Agricultural Impacts of a North American Free Trade Agreement 1

Transcription

1 Agricultural Impacts of a North American Free Trade Agreement 1 by P. Lynn Kennedy and Karol W. Hughes 2 1 The research presented here was supported by a USDA grant through the Center for North American Studies and by the Louisiana Agricultural Experiment Station. This article has been approved for publication by the Louisiana Agricultural Experiment Station as publication number ###. 2 P. Lynn Kennedy is an Assistant Professor and Karol W. Hughes is a Research Associate in the Department of Agricultural Economics and Agribusiness, Louisiana Agricultural Experiment Station, Louisiana State University Agricultural Center, Baton Rouge, Louisiana.

2 Baton Rouge, Louisiana

3 Agricultural Impacts of a North American Free Trade Agreement Abstract: Agricultural trade liberalization between the three NAFTA countries is modeled using a game theoretic framework. The model distinguishes between Canada, Mexico, the United States, and a politically passive restof-the-world. Through the use of intra-country compensation, a non-cooperative game shows that the countries do not achieve an agreement. With inter-country compensation, the cooperative game analysis shows that Canada is able to convince Mexico and the United States to join a North American Customs Union. The paper also reviews the gains and losses to various sectors as the result of free trade in North America. (Key words: NAFTA; agriculture; game theory) Introduction The discussions leading up to the passage of the North American Free Trade Agreement were filled with controversy as to NAFTA s effect on the three signatories. Opinions as to the implications of NAFTA ranged from Ross Perot s criticism that the agreement would result in a giant sucking sound as U.S. jobs move to Mexico, to views that NAFTA would serve as a catalyst for economic prosperity in North America (Racz, 1993). Regardless of this debate, the impact on domestic prices resulting from the removal of trade barriers between Canada, Mexico, and the United States will have welfare consequences throughout the economies of the three countries. Given the levels of agricultural protection prior to NAFTA, it is clear that the agreement will influence agricultural trade in North America (Barichello et al., 1991 and Grennes et al., 1991). With this liberalization comes both gains and losses to various segments of the agricultural sector. These changes in sectoral welfare, in turn, influence individual countries willingness to sign and honor the agreement. The objectives of this research are: 1) to analyze the stability of an agricultural North American Free Trade Agreement; and, 2) to quantify its welfare effects through the simulation of a North American customs union. To accomplish these objectives, a political preference 1

4 function (PPF) will be utilized within both a non-cooperative and cooperative game framework. This research will identify the Nash equilibrium solution to the non-cooperative game. These results will then be used as the basis for a cooperative game employing intercountry compensation to achieve a solution that is Pareto superior to that of the noncooperative game. The paper proceeds in the following manner. First, a theoretical framework is presented that identifies the political preference function. This section also defines Nash equilibria and the treaty action space. Next, the empirical analysis introduces the noncooperative and cooperative games employed and presents their outcomes. This is followed by a presentation of various price, quantity, and welfare indicators that result from the implementation of an agricultural customs union between Canada, Mexico and the United States. Finally, the paper concludes by discussing several implications of this research. Theoretical Framework This analysis employs a multi-commodity model of agriculture. In the model, N commodities are produced, consumed, and traded by K main countries and the rest of the world. Vectors of supply, demand, and excess demand describe the levels of aggregate production, consumption and trade for each country. The supply sector in country k produces some combination of the N commodities in order to maximize profits given prices, technology and endowments. Aggregate production of the N commodities is described by the vector of supply functions, S ( P ; X ), where P is the vector of prices observed by the k sk sk Sk supply sector and X is a vector of exogenous variables, such as technology, input prices, and Sk endowments for the supply sector of country k. Aggregate consumption of the N 2

5 commodities is described by the vector of demand functions Q ( P ; X ), where P is the k Qk Qk Qk vector of prices observed by the final demand sector and X is a vector of exogenous Qk variables for country k. The aggregate level of trade in the N commodities for country k is described by the vector of excess demand functions M ( P, P ; X, X ) where M > 0 indicates net imports and M < 0 indicates net exports k Sk Qk Sk Qk ki ki of commodity i for i = 1, 2,..., N. Governments intervene in domestic markets through either the use of price ( ) or supply/demand shift ( ) instruments. Price instruments, denoted as A for producers and Ski A for consumers in country k of commodity i, affect the prices observed by the supply and Qki final demand sectors. With the world price of commodity i represented as P the domestic Wi price functions for country k are: 1. P = P ( A, P ) and P = P ( A, P ), for i = 1, 2,..., N. Ski Ski Ski Wi Qki Qki Qki Wi Supply/demand shift instruments, shown as A Ski and A Qki for producers and consumers of commodity i in country k, are implicit elements of vectors X Sk and X Qk which shift supply and demand functions by modifying non-price elements of the producers or consumers decision process. Supply/demand shift instruments include policies such as area reduction programs, subsidization schemes, and food stamp/giveaway programs. In order to make these instruments explicit the vectors X Sk and X Qk are defined as follows, X Sk = X Sk ( A Ski ; X Sk ) and X Qk = X Qk ( A Qki ; X Qk ) 0 0 where X and X signify exogenous non-policy variables. Sk Qk Throughout the process of agricultural policy formulation, the welfare effects of various actions are taken into account by the government. Policy-makers behave as though 3

6 they are using a weighting system to compare the gains and losses of various groups. The product of a weight and a money metric welfare measure (e.g., consumer and producer surplus) is assumed to reveal the relative influence of a group s ability to transfer policy support to itself. This concept is referred to as a political preference function (PPF). The PPF used in this analysis is a weighted, additive function of money metric welfare measures for various societal groups. It is the objective function which, through their policy choices, policy-makers behave as though they seek to maximize. This measure is used by Gardner (1991) in analyzing income redistribution in agriculture. In addition, agricultural economists have estimated political preference functions in order to examine policy effects among various agricultural groups (Rausser and Freebairn, 1986). It is assumed that competition among groups for political influence and the desire of the political process to appease these groups gives rise to an equilibrium where the gradients of the PPF with regard to policy instruments are zero. Based on this assumption, the weights are estimated empirically at the point where the gradients are zero for the observed level of 3 policy instruments. Let producer quasi-rents ( k ), consumer utility (U ), and the government k budget (B ) be shown as functions of government policies using the following expressions, k 3. ( A, A ), k k k+ 4. U ( A, A ), and k k k+ 5. B ( A, A ). k k k+ The budget weight is normalized to one and the PPF, as a function of government policies, is shown as: 3 A more complete discussion of this process is found in Kennedy et al.,

7 6. V ( A, A ) = ( A, A ) + U ( A, A ) + B ( A, A ) k k k+ k k k+ Sk k k k+ Qk k k k+ where Sk is a strictly positive N 1 vector which represents the relative political weights of the producer groups in country k and Qk is a strictly positive scalar representing the relative political weight of the consumer group in country k. In modeling the policy decision process of interdependent countries, a Nash equilibrium occurs where each country chooses policy that maximizes its PPF given the policy choice of the other countries. This equilibrium is defined using a best response * correspondence. For a given A k+, government k chooses A k, one possible best response to A, such that k+ * 7. V k ( A k, A k+ ) V k ( A k, A k+ ), for all A k A k, where A is the set of all possible actions, which can be employed by government k. Every k * A k+ element of A k+ has at least one A k element of A k that is a best response for country k. A * * * * Nash equilibrium is defined as the set of actions (A k, A k+ ) where A k is a best response to Ak+ * * for country k, and A k+ is a best response to A k for the other countries k+. Differentiating equation 6 with respect to A Sk and A Qk, the first order necessary conditions for a maximum are +, +, +, +, +, * V k * * k U k * * * * B k * * * * ))))* * )))))))) * * * * )))) * * 0 * Sk * A * * A A * * * * A * * * Sk Sk Sk Sk 8. * * = * * * * + * * = * * * V * * U * * * * B * * * k k k k * ))))* * )))))))) * * * * )))) * * 0 * Qk * A * * A A * * * * A * * * Qk Qk Qk Qk * Under the assumption that V k is concave in A k given A k+, any A k which solves 5

8 * * * equation 8 maximizes V k. Thus, by definition, A k is a best response to A k+. (A k, A k+ ) is a Nash equilibrium if 6

9 +, +, * V k * * * * ))))* * 0 * * A * * * Sk 9. * * = * * * V k * * * * ))))* * 0 * * * * A Qk * *(A k, A k+ ) * * In the situation where the three main countries negotiate with one another, no agreement will be reached or kept unless all countries are made at least as well off as they were prior to the agreement. A necessary condition for a treaty is that there exist at least one pair of actions ** ** ( A k, A k+ ) satisfying ** ** * * 10. V k (A k, A k+ ) V k (A k, A k+ ) for all k. ** ** Actions (A k, A k+ ) satisfying equation 10 are called treaty actions. The treaty action space is the set of all treaty actions. In order to achieve an agreement in which all countries are made at least as well off as prior to negotiations, the settlement must lie within the treaty action space. Empirical Analysis The empirical analysis is conducted using 1990 as the base year. Eight commodity groups are distinguished: beef; corn; dairy; pork; rice; soybeans; sugar; and wheat. The PPF weights for the United States, Canada, and Mexico are derived through the evaluation of incremental changes in the observed policies from their base year levels. This is 4 accomplished using Modèl Internationale Simplifié de Simulation (MISS) based on For a more detailed description of the MISS model, see Kennedy (1995). 7

10 quantity data (USDA, 1996) and price data (USDA, 1994), and utilizing previously estimated elasticities (Gardiner, 1989). These changes are then used as approximations of the partial derivatives in Table 1. Political Preference Function Weights United States Canada Mexico rank weight rank weight rank weight Beef Corn Dairy Pork Rice Soy Sugar Wheat Consumer Budget equation 8. When equation 8 is solved for Sk and Qk, the PPF weights are obtained. These approximated weights, normalized such that the budget weight is one, are presented in Table 1. Non-Cooperative Game The first segment of the analysis employs a two-player, normal-form, non-cooperative game, defined by G = { A, A, A ; P, P, P }. Each country k chooses some 1 US CA MX US CA MX action A k A in order to maximize its PPF given the action of the other countries. The k policy strategies analyzed are liberalization which simulate the formation of a customs union among the NAFTA countries. To accomplish this, a common protection level is used that maintains the overall protection level versus the rest of the world. These games utilize the action space A = {SQ, CU } for k = US, CA, MX. Each country k has action choices which are: k k k 8

11 retaining the status quo (SQ k); and, joining an agricultural customs union (CU k). In this game, the political preference functions, P, P, and P, reflect changes in producer welfare, US CA MX consumer welfare, and budget savings resulting from policy changes. In these simulations, each government is allowed to provide compensation from budget savings to those sectors of their economy made worse off due to the policy liberalization. The rules used for budget compensation specify that only those sectors of the economy that undergo a decrease in welfare as a result of the policy change receive compensation. Budget compensation given to a sector cannot exceed the amount of that sector s welfare loss. Because the weight of budget savings in the political payoff function is one, a sector must have a PPF weight greater than one in order to receive compensation. Budget compensation is given in descending order of welfare weights. Finally, total budget compensation cannot exceed total budget savings. The search for solutions to games of this type employs the iterative elimination of dominated strategies (Kreps, 1990). For example, as presented in Table 2, this noncooperative game shows Canadian payoffs resulting from its choice of joining the customs union ( 0; 386; 243; 398 ) greater than or equal to its payoffs under status quo ( 0; 0; 0; 5 ). Thus, solutions in which Canada retains the status quo are not feasible solutions. Since the Canadian Table 2. Three-Player, Non-Cooperative Game Between the U.S., Canada, and Mexico. Mexico -- Status Quo Mexico -- Customs Union SQ CU SQ CU US US US US

12 SQCA 0 0 SQCA CUCA CUCA The numbers presented in each group are in million U.S. dollars and represent change in the Political Preference Functions for the United States, Canada, and Mexico, respectively. The Nash equilibrium, shown in bold, occurs at {SQ ;CU ;SQ }. US CA MX 10

13 status quo has been eliminated as a strategy, Mexico compares its payoffs under the status quo ( 0; 1 ) and joining the customs union ( -560; -86 ) and eliminates its strictly dominated customs union strategy. This simplifies the U.S. choice to retaining the status quo ( 0 ) or joining the customs union ( -86 ). As a result, no customs union is formed since Canada is the only country willing to join. The base solution to this non-cooperative game is presented in Table 2. The highlighted set of numbers signifies the Nash equilibrium game solution. Cooperative Game The second stage of the analysis employs a two-player, normal-form, cooperative game, defined by G = {A, A, A ; P, P, P }. Just as in the non-cooperative 2 US CA MX US CA MX game, each country k chooses some action A k A in order to maximize its PPF given the k action of the others. This game utilizes the action space A = { SQ, CU } for k = CA, MX, k k k US as defined previously. The political preference functions in this game, P, P, and P, CA MX US incorporate the provision of inter-country compensatory payments to reach an agreement that is Pareto superior to the non-cooperative game solution. Inter-country compensation is used to represent concessions made in the negotiating process. Using the non-cooperative game solution as a starting point, the cooperative game is simulated using the same compensation criteria as in the non-cooperative game, with one exception. Each country is allowed to give budget compensation to the others provided it is not made worse off than in the non-cooperative solution. Inter-country compensation, when required, is given up to the point where the compensating country s PPF declines below, or the compensated country s PPF increases to, non-cooperative solution levels, whichever 11

14 comes first. No country will agree to a treaty that makes it worse off than the non-cooperative game solution. The use of treaties allows countries to develop policy commitments that result in Pareto superior solutions. Although the game defined here involves monetary compensation to encourage others to join the customs union, a cooperative agreement might involve the mutual removal of trade obstacles in different sectors. For example, Canada might lower barriers to U.S. manufacturing exports in exchange for a United States reduction in agricultural protection. Similarly, concessions to Mexico might involve some type of development assistance. As shown earlier, the solution to the non-cooperative game resulted in the status quo, i.e., no change in the countries PPFs. As a result, a potential cooperative solution must be Pareto superior to the Nash equilibrium. Such a solution is presented in Table 3. By providing compensation to the other two countries from its budget savings, Canada is able to create a solution where each of the countries is better off than at the status quo. As a result, a customs union involving all three countries is the Pareto optimal solution. Table 3. Three-Player, Cooperative Game Between the U.S., Canada, and Mexico. Mexico -- Status Quo Mexico -- Customs Union SQUS CUUS SQUS CUUS SQCA 0 0 SQCA CUCA CUCA

15 The numbers presented in each group are in million U.S. dollars and represent change in the Political Preference Functions for the United States, Canada, and Mexico, respectively. The cooperative game solution, shown in bold, occurs at {CU ;CU ;CU }. US CA MX 13

16 Agricultural Impacts of a North American Customs Union The implementation of a North American Customs Union will have consequences for agricultural producers and consumers in each of the three countries. Not surprisingly, producers with high protection levels, relative to those in other countries, during the base period will be worse off due to the resulting customs union protection levels, while those with relatively low initial protection levels will benefit. This section will provide selected indicators which result from the formation of the customs union. These include: changes in producer and consumer prices; changes in production and consumption; and, changes in welfare. Changes in domestic prices resulting from the customs union are presented in Table 4. The formation of this union, when viewed from a price perspective, will hurt United States beef, rice, and sugar producers, Canadian beef, dairy, soybean, and wheat producers, and Mexican corn, pork, soybean, and wheat producers. From a consumer perspective: United States consumers will pay more for everything with the exception of beef; Canadian consumers pay more for everything with the exception of beef, dairy products, and wheat; and, Mexican Table 4: Changes in Domestic Prices Resulting from a North American Free Trade Agreement Producer Prices Consumer Prices U.S. Canada Mexico U.S. Canada Mexico Beef Corn Dairy Pork Rice

17 Soybeans Sugar Wheat

18 consumers pay less for everything except beef and dairy products. The changes in production and consumption, presented in Table 5, are consistent with those expected as a result of the price changes, with a few exceptions. An increase in the U.S. wheat producer and consumer prices results in a decrease in wheat production and an increase in wheat consumption, while an increase in the Mexican consumer price of rice results in a decrease in rice consumption. These instances are likely due to the cross-price elasticity effects, perhaps with respect to corn. Changes in producer welfare, as presented in Table 6, are also consistent with those expected based on the change in prices. The only exception occurs in the case of Canadian beef. It is interesting to note that, overall, the U.S. consumer is worse off due to the new trade environment, while Canadian and Mexican consumers gain. As a result of adjusting policies to join this customs union, Table 6 shows that the Canadian government experiences budget savings, while the United States and Mexico suffer budget losses. This facilitates the cooperative game solution, resulting from Canada providing compensation to Mexico and the United States. Table 5: Percentage Changes in Production and Consumption Resulting from a North American Free Trade Agreement Production Consumption U.S. Canada Mexico U.S. Canada Mexico Beef Corn Dairy Pork Rice Soybeans Sugar

19 Wheat

20 Table 6. Change in Welfare for Various Sectors Resulting from a North American Free Trade Agreement. United States Canada Mexico Beef Corn Dairy Pork Rice Soybeans Sugar Wheat Consumer Budget Social Gain Government Objective Conclusion NAFTA will influence the agricultural trade environment in Canada, Mexico, and the United States as various policies that distort trade between the three countries are phased out over the coming decades. This analysis has quantified the gains and losses to various agricultural sectors as a result of the formation of a customs union by the NAFTA participants. Although this analysis does not mirror the actual agreement, it gives an indication as to the effects of free trade among these nations. The results are particularly useful when compared to the actual North American Free Trade Agreement. For the most part, sectors shown to be harmed as a result of these policies have received special attention within the agreement. In light of the significant losses shown to occur in the Canadian dairy sector, it is interesting to note that dairy trade was not addressed by CUSTA (Normile and Goodloe, 1988), nor was a dairy agreement reached between Canada and Mexico under NAFTA (USDA, 1993). 18

21 A comparison of the non-cooperative and cooperative game between Canada, Mexico and the U.S. provides several implications for policy-makers. First, the solution to the noncooperative game implies that, if inter-country compensation is infeasible, it is not in the best interest of these countries to form a customs union based on agriculture alone. Second, the solution to the cooperative game indicates that it may be in the best interest of the countries to cooperate and form a union if agriculture is part of the bigger picture and compensation can be provided from budget savings or by way of concessions in other areas. Clearly, the existence of a solution to the cooperative game that is Pareto superior to the non-cooperative Nash equilibrium shows that it is in the best interest of these countries to cooperate. The inclusion of sectors other than agriculture, such as manufacturing and services, in an agreement of this type give countries an increased number of options for achieving solutions that increase the welfare of all countries involved. Bibliography Barichello, R.R., L. Bivings, C. Carter, T. Josling, P. Lindsey, and A. McCalla, The Implications of a North American Free Trade Area for Agriculture. International Agricultural Trade Research Consortium, Commissioned Paper No. 10, November Gardiner, W. H., V.O. Roningen, and K. Liu, Elasticities in the Trade Liberalization Database. United States Department of Agriculture, Economic Research Service. Staff Report No. AGES 89-20, May Gardner, B.L.. Redistribution of Income through Commodity and Resource Policies. In R.E. Just and N. Bockstael (eds.), Commodity and Resource Policies in Agricultural Systems. Berlin: Springer-Verlag, Grennes, T., J. H. Estrada, B. Krissoff, J. M. Gardea, J. Sharples, and C. Valdes, An Analysis of a United States-Canada-Mexico Free Trade Agreement. International Agricultural Trade Research Consortium, Commissioned Paper No. 10, November

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23 Kennedy, P.L., Game Theory in Multilateral Trade Negotiations: An Application to the Uruguay Round. Agrarökonomisch Monographien und Sammelwerke. Kiel: Wissenschafts-Verlag Vauk Kiel KG, Kennedy, P.L., H. von Witzke, and T.L. Roe, Strategic Agricultural Trade Policy Interdependence and the Exchange Rate: A Game Theoretic Analysis. Public Choice. 88(1996): Kreps, D., Game Theory and Economic Modelling. New York: Oxford University Press, Normile, M.A. and C.A. Goodloe. U.S.-Canadian Agricultural Trade Issues: Implications for the Bilateral Trade Agreement. United States Department of Agriculture, Economic Research Service, Staff Report No. AGES March Racz, G.N., Perot Tells Senate Panel NAFTA Pact Will Cost Americans Three Million Jobs. The Wall Street Journal. April 23, 1993: A7. Rausser, G.C. and J. Freebairn, Estimation of Policy Preference Functions: An Application to U.S. Beef Import Quotas. Review of Economics and Statistics. 56(1986): United States Department of Agriculture, Economic Research Service. Estimates of Producer and Consumer Subsidy Equivalents: Government Intervention in Agriculture, Statistical Bulletin No December United States Department of Agriculture, Economic Research Service. Production, Supply and Distribution View Database. Electronic Data Set. Washington, D.C., United States Department of Agriculture, Foreign Agriculture Service. North American Free Trade Agreement, Chapter Seven, Section II, Appendix A, Paragraph 5. Document on Internet