Trade creation and trade diversion in

the Canada – United States

Free Trade Agreement
Kimberly A. Clausing Department of Economics, Reed College

Abstract. In this paper the changes in trade patterns introduced by the Canada-United States
Free Trade Agreement are examined. Variation in the extent of tariff liberalization under the
agreement is used to identify the impact of tariff liberalization on the growth of trade both
with member countries and non-member countries. Data at the commodity level are used,
and the results indicate that the Canada-United States Free Trade Agreement had substantial
trade creation effects, with little evidence of trade diversion. JEL Classification: F13, F14

Création de commerce et diversion de commerce dans l’Accord de libre-échange Canada-

U.S. Ce mémoire examine les changements dans les patterns de commerce international
engendrés par l’Accord de libre-échange entre la Canada et les Etats-Unis. La variation dans
l’intensité de libéralisation tarifaire selon les secteurs dans l’Accord est utilisée pour iden-
tifier l’impact de la libéralisation tarifaire sur la croissance du commerce à la fois entre les
pays membres et avec les pays non-membres. A l’aide de données par produits, on montre
que l’Accord a eu des effets substantiels de création de commerce mais qu’il n’y a pas lieu
de croire qu’il y a eu beaucoup de diversion de commerce.

1. Introduction

Preferential trading arrangements are reshaping the world trading system. An incom-
plete inventory of recent initiatives includes proposals to extend NAFTA to Chile,
to create a Free Trade Area of the Americas, to continue the expansion of the Euro-
pean Union to other European countries, and to establish free trade among the
APEC nations. These initiatives, as well as many others throughout the world, have

This work has been supported in part by a National Science Foundation Graduate Fellowship.
I am grateful to the referees of this paper for constructive comments that greatly improved the
paper. In addition, I would like to thank James Hines, John Helliwell, Richard Caves, Donald
Davis, Daniel Trefler, Janet Ceglowski, and participants at seminars at Harvard University, the
University of Toronto, and the Federal Reserve Board of Governors for helpful comments on an
earlier version. Email: clausing@reed.edu

Canadian Journal of Economics 0 Revue canadienne d’Economique, Vol. 34, No. 3

August 0 août 2001. Printed in Canada 0 Imprimé au Canada

0008-4085 0 01 0 677–696 0 r Canadian Economics Association

678 K.A. Clausing

led to a fierce debate about the merits of regional trading agreements. While some
have heralded such agreements as stepping stones towards worldwide free trade,
others fear that these initiatives will be stumbling blocks, acting primarily to divert
trade from other countries to those countries receiving preferential treatment.
Although these issues are essential for the future of the world’s trading relation-
ships, a number of obstacles have prevented economists from reaching any con-
sensus on the effects of preferential trading agreements. The second-best nature of
tariff liberalizations under preferential trading arrangements makes it very difficult
to assess a priori whether the welfare effects from a preferential trading arrange-
ment will be positive, even for the members of the arrangement. In addition, the
empirical work has failed to reach firm conclusions on even the most basic issue
regarding preferential trading agreements: whether trade creation outweighs trade
diversion.
In this paper I attempt to better isolate the effects of a preferential trading agree-
ment, by analysing the Canada-United States Free Trade Agreement ~CUSFTA!.
The CUSFTA provides a valuable natural policy experiment, since policy makers
committed themselves to eliminate tariffs on all goods, creating variation in the
degree of tariff liberalization because of the substantial variation in the initial,
predetermined, tariff rates. This variation is used to identify the impact of tariff
liberalization on the growth of trade with both member countries and non-member
countries. Unlike the approaches of many previous studies of preferential trading
agreements that have relied on aggregate data, disaggregate data ~at the commodity
level! are used to analyze how actual tariff changes affect trade flows. Without
utilizing the variation in the extent of liberalization across goods, it would be far
more difficult to distinguish the effects of an agreement from other influences affect-
ing trade flows.
In this paper I find that the CUSFTA did have very noticeable effects on trade
flows between Canada and the United States. There is substantial evidence of
increased trade due to the agreement, particularly for those goods undergoing the
largest tariff liberalizations. Further, the data do not reveal the evidence one would
expect were trade diversion widespread.
In the next section I review the previous work in this area. In section 3 I examine
the theoretical framework for the hypotheses tested in this paper. The data are pre-
sented in section 4, and issues of specification are discussed. In section 5 I discuss
the main results, which are qualified in section 6. Section 7 concludes.

2. The effects of preferential trading agreements

2.1. Previous theoretical and empirical work

Before Viner, analysts often assumed that a customs union would be welfare improv-
ing, since some tariffs would fall and tariffs are, in general, welfare reducing. In
1950 Jacob Viner showed that a customs union will not necessarily improve wel-
fare, since the tariff reductions occur in a world of second best. Whether or not the
 Trade creation and trade diversion 679

increase in trade caused by the formation of a customs union would be welfare

improving depends on the source of the increased trade. Trade creation occurs
when the lowering of tariffs allows partner country imports to replace high-cost
domestic production; this improves welfare. Trade diversion, on the other hand,
occurs when the removal of tariffs causes trade to be diverted from a third country
to the partner country despite the fact that, were the countries treated equally, the
third country would be the low cost source of imports. In the Vinerian framework,
welfare therefore depends on the extent of trade creation relative to trade diversion.
Viner’s analysis illustrates the main result regarding the welfare effects of cus-
toms unions and free trade areas: no general statement can be made about the
welfare effects of preferential trading agreements. Whether or not the partner coun-
tries, much less the world, will gain depends on the assumptions laid out in the
model and the circumstances of the particular agreement. Further, the authors respon-
sible for this literature disagree on what is likely to happen in practice. Some authors,
such as Krugman ~1991, 1994!, believe that preferential arrangements between
natural trading partners are likely to be positive developments. Others, such as
Bhagwati ~1994!, fear that preferential trading arrangements may lead to trade diver-
sion as the international mechanisms to discipline trade diversion, such as article
XXIV of the GATT, are too weak.
Empirical researchers have also had difficulty reaching firm conclusions regard-
ing the effects of preferential trading agreements. In particular, past studies have
been unable to convincingly disentangle the effects of preferential trading agree-
ments from other effects occurring simultaneously. These studies generally fall into
one of three categories.

2.1.1. Ex post studies examining the share of intra-agreement trade

Many authors ~including Krueger 1999; Brada 1994; Cline 1978; de la Torre and
Kelly 1992; Drysdale and Garnaut 1993; Robertson 1970; Saxonhouse 1994b! have
examined trade shares before and after an agreement in order to assess what effect
the agreement may have had on trade patterns. It is often implicitly assumed that
the share of trade occurring with partner countries would not have changed in the
absence of the agreement. A more sophisticated counterfactual is necessary, how-
ever, in order to assess the effect of an agreement and the extent of trade creation
relative to trade diversion.

2.1.2. Ex post studies with more elaborate counterfactuals

Developing an accurate counterfactual of how much trade would have increased in
the absence of a given free trade agreement or customs union has proved difficult.1

1 For instance, Balassa ~1967, 1975! constructed a counterfactual of how trade would have changed
in the absence of European integration by calculating pre-integration income elasticities that then
were assumed to continue post-integration. It was later demonstrated, however, that income elas-
ticities varied substantially pre- and post-integration, making these results sensitive to the sample
period.
680 K.A. Clausing

Some ~including Frankel and Wei 1995; Frankel and Kahler 1993; Frankel 1997;
Krueger 1999; Aitken 1973; Aitken and Obutelewicz 1976; George et al. 1977;
Willmore 1976! have used gravity equations to assess the impact of preferential
arrangements on trade flows. These equations have the advantage of including sev-
eral variables that are affecting trade flows, such as income changes and exchange
rate variables. A dummy variable is typically used to assess the impact of various
preferential trading agreements on trade flows.
Still, there are problems with the gravity equation approach. First, the dummy
variables used to distinguish the effects of preferential trading agreements are blunt
instruments that have difficulty capturing only the effects of preferential trade lib-
eralization.2 Second, this type of analysis does not indicate the extent of trade
creation relative to trade diversion.3 Third, these studies examine trade flows at a
very aggregate level. Since these studies are therefore unable to exploit variations
in the extent of trade liberalization across goods or industries, it is more difficult to
distinguish the effects of liberalization from other influences that are acting on
trade flows.4

2.1.3. Ex ante studies of trade agreements

In addition to the ex post studies above, there have been a large number of ex ante
CGE studies that examine what effects can be expected from preferential trading
arrangements ~e.g., Brown, Deardorff, and Stern 1992; Brown and Stern 1989a,b;
Haaland and Norman 1992!. One flaw of CGE studies is that their results are very
sensitive to the assumptions, parameters, and data used in the model, and have to be
interpreted accordingly. While CGE models are useful for speculating what the
effects of a particular agreement might be, they do not allow an investigation of the
questions we are concerned with here.

2.2. Work on the Canada – United States Free Trade Agreement

Since CUSFTA went into effect in 1989, authors of several studies have considered
the effects of the agreement, including Statistics Canada ~1993!, Schwanen ~1997!,

2 One difficulty is that such dummy variables may also capture other effects that are difficult to
distinguish from preferential trade liberalization. For instance, Frankel and Wei ~1995! use a grav-
ity equation to estimate the effects of European integration. They find that the only years that the
EC dummy is statistically significant and positive are 1985 and ~perhaps! 1990. Since the trade
liberalization that occurred within the EC does not particularly coincide with the years in which
this dummy variable is larger, the dummy variable may be indicating that trade within the EC is
becoming more ‘regionalized.’ This need not imply, however, that trade creation has occurred
because of preferential liberalization.
3 If, for example, the coefficient on a dummy variable for partner trade is statistically significant
and positive, this does not tell us whether the excess trade among member countries was a result
of trade creation or trade diversion.
4 As Frankel ~1997, 93! notes, ‘some effects of regional trading agreements are lost in tests like
ours on highly aggregated data. The problem is particularly severe in a context, such as the
Canada-US FTA, where the small number of observations in the case of aggregated data is a
constraint. But Clausing’s finding that the effects differ widely @depending on the extent of liberal-
ization# . . . also illustrates the deeper perils of aggregation.’
 Trade creation and trade diversion 681

Thompson ~1994!, Helliwell, Lee, and Messinger ~1998!, Gaston and Trefler ~1997!,
and Head and Ries ~1999!. The question of this paper is not systematically addressed
in any of these papers, but they do provide insights into the effects of CUSFTA.
Statistics Canada ~1993! provides an overview of the changes in trade patterns
during the early years of the agreement, between 1989 and 1991. Schwanen ~1997!
undertakes a comprehensive study of changes in Canadian trade patterns, consid-
ering the effects of both CUSFTA and NAFTA between 1989 and 1995. Schwanen
compares trade in sectors that have been liberalized by these agreements to trade in
other sectors, finding that trade growth with the United States was much faster in
liberalized sectors.5 Helliwell, Lee, and Messinger ~1998! consider the effect of
CUSFTA on trade between Canadian provinces, using both aggregate data and data
at the industry level ~67 industries included!. They find that CUSFTA increased
international ~province-state! trade, while trade between the Canadian provinces
decreased.
Head and Ries ~1999! analyse a panel of 230 Canadian manufacturing indus-
tries, examining the impact of trade liberalization on efficiency and scale. Head and
Ries find that during the years following CUSFTA the Canadian manufacturing
sector experienced substantial rationalization. Rationalization is defined as a decline
in the number of plants accompanied by an increase in output per plant. Gaston and
Trefler ~1997! address the labour market effects of CUSFTA, trying to account for
the employment contraction in Canada during 1989–93. Although Gaston and Tre-
fler find that the net employment effects of the CUSFTA are negative, they estimate
that tariff cuts under CUSFTA account for no more than 15 per cent of the Canadian
job losses.

3. The theory of trade creation and trade diversion

The unilateral removal of a tariff generally increases imports of the good in ques-
tion, increasing domestic consumption and reducing domestic production. The gains
to consumers outweigh the loss of tariff revenue and producer surplus, leading to
overall welfare gains. As Viner pointed out, however, the analysis is more complex
if the tariff is only reduced on partner imports. An examination of figure 1 makes
this ambiguity clearer.
Figure 1 shows an analysis of a good in Canada that is initially protected by a
tariff. Imports are equal to the quantity AB, the difference between domestic demand
and domestic supply at the tariff-inclusive price. Consider, first, the case where S
U.S. is the U.S. supply curve. U.S. suppliers are not competitive prior to liberaliza-

5 Sectors are classified either as liberalized or as not liberalized and then are compared. This does
not allow a consideration of the extent of liberalization or of disaggregate data, such as those
employed in this study. Trade diversion is not explicitly considered, although data on trade with
the rest of the world are also provided. Nonetheless, Schwanen ~1997! addresses many important
effects of CUSFTA and NAFTA, including not only trade effects but also investment and employ-
ment effects.
682 K.A. Clausing

FIGURE 1 Trade creation and trade diversion

tion. Once the tariff is eliminated on U.S. goods, imports from the United States
replace those from the rest of the world. Since the U.S. duty-free price is lower than
the tariff-inclusive world price, demand increases and Canadian domestic produc-
tion is reduced. New imports are higher, at quantity CD. Domestic consumers gain
areas FGHI, domestic producers lose area F, tariff revenue falls by HL, and the
overall welfare effects are ambiguous. Trade creation leads to a gain of GI, but trade
diversion leads to a loss of L, as the U.S. imports replace lower cost ROW imports.
In practice, there are several cases when the outcome would be less ambiguous.
For example, if the United States were already the low cost producer before the
FTA, trade creation would result in welfare gains equal to areas GIKM, without any
trade diversion losses. If U.S. supply were instead uncompetitive before the tariff
reduction, however, and just epsilon less than the ROW tariff inclusive supply after
the FTA, only trade diversion would take place, with a loss in tariff revenue of HL
but no noticeable gains.6,7
The CUSFTA lowered tariffs on thousands of goods, so the aggregate effect will
depend on the extent of trade creation and diversion in many different markets.
Further, there may be a host of other more indirect effects as changes in one market

6 With upward-sloping supply curves for the partner country or the world, the same ambiguities
hold. One can construct examples with only trade creation, only trade diversion, or intermediate
cases.
7 Some authors, such as Kowalczyk ~2000!, Harrison, Rutherford, and Wooton ~1993!, and Ethier
and Horn ~1984!, have criticized the literature’s excessive reliance on the notions of trade creation
and trade diversion and have suggested alternatives. Kowalczyk, for example, develops a general
equilibrium model that instead considers volume of trade and terms of trade effects. This model,
while presenting the economic effects differently, raises many of the same questions. In general,
while the alternative frameworks have merits, none has gained widespread acceptance.
 Trade creation and trade diversion 683

affect others. Nonetheless, this simple framework prompts two essential areas of
enquiry to consider as we examine data on how trade patterns changed in the years
following CUSFTA.
First, to what extent did trade between Canada and the United States increase as
a result of tariff liberalization within the agreement? What is the magnitude of trade
response to tariff reductions? The graphical analysis above predicts that larger tariff
reductions should lead to greater increases in trade with the partner country. Is that
pattern observed in the data?
Second, to the extent that trade did increase, how much of this increase was a
result of trade diversion? In particular, do imports from the rest of the world fall
more ~or increase less! for trade that was more highly liberalized between partners?
Are the same goods that are experiencing disproportionate gains in trade with the
partner country experiencing disproportionately slower growth in trade with the
rest of the world?

4. Data and methodology

4.1. The data

If one considers the most commonly used methods for studying the effects of trade
agreements on trade, it is difficult to parse out any effects of the Canada-United
States Free Trade Agreement. For example, many ex post analyses of trade agree-
ments have focused on how the share of trade between members has changed in the
wake of the agreement. Here, though, trade shares are not particularly instructive.8
In addition, a gravity equation analysis of U.S. and Canadian trade flows fails to
discern an effect of the agreement.9

8 Figures showing trade shares are available upon request. The share of exports and imports occur-
ring with the partner country ~the United States or Canada! does not increase in most cases, and
when it does ~the share of Canadian exports destined for the United States!, it is highly correlated
with the simultaneous depreciation of the Canadian dollar vis-à-vis the U.S. dollar. Still, there are
several difficulties with using simple trade shares, as noted in the text above. Further, even more
sophisticated measures of trade bias ~such as those discussed in Drysdale 1988, 86–8! lead to
ambiguous conclusions regarding the effects of CUSFTA on trade flows. Tables of these calcula-
tions are available upon request.
9 An appendix of tables containing the gravity equation analysis is available upon request. The
typical gravity equation specification is estimated with dummy variables included to capture the
effects of CUSFTA. The specification is: ln ~Tradeij ! 5 a 1 b1 ln~GDPi * GDPj ! 1 b2 ln ~GDPper
capitai * GDPper capitaj ! 1 b3 ln~distance ij ! 1 b4 ln~Ex.Rate ij ! 1 b5 Z. All tested approaches fail
to find effects of the Canada – United States Free Trade Agreement on trade flows. In the first
approach, a dummy variable is included for the partner country ~Canada or the United States! in
all years, as well as a separate dummy variable for the years following the agreement. The latter
variable is never statistically significant. The second approach includes dummy variables for the
partner country for each year following the agreement. These yearly dummy variables are also not
statistically significant. A third approach estimated regressions on subsets of data before and after
the agreement. A dummy for partner trade was included in each in an attempt to discern differ-
ences before and after the agreement. In all cases, the 95 per cent confidence interval for the value
of the partner dummy coefficient in these regressions substantially overlapped, implying that one
can not distinguish a difference in excess trade between the two countries before and after the
agreement.
684 K.A. Clausing

TABLE 1
Summary statistics, disaggregate United States import data

Number of
Mean SDev Observations

Imports from Canada 12,100 179,000 50,240

~thousands of U.S.$!
ROW imports 50,400 523,000 50,240
~thousands of U.S.$!
Candian tariff rate 3.5 5.1 40,429
Rest of world tariff rate 5.8 16.2 49,528
Change in Canadian tariff rate 0.5 2.6 30,660

U.S. data is for the years 1989–94. Rest of world ~ROW! imports are imports from all
countries except Canada. The tariff rate is the duties paid relative to the total value of
imports for a given commodity in a given year. The change in the tariff rate is the
percentage point decrease in a given commodity’s tariff in a given year. Data are from
the U.S. Census, reported in Feenstra ~1996!.

However, aggregate data could mask changes that may be occurring at a disag-
gregate level. A large percentage of trade between Canada and the United States
was free before the agreement, and it could be the case that the most liberalized
trade flows were too small to be picked up by the aggregate analysis. Also, the use
of more disaggregate data allows one to exploit the variation in the extent of tariff
liberalization under the agreement. Without utilizing such variation, it is difficult to
identify the effects of tariff liberalization.
Data exist from the U.S. Census ~reported in Feenstra ~1996!! that describe imports
and exports broken down by commodity and country, according to the Harmonized
Classification system. This system was adopted by Canada in 1988 and the United
States in 1989, and the tariff liberalizations taking place within the CUSFTA were
also scheduled according to the Harmonized system. This analysis uses the harmo-
nized data, covering the period 1989 to 1994 for the United States. Import values
are provided in the data, and tariff rates are calculated as the duties collected rela-
tive to the total value of trade in a given category. Tariff liberalization under the
agreement began in 1989. While some tariffs were eliminated immediately, tariffs
were typically brought down in equal increments over five or ten years.
The Harmonized Classification System, in its fullest detail, separates trade into
over 8,000 ten-digit categories. Table 1 shows summary statistics for the data set.
There is a substantial variation in the level of initial protection as well as the degree
of tariff liberalization. For U.S. imports from Canada, table 2 shows the percentage
of commodities in different categories of tariff protection, both by the number of
observations and by the amount of trade. Even at the onset of the agreement in
1989, a large percentage of imports were freely traded. Still, there are many obser-
vations where tariffs are high. By 1994 Canadian imports are subject to much lower
tariffs than they were previously.
 Trade creation and trade diversion 685

TABLE 2
The pattern of protection in 1989 and 1994 ~for U.S. imports from Canada!

1989 1994

Per cent Per cent Per cent Per cent

of obs. of imports of obs. of imports

Free trade 22.3 62.6 26.7 62.7

Tariffs under 5 per cent 45.0 33.8 60.0 36.6
Tariffs between 5 and 10 per cent 20.8 3.1 9.3 0.6
Tariffs between 10 & 25 per cent 10.2 0.5 3.7 0.1
Tariffs over 25 per cent 1.6 0.0 0.2 0.0

Table 3 shows the same information for U.S. imports from countries other than
Canada. As one can see from this table, in both 1989 and 1994 there is a substantial
amount of trade in the United States that is covered by significant tariff barriers.

4.2. Specification
In order to assess the effects of the tariff liberalization measures within CUSFTA,
this analysis focuses on the two main questions raised at the end of section 3:

1. To what extent did trade between Canada and the United States increase as a
result of tariff liberalization within the agreement?
2. To the extent that trade did increase, how much of this increase was a result of
trade diversion?

By examining how the growth of trade between the two countries depends on the
extent of tariff liberalization, one can assess how much trade between the two coun-
tries increased as a result of the agreement. To assess the extent of trade diversion,
it is necessary to assume that tariff rates are distributed across goods in a manner
that is independent of the natural rate of import growth. In section 6, the implica-
tions of removing this assumption will be discussed in greater detail.
The specification of the regression equations emerges from a simple supply and
demand framework. Take the case of linear-in-logs import demand and export sup-
ply curves. In particular, import demand schedules for various goods ~indexed by i !
take the form:

ln Di 5 g d 1 dpd ln Pi 1 dzd Z. ~1!

dpd is negative, so that a higher price implies a lower import demand; Z are various
terms that vary over time, such as real exchange rates and income. Export supply
schedules are

ln Si 5 g s 1 dps ln Pi 1 dzs Z. ~2!

686 K.A. Clausing

TABLE 3
The pattern of protection in 1989 and 1994 ~for U.S. imports from countries other than Canada!

1989 1994

Per cent Per cent Per cent Per cent

of obs. of imports of obs. of imports

Free trade 15.8 13.7 16.4 22.2

Tariffs under 5 per cent 42.4 64.1 44.6 57.8
Tariffs between 5 and 10 per cent 25.1 13.9 23.5 12.9
Tariffs between 10 & 25 per cent 14.5 6.3 13.9 6.0
Tariffs over 25 per cent 2.1 1.9 1.5 1.1

Here dps is positive, so that export supply increases with higher prices. The market-
determined price generates an equilibrium level of trade where import demand and
export supply are equal. Changes in the equilibrium level of trade will result from
factors that change prices ~P ! or factors that vary over time ~Z!, such as national
income.
Tariffs drive a wedge between the import demand curve and the export supply
curve, acting to increase the prices paid by consumers of imports while reducing
the prices received by producers of exports. With an ad valorem tariff, the price
becomes Pi ~1 1 Ti !, and the import demand function is

ln Di 5 g d 1 dpd ln~Pi ! 1 dpd ln~1 1 Ti ! 1 dzd Z. ~3!

Setting the supply and the tariff-inclusive demand functions equal, one can find an
equation determining the equilibrium price, which in turn can be employed to find
the quantity traded in the presence of tariffs. The quantity transacted depends on
both the tariff level, T, and time-specific factors, Z.
ln Di 5 Constant Term 1 B ln~1 1 Ti ! 1 CZ. ~4!

Here, B is a term that depends on the price elasticities of import demand and export
supply, dpd dps 0~dps 2 dpd !. This term is negative as long as dpd is negative and dps is
positive; C also depends on these elasticities, as well as dzd and dzs. As tariffs are
eliminated, holding other factors constant, trade increases. The change in trade over
a given time period is given by
ln Di, t 2 ln Di, t21 5 B~ln~1 1 Ti, t ! 2 ln~1 1 Ti, t21 !! 1 C~Z i, t 2 Z i, t21 !. ~5!

When tariffs are zero, the free trade level of trade occurs; as tariffs are higher,
trade decreases, eventually falling to zero at the prohibitive tariff level. As tariffs
are reduced between Canada and the United States, prices change so that the new
values of import demand and export supply are equal. The resulting change in trade
can be estimated by the following simple equation:
 Trade creation and trade diversion 687

%DImportsit 5 a 1 b1 DTariffit 1 bT Year Effects. ~6!

This is the first estimating equation.10 Tariff changes are observed. Year effects
~dummy variables for all but one year! are included to control for circumstances
that vary over time, such as exchange rates, cyclical factors, and so on. One option
would be to include each of these variables directly. Owing to the limited time
dimension of the panel, however, I have employed time-specific dummy variables
instead.
An additional variable that may affect the responsiveness of imports to tariff
changes is also considered: the share of imports that originated in Canada prior to
the liberalization. Recall from figure 1 that the degree of trade creation due to tariff
liberalization will depend on the prior competitiveness of the partner country. For
example, if Canada is already the most competitive source of imports, tariff reduc-
tions on Canadian goods will likely lead to trade creation. On the other hand, if
Canada is not competitive prior to liberalization, it is possible it may not be com-
petitive after liberalization, and imports may not increase as a result. For instance,
free trade on U.S. coffee or mango imports coming from Canada is unlikely to lead
to increases in U.S. imports of these goods from Canada. Thus, in some specifica-
tions below, I also include a variable indicating the original market share of Canada
in the total U.S. imports of commodity i.11

%DImportsit 5 a 1 b1 DTariffit 1 b2 Canada Share i, t21 1 bT Year. ~7!

5. Results

Before turning to the regressions, consider one simple graphical illustration of the
disaggregate data. I divide the sample into several groups based on the extent of
liberalization during the time period 1989–94. Using these categories, one can
show how trade for each category changed in the wake of the agreement. Figure 2
shows the growth of U.S. imports from the partner country, Canada, as well as from
the rest of the world.12 Consider, first, the lighter bars, which show U.S. imports
from Canada. The trade that was already freely flowing from Canada to the United
States increased approximately 40 per cent over the five years following the agree-
ment. However, the more extensive the liberalization, the faster trade grew. For
example,

10 The %DImports is approximately equal to the term ln Di, t 2 ln Di, t21 . The DTariff variable is
approximately equal to the term ~ln~1 1 Ti, t ! 2 ln~1 1 Ti, t21 !! when the tariff rate is small, which
is generally the case in this data set.
11 This variable may also be a useful test of the theory ~discussed in Frankel 1997, chap. 8! that
natural trading blocs ~i.e., preferential trading arrangements between countries that already trade a
great deal with each other! should be less likely to lead to trade diversion and hence more likely
to increase welfare.
12 Figure 2 shows the growth in trade for the average commodity in each category. If one instead
examined the growth in trade for the total value of trade in each category, a similar pattern would
be seen.
FIGURE 2 Growth in U.S. imports from Canada and the rest of the world, 1989–94
 Trade creation and trade diversion 689

the imports that saw tariff reductions in excess of 5 per cent saw trade increase
dramatically, to approximately twice its 1989 level by 1994.
This figure suggests increases in trade resulting from tariff liberalization. But
was the increase in trade due to trade creation or trade diversion? If trade diversion
were present, then one would expect, all other things equal, trade with non-partner
countries in goods highly liberalized with respect to Canada to increase more slowly
than trade in goods less liberalized, or not liberalized at all. Figure 2 also shows
import growth from the rest of the world. Import growth from the rest of the world
does not appear to be systematically related to the extent of Canadian liberalization.
How should one interpret this finding? One possibility is that trade diversion did
not occur. Still, it could also be the case that trade diversion did exist, if the goods
where imports were naturally growing rapidly were also those previously protected.
However, as discussed further in section 6 below, there is little reason to suspect
that is the case.

5.1. Regression analysis

The first regression equations attempt to relate the variation among goods in the
percentage change in imports from year to year to the extent of tariff liberalization
and year dummy variables. The year dummy variables are intended to capture the
effects of income changes and variations in the exchange rate.13
The data cover five years of changes; initial results for equations explaining the
percentage change in U.S. imports from Canada are presented in table 4. The elim-
ination of tariffs did have a statistically significant, positive, and large effect on
imports. Equation ~1! indicates that each one percentage point reduction in tariffs is
associated with a 9.6 per cent increase in imports from Canada.14 Equation ~2! adds
the share of imports from Canada in the previous year as an independent variable.
This variable is negative and statistically significant, indicating that a 1 per cent
increase in the original share of imports from Canada is associated with a 0.5 per
cent reduction in the increase in U.S. imports from Canada, when changes in other
variables are controlled for. This is contrary to the above, where it was hypothesized
that there would be greater trade creation gains where Canadian export firms were
initially more competitive.15

13 I used year dummy variables, rather than including these variables directly, since the time dimen-
sion of the panel data is very short.
14 In many of these specifications, the adjusted R-2 are not very satisfying. The low explanatory
power results largely from the very disaggregate data. A host of unmeasurable influences, such as
varying supply conditions or changes in tastes, likely accounts for the bulk of the variation appar-
ent in the data. If one aggregates the data to progressively fewer numbers of commodities, one
finds that the explanatory power of the regressions increases correspondingly. However, this
greater explanatory power comes at a cost: the year dummies explain more and more of the varia-
tion, while we steadily lose variation in tariff liberalization and hence are less able to discern the
impact of tariff liberalization on trade flows.
15 A possible explanation for this finding may be that the tariff liberalization gave Canadian produc-
ers preferential treatment relative to those in other countries, and thus Canadian firms were able to
increase their exports most where their initial share of the market was smallest.
690 K.A. Clausing

TABLE 4
The change in U.S. imports from Canada, 1989–94
~Dependent variable: per cent change in imports
from Canada, year over year!

Equation ~1! Equation ~2!

Tariff change 0.0964 0.0886

~0.0065! ~0.0065!
Share from Canada 20.4835
~0.0254!
Year dummy 1990 20.2441 20.2558
~0.0238! ~0.0237!
Year dummy 1991 20.2165 20.2246
~0.0237! ~0.0236!
Year dummy 1992 20.1089 20.1121
~0.0237! ~0.0236!
Year dummy 1993 20.1078 20.1077
~0.0237! ~0.0236!
Constant 0.4519 0.5652
~0.020! ~0.0178!

Number of obs. 28,551 28,551

F 71.6 120.7
Prob ~ F! 0.00 0.00
Adjusted R-2 0.012 0.025

NOTES
The dependent variable is year-to-year per cent changes in
imports between 1989 and 1994 for the United States. The
tariff change is the percentage point decrease in a given com-
modity’s tariff since the previous year ~typically a positive num-
ber!. The share from Canada variable is the share of total
imports of that product that originated in Canada in the pre-
vious year. Standard errors are in parentheses.

Table 4 uses a panel of year-to-year changes in imports to study the effects of

tariff liberalization on imports. This has the advantage of allowing an investigation
of several trade changes as tariffs are slowly lowered. I also examined regressions
explaining the change in imports over the entire time period ~1989–94! as a func-
tion of tariff liberalization. The results are given in table 5 and are consistent with
the previous results. The tariff change variable is of a very similar magnitude, indi-
cating that a 1 percentage point reduction in tariffs is associated with a 10 or 11 per
cent increase in imports from Canada. The share variable indicates that a 1 per cent
increase in the original share of imports from Canada is associated with a 0.69 per
cent reduction in the increase in U.S. imports from Canada, when the other vari-
ables are controlled for.

5.2. Estimates of increased trade due to CUSFTA

One can use the regressions in table 5 to estimate an elasticity that measures the
effect of changes in tariffs over this time period on import growth. In equation ~2!,
 Trade creation and trade diversion 691

TABLE 5
The growth in U.S. imports from Canada, 1989–94
~Dependent variable: per cent change in imports
from Canada, from 1989 to 1994!

Equation ~1! Equation ~2!

Tariff change 0.1107 0.1041

~0.0119! ~0.0119!
Share from Canada 20.6858
~0.0960!
Constant 0.4325 0.5976
~0.0361! ~0.0426!

Number of obs. 3,692 3,692

F 85.7 68.9
Prob ~ F! 0.00 0.00
Adjusted R-2 0.022 0.036

NOTES
The data cover the total percentage change in U.S. imports
from Canada between 1989 and 1994. The tariff change is the
percentage point decrease in a given commodity’s tariff brought
about by the agreement between 1989 and 1994. The share
from Canada variable is the share of total imports of that prod-
uct that originated in Canada in 1989. Standard errors are in
parentheses.

each 1 percentage point cumulative reduction in tariffs is associated with imports

10 per cent higher in 1994. Using this elasticity and taking into account the average
change in tariffs, one can estimate the effects of CUSFTA on trade. For the United
States, this estimate suggests that imports from Canada were 26 per cent higher,
owing to CUSFTA. Comparing this figure to the actual growth in U.S. imports from
Canada by 1994, I estimate that over half ~54 per cent! of the $42 billion increase in
U.S. imports from Canada was due to CUSFTA.16

5.3. Trade diversion?

In order to examine the possibility of trade diversion, a series of regressions was
examined in which the dependent variable was the percentage change in imports of
a particular commodity from the rest of the world. If trade diversion were present,
one would expect the percentage change in imports from the rest of the world to be
negatively related to the extent of tariff liberalization with Canada. Table 6 shows
regressions for U.S. data. The specifications shown are parallel to those of table 4,
with the exception of an additional independent variable indicating the degree of
liberalization of imports from Canada. Equation ~2! also includes the change in
imports from Canada as an explanatory variable.

16 One can make similar calculations, of course, using coefficients from other specifications. These
estimates are quite similar to those reported here.
692 K.A. Clausing

TABLE 6
Regressions examining the change in imports from the ROW ~Dependent variable:
per cent change in imports from the rest of the world, year over year!

Equation ~1! Equation ~2! Equation ~3!

ROW tariff change 0.0215 0.0214 0.0252

~0.0034! ~0.0034! ~0.0040!
Canadian tariff change 0.0016 0.0016 0.0030
~0.0022! ~0.0022! ~0.0022!
Per cent change Can Im 20.0000
~0.0000!
Share from Canada 0.1604
~0.0121!
Year dummy 1990 20.1357 20.1357 20.1339
~0.0100! ~0.0100! ~0.0100!
Year dummy 1991 20.1622 20.1622 20.1604
~0.0100! ~0.0100! ~0.0100!
Year dummy 1992 20.0710 20.0710 20.0703
~0.0100! ~0.0100! ~0.0100!
Year dummy 1993 20.0380 20.0380 20.0378
~0.0100! ~0.0100! ~0.0100!
Constant 0.1951 0.1951 0.1644
~0.0071! ~0.0071! ~0.0074!

Number of obs. 28,881 28,881 28,881

F 67.1 57.5 83.1
Prob ~ F! 0.00 0.00 0.00
Adjusted R-2 0.014 0.014 0.020

NOTES
The data cover year to year percentage changes in U.S. imports from countries other
than Canada between 1989 and 1994 for the United States. The ROW tariff change is
the percentage point decrease in a given commodity’s tariff in a given year, for coun-
tries other than Canada. The Canadian tariff change is the percentage point decrease in
a given commodity’s tariff in a given year, for Canada. The % Change Can Im variable
is the percent change in imports from Canada, year over year. The share from Canada
variable is the share of total imports of that product that originated in Canada in the
previous year. Standard errors are in parentheses.

Turning to the results, coefficients on the ‘ROW tariff change’ variable indicate
that to the extent that tariffs on goods from non-Canadian countries decreased,
imports from these countries increased. A 1 percentage point reduction in tariffs
was associated with a 2 per cent increase in imports. In all cases, the coefficients on
the variables indicating tariff liberalization on Canadian goods are statistically indis-
tinguishable from zero. Thus, there is no discernible relationship between the extent
of Canadian tariff liberalization and import growth from countries in the rest of the
world.
One might expect the percentage change of imports from the rest of the world to
be lower as tariff reductions on Canadian goods are higher and increases in Cana-
dian imports are larger. For example, if the United States lowers tariffs on mango
 Trade creation and trade diversion 693

imports from Canada, this should not result in any trade diversion, since Canada
will not export mangos to the United States under most imaginable circumstances.
On the other hand, if a reduction in the tariff on wooden furniture from Canada
results in an increase in imports of such furniture, this may lead to fewer imports of
furniture from other countries, thus causing trade diversion.
One way to investigate this sort of relationship is to include variables that indi-
cated the percentage change in imports with the partner country; this specification
is reported in equation ~2!. The estimated coefficient on this variable is 0. I also
tested regressions included interaction terms between the change in Canadian imports
and tariff liberalization ~not reported here!. In all cases, the interaction terms were
statistically indistinguishable from zero.
One can also test specifications similar to those in table 5 for imports from the
rest of the world. Though not reported here, the results were very similar to those of
table 6. The one noticeable change was that changes in imports from Canada were
sometimes positively related to changes in imports from the rest of the world.17

6. The variation in initial tariff rates

One useful aspect of studying the CUSFTA is that policy makers committed them-
selves to lowering tariffs on all goods. The initial tariff rates and schedules were
predetermined, thus making the variation in tariff rates useful for identifying the
impact of tariff changes on trade flows. If tariffs are distributed among the goods in
a way that is correlated with import increases, however, this makes it more difficult
to discern whether increases in trade between the two countries are due to trade
creation or trade diversion. For example, if tariffs were for some reason higher for
goods that are likely to have larger increases in imports, this could bias upward the
size of the import responses measured above and bias downward the estimates of
trade diversion due to the agreement. However, while this is a noteworthy consid-
eration, there are several reasons to suspect that this concern should not invalidate
the results presented here.
First, work by Gaston and Trefler ~1997! uses industry-level data to address the
exogeneity of tariff cuts under the CUSFTA for Canada. After constructing tariff-
reduction instruments, they conclude that they are unable to reject the hypothesis
that tariff cuts under the CUSFTA are exogenous. Second, in my own analysis using
the data set of this study, all of the variables that I am able to examine show no clear
relationship with initial tariff levels. For instance, the level of imports in the first
year of the data is not positively correlated with tariff levels, as one might suspect
if the above concerns are important.18

17 This result is not too surprising, since imports of a particular good may rise simultaneously from
several countries, owing to an increased demand for the product, bad supply conditions at home,
or other factors.
18 Results are available from the author upon request.
694 K.A. Clausing

Finally, there is no clear theoretical rationale common in the literature that would
lead one to suspect that goods with large tariffs would also be those goods where
import growth was naturally higher. There is a large literature in which the political
economy of trade policy has been considered, more specifically, the factors that
influence tariffs.19 The authors attempt to reconcile the economic arguments in
favour of free trade with the reality that trade typically is not free. If policy makers
did maximize an economist’s perception of social welfare, it is unlikely that they
would use tariffs at all.20 In practice, though, policy makers may be inclined to
allow tariffs on commodities that are deemed special because of high profits, high
wages, suspected spillovers, or simply particularly aggressive lobbying.

7. Conclusions

The CUSFTA had substantial effects on trade between Canada and the United States.
The tariff liberalization brought about by CUSFTA was responsible for over half of
the $42 billion increase in U.S. imports from Canada between 1989 and 1994. The
commodities that experienced the largest reductions in tariffs had the largest increases
in trade. In addition, there was little evidence of trade diversion from non-member
countries.
The use of disaggregate data makes it possible to distinguish effects that are
more difficult to discern using aggregate data. Since initial tariff rates varied sig-
nificantly, it is possible to compare the growth of imports that were extensively
liberalized, less extensively liberalized, or not liberalized at all. This variation in
tariff liberalization allows an identification of the impact of the agreement on trade
flows with both member and non-member countries.
These results suggest an encouraging assessment of the CUSFTA. Since the
gains due to the agreement were not at the expense of other countries, it is less
likely that the CUSFTA will discourage future efforts towards free trade worldwide.
More likely, the CUSFTA increased the constituencies with an interest in free trade.
However, this analysis certainly does not resolve all questions concerning the
desirability of preferential trading agreements. Individual circumstances associated
with such arrangements vary, and each arrangement must be judged on its own
merits. Nonetheless, the importance of using disaggregate data to assess the effects
of a given trade agreement is indicated by this paper. Ex post analyses that rely on
aggregate data may be less informative, since it is difficult to separate the effects of
liberalization from other influences affecting the data.

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