An empty promise: average cost savings and scale economies among Canadian and American manufacturers, 1910-1988.

• Author: Keay, Ian

1. Introduction

On January 1, 1989, a bilateral trade agreement between Canada and the United States came into effect. This free-trade agreement (FTA) called for the reduction and eventual removal of Canadian and American tariff barriers on a wide range of goods traded between the two countries. In Canada, at least, there was considerable debate surrounding the negotiation and implementation of this pact. Economists' claims that there would be significant welfare improvements accruing to both Canada and the United States as a result of the exploitation of scale economies, triggered by the removal of tariff protection, played an important role throughout the course of this debate.

Recently, a large and growing body of literature focusing on the effects of bilateral tariff reductions has developed. This work adopts an ex post perspective in an effort to determine what effect trade liberalization has had on economic variables, such as productivity (Harrison 1994; Tybout and Westbrook 1995; Bernard and Jensen 1999), wages and employment (Gaston and Trefler 1997; Beaulieu 2000), plant production levels (Head and Ries 1999), and the trade-off between short-run adjustment costs and long-run efficiency gains (Trefler 2001). In general, these studies have found that the costs and benefits associated with trade liberalization are both difficult to isolate and unlikely to be substantial. This generalization holds with particular strength among wealthy, industrialized nations, such as Canada and the United States.

In light of the optimistic expectations regarding welfare improvements that were articulated prior to the introduction of the Canada-U.S. FTA, it is surprising that the ex post empirical evidence has been so muted. In this article, I argue that the ex ante expectations were overly optimistic. This revisionist exercise is relevant far beyond a specifically Canadian or historical context. Any assessment of the efficacy of trade liberalization between Canada and the United States will be dependent on the anticipated costs and benefits; a successful trade pact is one that exceeds expectations; an unsuccessful trade pact is one that falls short of expectations. Therefore, it is important to determine the extent to which our ex ante expectations were reasonable. More generally, the revisionist exercise undertaken in this article can help to determine the conditions under which we can safely anticipate welfare improvements stemming from the exploitation of scale economies induced through the liberalization of international trade.

In the sections that follow, I investigate the extent to which average cost savings were available through the exploitation of scale economies (1) among a sample of 44 Canadian and American manufacturing firms, representing four industries in each nation, covering the years 1910-1988. The results indicate that ex ante optimism regarding the potential for average cost convergence that was founded on data exclusively from the 1972-1988 period and that relied on the estimation of local scale elasticities alone would not have been unreasonable. However, a consideration of the global curvature properties of Canadian and American producers' long-run average cost functions and the employment of data from a much longer time series could have substantially undermined this ex ante optimism. I conclude, therefore, that the formation of reasonable expectations requires an investigation of global as well as local scale effects and the employment of data that spans macroeconomic cycles.

Section 2 provides a brief review of some of the quantitative literature that contributed to the formation of optimistic expectations concerning the economic effects of trade liberalization between Canada and the United States. In this section, I also illustrate that reliance on data from 1972-1988 and the estimation of local scale economies lead us to a fairly sanguine conclusion regarding the potential for average cost savings as a result of output adjustment following the implementation of the FTA. In section 3, two caveats are introduced; I report on the implications stemming from a consideration of global curvature properties, and I discuss the impact of employing a longer time series. The final section summarizes the conclusions.

2. The Formation of Optimistic Expectations

   A Review of the Literature

   Average costs, [C.sub.t]/[Q.sub.t] = f([A.sub.t], [Q.sub.t], [W.sub.xt]), are a product of technology, f(***), productivity, [A.sub.t], the scale of production, [Q.sub.t], and input prices, [W.sub.xt]. Optimistic expectations regarding welfare gains stemming from trade liberalization are based, at least in part, on the belief that average costs will decline as output adjusts in response to increased competition in the domestic market and increased access to foreign markets.

   There has been considerable empirical study of the relationship between trade liberalization and the scale of production. Tariff protection, in conjunction with transport costs, differentiated products, and regional tax and industrial policies may allow firms to price their output over marginal cost. One of the implications of this "tariff-limit pricing behavior," in which firms set prices at the international market price plus the domestic tariff regardless of their marginal costs, is that, in equilibrium, it may be optimal for firms to produce to the left of their point of minimum efficient scale (MES). (2) A bilateral reduction of trade barriers and the accompanying increase in competition may, therefore, encourage firms to increase output, resulting in lower average costs as firms move toward their point of minimum efficient scale. This view has been consistently articulated by those who have studied the relationship between Canadian tariffs, market structure, and manufacturers' performance. (3)

   In particular, Wonnacott and Wonnacott (1967, p. 5) claimed that, "... (tariff) protection results in higher Canadian prices and costs because of three organizational factors: the size of the firm; the level of managerial efficiency necessary to survive; and oligopolistic opportunities offered by the protected market." They predicted that trade liberalization

   would result in lower Canadian average costs and prices, increased exports and nominal wages, and an increase in Canadian GNP of approximately 10.5%. (4) More recently, Harris (1984) and Cox and Harris (1985, 1986) provided impetus to the formation of optimistic expectations at a key juncture in the debate surrounding the negotiation of the FTA. Cox and Harris argued that, "... freer trade, by subjecting domestic industry to increased foreign competition and allowing access to the larger world market, results in lower price-cost margins and in firms' achieving ... lower costs of production." (1985, p. 116). They predicted that Canadian GNP could increase by 8-12% (5) after the complete removal of tariff barriers between Canada and the United States, 2-5% (6) if Canada unilaterally removed tariff barriers, and they claimed that there could be as much as a 37% (7) increase in the value added generated in individual sectors subject to bilateral-sectoral tariff reductions.

   The optimistic predictions made by Wonnacott and Wonnacott, and Cox and Harris relied on two key assumptions. First, they assumed that firms practiced tariff-limit pricing. Second, they argued that firms' average costs were sensitive to output adjustment. The tariff-limit pricing assumption implies that the scale of production among Canadian and American producers could potentially expand dramatically in response to the bilateral removal of trade barriers. In this article, I accept the tariff-limit pricing assumption because it implies an expansion of output levels following trade liberalization that biases my results in favor of average cost savings. This allows me to focus all of my attention on a critical assessment of the second central assumption underlying the formation of ex ante optimism regarding the implementation of the Canada-U.S. bilateral trade agreement; that there were considerable scale economies available for exploitation.

   Average Cost Performance

   To begin my investigation of the strength of the empirical foundations underlying the ex ante optimism surrounding the FTA, it is necessary to establish the pattern and extent of average cost differentials between Canadian and American producers. Annual average cost figures specific to each of the 21 Canadian and 23 U.S. firms included in my sample have been calculated by adding firm-specific labor, capital, and intermediate input costs (8) to derive total cost, then dividing this figure by firm-specific output. (9) Because I am interested in the connection between output and average costs at the industry and sectoral levels, the experiences of individual firms are not discussed in this article. In an effort to reflect average cost performance at the industry level, I have used three different aggregation schemes to derive nation-specific average cost series for oil refineries, paper mills, steel mills, and textile mills (10): an unweighted geometric mean across all firms in each industry and nation, an industry- and nation-specific mean weighted by each firm's share of the domestic industry's capital stock, and the median firm's average costs. In Table 1, the ratio of Canadian relative to American industry average costs are reported for all three aggregation schemes averaged over four time periods: all available years, the years prior to 1946, the years between 1946 and 1971, and the years between 1972 and 1988. (11)

   Among all four industries studied in this article, the firm-level average cost distributions overlapped. This implies that the lowest average cost producer among the firms in the high-cost nation had lower average costs than the highest average cost producer among the firms in the low-cost nation. Despite the overlapping distributions, when...