Free Trade Agreement
(FTA) Definition: How It
Works, With Example
By ADAM BARONE Updated June 04, 2022
Free Trade
Agreement (FTA)
[fré ‘trad a-'gré-mant]
A pact between two or
more nations to reduce
barriers to imports and
exports among them.
@ Investopedia
Investonedia / Julie Rang
Scanné avec CamScannerTABLE OF CONTENTS v
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.
Scanné avec CamScanner| KEY TAKEAWAYS
¢ Free trade agreements reduce or
eliminate barriers to trade across
international borders.
e Free trade is the opposite of trade
protectionism.
e Inthe U.S. and the E.U., free trade
agreements do not come without
regulations and oversight.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.
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.
Scanné avec CamScannerImportant: The benefits of free
trade were outlined in "On the
Principles of Political Economy and
Taxation," published by economist
David Ricardo in 1817.4
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.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. [4
Scanné avec CamScannerFree Trade Models
Mercantilism
Prior to the 1800s, global trade was dominated
by the theory of mercantilism. This theory
placed priority on having a favorable balance
of trade relative to other countries, and
accumulating more gold and silver.
In order to attain a favorable balance of trade,
countries would often place trade barriers like
taxes and tariffs to discourage their residents
from purchasing foreign goods. This
incentivized consumers to purchase locally-
made products, thereby supporting domestic
industries.
Scanné avec CamScannerComparative Advantage
Ricardo introduced the law comparative
advantage, which states that countries can
attain the maximum benefits through free
trade. Ricardo demonstrated that if countries
prioritize producing the goods that they can
produce more cheaply than other countries
(i.e., where they have a comparative
advantage) they will be able to produce more
goods in total than they would by limiting
trade.
Scanné avec CamScannerAdvantages and Disadvantages of
Free Trade
Rapid Development
Free trade has allowed many countries to
attain rapid economic growth. By focusing on
exports and resources where they have a
strong comparative advantage, many
countries have been able to attract foreign
investment capital and provide relatively high-
paying jobs for local workers.
Lower Global Prices
For consumers, free trade creates a
competitive environment where countries
strive to provide the lowest possible prices for
their resources. This in turn allows
manufacturers to provide lower prices for
finished goods, ultimately increasing the
buying power for all consumers.
Scanné avec CamScannerUnemployment and Business Losses
However, there are economic losers when a
country opens its borders to free trade.
Domestic industries may be unable to
compete with foreign competitors, causing
local unemployment. Large-scale industries
may move to countries with lax environmental
and labor laws, resulting in child labor or
pollution.Increased Dependency on the Global
Market
Free trade can also make countries more
dependent on the global market. For example,
while the prices for some goods may be
cheaper on the world market, there are
strategic benefits for a country that produces
those goods domestically. In the event of a
war or crisis, the country may be forced to
rebuild these industries from scratch.
Free Trade Pros and Cons
Pros
« Allows consumers to access the cheapest
goods on the world market.
« Allows countries with relatively cheap
labor or resources to benefit from
foreign exports.
« Under Ricardo's theory, countries can
produce more goods collectively by
trading on their respective advantages.
Scanné avec CamScannerCons
e
Competition with foreign exports may
cause local unemployment and business
failures.
Industries may relocate to jurisdictions
with lax regulations, causing
environmental damage or abusive labor
practices.
Countries may become reliant on the
global market for key goods, leaving
them at a strategic disadvantage in times
of crisis.
Scanné avec CamScannerPublic Opinion on Free Trade
Few issues divide economists and the general
public as much as free trade. Research
suggests that faculty economists at
American universities are seven times more
likely to support free-trade policies than the
general public. In fact, the American
economist Milton Friedman said: “The
economics profession has been almost
unanimous on the subject of the desirability of
free trade.” 2]
Scanné avec CamScannerFree-trade policies have not been as popular
with the general public. The key issues include
unfair competition from countries where lower
labor costs allow price-cutting and a loss of
good-paying jobs to manufacturers abroad.
The call on the public to Buy American may
get louder or quieter with the political winds,
but it never goes silent.Free-trade policies have not been as popular
with the general public. The key issues include
unfair competition from countries where lower
labor costs allow price-cutting and a loss of
good-paying jobs to manufacturers abroad.
The call on the public to Buy American may
get louder or quieter with the political winds,
but it never goes silent.
The View From Financial Markets
Not surprisingly, the financial markets see the
other side of the coin. Free trade is an
opportunity to open another part of the world
to domestic producers.
Moreover, free trade is now an integral part of
the financial system and the investing world.
American investors now have access to most
foreign financial markets and to a wider range
of securities, currencies, and other financial
products. Ad
Scanné avec CamScannerHowever, completely free trade in the financial
markets is unlikely in our times. There are
many supranational regulatory organizations
for world financial markets, including the
Basel Committee on Banking Supervision, the
International Organization of Securities
Commission (LOSCO), and the Committee on
Capital Movements and Invisible Transactions.
Real-World Examples of Free Trade
Agreements
The European Union is a notable example of
free trade today. The member nations form an
essentially borderless single entity for the
purposes of trade, and the adoption of the
euro by most of those nations smooths the
way further. It should be noted that this
system is regulated by a bureaucracy based in
Brussels that must manage the many trade-
related issues that come up between
representatives of member nations.
Scanné avec CamScannerU.S. Free Trade Agreements
The United States currently has a number of
free trade agreements in place. These include
multi-nation agreements such as the North
American Free Trade Agreement (NAFTA),
which covers the U.S., Canada, and Mexico,
and the Central American Free Trade
Agreement (CAFTA), which includes most of
the nations of Central America. There are also
separate trade agreements with nations from
Australia to Peru. [3] [4]
Collectively, these agreements mean that
about half of all goods entering the U.S. come
in free of tariffs, according to government
figures. The average import tariff on industrial
goods is 2%. [5]
Scanné avec CamScannerAll these agreements collectively still do not
add up to free trade in its most laissez-faire
form. American special interest groups have
successfully lobbied to impose trade
restrictions on hundreds of imports including
steel, sugar, automobiles, milk, tuna, beef, and
denim.
Scanné avec CamScannerWhy Were Free Trade Zones Created
in China?
Starting in 2013, China began establishing free
trade zones around key ports and coastal
areas. These were areas where national
regulations were relaxed in order to facilitate
foreign investment and business
development. [¢!
What Is a Free Trade Area?
A free trade area is a group of countries that
have agreed to mutually lower or eliminate
trade barriers for trade within the area. This
allows participating countries to benefit from
reduced tariffs, while maintaining their
existing protections for trade with countries
outside of the area.
Scanné avec CamScannerWhat Are the Arguments Against
Free Trade?
Opponents often assert that free trade invites
foreign competition with domestic industries,
causing job loss and harming key industries. In
some cases, free trade cause manufacturers to
move their operations to countries with fewer
regulations, rewarding companies that cause
pollution or use abusive labor practices. In
other cases, countries with weak IP laws may
steal technology from foreign companies.
Scanné avec CamScannerThe Bottom Line
Free trade refers to policies that allow permit
inexpensive imports and exports, without
tariffs or other trade barriers. In a free trade
agreement, a group of countries agrees to
lower their tariffs or other barriers to facilitate
more exchanges with their trading partners.
This allows all countries to benefit from lower
prices and access to one another's resources.
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