was clear that agriculture</sup> would be a major stumbling block. At stake is much more<sup>than the efficiency</sup> gains that liberalizing agriculture, and particularly<sup>maize, would bring to</sup> Mexico, substantial as we find them to be. Maize protection<sup>is Mexico's de</sup> facto rural employment and anti-poverty program, so<sup>distributional concerns</sup> complicate the liberalization process. Further complications arise because, while high maize prices almost certainly contribute<sup>to rather than alleviate</sup> poverty, rapid liberalization would increase poverty on the transition path.

This paper focuses on the distributional effects<sup>of liberalizing maize</sup> in Mexico, the policies that can be put in place to alleviate<sup>them, and the</sup> incentive problems such policies in turn lead to.<sup>Our results, however, are</sup> of much wider interest than the FTA negotiations themselves.<sup>Agriculture has</sup> been a major stumbling block in trade negotiations everywhere.<sup>Agriculture</sup> has always been excluded from GATT negotiations until the<sup>recent Uruguay</sup> round, which almost collapsed because of it. In many cases<sup>the reasons are</sup> similar to the ones discussed in this paper.

Transition problems like the ones analyzed in this paper<sup>are likely to</sup> arise in most major economic reforms. In particular, we<sup>focus on the</sup> implications for policy design of the absence of well functioniug<sup>capital</sup> markets; on the welfare costs of reforming only gradually;<sup>on the incentive</sup> problems created by trade adjustment policies; and on the<sup>redistributive</sup> aspects of policy reform in the presence of realistic<sup>limits on the array of</sup> intervention instruments available to the Government.
2 Maize is Mexico's key crop and main rural employer; it occupies the largest acreage, it is the most costly in terms of fiscal subsidies, and it is the most protected1l. It is grown by subsistence farmers, mostly in rain-fed lands; it is also grown by medium and large scale farmers in rain-fed and irrigated lands. Since irrigated lands have higher yields, the latter groups, who are not among the poor, receive large infra-marginal rents. Only 0.32 of every peso of subsidy reaches subsistence farmers (Levy and van Wijnbergen (1991)).

Tortillas, Mexico's main staple food, are mainly made from maize. The government subsidizes tortillas, but the subsidies fail to fully offset the effects of maize protection; thus the rural poor are taxed on their main consumption good. For landless workers and the 65X of maize producers whose land is so marginal that they are actually net maize buyers, this tax exceeds the subsidy they receive as producers.z3 We show that liberalization lowers the value of rain-fed land, thus hurting the sub-set of the rural poor who own land by reducing the rents derived from this asset. This would lower the value of the main asset farmers can collateralize, reducing their access to credit at the very moment when such access is needed most. Liberalization also lowers the demand for rural labor. And since migration links rural and urban labor markets, I/ Import controls support a price 70X above the world price (allowing for transport costs ance quality differentials); 42X of the total arable land is allocated to this crop, which employs one out of three rural workers; subsidies to maize and tortillas cost about US$ 1 billion in 1991.

&/ In urban areas the tax is partly offset by deliveries of tortillas through the 'tortivale' program. Under this program each urban family earning less than two minimum wages receives one kilo of tortillas per day free. This is less than daily family consumption, so the program is infra-marginal.
3 liberalization of maize lowers wage rates across the board. The effects of liberalization thus spill-over to the urban poor.

Lump-sum transfers are not a feasible option in Mexico, so other policies to protect the poor are needed. Moreover, Mexico's poor<sup>have limited</sup> access to capital markets, access which may in fact be reduced by the liberalization because it lowers land prices. Hence, these policies must not only focus on steady-state welfare, but also on the transition period.<sup>And</sup> because the FTA is a permanent shock, these policies should also<sup>facilitate</sup> change towards other activities.

In section 2 we sketch an inter-temporal model to trace the impact on households' welfare of Mexico-US free trade in agriculture, and of different adjustment policies. In section 3 we quantify the trade-offs<sup>between the</sup> speed of liberalization and the size of the efficiency gains; we also study the impact on labor and land markets. Section 4 designs a program<sup>to</sup> facilitate adjustment towards free trade in maize that protects<sup>the rural poor</sup> during the transition. Political economy considerations that<sup>bear on the</sup> design of this program are addressed in section 5. Section<sup>6 concludes.</sup>

# 2. Model Structure

# 2.1 Static RelationshiDs

The economy is divided into an urban and a rural sector. The urban sector produces only a tradeable industrial good and a non-tradeable services good. Each of these goods is produced with fixed intermediate inputs and a Cobb-Douglas technology for urban labor and sector-specific capital.

Land and rural labor produce five tradeable goods in the rural sector: maize, other basic grains, fruits and vegetables, other agricultural goods, and livestock. We distinguish between rain-fed (TI) and irrigated (T2) land,
4 because yields and land/labor ratios for the same crop differ between types of land. We include tortillas as a pure consumption good. Tortillas are nontraded, but by assumption perfectly elastically supplied at the zero-profit, tax/subsidy inclusive price; their price depends only on the producer price of maize and any taxes or subsidies.

We distinguish six types of houselholds, classified by ownership of factors of production. Four are in rural areas: landless rural workers, whose only asset is labor; subsistence farmers, who on average own two hectares of rain-fed land, work their own land and participate in the rural labor market; rain-fed farmers, who own the remainder of the rain-fed land and half of the land used for livestock; and owners of irrigated land, who own the irrigated land, and the other half of livestock land. Neither rain-fed nor irrigated farmers supply labor. Urban workers supply all urban labor, and urban capitalists own the urban capital stock.

Urban workers, landless rural workers and subsistence farmers all have the same preferences, as do rain-fed and irrigated land owners and urban capitalists. The first group allocates a much larger share of expenditure to rural goods than the second, so changes in food prices have a much larger impact on the first group'/.

Migration plays an important role in determining the incidence of changes in agricultural protection. While migration to the US has attracted most international attention, rural-urban migration inside Mexico is quantitatively more important. Mexico's rapid urban growth has been largely J/ Preferences are given by a nested Cobb-Douglas/CES/CES utility function. The outer nest CD allocates expenditures between a composite rural good, industry and services. The next CES nest aggregates the five rural goods into a composite rural good. The last CES nest distributes maize consumption between raw maize and tortillas.
5 by such migration, and involves<sup>numbers in excess of any available estimate of</sup> the number of Mexican migrants<sup>currently in the US (Garcia y Griego (1989)).</sup> We therefore focus on internal<sup>migration, and assume that migration</sup> flows keep the ratio of per-capita<sup>utility differentials between landless</sup> rural workers (the most likely<sup>migrants) and urban workers (the most likely</sup> target group) constant. We use<sup>utility differentials rather than wage</sup> differences (as in the Harris-Todaro<sup>m4odel)</sup> because urban transfers like<sup>the</sup> tortivale program also affect migration<sup>choices. We capture allsucheffects</sup> by focusing on total utility.<sup>With LrU the stock of migrants from rural to</sup> urban areas, U. and Uu per capita<sup>utility of a worker in the rural and urban</sup> areas, respectively, and the superscripz<sup>0 an initial equilibrium, we get:</sup> _Llu = kf (U/UU) / (L/U,") ] - k ; k> O 1n2 (1 )_ where vi is the elasticity of migration<sup>to urban-rural utility differentials.</sup> Keeping utility differentials constant<sup>is achieved by setting v very high.</sup> We distinguish physical (the actual<sup>physical hectares of land allocated</sup> to a particular crop) from effective<sup>land (the amount actually usable). The</sup> relationship between them is: where - denotes effective land; the subscript<sup>jrefers to the four</sup> agricultural goods. Equation (2)<sup>is intended to capture incentives for crop</sup> rotation and other practices that<sup>preclude allocating all land to a single</sup> crop. Irrigated land is assumed<sup>to be better than rain-fed in that 01,02 j,</sup> so that diminishing returns set<sup>in more slowly than in rain-fed lands. Hence,</sup> for the same price change, the supply<sup>response in irrigated lands is stronger.</sup> Agricultural production functions<sup>exhibit constant returns to scale to</sup> labor and effective land; thus<sup>value added in maize, m, in rain-fed lands is:</sup>
6 LRl1, TIm are rural labor and raiLi-fed lands allocated to maize; Pl5 rIM02 and Al5 **-** _Xlw*alm_ Similar functions apply to the other agricultural products in both types of land. Since 0 < A < a < 1, there are diminishing returns to physical land for given labor intensity. Thus, for a wide range of prices there need not be full specialization in agriculture.

Trade interventions are modelled as combinations of production and consumption taxes/subsidies. We also model direct lump-sum transfers to urban workers through the tortivale program. Such tortilla deliveries are inframarginal, and thus equivalent to a direct income transfer. For given taxes and subsidies, domestic prices for tradeable goods follow world prices, as we assume domestic goods to be perfect substitutes for world goods, and take world prices to be exogenous. But services are non-traded, so this market, like the markets for rural and urban labor, and rain-fed and irrigated land, is cleared by prices. Our model thus determines, via the excess demand functions in (4), factor prices and the real exchange rate: P contains the rural and urban wage rates, the rental rates on rain-fed and irrigated land, and the price of services (the real exchange rate). The vectors of goods' supply and demand are, respectively, qs and qd, the subscript s refers to services, and the superscript D denotes the market
7 demand for a particular<sup>type of labor or land. LRO and LUO are the initial</sup> distribution of the total<sup>labor force so that in the base caseLVO-0.</sup>

# 2.2 Inter-Temporal Relationships

At each period the economy<sup>is described by the excess demand functions</sup> in (4). But from one time<sup>period to the next the economy changes ac a result</sup> of exogenous and policy-induced<sup>changes. The exogenous changes are: (i)</sup> growth of labor and<sup>populations',</sup> (ii) Hicks-neutral technical<sup>change, (iii)</sup> growth of the urban capital<sup>stock5J, (iv) government spending in non-</sup> agriculture items, and<sup>(v) the path of world prices. Importantly for our</sup> results, we assume that<sup>the rate of growth of productivity in rain-fed</sup> agriculture is lower<sup>than in irrigated agriculture. This reflects the fact</sup> that high yielding varieties,<sup>pesticides, fertilizers and other innovations</sup> are easier to implement<sup>in irrigated lands.</sup> We model two policy-induced<sup>changes to alter the economy's growth path:</sup> trade policy and agriculture<sup>investments. Within trade policy, attention</sup> focuses on the sectors where<sup>liberalization</sup> occurs, on the date at which changes start, and on the<sup>speed at which they take place. Within agriculture</sup> investments, we focus on<sup>the size and time-profile of irrigation investments.</sup> Investments in irrigation<sup>infrastructure</sup> change the endowments of irrigated and rain-fed<sup>land with a 1-period gestation lag:</sup> 4/ To reflect Mexico's<sup>demographic transition, the rate of growth of labor,</sup> 3X, is set higher than<sup>the rate of growth of population, 2X. During the</sup> transition period, see below,<sup>the rate of growth of labor slowly declines</sup> until in the steady-state<sup>it equals that of population. Thus, households who</sup> own labor initially grow<sup>faster than households who own only land or capital.</sup> _V/_ In a fuller model of<sup>the impact of the FTA, investment rates in industry</sup> and services would clearly<sup>be endogenous. Here, however, we are interested in</sup> the effects of changes<sup>in agricultural liberalization</sup> only.
8 _Tic 1 TIC-,_ - _RIXti T2; r' T2t. 1_ + _Rt-l)_ RI is the number of hectares of rain-fed land transformed to irrigated land. Owners of rain-fed land (subsistence peasants and rain-fed farmers) are assumed to benefit from irrigation investments in proportion to the initial share of rain-fed land held by eqch group. The investments are paid for by the government. The real resource costs of irrigation are an increasing function of the stock of irrigated land, reflecting the fact that as these investments increase, lands of poorer-quality are encountered (greater distance from water resources, etc.). We capture this by: where Qt is an index of marginal costs of irrigation investments.

The rates of growth of labor in each period, glt, are exogenous, but migration responds to endogenously determined utility differentials, implying in turn that the urban and rural labor force are determined endogenously by: _LRt_ = _(LRt-.,_ - _Lzu,,)_ (1 + _gc1_<sup>_)_</sup> ; LUt _- (LUt-I +_ Lrtl) 1 (1 _+ glt-l)_ (7)

# 2.3 The Transition Path and the Steady-State

We divide the future into a transition path and a steady-state. The transition path lasts T-1 years; the steady-state obtains from period T onwards, going out to infinity. All policy-induced changes take place during the transition period. During this period the rate of growth of labor also converges to that of the ,->,ulation. In the steady-state, on the other hand, all households grow at the same rate, and the rate of growth of aggregate output, which equals the rate of growth of the capital stock, is given by the sum of labor and productivity growth.
9 Hence, by assumption, static and intertemporal relative prices remain unchanged over the interval [T,m). This allows us to Hicks-aggregate the steady-state path of the economy. It suffices to simply. calculate period T values, since all future periods will be identical up to a uniform scale. factor (growth rate) for all quantities. The aggregation process therefore only affects discount factors between T-1 and T; these are larger than those between earlier periods because this 'period' is replicated an infinite number of times (again, up to a uniform scale factor for all quantities).

Let the common and constant post-T grtwth rate be g and the real world interest rate rw. Define 6-l/(l+rw) and 5^-(,+g)/(l+rw), where 6a is the period-to-period growth-adjusted discount factor. Then the following expressions obtain for discount factors from year i back-to-period-l, 6(i): Consider now the Net Present Value, NPVy, of (yt), where yt-yt,1(l+g) for all t > T: Thus the infinite horizon is captured by calculating period T only (out of all [T,-) periods), but adjusting the period T discount factor to equal:

# 2.4 Budget Constraints and Welfare Measures

Only urban capitalists save and invest. Private investment is driven by the exogenously given growth of the capital stock. Private savings is a
10 constant proportion of urban capitalist's income. This proportion is exogenous during the transition period, but is endogenized in the steady-state to satisfy t:heir inter-temporal budget constraint. Thus, if during the transition period they accumulated debt (assets), the steady-state savings rate is increased (decreased) so that the discounted value at time T of future savings over investment equals the value of the debt (assets) accumulated up through period T-1; see the appendix for details.

Household's welfare is the present discounted value of the time-paths of utility (UhO. .. .UhT-l;UhT). Let the rate of time-preference, p, be constant and equal for all households, and use a CRRA utility function to aggregate utility over time. If a is the inter-temporal elasticity of substitution, we calculats welfare of household h as: where gc is the steady-state rate of growth of per-household consumption.

Because all private households satisfy their inter-temporal budget constraint, the present -iscounted value (PDV) of the government deficit (surplus), equals the PDV of the trade deficit (surplus), B. We do not impose the condition that B - 0. Rather, we measure the difference between the PDV of the government deficit in the base path, denoted by BO, and any B generated by an alternative path, and interpret the difference as the change in resources generated by the policy change. For each path we calculate the lump-sum transfers (taxes) required so that each household in each period has
11 the same current utility as in the base path. When the value of these income compensations are included as part of government's expenditures, as if in fact these compensations had been given, the difference between BO and B is the aggregate efficiency gain of any policy change.

# 3. The Impact of Free Trade in Maize

We study the implications of liberalizing maize by comparing a reference path for the economy that leaves maize and tortilla policies at their present levels with various alternatives where maize and tortilla prices are freed-up; on the reference path there is no irrigation investmentil, and US protection of its Fruits & Vegetables (F&V) sector stays at its present level.71 Table 1 shows the efficiency gains and distributional impact of eliminating all taxes and subsidies to maize and tortillas. The efficiency gains measure the increase in national income assuming the government delivers lump-sum transfers (or levies) so that every household has always the same utility as in the reference path. The welfare changes measure the impact of various alternative adjustments, but exclude the effects of such transfers.

In this section we only focus on the first two columns, where we evaluate the effects of liberalization without any adjustment policies. The first column shows the impact of an immediate elimination of all maize and §/ Also, on the reference path real government spending and the capital stock in industry and services grow at 4X annually. Productivity in the urban sector grows at 2%, and in rain-fed (irrigated) agriculture at 0.5 (1.5Z).

2/ We assume that protection to other agricultural sectors, basic grains in particular, is removed over a 5 year horizon. This allows sharper focus on wliether to include maize in the FTA, and what kind of supporting policies are advisable. Because liberalization of grains is already incorporated in the base scenario, these results only provide measures of the efficiency gains (costs) from including (excluding) maize in the FTA.
12 tortilla taxes and subsidies; the second column shows the effects of a gradual change where maize moves linearly to world prices over 5 years (so that in the sixth year domestic and world prices are equal).

Table 1: Welfare and Efficiency Effects

||Maize 1Y<br>no CNA|Maize 5Y<br>no CNA|Maize 1Y<br>GPA|Maize 5Y<br>CNA|Maize SY<br>CNA|Maize 6Y<br>CNA early|
|---|---|---|---|---|---|---|
||no F&V|no F&V|no F&V|no F&V|F&V|F6V<br>l|
|Subsistence Farmer'|0.967|0.971|1.007|1.011|1.013|1.015|
|Landless Rural Workere|0.984|0.985|0.993|0.995|1.000|1.001|
|Rain-Fed Farmer"|0.943|0.949|0.996|1.001|1.000|1.003|
|Irrigated Farmere|1.028|1.024|1.019|1.015|1.028|1.025|
|Urban Worker|0.984|0.986|0.993|0.995|1.000|1.001|
|Urban Capitalist"|1.018|1.017|1.013|1.012|1.007|1.006|
|Efficiency Gainsw|42.44|40.08|51.96|49.57|44.81|43.18|
|Cumulated Fiscal Gaine|23.17|21.94|18.04|16.76|13.64|12.50|

a/Measured as a percentage of the reference case.

b/1989 USS billion; Mexico's GDP was 207 billion in 1989.

Instantaneous liberalization leads to very large efficiency gains. The PDV of these gains is US$ 42.4 billion. With a growth-adjusted discount rate of about 3%A , these efficiency gains translate into US$ 1.22 billion of 1/ We assume a (risk-adjusted) world real interest rate of 7%, and long term rates of technical progress and population growth such that steady-state growth is 4X. The growth-adjusted discount rate thus is 2.91 (-(1.07/1.041)*100), implying a growth-adjusted discount factor of 0.972.
13 additional consumption per annum, or 0.6% of 1989 GDP. This is a very significant number for gains from removing taxes and subsidies to only two commodites: maize and tortillas. The efficiency gains of gradual liberalization are less, at US$ 40.1 billion, but actually not by very much. Distributing the adjustment over a five year period reduces the net discounted value of the efficiency gains by only 5.5%. Thus the efficiency costs of a more gradual approach do not seem large when compared to the benefits that maize liberalization eventually leads to.

But the aggregate efficiency gains have substantial distributional effects. To understand how different groups are affected by the policy change, first look at what happens to the prices of the factors of production. The more straightforward one is labor. As Figure 1 shows, <!-- Start of picture text --> Rural Product Wages<br>i1.16.A<br>1.4 _ /<br>06 AK<br>1024_<br>X OS _ *<br>Yews.<br>I_Y.___ CM______ to__<br><!-- End of picture text --> Figure 1 rural product wages are adversely affected by the cut in maize prices. While maize is less labor-intensive than fruits and vegetables, it is more labor-intensive than all other activities in agriculture, hence rural product wages fall once maize prices go down.

Table 2 shows the discounted value of all current and future rental income for both types of land. Column 1 indicates that the value of rain-fed land drops by almost 251 under immediate liberalization, clearly a very significant capital loss. This is because most maize is grown in rain-fed lands, where substitution possibilities towards other crops are much more limited than on irrigated land. The value of irrigated land actually goes up.
14 Because both substitution possibilities and labor-intensity are higher in irrigated lands, the positive effect of lower rural product wages offsets the negative impact of lower maize prices.

|Table<br>2: L|and Values<br>end Lan<br>Rain-fed<br>Land|d-Holdingsl<br>Irrigated<br>Land|Land-holdings<br>of<br>Subsistence and<br>Rain-fed<br>**farmers**|Land-holdings<br>of<br>Irrigated farmers|
|---|---|---|---|---|
|Base Case|12.065|40.169|12.065|40.169|
|Case 1: 0 year adjustment, no CNA Program|9.231|40.800|9.231|40.800|
|Case Z: 5 year adjustment, no CNA program|9.443|40.725|9.443|40.725|
|Case 3: 0 year adjustment, with CNA program|9.180|40.668|11.499|40.668|
|case4:5 year adjustment, with CNA program|9.390|40.597|11.703|40.597|
|case5:5 year adjustment, with CIA program,<br>acceass to US F&V market|9.608|42.175|12.030|42.175|
|case 6:as 5. but maize price cuts take last 6<br>years & start**one**year after CIA program|9.726|42.137|12.141|42.137|
|a/million pesos of 1989 per hect.are.|||||

Contrasting the fall in land values with the reduction in rural product wages, it is clear that a larger part of the adjustment falls on land. The reason for this is that labor is more mobile than land. Labor can be reallocated within agriculture towards other crops with much more ease than rain-fed land, and in addition some of the impact on labor is shifted to urban workers through rural-to-urban migration.

Figure 2 shows the migration response. Note first that under the reference case migration is substantial. Long-term productivity trends do not favor agriculture, particularly not rain-fed agriculture. This, together with the exhaustion of land on the extensive margin, makes it clear that even with current maize policies future migration will be substantial. The model predicts a cumulative migration of almost 1.2 million workers over the next decade. Such large migration suggests that maize protection as a rural
15 <!-- Start of picture text --> CU( ULATIVE MIGRATgON<br>2<br>to. ,become<br>I4<br>1 l.2 - r _<br>{0°5 / /<br>00.4<br>0.2<br>0r<br>Yews<br><!-- End of picture text --> employment policy is likely to fail increasingly or, alternatively, much more expensive than it already is.

Immediate liberalization has a large impact on migration, adding 700,00 workers in a single year (F4 ire 2). Gradual liberalization Figure 2 also increases migration over the reference case, but does so at a slower pace. However, after the adjustment is over, the cumulative amount of migration is the same. Table 1 shows what these factor price developments imply for households' welfare. Rural landless workers lose out as rural wage rates fall. But their welfare drops less in percentage terms than rural product wages do, because they are also consumers of maize and profit from lower maize prices. As Figure 3 shows, the drop in the rural consumption wage is less than the fall in the rural product wage.

<!-- Start of picture text --> Consumption & Product Wages<br>__________<br>wIl2 . >m<br>O .. ; i 7<br>~ W<br>0-in-W. sr. no CNGWI S, oCl<br><!-- End of picture text --> Figure 3 Subsistence farmers own rain-fed land and hire out as day laborers to other farmers; they are thus doubly hit as both the value of their land drops by 25X, and their labor income declines in line with the drop in rural wages (though they also benefit from lower consumer prices). The situation is more
16 complex for rain-fed and irrigated farmers. They both lose because of lower maize prices, but they gain because of lower rural wages (since they are both net users of labor). These two factors are capitalized in land prices, and the balance is clear from table 2: rain-fed farmers lose substantially, while irrigated farmers experience a small gain. Note that under gradual liberalization values of rain-fed land fall less than under immediate, since protection-induced rents can be reaped for five additional years.

Figure 4 illustrates how this affects rain-fed farmers. The shaded area measures the differences in utility between immediate ('cold turkey') and gradual liberalization. The gradual path gives them additional rents during the transition (although at declining rates), but it produces no further gain once the transition is over.

<!-- Start of picture text --> Cold Turkey vs Gradualism<br>UVility of Rain4ed Farmers<br>4.2<br>4.15 -<br>4.'<br>4.0_<br>54<br>3.9<br>3.8<br>OM___ Y___w_CNA<br>| ~~-O _ Y, no CNA -- S Yrs. mFo4A<br><!-- End of picture text -->

Figure 4 Migration slows the drop in rural wages at the cost of increased pressure on urban wages. Figure 5 shows that despite lower consumer prices for maize, urban worker's real consumption wages fall relative to the base case. And with I the marginal product of capital <!-- Start of picture text --> Urban Consumption Wages<br>(no adlustment progrs)<br>)-.116- odownward<br>1.4<br>§1.I2 f w<br>0108 ^~<br>jo.os . . 4 . . . . . .<br>Yes<br>[~ 1 Y. noOL C@ 5SYrs .o nelA|<br><!-- End of picture text -->

Figure 5
17 increasing as a result of higher urban employment, capitalists are better off.

To sum up: the efficiency gains of liberalization in the absence of adjustment policies are substantial, but unevenly distributed. Immediate liberalization produces larger gains, but gradualism is not very costly; the aggregate efficiency gains foregone during the five year transition are small. But the converse of this is that gradualism barely mitigates the welfare loss for the groups affected. Of course, prolonging the liberalization over more than five years further insulates the groups concerned from welfare losses, but also further reduces the aggregate efficiency gains. The issue is tnerefore not only how fast to liberalize, but also what measures are taken during the transition to transfer some of the efficiency gains to the groups most affected by it. How this can be done is the subject of the next section.

# 4. What TvDe of Trade Adjustment?

The inclusion of Mexican agriculture into the FTA is a permanent change. A poverty-minded adjustment program for such a change should therefore have two objectives: first, transfer income to those among the poor that are adversely affected. Second, facilitate their finding alternative sources of income. The major problem in the design of such a program is that the first objective usually conflicts with the second.<sup>21</sup> A program designed to help maize producers would provide incentives to increase, or at least maintain, maize production, because benefits would decrease with lower output; such a program would discourage farmers from searching for alternative activities. Moreover, if the benefits are significant, the program would also provide incentives for rent-seeking and .2/ cf Diamond (1982) for this point.
18 graft; the number of 'registered' maize producers would soon exceed the rural population. This is particularly important in Mexico, where administrative capacity is weak, as are records of farm size and output. But, more fundamentally, a program focused on transfering income to maize producers fails to alter underlying conditions in agriculture. For the adjustment program to be transitory, it must increase the productivity of the factors owned by the groups affected by the policy change, so that after the program ends these groups do not need further assistance. Section 3 indicates that in Mexico's case this translates into programs that can increase land values and stimulate the permanent demand for rural labor.

Table 2 indicates that at free trade prices the average rental rate on irrigated land is four times that of rain-fed land. Thus a program of investments in land improvements has a substantial potential for increasing land productivity.i0/ Such a program is particularly promising because private irrigation investment has been discouraged by land tenure problems and explicit regulation, while public investment has been curtailed for budgetary reasons. W As a consequence, the return on such a program is likely to be high.

A public investment program focused on land improvements generates transitory demand for rural labor. By supporting the rural wage rate during the construction period it eases the transition towards free trade for landless rural workers and subsistence farmers; and by slowing down migration 1Q/ We refer to a program of 'land improvements' to emphasize that it involves not only irrigation infrastructure, but also investments in drainage, land levelling, ditch-clearing, etc.

_I/_ See Sanchez Ugarte (1991) for a description of water's regulatory regime in Mexico.
19 it helps insulate urban workers from<sup>the policy change. And because irrigated</sup> land is about 2.4 times more labor-intensive<sup>than rain-fed (at the free trade</sup> crop composition), the program stimulates<sup>the permanent demand for rural</sup> labor. Thus, once the program is finished<sup>it continues to provide employment</sup> opportunities in the rural areas.

But the program also helps to increase<sup>the value of the land owned by</sup> subsistence and rain-fed farmers.<sup>As some of their land is improved with</sup> irrigation and drainage, the capital<sup>loss suffered due to removal of</sup> protection is reduced. This in turn<sup>restores the value of their main</sup> collateral and enhances their access<sup>to credit. In addition, transforming land</sup> from rain-fed to irrigated lowers<sup>risks faced by farmers and augments crop</sup> choice. This facilitates a permanent<sup>adjustment away from maize cultivation.</sup> Simulations three and four explore<sup>such a program. In both simulations</sup> we assume that a total of 1.1 million<sup>hectares of land are transformed from</sup> rain-fed to irrigation, with investments<sup>beginning in the second year and</sup> lasting a total of five years!V;<sup>in simulation three maize and tortilla</sup> prices are liberalized immediately, while simulation four assumes a<sup>pari-passu</sup> five year adjustment path for price<sup>liberalization</sup> and irrigation investments.

Table 1 shows that the efficiency<sup>gains of maize liberalization</sup> accompanied by irrigation investments<sup>are over 20% higher than in the absence</sup> of irrigation (with slightly larger<sup>gains when liberalization is immediate).</sup> Moreover, the efficiency gains<sup>when gradual liberalization is accompanied by</sup> the irrigation program exceed<sup>by almost 17% the gains from immediate</sup> _12/_ The program is assumed to irrigate 0.25 million hectares in<sup>each of the</sup> first three years, 0.20 in the<sup>fourth and 0.15 in the fifth. This program is</sup> feasible given Mexico's previous<sup>experience in this area. We refer to the</sup> program as the 'CNA program' because<sup>it would be implemented by the Comision</sup> Nacional del Agua, Mexico's agency<sup>in charge of irrigation construction.</sup>
20 liberalization without adjustment program. Clearly, the potential gains from irrigation investments are large. This increased efficiency has two sources: one, the four-to-one difference in the level of productivity of irrigated vs. rain-fed land. Two, an increase in the average rate of technical change in agriculture: technical change is faster in irrigated land, and the program increases the share of total arable land that is irrigated.

Equally interesting are the distributive effects of the program. Column 4 of table 1 indicates that the two groups directly dependent on the value of rain-fed land are both better off when gradual liberalization is accompanied by the irrigation program. The reason for this is shown in table 2: although land prices are almost the same as in simulations 1 and 2 (the differences resulting from different behavior of wage rates), the value of the land holdings of these two groups is almost restored to the pre-liberalization levels, as now these groups hold a mix of rain-fed and irrigated land.

Figure 6 shows that rural wage <!-- Start of picture text --> Rural Consumption Wages<br>1 ._<br>Yew.<br>-5 , no C4A5Yre. -- c-further A<br><!-- End of picture text --> rates are also higher when liberalization is accompanied by the irrigation program, generating benefits for landless rural workers and subsistence farmers and, by slowing migration, for urban workers as well. As a consequence, Figure 6 the welfare of landless rural workers and urban workers is almost restored to the protection level (cf. table 1). The converse of this tightening in the labor market is reflected in urban
21 capitalists and irrigated farmers' welfare, which is correspondingly diminished (though still higher than under protection).

Figure 7 depicts the time-path of utility for rain-fed farmers for **4.2** Utility Rain-Fed Farmers the five year liberalization paths 401 **4.05** with and without the CNA program. 3 With the CNA program rain-fed farmers **3.85** - are initially worse-off, reflecting **3.8** i i 3 S **8 89** the interaction between the rural **Fo** labor market and the gestation period Figure 7 of irrigation investments. For them, the initial impact of the CNA program is a tightening of the rural labor market, with negative implications for second-period utility. It is only after the third year, when the irrigation works come on stream, that the benefits of land improvements out-weigh the costs of higher rural wages. And though their welfare is higher than on the reference path, it takes five years for current-period utility to be higher. This interaction between the path of price declines on the one hand, and the timing of irrigation investments, on the other, determines when the different groups receive the benefits of the adjustment program. All this is masked by the discounted value of utility, but such timing issues can be very important for the political economy aspects of the reform (cf the next section).

The scenarios presented so far have ignored any change in US protection towards Mexico's export crops. Simulation five considers a scenario where the gradual liberalization of the Mexican maize market is accompanied by a gradual liberalization over the same five year period of the US market for fruit &
22 vegetables, the sector with<sup>the most significant agricultural trade barriers</sup> in the USL3/. We assume that<sup>this simultaneous trade liberalization is</sup> accompanied by the same five<sup>year CNA program considered before.</sup> Consider first the distributional<sup>effects of improved market access.</sup> to the US fruit & vegetable market.<sup>This policy combination generates a Pareto</sup> improvement vis-a-vis the<sup>reference case: the welfare of all households is at</sup> least equal to the protection<sup>situation, and for some there is a gain.</sup> <!-- Start of picture text --> 2 CUMULATIVE MIGRATION<br>-. / ,,^<br>1.2<br>02 <. . . . .<br>0.4.<br>o 1 _ 2 s 3 * S 6 7 8 S<br>_I__ _C__ _ 5_Y. _V__ __Y__ X _ IA<br>Figure 8<br><!-- End of picture text --> Because fruits and vegetables<sup>is the</sup> most labor-intensive crop,<sup>aprice</sup> increase shifts out the demand<sup>for</sup> rural labor, which translates<sup>into</sup> higher rural wages, reduced<sup>migration</sup> (Figure 8), and higher<sup>urban wages.</sup> Thus, the opening of the US market has a positive distributional<sup>effect</sup> via higher wage rates. By reducing labor displacement, it facilitates<sup>the transition towards free trade in maize.</sup> Irrigated farmers are more<sup>than compensated for the higher rural wages</sup> by higher prices for fruits<sup>& vegetables: their welfare increases (table 1).</sup> But rain-fed farmers profit<sup>little from improved export prices for fruits and</sup> vegetables, but must pay higher<sup>wages; thus, they constitute the only group in</sup> the rural areas who do<sup>not benefit directly from a comprehensive FTA.</sup> J3/ These barriers are equivalent<sup>to a 20X tariff (Feenstra and Rose (1991)).</sup> But because the sector labelled<sup>here 'fuits and vegetables' includes other</sup> crops (cf the data appendix)<sup>the tariff is scaled back to 5%. Thus prices</sup> faced by Mexican fruit<sup>and vegetable exporters increase by 1% during each of</sup> the five years of adjustment,<sup>and then stay constant at the higher level.</sup>
23 Next, consider the effects of the US liberalization on aggregate efficiency. Table 1 shows that the ag;regate efficiency gains in simulation five are slightly lower than in four, which has the same path for maize<sup>prices</sup> and irrigation investments. This seemingly paradoxical result<sup>fol,ows from</sup> second-best effects. Because of the urban-rural<sup>wage differential, re-</sup> allocating labor from rural to urban areas gives, ceteris paribus, efficiency gains. By slowing down migrdtion, the gradual liberalization of<sup>the US market</sup> diminishes the size of the gains from labor re-allocation into urban<sup>areas.</sup> Consider next the fiscal impact <!-- Start of picture text --> FISCAL COSTS MAIZE & RR. INTERVENTIONS<br>* 2<br>Is<br>0.5- . . . .<br>1 2 3 7 a s<br>IA - ft,. W<br><!-- End of picture text --> of the adjustment program. We focus on the trade-off between fiscal 25 savings from the reduction in maize and tortilla subsidies vs. the fiscal cost of the CNA irrigation program. Figure 9 plots the fiscal impact of maize and tortilla subsidies: (i) the cost of maize production subsidies, Figure 9 (ii) the revenue from tortilla taxes, (iii) the cost of the tortivale program; and, for simulations 3 and 4, (iv) the cost of irrigation investments>/.

On the reference path the fiscal costs of maize interventions actually decline through time. This is because tortilla consumption,<sup>which under</sup> current policies is taxed, grows faster than subsidized maize<sup>production.</sup> When irrigation investments are undertaken, the fiscal position initially deteriorates, but then improves after the fifth or<sup>sixth year. With gradual</sup> 14/ Investment costs reflect the time-profile<sup>of the CNA program and the</sup> increased marginal costs of irrigating lower<sup>quality lands. The last 150,000</sup> hectares are, on average, 49% more expensive<sup>than the first 250,000.</sup>
24 liberalization, this deterioration is initially quite sharp, because only small savings are made each year on the costs of maize interventions. With immediate liberalization, the savings from maize interventions actually dominate the costs of irrigation investments in the first year, and the fiscal costs over the next four years are smaller than in the case of gradual liberalization. After the sixth year, when the irrigation program is complete, both alternatives generate lower costs than current policiesL51.

Table 1 indicates the net fiscal impact of each alternative: the net present value of the fiscal surplus in simulation three (four) is 3.5% (3.2%) higher than on the reference path. Current maize policies cost more than the adjustment programs proposed to ease the transition to free trade.

# 5. On the Pace of Adiustment

Much of the economic literature, and in fact Mexico's own experience, argues for fast-paced reforms. But in this case several points argue for a more gradual approach. First, the impact of speed of reform on labor markets and migration. As shown in figure 2, if maize prices are liberalized instantaneously, around 700,000 workers are predictei to move almost straight away. This implies a migration of between 1 and 5 million people (average family size in rural areas is 7). This would put demands on urban infrastructure and labor markets that would be almost impossible to meet. A more gradual reform leads to the same migration, but spreads it out over most of the coming decade, buying time to set up the infrastructure and training facilities needed to accommodate such a large group of migrants.

DJ The fiscal costs of intervention do not fall to zero because the costs of the tortivale program still have to be covered (though the tortivale program is cheaper because of the lower producer price of maize).
25 The second problem stems from the pblitical dimensions of such a large reform effort. A reform that inflicts substantial losses on particular groups in society may be more difficult to implement, even if the majority benefits. In section 4 we argued that a program focused on improving currently rain-fed land by irrigation and other productivity enhancements intervenes at the right margin; it makes subsistence and rain-fed farmers better off since the value of their land holdings recovers, and also benefits landless rural workers through the labor market impact. But to fully restore land values to preliberalization levels requires at least five years, because of technical and engineering constraints on construction. Immediate liberalization of maize, even if accompanied by the irrigation program, would therefore still impose substantial transitory losses: cf Figure 10 for the case of rain-fed farmers.

A gradual phasing-out of maize price supports mitigates this <!-- Start of picture text --> UtiAdltyn Assisan-e & Timing<br>4.2<br>4.15<br>t4.05 T /<br>3 1 2 _ 3 _ 4 __5. 5 6 7 S<br>Yews<br>s Y. CNA +I - 51rv DAM<br><!-- End of picture text --> problem, although a relative decline (compared to the base case) is difficult to avoid for this group. But note that an absolute drop in utility is avoided if the CNA program is accompanied by gradual phasing-out of maize price supports.

Figure 10

# A final argument concerns

period-to-period losses. The rural poor have little access to capital markets to help them smooth consumption. Many live in extreme poverty, and may have higher discount rates than assumed here, as survival is at stake. This implies that initial losses, even if the net change in discounted welfare is
26 positive at the discount rate used here, may<sup>be particularly costly. But if</sup> the adjustment program was suchi that at no Roint during the transition utility was less than on the reference path, the reforms<sup>would not hurt the rural poor</sup> for any discount rate. The government can then<sup>argue that they are being made</sup> better-off, or at least not losing out, without<sup>asking them to wait five years</sup> before benefits materialize. Because it is administratively<sup>impossible for</sup> the government to reach the rural poor directly,<sup>and because gradualism may</sup> avoid initial losses, this too calls for gradualism<sup>as a second best solution.</sup> Simulation 6 explores these issues. We consider<sup>the same liberalization</sup> of the US market for fruits & vegetables and the same<sup>irrigation program, but</sup> assume that the liberalization of maize and tortilla prices<sup>is spread over</sup> six years. Further, we assume that the change<sup>in maize and tortilla prices</sup> begins one-year after the irrigation program starts.<sup>This 'irrigation first'</sup> scenario could be interpreted as a signal from thu government<sup>to farmers of</sup> its intentions to help them adjust to free trade in maize:<sup>the government</sup> invests in productivity improvements before any sacrifice is asked for. This policy insures that all households see their welfare increase vis-a vis the reference path though this comes at an efficiency cost. But this cost is not very large: total efficiency gains are only 4X smaller than the case where maize prices move pari-passu with the irrigation program.

<!-- Start of picture text --> Utility Subsistence Farmers (froction of bas case)<br>1.02<br>1.01c<br>s°/<br>0.995<br>O.S9 . . . . . .<br>Yew<br>- V. raw Y. A<br><!-- End of picture text --> Figure 11
27 <!-- Start of picture text -->
1.005- Utility Rural Workers<br>t.004 r<br>t 002 /<br>1.002<br>lat.001<br>0.989<br>0.998<br>0.997<br>1 2 4 S 6 893 9<br>Yews<br>|0-- Sm -a-- T. CYNA. F&V - 6 Y. C,A arty. F&<br>Figure______________________12________<br><!-- End of picture text -->

**Figure** 12

The pay-off to this efficiency cost is shown in Figure 11 and Figure 12: landless rural workers and subsistence farmers are better off at every point in time than under protection. And because spreading the maize pricing over a longer horizon also slows down migration, urban workers also have higher utility at each point in time. Thus, if price reforms and<sup>adjustment programs</sup> are timed carefully, incorxoratine maize into the FTA can strengthen poverty alleviation efforts.

Consider now farmers on rainfed lands. Despite the timing changes in the irrigation and liberalization program, their utility is still less than the reference<sup>case</sup> for three years (Figure 13). As discussed, the CNA program tightens the rural labor market. And while <!-- Start of picture text --> Utility Rain-fed Farmers<br>4.22<br>4.2<br>4.10<br>4.12<br>408 2 i S 6 7 8 9<br>T<br><!-- End of picture text --> Figure 13 higher rural wages improve initial utility of subsistence farmers and landless workers, they also raise wage costs for rain-fed farmers. Thus, because the government can only<sup>help the</sup> first two groups via higher rural wages, it cannot simultaneously<sup>help rain-</sup>
28 fed farmers in the initial phase of the reforms. This may call for other instruments to provide transitory support to this group (see below).

Figure 14 shows the fiscal impact of these timing changes. Initially fiscal expenditures increase substantially because there are no savings from reduced maize subsidies while outlays for irrigation are made. But though it <!-- Start of picture text --> FISCAL COSTS MAIZE & [RR. INTERVENTIONS<br>4.s (Timing Issues)<br>4<br>2.5<br>os '_ _ _<br>Yews<br>|ct ct S os- Cs S. Y,. r FtV 6 t. CI4 ea. Fb<br><!-- End of picture text -->

takes 5 years for the fiscal costs of Figure 14 interventions to fall below those under protection, table 1 shows that in present value terms this policy is still cheaper than continuing protection forever. The fiscal issue associated with the adjustment program is thus not one of overall costs, but one of transitory financing.

But to label an issue as 'transitory' is not to dismiss it as irrelevant. Fiscal authorities will want to insure that if resources are commited to irrigation investments, maize prices will indeed be freed; adding the costs of irrigation investments to the costs of maize policies would put an undue burden on the fiscal accounts. At the same time, policy makers in charge of agriculture will want to insure that if maize prices are freed, the resources required for irrigation investments will indeed be there; liberalizing agriculture in the absence of resources for adjustment would put an undue strain on the welfare of large numbers of the rural population. Thus the reform process needs a 'commitment technology' to insure that its two components -maize liberalization and the irrigation program- are carried out.
29 Signing maize price liberalization as part of the FTA solves the first half of the commitment problem. But the second half still needs attention because there are legal impediments to multi-year commitments of fiscal expenditures in Mexico. What guarantees do the rural groups potentially affected by maize liberalization have that the irrigation program will be completed once the FTA negotiations are finished, even if the government 'moves first' with its irrigation investment? What is optimal for the government to promise now may well not be optimal for it to deliver once the FTA has been signed.

The need for transitory financing for the adjustment program provides part of the solution. In particular, a multilateral organization could provide financing during the adjustment process to the FTA. Since the overall fiscal gains are positive in discounted value terms, the loan can be paid back out of the savings made later in time. If such financing is made contingent, not on the price reforms being carried out, but on the irrigation programs promised, it would become expensive to renege. The credibility of the program is then increased by increasing the costs of failing to follow it through.

Recall also that liberalization reduces the value of the main collateral owned by subsistence and rain-fed farmers. These farmers will have better access to credit only if commercial banks are certain that the land improvements that will raise the value of the land available for collateral will indeed incur. A program of public credit guarantees could insure farmers access to credit. But, equally important in our context, by committing itself through credit guarantees, the government not only signals its intent to implement the adjustment program, but also makes it more costly for itself to not implement it: after all, not following through on the irrigation program
30 would reduce the value of the<sup>collateral for loans that carry a public</sup> guarantee. Again, increasing the<sup>expected cost of the guarantee scheme makes</sup> reneging on promises to implement<sup>the CNA program less attractive.</sup>

# 6. Conclusions

Empirical evidence and theoretical<sup>analysis overwhelmingly support the</sup> view that liberalizing international<sup>trade leads to efficiency gains. Recent</sup> forays in the economics of imperfect<sup>competition have created some question</sup> marks by bringing in rent-shifting<sup>and second best aspects, but have not led</sup> to any strong presumption against<sup>this claim (Krugman and Helpman (1989)).</sup> This paper fits the mold by<sup>demonstrating that the efficiency gains from</sup> liberalizing agricultural trade<sup>between the US and Mexico are quite large.</sup> But if the gains are so large,<sup>why has agriculture turned out to be so</sup> hard to open up? Our analysis<sup>raises points that are likely to feature in any</sup> satisfactory answer to this question.<sup>We show, in a realistic analysis of the</sup> consequences of including agriculture<sup>in the currently-negotiated</sup> FTA between Mexico and the US, how efficiency<sup>gains fail to filter through to important</sup> groups in society. In particular<sup>we show that in the absence of adjustment</sup> measures all benefits accrue to<sup>the richer groups in both rural and urban</sup> areas. These effects are dramatically<sup>brought out early in the reform process</sup> by being capitalized in land values.<sup>This is surely a factor in the</sup> resistance by farmers against easing<sup>protection of agriculture.)M</sup> Standard trade theory counters<sup>these arguments by pointing out that</sup> aggregate efficiency gains imply that<sup>winners can compensate losers and still</sup> 16/ Krugman (1982) also links<sup>resistance to trade liberalization to factor</sup> price effects.
31 be better off themselves. This paper starts from the premise that instruments to effect such lump-sum transfers are not available. Compensatinns could also occur, although imperfectly, through indirect taxes and subsidies (Dixit and Norman (1980)), but this would require a degree of differentiation in the tax structure that would itself trigger substantial administrative and incentive problems. In more realistic circumstances specific adjustment programs have to be designed to accompany a major trade reform.

Liberalizing maize in Mexico in the context of a permanent change like the FTA creates two incentive problems. First, it clearly hurts maize growers. But compensating farmers pro rata to their maize production would create an incentive to continue maize production, the opposite of what the reform is designed to achieve to begin with. Second, liberalizing maize has a substantial impact on rural labor markets and migration. Rural employment programs could be used to mitigate large labor dislocations and transfer income to workers. But such a program raises a key issue: how to get out of it as time goes by. If in current circumstances the Government feels compelled to assist, those affected have every incentive not to adjust so as not to lose the transfers by changing the incentive structure the Government itself faces (Tornell (1991)). Temporary adjustment programs need built in incentives for change.

We point out that to avoid these incentive problems adjustment programs should focus not on offsetting the income loss associated with past activities, since that provides an incentive to continue them; instead they should focus on improving the productivity of the assets owned by the groups harmed by the reforms. This solves both incentive problems; by not linking the program to past activities, there is no incentive to continue them; and
32 once the assets of those affected are more productive, other opportunities will be easier to find, reducing pressure on the Government to help out.

This paper argues the need for such a program in the context of opening up Mexican agriculture, and designs one along the lines sketched before.. In the specific circumstances of Mexican agriculture, this translates into investments that increase the productivity of rain-fed land via irrigation and other land improvements. We find that a program that transforms about 8X of the total stock of rain-fed land to irrigated restores the value of the landholdings of those affected by the liberalization. This restores the collateral value of land, and thus enhance subsistence and rain-fed farmers' access to credit precisely at the time when credit is most needed. In addition, the program helps owners of labor by generating rural employment during the construction period. More fundamentally, it increases the long term demand for rural labor because irrigated land is substantially more labor-intensive than rain-fed. Thus, the program provides workers with alternatives once it ends; its transitory nature is thus credible.

Improving the value of assets people own is like an investment program and thus takes time. In contexts where capital markets are imperfect those affected may not be able to borrow against the value of future assets to smooth consumption overtime. This is particularly important if those affected are, as in Mexico's case, amongst the poorest groups in society. We therefore argue for a gradual pace of reform. We first compute the efficiency gains of trade reforms under different liberalization speeds, and find that gradualism is not too costly: spreading the liberalization over a five year period lowers the present discounted value of the efficiency gains by only 5-6X. We next show that careful timing of both the liberalization and the adjustment program
33 implies that the rural poor have always higher utility along the adjustment path than under the protection path.

Embedding trade liberalization in a Free Trade Agreements is a form of commitment technology to the reform process; thus arguments for 'cold turkey' reforms on the grounds that this is the best form to show commitment to the reforms are less compelling in this case. But there is a different commitment problem, created by the time delays inherent in adjustment programs. How can the potential beneficiaries of adjustment programs be assured that those programs will be implemented once the trade liberalizations have been negotiated in the FTh? We argue that gradualism also contributes to solve this time-consistency problem. Because gradualism gives time to implement the productivity-enhancing programs, the beneficiaries do not have to give anything up before the benefits start coming in. Support by external organizations contingent on the adjustment programs can help in solving such commitment problems.

We hope the principles outlined in this paper for the design of adjustment programs will contribute to find efficient solutions to. similar transitional problems. The analysis also suggests, however, that application of these principles requires careful analysis of the specifics of each case, and of the mechanisms through which the different groups are affected. There may be general principles, but there are unlikely to be rigid rules applicable to each and every reform program.

# References

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Diamond, P. (1982), "Protection, Trade Adjustment Assistance and Income
34 Distribution", in Bhagwati, opp.cit.

- Dixit, A.K. & Norman V. (1980) Theory of International<sup>Trade, Cambridge</sup> University Press: London.

- Feenstra, R. & Rose, A. (1991) "Trade with Mexico<sup>and Water Use in California</sup> Agriculture," miieo, University of California, Davis.

- Garcia y Griego (1989) "The Mexican Labor Supply,<sup>1990-2010," in Mexican</sup> Migration to the United States: Origins. Conseauences<sup>and Policy</sup> ORtions, edited by W. Cornelius, University of California:<sup>San Diego.</sup>

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- Krugman, P. (1982), "Trade in Differentiated<sup>Products and the Political</sup> Economy of Trade Liberalization", in Bhagwati,<sup>opp.cit.</sup>

- Levy, S. and van Wijnbergen, S. (1991)<sup>"Maize and the Mexico-United States</sup> Free Trade Agreement," forthcoming, El Trimestre<sup>Economico.</sup>

- Sanchez Ugarte, F. (1991) "La Utilizacion Eficiente<sup>del Agua y los Derechos de</sup> Propiedad," in El Efecto de la Regulacion en Algunos Sectores<sup>de la</sup> Economia Mexicana, Gil Diaz, F. & Fernandez,<sup>A. eds., Fondo de Cultura</sup> Economica: Mexico City.

- Tornell, A. (1991), "Time Inconsistency of Protectionist<sup>Programs", Ouarterly</sup> Journal of Economics, Vol. CVI, pp.963-975.