U.S.-Mexico Trade Relations: NAFTA and Classical Economics

Introduction

When considering the nature of U.S.-Mexican trade relations, it is difficult not to think of the statement attributed to Mexican President Porfirio Díaz at the turn of the last century: "Poor Mexico, so far from God, and so close to the United States." Mexico does indeed continue to occupy a difficult position relative to its richer and more powerful neighbor to the north — a position defined and continually recreated by the nature and mechanisms of international trade between the two nations. This paper examines the nature of the trade relationship between the United States and Mexico in the light of several classical economic theories and models, as well as in respect to recent developments following the 1992 signing of the NAFTA accord and the increasing globalization of the past several decades.

We begin by discussing and summarizing some useful models and theories from classical economics, including two models developed by David Ricardo, the eighteenth- and nineteenth-century economist who was especially concerned with understanding the ways in which wages and value are determined in a society.

Ricardo believed in what he termed the "iron law of wages" — that wages tend to settle at the subsistence level. While wages may rise temporarily above that level, any such rise will be short-lived because of competition among workers. This is an important point for the topic at hand because a more open trade relationship between the United States and Mexico (as has existed since NAFTA went into effect in 1994) tends to produce a de facto larger workforce, since workers from both countries are now competing directly with each other in ways that they were not under conditions of greater economic protectionism. Any rise in wage rates above subsistence will cause the working population to increase to the point that heightened competition among the surplus of laborers will drive wages back down to the subsistence level.

Economic Theories and Models

Ricardo was also determined to understand how the value of goods — both products and services — is established. He came to believe that value is a direct function of the labor needed to produce the good in question. This is important in regard to trade relations between the United States and Mexico precisely because the value of labor in the two countries is not the same, meaning that more labor hours are available from Mexican workers on a comparable cost basis. According to his labor theory of value, a clock costing $100 required ten times as much labor for its production as a pair of shoes costing $10.

Perhaps most relevant of all these concepts to the topic at hand, Ricardo also developed an economic model to help explain the dynamics of international trade: the theory of comparative advantage. In a now-classic illustration, Ricardo explained how it was advantageous for England to produce cloth and Portugal to produce wine — as long as both countries traded freely with each other — even though Portugal might have produced both wine and cloth at a lower cost than England.

The following table illustrates Ricardo's theory of why it is often economically advantageous for a nation to specialize in certain products and then trade them, rather than trying to compete across all commodities it can produce.

Table 1: Cost per unit in man-hours

England — Wheat: 15 man-hours; Wine: 30 man-hours.
Portugal — Wheat: 10 man-hours; Wine: 15 man-hours.

In this example, a unit of wine in England costs the equivalent of 2 units of wheat to produce (the opportunity cost of a unit of wine is 2 units of wheat). In Portugal, a unit of wine costs 1.5 units of wheat to produce. Because relative or comparative costs differ, it is mutually advantageous for both countries to trade even though Portugal has an absolute advantage in producing both commodities. Portugal is relatively better at producing wine than wheat — this is Portugal's comparative advantage in wine — while England is relatively better at producing wheat than wine, giving England a comparative advantage in wheat production.

The table below shows how trade might be advantageous. England is assumed to have 270 man-hours available for production. Before trade takes place, it produces and consumes 8 units of wheat and 5 units of wine. Portugal has fewer labor resources, with 180 man-hours available. Before trade, it produces and consumes 9 units of wheat and 6 units of wine. Total combined production is 17 units of wheat and 11 units of wine.

Table 2: Production before and after trade

England — Before trade: 8 wheat, 5 wine; After trade (specializing in wheat): 18 wheat, 0 wine.
Portugal — Before trade: 9 wheat, 6 wine; After trade (specializing in wine): 0 wheat, 12 wine.
Total — Before trade: 17 wheat, 11 wine; After trade: 18 wheat, 12 wine.

If both countries specialize — Portugal producing only wine and England producing only wheat — total production rises to 18 units of wheat and 12 units of wine. Specialization has enabled the world economy to increase production by 1 unit of wheat and 1 unit of wine.

It should be noted that while Ricardo's model of comparative advantage remains widely accepted, it makes several assumptions — as is typical of classical economic theories — that do not obtain in real-world trade relations. Among the important assumptions contrary to fact are the following: there are no transportation costs involved in shipping goods, there are no economies of scale, there are no trade barriers, and there exists perfect knowledge on the part of all economic agents so that every buyer and seller always knows where the cheapest version of any given product may be found.

Another important model for understanding U.S.-Mexico trade is the factor proportions theory, which predicts that countries will over time become net exporters of those products that make intensive use of the country's relatively abundant factors. Thus, to understand why Canada is a primary exporter of newsprint, one must recognize that newsprint production makes intensive use of forest land and capital — factors that are relatively abundant in Canada.

The Heckscher-Ohlin model is related to the factor proportions theory and may in fact be derived from it. It should be clear from the factor proportions theory — and indeed from common sense — that any nation with abundant natural resources generally has a comparative advantage in producing goods that use those same resources. The Heckscher-Ohlin model is more complex and subtle, but the same basic concepts are involved.

The Heckscher-Ohlin theorem states that a capital-abundant country will export capital-intensive goods, while a labor-abundant country will export labor-intensive goods. Each country exports the good it produces relatively more efficiently than the other. In this model, a country's advantage in production arises solely from its relative factor abundance.

The Heckscher-Ohlin theory is primarily concerned with the two most significant elements of production: labor and capital. Countries like the United States have relatively high rates of capitalization, meaning that the average worker has access to an abundance of machinery and technology. This high degree of capitalization is associated with relatively higher wages, which in turn makes goods that require a great deal of labor — such as clothing — relatively more expensive to produce domestically. Clothing produced entirely within the United States is thus very expensive compared with clothing produced in nations with low capitalization rates and low wages, such as Mexico.

However, the model correctly notes that not everything is cheaper to produce where labor costs are low. Goods that require high capitalization and relatively little labor — such as modern automobile production — can be accomplished more cheaply in a highly capitalized nation like the United States. An understanding of these basic economic principles is helpful in understanding the trade relationship between the two countries, which can in general be summarized as following classical economic models: each country trades what it can produce cheaply for what the other nation can produce and export cheaply.

While economics provides essential tools for understanding the trade relationship, it is impossible to fully understand that relationship without also considering the political context. Among the most important political factors is the nature of the trade agreements themselves. Although the best-known of these is NAFTA, it is not the only agreement that defines the relationship between the two countries.

To understand the underpinnings of NAFTA, one must look back to the end of World War II. One of the lessons many world leaders drew from that conflict was the need to reduce the harmful effects of protectionist monetary and trade policies that had grown steadily since 1871, and especially the protectionist trade restrictions developed and enforced by a number of countries after 1918. This realization initiated a series of fundamentally anti-protectionist, multilateral trade agreements wedded to various other forms of international economic cooperation.

Economic Background and Research Assumptions

This trend toward open borders for the trade of products and services, and toward international monetary policies encouraging the free flow of capital across borders, has grown stronger over the past two decades — in large measure because of the rising influence of transnational corporations — despite growing and legitimate concerns in the labor and environmental movements about the costs of unrestrained trade.

The immediate post-war concerns about economic protectionism resulted in the General Agreement on Tariffs and Trade, commonly called GATT. In 1947, 23 countries signed GATT; together they accounted for four-fifths of world trade (Zeiler, 1999, p. 18). Like NAFTA and similar agreements, GATT is a multilateral trade agreement whose major goal is to establish principles that each member country must abide by. Each signatory must, on the basis of "reciprocity and mutual advantage," negotiate "a substantial reduction in customs tariffs and other impediments to trade, and the elimination of discriminatory practices in international trade."

Also prominent in international economic discussions has been the World Trade Organization (WTO), another important free-trade organization that grew out of the post-World War II political environment. The WTO is an international organization whose stated mission is to supervise international trade and to promote the liberalization of world trade — that is, the reduction of tariffs and other regulatory barriers to the free exchange of products and services across international borders.

The WTO may be seen in key ways as the successor to GATT. GATT was actually intended as a temporary arrangement by many of its founders, who hoped it would be quickly replaced by a specialized United Nations agency to be called the International Trade Organization. The ITO never materialized — in part because of the slow pace at which innovations are instituted at the UN, and perhaps even more importantly because GATT itself had proved so successful at liberalizing world trade in a short period of time. By the mid-1990s, however, a number of countries were calling for a stronger multilateral body to monitor trade and resolve disputes (Danaher & Burbach, 2000, chapter one).

The WTO came into being on January 1, 1995. The 104 countries that composed its initial membership pledged to help enforce all prior GATT agreements. GATT itself ceased to exist in 1994, ceding its liberalization role to the WTO, which then became responsible for the negotiation and implementation of new trade agreements (Danaher & Burbach, 2000, p. 39).

Before leaving the topic of the WTO, a brief note on globalization is warranted. Globalization, or transnationalism, refers broadly to the current flows of capital, people, information, images, and culture across national borders. Such flows have been brought about in large measure through two important and related processes: the reduction of formal trade barriers and the technological advances that make rapid communication and transportation possible.

One further set of important post-war economic institutions deserves mention: the International Monetary Fund (IMF) and the World Bank, both originating during or just after the war years. Both were part of a plan by the world's wealthier nations — along with some poorer ones — to lay the groundwork for a post-war world marked by economic cooperation and stability. The United States was the primary shaper of both institutions, which have had a significant influence on the Mexican economy (Low, 1994).

The World Bank was created primarily to support economic and political reconstruction and development in its member countries by facilitating capital investment for productive purposes. It made loans directly and also recruited private parties to invest in projects in developing nations (Zeiler, 1999, p. 187). The IMF's mission was distinct but related: it was charged with stabilizing international monetary exchange rates and encouraging cooperation in currency exchange. It has often been unable to fulfill this mission — especially during the 1970s, when rising oil prices following OPEC's actions severely destabilized the economies of Mexico and other developing nations. The IMF's inability to stabilize developing-nation currencies has bred deep suspicion among those nations. Perhaps even more damaging in the eyes of the developing world has been the perception that IMF policies have not merely failed poor nations but have actively benefited wealthy ones like the United States. These tensions are keenly felt between Mexico and the United States (Esty, 1994, p. 154).

We come finally to NAFTA, the trade pact signed in 1992 (and which went into effect on January 1, 1994), whose primary goals were the elimination of most tariffs and other barriers to the free trade of goods and services among the three largest nations of North America: Canada, the United States, and Mexico. The major economic impetus for establishing such a free-trade zone was the dramatic success that European Union member states had achieved by eliminating tariffs to increase intra-regional trade.

A tariff is simply one type of tax — often called a customs tax — levied on a product (or, less frequently, a service) traded across an international border, or traded across the borders of a trade bloc into non-member countries. Tariffs both protect domestic workers' jobs and serve as rewards to political allies, and they are an ancient practice.

The general inspiration for NAFTA was thus both the European Union and the long-established practice of taxing internationally traded goods. Its particular basis was a free-trade agreement between the United States and Canada finalized in 1988. NAFTA was in some sense simply an extension of that bilateral agreement into a trilateral one — with the important distinction that while the United States is wealthier than Canada, both are undeniably stable, wealthy, developed nations. By bringing Mexico in as an equal partner, when Mexico is far closer in economic and political structure to a developing nation, the nature of the agreement was altered in important ways, with significant consequences for all partners, including the United States.

The primary intent of NAFTA, like similar agreements, was the reduction of tariffs and all other barriers to trade among the three countries, with some barriers removed immediately and others phased out over time. Not only have goods been able to pass more freely across the borders of the three countries, but companies in each country have also gained greater access to banking, financial services, and communications technologies in the other two nations.

NAFTA has allowed companies in one nation to do business more easily in the other two and has created a more unified economic and political identity for the largest nations of the continent. This would seem at first glance to be a positive development, since most observers hold at some level that free markets and fair competition, unburdened by the protectionist politics of tariffs and other trade barriers, benefit everyone.

The effects of NAFTA have not been quite so straightforward, however. While many trade barriers were erected simply to protect domestic workers and industries — and there is nothing inherently wrong with a government attempting to protect its own workers and companies — others were designed to uphold important moral and legal principles such as environmental protection and the prohibition of child and slave labor (Zeiler, 1999).

We might expect from the theoretical models and historical economic relationship between the two countries that, as trade barriers fall between the United States and Mexico, industrial activity in Mexico would shift toward those sectors in which Mexico holds a comparative advantage. This follows from the assumption that countries will export — and therefore produce — those goods that give them a comparative advantage. Because of the relatively low rate of capitalization in Mexico, the country has a comparative advantage not in producing highly industrialized goods (which require relatively high amounts of technology and capital and relatively little labor) but in producing those goods that require little capitalization and a large supply of low-cost labor.

Conclusion

As tariffs and other forms of economic protectionism are removed, the relationships between countries more closely resemble classical economic models such as the factor proportions theory and the model of comparative advantage, and we have seen this occur between the United States and Mexico over the last several decades. However, adherence to classical economic models — while providing a certain intellectual neatness — is not necessarily an unqualified good. Serious questions remain about the exploitative nature of U.S. trade policies vis-à-vis Mexico, and about the future of both workers and the environment under the expanding power of NAFTA and the WTO.