"Trade, Industrial Policy, and Canadian Manufacturing" by Richard G. Harris (with the Assistance of David Cox): A Review Article

"Trade, Industrial Policy, and Canadian Manufacturing" by Richard G. Harris (with theAssistance of David Cox): A Review ArticleAuthor(s): John WhalleySource: The Canadian Journal of Economics / Revue canadienne d'Economique, Vol. 17, No. 2(May, 1984), pp. 386-398Published by: Wiley on behalf of the Canadian Economics AssociationStable URL: http://www.jstor.org/stable/134964 .

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'Trade, industrial policy, and Canadian manufacturing' by Richard G. Harris (with the assistance of David Cox): a review article* J 0 H N W H A L L E Y / University of Western Ontario

Abstract. This paper reviews the recent monograph by Richard Harris (1984), which uses an applied general equilibrium model incorporating scale economies and imperfect competition to analyse Canadian trade policies. Estimates of the annual gain to Canada from multilateral free trade with the rest of world of around 8-10 per cent of GNP are obtained. Unilateral free trade yields gains of 4 per cent of GNP. Results also carry the important implication that any applied general equilibrium model analysing trade policy in a small open economy that does not incorporate scale economies and imperfect competition is likely to be seriously mispecified. The monograph makes a major contribution to both applied general equilibrium research and the debate on trade policy in Canada by injecting a whole new and important line of enquiry. At the same time there are issues used concerning the model structure and the scale economy and other parameter estimates that may be sources of bias in the results.

Commerce international, politique industrielle et l'industrie manufacturiere canadienne. Ce memoire fait la recension critique d'une monographie recente de Richard Harris qui utilise un modele d'equilibre general applique tenant compte des economies d'echelle et de la concurrence imparfaite pour analyser les politiques commerciales du Canada. Cette etude en arrive a evaluer a un niveau de 8-10% du produit national brut les gains annuels que le Canada pourrait tirer d'un commerce libre negocie multilateralement. Une liberalisation unilaterale du commerce engendrerait des gains annuels correspondant 'a quatre pourcents du produit national brut. Ces resultats ne sont pas sans avoir de consequences pour ce qui est de la credibilite des resultats des analyses de la politique commerciale dans une petite economie ouverte a l'aide d'un modele d'equilibre general applique qui ne tient pas compte des economies d'echelle et de la concurrence imparfaite. La monographie d'Harris constitue une contribution importante 'a la fois aux analyses d'equilibre general appliquees et au debat sur la politique commerciale au Canada en ouvrant des perspectives nouvelles aux enquetes. Cependant, il semble qu'on puisse soulever certaines questions quant 'a la structure du modele, a la nature des economies d'echelle et quant 'a l'estimation de certains autres parametres - autant de sources possibles de biais dans les resultats.

I am grateful to David Cox, Sylvester Damus, Irene Majski, Michael Parkin, and Ron Wonnacott for comments on an earlier draft.

* Editor's note: This is a commissioned review article of the monograph by Richard Harris on trade and industrial policy in Canada (OEC). Because of the wide outside interest in this work and in order to expedite the review process, this article has been based on the typescript monograph. The monograph is scheduled to be published by the Ontario Economic Council in May 1984.

Canadian Journal of Economics / Revue canadienne d'Economique xvii, No. 2 May / mai 1984. Printed in Canada / Imprime au Canada

0008-4085 / 84 / 386-398 $01.50 C) 1984 Canadian Economics Association



'Trade, industrial policy, and Canadian manufacturing' / 387

This monograph by Richard Harris (1984) is undoubtedly one of the most important pieces of applied research to be done on a Canadian policy issue for many a year. Using an applied general equilibrium model incorporating scale economies and imperfect competition, estimates of the annual gain to Canada from multilateral free trade with the rest of the world of around 8-10 per cent of GNP are obtained. Unilateral free trade yields gains of 4 per cent of GNP. Although these estimates do not explicitly apply to a bilateral free trade initiative with the United States, given that around 70 per cent of Canadian trade is with the United States, the numbers are close to those suggested some seventeen years ago by Paul and Ron Wonnacott (1967) as likely long-run gains from free trade between Canada and the United States. The important difference is that unlike the earlier estimates, these have been produced from a tightly specified model using empirically based parameter estimates. 1

These results also carry the important implication that any applied general equilibrium model analysing trade policy in a small open economy which does not incorporate scale economies and imperfect competition is likely to be seriously mispecified. These estimates are dramatically larger than other estimates of gains from trade liberalization using constant returns to scale. Compare Harris's results to the Scitovsky (1958) estimate that the formation of the EEC would yield annual static welfare gains in the region of one-twentieth of 1 per cent of 1952 GNP; or the Johnson (1958) estimate that in joining the EEC, Britain would realize a total gain in the region of 1 per cent of 1970 GNP over a twelve-year period. Interestingly, Harris's results for non-scale economy cases seem to confirm the rule of thumb suggested some years ago by Balassa (1975) that gains from exploiting scale economies and increased competition as a result of trade liberalization are likely to exceed more conventionally estimated static gains by a factor of around 5 to 1.

Even though available only in mimeographed form, Harris's results have already been widely cited, and this work has been one of a number of catalysts that have reinvigorated debate in Canada on the u.s.-Canadian free trade issue. Its impact on applied general equilibrium studies, where constant returns to scale models have been the norm, has only just begun to be assessed, and this work will undoubtedly serve as a major point of departure for future efforts in this field. In short, there can be no doubt as to the importance of this work for both Canadian policy makers, and applied general equilibrium modellers here and abroad.

My first reaction is to applaud the enterprise and technical ability that this book displays. It makes a major contribution to both applied general equilibrium research and the debate on trade policy in Canada by injecting a whole new and important line of enquiry. At the same time I do have some reservations regarding the model

1 It is interesting, however, that similar orders of magnitude are produced by these two quite different approaches. The approach used by the Wonnacotts is to adopt the macro assumption that productivity in Canada will increase to u.s. levels in the event of free trade with the United States, which is then justified in terms of its micro detail. The Harris approach is to build up from micro detail without the same broad macro assumptions. The Harris model differs from the earlier Williams (1976) study, which assumed constant returns to scale in producing larger estimates of the gains to Canada from a u.s.-Canadian free-trade arrangement. These are estimated by Williams to be 4 per cent of real consumption or a 2.5 per cent increase in real GNP.



388 / John Whalley

structure and the scale economy and other parameter estimates used. The debate on the empirical evidence on the strength of scale economy effects goes back to Friedman (1955) and earlier, and from my reading of the literature these issues still remain unresolved today. The data used to specify the trade barriers which Canada faces abroad are inappropriate, and some of the results (particularly the impacts of free trade by industry) are clearly implausible. I also have reservations concerning the way non-competitive behaviour is incorporated in the model. While the main focus of the reaction to Harris's work has been on the scale economy aspects of his model, my sense is that other features, such as international capital mobility, may also be important in determining his results, thus raising further issues of empirical specification. The way the model is closed by specifying the behaviour of the foreign country also seems to leave some questions unanswered.

To execute modelling activity of this type, one has to be a 'Jack of all trades,' mastering the theory underlying the model, the computer code, the data, the policy issues, and the major implications of results. As a modeller, I am only too well aware of how easy it is to select one small element from the mosaic for closer scrutiny and to find in it features that are implausible or unacceptable. Thus, while the precise numbers may not stand the test of time, I have no doubt that this work will be remembered as pioneering empirical research. It is work that should definitely be continued and refined, for the policy debate can advance only if enterprising pioneers, such as Harris, persist in the blending of well articulated theoretical structures with the best currently available empirical evidence.

SUMMARY OF THE MODEL AND CALCULATIONS 2

Harris represents the Canadian economy in terms of a static general equilibrium model in which twenty Canadian non-competitive manufacturing industries each use increasing returns to scale production processes, while nine competitive non- manufacturing industries face constant returns to scale production functions. For all products heterogeneity between comparable domestic and imported products is assumed. This is the 'Armington' assumption used in many other applied models. Canadian producers are takers of import prices but makers of export prices. Different export price elasticities by product are incorporated, and a subtle difference in the elasticity of Canadian export demands between a reduction in the foreign tariff and Canadian producer prices. Capital is both internationally and intersectorally mobile and in perfectly elastic supply. Labour is internationally immobile but intersectorally mobile and in fixed supply.

The production technology in each competitive non-manufacturing industry is Cobb-Douglas in both primary factors and intermediate inputs. Each non-competitive manufacturing industry, however, has a cost function specified for a representative firm to include both fixed and variable costs. The variable cost component is also a Cobb-Douglas unit cost function, but fixed costs, which include capital and labour costs, lead to declining average costs.

2 Beyond the detailed description in the book (Harris 1984), shorter summaries of both the model structure and the main results are given in Cox and Harris (1983), and Harris (1983).




Within each non-competitive industry all firms are identical. In the long run there is exit and entry and the number of firms is endogenous, with entry (exit) occurring in response to above- (below-)normal profits. In the short run both the number of firms in each non-competitive industry and their mark up is fixed.

Two different formulations of the price making behaviour of non-competitive firms are considered. The first, following Negishi (1961), assumes that each firm perceives the market demand function for its product and sets the monopoly price. The second, following Eastman-Stykolt (1967), assumes collusive behaviour. In the presence of a domestic tariff, firms collude on the world price plus the tariff. Price setting behaviour is assumed to correspond to a weighted average of these two rules.

Equilibrium is characterized by a set of prices that clears both goods and factor markets. In short-run equilibrium firms may earn above normal profits or make losses without shutting down. In long-run equilibrium a zero profit condition applies, and from the Negishi portion of the price setting behaviour the elasticity of the firm's perceived and true demand functions must be the same.

The model is calibrated to a 1976 benchmark equilibrium data set that incorporates actual mark-up behaviour and numbers of firms. The model is then solved for a long-run equilibrium, different from the 1976 equilibrium, which serves as the point of comparison in subsequent counterfactual equilibrium exercises. For any policy change, for example, a unilateral or multilateral elimination of trade restrictions, a new equilibrium is calculated and the welfare gain or loss to Canada determined along with other characteristics such as changes in industry outputs, input demands, and relative prices.

Five sets of model parameters affect results from the model. The first are those determining the slope or elasticity of the average cost curves for non-competitive industries. These parameters crucially affect the size of potential gains from rationalization (elimination of collusion) or from penetration of foreign markets that accompany trade policy changes abroad. The second are the trade policy parameters themselves. The level assumed for foreign protection determines the potential benefits from entry to foreign markets under multilateral free trade. The level of domestic protection determines how far collusive behaviour can raise prices above world prices. The third are the weighting parameters, which determine whether prices are set following primarily collusive or monopolistic behaviour. These parameters determine the strength of the rationalization effect accompanying either unilateral or multilateral free trade. The fourth are the export price elasticities that Canada faces. They affect how large the penetration of foreign markets will be under multilateral free trade. Finally, there are the import price elasticities, which potentially restrict the domestic rationalization effect from increased foreign competition under either unilateral or multilateral free trade.

All these parameters interact with one another in determining the model outcome, and Harris is careful to stress the importance of the chosen values for results. Most are based to some degree on literature estimates. Scale economies reflect partially the recent Fuss and Gupta (1981) estimates for Canada and partially engineeiing studies. Trade barriers in Canada are based on Statistics Canada data; abroad (the United States), data from Whalley (1980) are used. Trade elasticities are based on estimates



390 / John Whalley

due to Stern et al. (1976). There are no literature-based estimates of the weighting parameters between collusive and monopolistic behaviour, and a best guess is used. This pattern is similar, therefore, to other applied general equilibrium models where key elasticities and other parameters are crucial for results. In this case some new ones are added: scale economy elasticities of average cost functions and parameters determining price setting behaviour in non-competitive industries.

The model works (in simplified terms) in the following way. Unilateral free trade increases domestic competitive forces, removes collusion and forces partial rationalization of domestic industry, giving a gain of approximately 4 per cent of GNP.

Free trade is thus a substitute for effective anti-monopoly or combines legislation. Multilateral free trade has the added benefit of allowing penetration of a large foreign market, permitting economies of scale to be realized. For Canada, with a population of 25 million, penetrating large foreign markets - such as the United States, with a population of over 200 million - gives an annual welfare gain from multilateral free trade of around 8-10 per cent of GNP.

Harris also reports results for other cases, including the use of employment, capital, and labour subsidies for Canadian industries, and restrictions on the number of firms (forced rationalization). Employment subsidies tend to discourage rationalization and promote inefficiency, as do capital subsidies, which in the long run encourage entry and produce shorter production runs. Export subsidies are more mixed in impact, although if industries have significant enough scale economies positive effects for Canada can result.3 Rationalization produced from limits on number of firms lowers average costs but not consumer prices, unless limits on collusive behaviour are also introduced.

MODELLING EQUILIBRIUM UNDER SCALE ECONOMIES AND

NON-COMPETITIVE BEHAVIOUR

It is the scale economy features of Harris's work that have attracted most attention, and it seems sensible to begin with this aspect of the modelling exercise. In fact, it is not only scale economies per se, but the assumption of partly non-competitive (collusive) behaviour that is central to Harris's argument.

With increasing economies of scale everywhere there should, of course, be only one firm in any industry producing homogeneous products. In Harris's model this is not the case. In the presence of domestic protection and collusive behaviour, firms collude around the focal point of the world price plus the tariff. Thus, given the cost function for a typical firm in an industry, the output of the firm consistent with pricing in this way is endogenously determined (after allowing for the mark-up). So too is the number of firms.

X-inefficiency results from this collusive behaviour. Free trade lowers the collusive price by eliminating domestic protection, yielding rationalization gains. Simply put, free trade serves as 'trust busting.' Thus, the first point to keep in mind is

3 However, this analysis ignores the issue of whether Canada's trading partners will impose counter- vailing duties against such subsidies.




that it is not simply scale economies that product Harris's large effects but the interaction between non-competitive behaviour and scale economies.

The weakness, however, is that from a theoretical point of view the model relies on an ad hoc assumption of collusive behaviour. Collusive behaviour, is assumed rather than derived from profit maximizing behaviour of firms. A further weakness is that in Canada there is collusion, abroad there is not. Why this should be the case, or why the presence of a national border generates such collusive behaviour is nolt made clear; nor is it a feature generated by the model.

This lack of a theory of collusive behaviour becomes even more troublesome when it is recognized that the model incorporates international capital mobility. Capital that participates in a competitive process abroad, and can come in behind the domestic tariff wall seeking profits becomes a party to collusion when it arrives in Canada. To my mind, this model treatment of collusion is unconvincing, especially so in the case of unilateral free trade where the gain to Canada comes directly from the rationalization effect from the limits free trade places on collusion.

THE SPECIFICATION OF SCALE ECONOMICS

Beyond the use of collusive pricing behaviour, the other central feature of Harris's model is the size of the scale economy parameters used. This is evident from the results. An increase in manufacturing output of only around 25 per cent accompanies a multilateral elimination of protection, although subaggregate outputs change by substantially more. Given that manufacturing is only around 20 per cent of GNP and that the direct revenue gain from foreign tariff elimination is at best 1-2 per cent of GNP, this suggests that a significant scale economy effect is present.

Studies by Baldwin and Gorecki (1983a, b) using a special data base constructed for the Economic Council using 'census plant' data seem to provide support for the presence of both scale economies and inefficiency in Canadian industries protected through tariffs. They show Canadian plant sizes to be only approximately 70 per cent of those in comparable u.s. industries, and in Canadian industries characterized by high tariffs and high concentration production runs are shorter and product diversity greater. The Baldwin-Gorecki work does not, however, provide estimates of the strength of scale economy effects as represented by the curvature of average cost curves.

Harris does not clearly present his average cost elasticity parameters but does report the source of his scale economy parameters as a paper by Fuss and Gupta (1981) along with engineering estimates. The engineering estimates are larger than the Fuss and Gupta estimates. From the estimates reported (Harris, table 2.4), significant scale economy effects are clearly present.

In evaluating Harris's results, it must be kept in mind that there are unresolved empirical issues as to the numerical significance of scale economy effects, especially those produced by regression studies. The Fuss and Gupta estimates, important as they are, are but one of a number of contributions to this ongoing debate. At the heart of the debate is Friedman's (1955) demonstration4 that in regressing average cost on

4 A similar issue was subsequently raised by Friedman (1957) in connection with biasedness in estimation of consumption functions. See also Stigler (1966, 11 problem no. 4).



392 / John Whalley

$

True AC

I I

ql qo q2 q

FIGURE 1 Regression fallacy in estimating average cost function

output one may fallaciously conclude that scale economies are important, even though no scale economies are present.

Figure 1 demonstrates how this fallacy can occur. If we assume that the true average cost for the firm is independent of output, (constant AC as under constant returns to scale), but that output is stochastic, an error term of zero (qo) produces an observation on the true average cost. Any negative disturbance (ql) produces costs above true average costs, any positive disturbance (q2) produces costs below true average cost. An attempt to estimate an average cost function by regressing average cost on output may thus show scale economies when none is present. The issue thus becomes whether the estimates Harris uses reflect this bias.

Attempts to estimate scale economies taking this regression fallacy into account frequently fail to find significant scale economies. In one such recent study for Canada, Rao and Preston (1983), whose results were not available to Harris, find slightly diminishing or constant returns to scale for both durable and non-durable manufacturing (Harris's increasing returns industries) and slightly increasing returns to scale for non-manufacturing industries (Harris's constant returns industries).

In the case of engineering estimates that produce even larger scale economies for Canadian manufacturing than Fuss and Gupta, this issue does not apply. However, a concern frequently raised with such studies is whether in surveying engineers as to incremental costs for extra output, only variable costs are taken into account, since average and marginal costs will behave differently.

These comments, of course, are directed as much at the literature on scale economies as at the Harris monograph; but unfortunately for a user of elasticity estimates, these issues cannot be avoided. As with other applied general equilibrium literature, the sensitivity of results to the elasticity specifications used needs careful




investigation for scale economy parameters (as with other parameter values). Clearly a potential weakness of the Harris estimates is that they are based on one set of scale economy parameters.

THE SPECIFICATION OF TRADE BARRIERS

A further problem with Harris's results concerns the specification in the model of the trade barriers Canada faces abroad, especially in the United States, where around 70 per cent of our exports are sold. Indeed, a not unreasonable reaction is surprise at the size of the Harris estimates of the impacts of multilateral free trade, since around 25 per cent of u.s.-Canadian trade is in autos, which are already duty free. Adding lumber and resources, much of which is duty free (or close to it) in the United States, produces a figure that approximately 60 per cent of Canadian exports currently enter the United States duty free. By 1987 (the year of the full implementation of the Tokyo Round) estimates are that around 85 per cent of Canadian exports will enter the United States duty free. While these figures are biased to some extent, since the commodity pattern of Canadian exports is distorted by the incentives to export through the duty-free holes in the tariff, it none the less seems worthwhile to ask where the large estimated gain in Harris's model originates.

The answer is not only that Harris uses protection estimates for 1971 which are significantly higher than currently, but that the estimates of u.s. protection used to represent levels of protection Canada faces abroad are inappropriate for Canada. Unfortunately, Harris uses estimates produced by Whalley (1980) for tariffs and ad valorem equivalents of non-tariff barrfers (NTBS) for the United States in their trade with the EEC and Japan. These estimates are inappropriate for Canada, since they ignore both the substantial implicit preferences Canada already has in u.s. markets5 and the fact that major U.S. NTBS (such as Voluntary Export Restraints on autos) are focused most heavily on the EEC and Japan, rather than Canada.

Thus, for the multilateral free-trade model experiment Harris's estimates show a 121 per cent increase in the production of transport equipment (a 255 per cent increase in exports), even though we already have free trade under the Auto Pact. Equally, there is a 60 per cent increase in agricultural output (a 245 per cent increase in exports), because the model incorporates NTB ad valorem equivalent estimates, which do not apply to Canada. Only 15 per cent of our agricultural trade is with the United States and in Harris's model the United States and rest of the world are treated as one region, which is assumed to eliminate its protection. When combined with the treatment of collusive behaviour and the scale economy parameter issue, this seems to provide grounds for arguing that Harris's estimates may be upward biased.

Indeed, in analysing the impacts of trade policy changes on Canada, Harris's model is unable to capture several effects that potentially work in the opposite direction. One is that because we currently enjoy preferential access to u.s. markets relative to other u.s. trading partners (particularly Japan and the EEC) we may lose

5 For instance, unpublished data from the u.s. Special Trade Representatives Office indicate that for 1976 the average u.s. tariff on all imports was 5.7 per cent, whereas the average u.s. tariff on imports from Canada was only 1.8 per cent. The average 1976 tariff in Canada on all imports was 9.5 per cent and on imports from the United States was 8.5 per cent.



394 / John Whalley

from multilateral free trade because our margin of preference under arrangements such as the Auto Pact might be removed. Another is that the u.s. foreign tax credit effectively subsidizes capital investment in Canada, which, in turn, may be increased by Canadian protection. Yet another is the argument that Canadian protection may reduce income transfers to foreign owners of factors (especially natural resources) located in Canada. Of course, it may be that none of these effects is significant, but readers of Harris's book should know that they remain unaccounted for in his model.

INTERNATIONAL CAPITAL FLOWS AND THE MODELLING OF

FOREIGNERS B E H A V I O U R

A further feature of Harris's formulation is the assumption of the international perfect mobility of capital (despite the ongoing debate on the Feldstein / Horioka (1980) paper, which argues the contrary), and the large response in capital flows that multilateral trade liberalization produces. In the multilateral free-trade case the additional capital service inflow into Canada is around $14 billion (1976 data), which on my reckoning (using Harris's tables) is approximately the size of the pre-change capital service used in manufacturing. While not emphasized in Harris's discussion, this seems likely to provide a further contribution to the large welfare gain from multilateral free trade that Harris reports. The effect of a tariff reduction abroad is to raise the marginal value product of capital in Canada, capital flows in, and the trapezoid under the shifted marginal value product schedule accrues to Canada. How large a gain results from this feature is unclear, but it would seem to me to be potentially large. While Harris shows only a 2 per cent gain for the constant returns to scale case when capital mobility is also present, this latter case also seems to be accompanied by a much smaller capital flow. Capital mobility may therefore still be an important determinant of the large results in the increasing returns to scale case.

Another related issue concerns the modelling of the behaviour of foreigners, which is used to close the model. Canada is a price taker for imports, a price maker for exports, and faces a perfectly elastic supply function for foreign capital services at the world rental rate. This implies that foreigners have perfectly elastic export supply functions and non-perfectly elastic import demand functions. As Whalley and Yeung (1984) have pointed out, if the set of excess demand functions of the foreign country is to satisfy Walras's Law (the condition that at any set of prices, whether or not they are equilibrium prices, the value of excess demands equals zero6) such a specification is impossible. In the two-good case the import supply elasticity assumption requires a straight-line offer curve, and the export demand elasticity assumption requires curvature to the offer curve. Harris's case is more complex because of the added elastic capital supply feature. However, the model closure for foreigners' behaviour would seem to imply a passive adjustment of capital supplies so that Walras's Law holds for foreigners. This does not at first sight seem to be consistent with the capital inflow required, given the changes in the value marginal productivity of capital in Canada produced by the model for a trade policy change abroad.

6 That is, foreigners are on their budget constraint.




IMPLICATIONS FOR CANADIAN POLICY MAKING

Despite all these problems, the fact remains that any, save the strangest neoclassical general equilibrium model, would likely show gains to Canada from multilateral free trade with the United States. The main points of debate in terms of policy significance are quantitative rather than qualitative. Therefore, accepting the Harris results at face value, it is useful to ask what their implications are for Canadian trade policy making.

It seems to me that three major implications follow. First, if the gains from multilateral free trade are as large as 10 per cent of GNP per year, it becomes correspondingly more difficult to argue that concerns over national sovereignty should dissuade us from persuing multilateral free trade arrangements, especially bilateral free trade with the United States. Secondly, in the unilateral tariff removal case Harris shows a significant gain to Canada despite a terms of trade deterioration, the same deterioration that led Boadway and Treddenick (1978) to show unilateral free trade to be a losing proposition for Canada. Thirdly, the gain from rationalization that occurs with unilateral free trade suggests that the usual regional analysis of Canadian trade policy may not hold (i.e., that Ontario and Quebec gain from Canadian protection owing to their ability to sell manufactures to the west at higher prices behind the protective wall).

These implications are clearly not without significance at the present time. Since the 1911 election, it has been an article of faith of successive governments that proposing an explicit free trade arrangement with the United States would be a prescription for electoral disaster. However, while trade policy in recent decades has not been characterized by any official change in stance on the issue of general free trade with the United States, de facto we have moved substantially down this road through multilateral tariff reductions under the GATT. While our main trade issues (at least in terms of the volume of trade) have been with the United States, by and large we have been content to deal with them through the multilateral framework of the GATT .7

This approach is now being queried on a number of grounds. As the number of participants in the GATT has grown (there were nearly 100 signatories to the Tokyo Round accords), the GATT has become a clumsier and less workable multilateral framework. If over 70 per cent of our trade is with one country, why, one could argue, should we conduct trade negotiations simultaneously with so many countries? One possible response, of course, is that the United States wants to do things this way.

Furthermore, the GATT shows signs of both impotence and fragmentation. The impotence reflects the fact that GATT negotiating rounds have successfully reduced tariffs multilaterally, but have made little or no progress on NTBS, which most commentators now agree provide the more major trade impediments. The fragmentation reflects the pressures to break away from the non-discrimination principles in the GATT; u.s. reciprocity proposals are one such example.

The tensions between multilateralism under the GATT and bilateralism (free trade with the United States) clearly present a dilemma for Canada. Genuine multilateral-

7 The Auto Pact is the one major exception.



396 / John Whalley

ism can be a major benefit to a small country such as Canada, since it gains access to large foreign markets, and foreigners gain access only to its relatively small market. However, multilateralism of the current GATT variety may well have little more to offer. Bilateralism, as represented by u.s.-Canadian free trade, may be more attractive. The implication of Harris's results seems to be clearly that the potential gains to Canada from multilateral free trade are so large that an active bilateral negotiation with the United States covering 70 per cent of Canadian trade may well be better than inactive multilateralism under the GATT. Hence, Harris's view that u.s.-Canadian free trade should be pursued - and pursued with great vigour.

IMPLICATIONS FOR APPLIED GENERAL EQUILIBRIUM

A N A L Y S I S

In addition to having major implications for Canadian trade policy, Harris's work also has important messages for applied general equilibrium analysis. Much of the activity in this field has been summarized in a recent survey paper by Shoven and Whalley (forthcoming), where applied models in the tax and trade areas are discussed. The main point emphasized by Harris is that because of his work the two issues of scale economies and imperfect competition cannot be ignored in the future, as has been true of most of the work in the past. Harris's results clearly show that incorporating these features can make a big difference to empirical estimates of trade policy impacts, especially in a small economy such as Canada. However, there are a number of additional subleties, which have to be weighed alongside the simple statement of this point.

First, it is a little simplistic to argue on the basis of Harris's work that all that matters in trade policy analysis are scale economy effects, since a crucial ingredient in producing Harris's large welfare effects for Canada from multilateral free trade is the asymmetry in the relative size of the two economies modelled. Canada, with a population of 25 million penetrates a u.s. market of 225 million. Thus, in addition to scale economies being present, it is also crucial for the results that trade liberalization occur simultaneously in a large and a small economy. In other words, while the gain to Canada from multilateral free trade may be large, the joint gain to Canada and the United States as a fraction of joint GNP may still be small.

Secondly, it is tempting for those seeing the Harris results for the first time to conclude that the main effect of incorporating scale economies into an empirical general equilibrium trade model is to magnify the effects produced by a model with constant returns to scale. Unfortunately, this simple intuition is not a reliable guide, since scale economies can change qualitative as well as quantitative conclusions. Consider, for instance, EEC-U.S. trade. Because the United States is a net importer of manufactures from the EEC and a net exporter of non-manufactures, incorporating scale economies in manufacturing in both economies can lead to different qualitative as well as quantitative implications for a change in trade policies.

Thus, rather than simplify matters, scale economies serve to complicate applied general equilibrium modelling exercises. So far, modellers have spent a considerable amount of time searching the literature for income, price, and production substitution




elasticities. They have also agonized over modelling issues such as the treatment of time, whether economies face given international prices for goods and / or factors, and other issues that can sharply affect both qualitative and quantitative conclusions from the modelling effort. Harris's work introduces an entirely new set of elasticities to worry about: elasticities of average cost functions; and a fresh set of modelling issues: how scale economies and imperfect competition are to be dealt with.

While not everyone will agree with the way Harris incorporates these features into his model or even whether they are empirically significant enough to merit being incorporated, the large size of the estimated welfare gains from multilateral free trade will serve as a chilling reminder to constant-returns-to-scale modellers to beware for some time to come. Undoubtedly, a generation of PH D students both in Canada and abroad will be forever grateful to Harris for his pioneering foray into policy-relevant numerical modelling. While the numbers may not stand the test of time, the insights on the potential importance of scale economies and market structure most surely will.

REFERENCES

Balassa, B., ed. (1975) European Economic Integration (Amsterdam: North-Holland) Baldwin, J. and P. Gorecki (1983a) 'Trade, tariffs, and relative plant scale in Canadian

manufacturing industries: 1970-1979.' Discussion Paper No. 225, Economic Council of Canada (1983b) 'Trade, tariffs, product diversity and length of production run in Canadian manufacturing industries: 1970-1979' Discussion Paper No. 247, Economic Council of Canada

Boadway, R. and J. Treddenick (1978) 'A general equilibrium computation of the effects of the Canadian tariff structure.' This JOURNAL 11, 424-46

Cox, D. and R.G. Harris (1983) 'Trade liberalization and industrial organization: some estimates for Canada.' Queen's University Discussion Paper No. 523

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Documents

"Trade, Industrial Policy, and Canadian Manufacturing" by Richard G. Harris (with the Assistance of David Cox): A Review Article