Free Trade

A. What is a Free Trade Agreement (FTA)?

A free trade agreement is a pact between two or more nations to reduce barriers to imports
and exports among them. Under a free trade policy, goods and services can be bought and sold
across international borders with little or no government tariffs, quotas, subsidies, or
prohibitions to inhibit their exchange.

The concept of free trade is the opposite of trade protectionism or economic isolationism.

B. How a Free Trade Agreement Works

In the modern world, free trade policy is often implemented by means of a formal and mutual
agreement of the nations involved. However, a free-trade policy may simply be the absence
of any trade restrictions.

A government doesn't need to take specific action to promote free trade. This hands-off stance
is referred to as “ laissez-faire trade” or trade liberalization. Laissez-faire is an economic
theory from the 18th century that opposed any government intervention in business affairs.
The driving principle behind laissez-faire, a French term that translates to "leave alone"
(literally, "let you do"), is that the less the government is involved in the economy, the better
off business will be, and by extension, society as a whole.

Governments with free-trade policies or agreements in place do not necessarily abandon all
control of imports and exports or eliminate all protectionist policies. In modern international
trade, few free trade agreements (FTAs) result in completely free trade.

For example, a nation might allow free trade with another nation, with exceptions that forbid
the import of specific drugs not approved by its regulators, or animals that have not been
vaccinated, or processed foods that do not meet its standards.
Or, it might have policies in place that exempt specific products from tariff-free status in order
to protect home producers from foreign competition in their industries.

C. The Economics of Free Trade

In principle, free trade on the international level is no different from trade between neighbors,
towns, or states. However, it allows businesses in each country to focus on producing and
selling the goods that best use their resources while other businesses import goods that are
scarce or unavailable domestically. That mix of local production and foreign trade allows
economies to experience faster growth while better meeting the needs of its consumers.

This view was first popularized in 1817 by economist David Ricardo in his book, "On the
Principles of Political Economy and Taxation." He argued that free trade expands the diversity
and lowers the prices of goods available in a nation while better exploiting its homegrown
resources, knowledge, and specialized skills.
 D. Arguments on free trade

Free trade means that countries can import and export goods without any tariff barriers or other
non-tariff barriers to trade.

Essentially, free trade enables lower prices for consumers, increased exports, benefits from
economies of scale and a greater choice of goods.

In more detail, the benefits of free trade include:

1. The theory of comparative advantage

This explains that by specialising in goods where countries have a lower opportunity cost, there
can be an increase in economic welfare for all countries. Free trade enables countries to
specialise in those goods where they have a comparative advantage.

2. Reducing tariff barriers leads to trade creation

Trade creation occurs when consumption switches from high-cost producers to low-cost
producers.

• The removal of tariffs leads to lower prices for consumers (Prices fall from P1
to P2)
• This fall in prices enables an increase in consumer surplus of areas 1 + 2 + 3 +
4
• Imports will increase from Q3-Q2 to Q4-Q1
• The government will lose tax revenue of area 3. Tax revenue from imports was
T (P1-P2) × (Q3-Q2)
• Domestic firms producing this good will sell less and lose producer surplus
equal to area 1
• However, overall there will be an increase in economic welfare
of 2+4 (1+2+3+4 – (1+3)
• The magnitude of this increase depends upon the elasticity of supply and
demand. If demand elastic consumers will have a big increase in welfare
• Essentially, removing tariffs leads to lower prices for consumers – so the price
of imported food, clothes and computers will be lower. When the UK joined the
EEC – the price of many imports from Europe fell.
3. Increased exports

As well as benefits for consumers importing goods, firms exporting goods where the UK has a
comparative advantage will also see a significant improvement in economic welfare. Lower
tariffs on UK exports will enable a higher quantity of exports boosting UK jobs and economic
growth.

4. Economies of scale

If countries can specialise in certain goods they can benefit from economic of scale and lower
average costs; this is especially true in industries with high fixed costs or that require high
levels of investment. The benefits of economies of scale will ultimately lead to lower prices for
consumers and greater efficiency for exporting firms.

5. Increased competition

With more trade, domestic firms will face more competition from abroad. Therefore, there will
be more incentives to cut costs and increase efficiency. It may prevent domestic monopolies
from charging too high prices.

6. Trade is an engine of growth.

World trade has increased by an average of 7% since 1945, causing this to be one of the
significant contributors to economic growth.

7. Make use of surplus raw materials

Middle Eastern countries such as Qatar are very rich in reserves of oil, but without trade, there
would be not much benefit in having so much oil. Japan, on the other hand, has very few raw
materials; without trade, it would have low GDP.

8. Tariffs may encourage inefficiency

If an economy protects its domestic industry by increasing tariffs industries may not have any
incentives to cut costs.
 E. Arguments against free trade

Many economists support free trade. However, in some circumstances, there are arguments in
favour of trade restrictions. These include when developing economies need to develop infant
industries and develop their economy. Following are the reasons for blocking free trade.

1. Infant industry argument

If developing countries have industries that are relatively new, then at the moment these
industries would struggle against international competition. However, if they invested in the
industry then in the future they may be able to gain comparative advantage.

• This shows that comparative advantage can change over time.

• Protection would allow developing industries to progress and gain experience
to enable them to be able to compete in the future.
• More on infant industry argument.

2. The Senile industry argument

If industries are declining and inefficient they may require significant investment to make them
efficient again. Protection for these industries would act as an incentive to for firms to invest
and reinvent themselves. However, protectionism could also be an excuse for protecting
inefficient firms

3. To diversify the economy

Many developing countries rely on producing primary products in which

they currently have a comparative advantage. However, relying on agricultural products has
several disadvantages

• Prices can fluctuate due to environmental/weather factors

• Goods have a low-income elasticity of demand. Therefore with economic
growth demand will only increase a little.

4. Raise revenue for the government.

Import taxes can be used to raise money for the government – however, this will only be a
relatively small amount of money

5. Help the Balance of Payments

Reducing imports can help the current account as it restricts imports. However, in the long-
term, this is likely to lead to retaliation and also cause lower exports so it might soon prove
counter-productive.

6. Cultural Identity

This is not really an economic argument but more political and cultural. Many countries wish
to protect their countries from what they see as an Americanisation or commercialisation of
their countries.
 7. Protection against dumping

Dumping occurs when a country has excess stock and so it sells below cost on global markets
causing other producers to become unprofitable. The EU sold a lot of its food surplus from the
CAP at very low prices on the world market; this caused problems for world farmers because
they saw a big fall in their market prices. Other examples include allegations that China has
been dumping excess supply of steel on global markets causing other firms to go out of
business.

8. Environmental

It is argued that free trade can harm the environment because LDC may use up natural reserves
of raw materials to export. Also, countries with strict pollution controls may find consumers
import the goods from other countries where legislation is lax and pollution allowed.

• However, supporters of free trade would argue that it is up to individual

countries to create environmental legislation