What is Free Trade

Free trade is a market model in which trade in goods and services between or within countries flows freely without any restriction, such as tariffs, quotas, non-tariff barriers, or taxes. Utilizing the argument that the free market is the best “governor” to ensure increase in wealth, free trade demands that government intervention with the “free” market be eliminated and all restrictions be removed. In history, the merit of free trade was extensively discussed by Adam Smith in 1776 in his book The Wealth of Nations,, examining the gains of free trade in the context of specialization and division of labor (absolute advantage theory).
The idea of free trade was also later formulated by David Ricardo by using one factor of production with constant productivity of labor in two goods, but with relative productivity between the goods different across countries (comparative advantage theory). David Ricardo claimed that gains from free trade will be great once a policy of free trade is adopted in an institutional setting. For Jagdish Bhagwati, the classical and neoclassical schools of economic theory constantly emphasized the advantages of free trade policies for the improvement of popular living standards and the promotion of overall rates of economic growth, and the disadvantages of protectionism. The basic conclusion of classical and contemporary neoclassical economic theory is that the advantages of free international trade represent basically only a special case of the advantages of the free market system in general.
Nevertheless, in the 20th century, “New Trade Theory” manifested itself as the economic critique of international free trade from the perspective of increasing returns to scale and the network effect. Some economists asked whether it might be effective for a nation to shield infant industries until they grow to sufficient size to compete internationally. According to this theory, the optimum-tariff and infant-industry arguments constituted some grounds for protection and protectionist policies by some countries, and more importantly were seen as a departure from free trade within the framework of the traditional theory. However, the general trend in international trade is in line with the reduction of tariffs and other trade restrictions through international negotiations.
Theories
Absolute advantage in trade theory was introduced to the literature by Adam Smith, whose view of the economic system was that nations’ wealth is equal to their production capacity. In his positive-sum economy it is perfectly possible to make everybody better off and real incomes per head are able to rise indefinitely as a policy of laissez-faire promotes economic growth. In his view, as self-interest is combined with competition, which also serves public interest, division of labor increases productivity. He fortified the idea of free trade with only one production factor, which was labor. His labor theory of value states that the value of a good is determined by the amount of labor required to produce it. Nevertheless he did not consider how to deal with capital, land, and profits.
Comparative advantage was offered by David Ricardo in order to fill gaps in Adam Smith’s approach on absolute advantage of nations in trade. Ricardo, like Adam Smith, was opposed to tariff and other restrictions on international trade. The Ricardian model focuses on comparative advantage of nations. It is considered perhaps the most important approach in international free trade theory today. In a Ricardian model, countries specialize in producing what they produce best, and comparative advantage is the ability to produce a good at a lower cost, relative to other goods, compared to another country. In Principles of Economics, Ricardo states comparative advantage is a specialization technique used to create more efficient production and describes opportunity cost between producers.
Ricardo’s idea of comparative advantage suggests that unrestricted free trade brings about increased world production; that is, that trade is a positive-sum game, and also suggests that opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. However, it has its own limitations as well. The most important limitations are that nations strive only to maximize production and consumption; only two countries produce and consume just two goods; no transportation costs of trading goods; labor is the only resource used to produce goods; and ignore efficiency and improvements gains from producing just one good.
The Heckscher-Ohlin factor productivity theorem was introduced by Eli Heckscher and his student Bertil Ohlin in the 1920s as an alternative to the Ricardian basic comparative advantage theory. This theorem builds its own assumptions on David Ricardo’s theory of comparative advantage by predicting patterns of trade. For this theorem, relative endowments of the factors of production (labor and capital) determine a country’s comparative advantage. It also suggests that the pattern of international trade is determined by differences in factor endowments. In addition, this theorem has variable factor proportions between countries, e.g., highly developed countries have a comparatively high ratio of capital to labor in relation to developing countries. This makes the developed country capital-abundant relative to the developing country and the developing nation labor-abundant in relation to the developed country. Similarly, this theorem has also its own limitations. Even so, this approach does not answer certain question. Why does a country with cost advantage not capture the whole export market? What would happen if countries have similar relative factor endowments? What would happen in the case of intra-industry trade? What would happen in the case of trade liberalization?
Arguments in Favor of Free Trade
According Anne Krueger, one of central themes of economics for the last two centuries has been the proposition that free trade between nations will be beneficial, and any nation that adopts a policy of free trade will benefit highly from free trade opportunities. Nevertheless, the protection to infant industries and pressure for it found enough support to create circumstances that support protectionism in trade. There are mainly two different opposite arguments in international free trade literature. These are arguments in favor of free trade and against of free trade.
Arguments for free trade mostly concentrate on its enhancing power of national welfare. To be able to explain the welfare impacts, these arguments focus on three aspects. These are (1) the efficiency gains from free trade; (2) the additional gains from economies of scale; and (3) the political argument.
Efficiency arguments: Although moving toward free trade may represent very real financial losses for the small minority of companies with the political influence to get themselves protected from foreign competition, these losses are normally much lower than the gains to the great majority of the population. The neoclassical school underlines the case for free trade with propositions on efficiency and aggregate welfare. For Arye Hillman, the neoclassical school defends the idea that, given sufficient information, compensating lump-sum transfers can ensure that a policy of free trade is in the self-interest of every individual of an economy. Paul Krugman and Maurice Obstfeld stated that the first case for free trade is the argument that producers and consumers allocate resources most efficiently when governments do not distort market prices through trade policy With restricted or protected trade, consumers pay higher prices and distorted prices cause overproduction either by existing firms producing more or by more firms entering the industry
The efficiency argument for free trade is based on the result that in the case of a small country, free trade is the best policy for the national welfare. According to this argument, a tariff causes a net loss to the economy and a move from tariff equilibrium to free trade eliminates the efficiency loss and increases national welfare.
There are two basic arguments in defense of free trade in the presence of domestic distortions: (1) domestic distortions should be corrected with domestic (as opposed to international trade) policies; for example: a domestic production subsidy is superior to a tariff in dealing with a production-related market failure; and (2) market failures are hard to diagnose and measure; for example: a tariff to protect urban industrial sectors will generate social benefits, but it will also encourage migration to these sectors that will result in higher unemployment.
Additional gains from economies of scale: Protected markets in small countries do not allow firms to exploit scale economies. For example, in the auto industry, an efficient scale assembly should make a minimum of 80,000 cars per year. In Argentina, 13 firms produced a total of 166,000 cars per year. Therefore, the presence of scale economies favors free trade that generates more varieties and results in lower prices, and free trade provides a wider range of opportunities and thus a wider scope for innovation.
Political argument for free trade: A political commitment to free trade is considered as the best strategy. Any policy that deviates from free trade would be quickly manipulated by special interests, leading to decreased national welfare. Free trade requires security and consistency in politics; therefore, it can be used as a kind of pressure on countries to sustain their political balances.
Arguments Against Free Trade
There are three theoretical arguments against the policy of free trade. Arguments against free trade focus on (1) market failure argument, (2) benefits of tariffs, and (3) infant industries argument.
The terms of trade argument for a tariff: An optimum tariff based on the application of a country’s market power in the international market improves its terms of trade. For a large country (that is, a country that can affect the world price through trading), a tariff lowers the price of imports and generates a terms of trade benefit. This benefit must be compared to the costs ofthe tariff (production and consumption distortions). It is possible that the terms of trade benefits of a tariff outweigh its costs. Therefore, free trade might not be the best policy for a large country.
The domestic market failure argument: According to Arye Hillman, in the absence of compensatory transfers or other income adjustments, there will be no consensus how to select a trade policy that will benefit everybody in the society. Producer and consumer surplus do not properly measure social costs and benefits. Consumer and producer surplus ignore domestic market failures such as (1) unemployment or underemployment of labor, (2) technological spillovers from industries that are new or particularly innovative, and (3) environmental externalities.
A tariff may raise welfare if there is a marginal social benefit to production of a good that is not captured by producer surplus measures. The domestic market failure argument against free trade is a particular case ofthe theory ofthe second best. The theory ofthe second best states that a hands-off policy is desirable in any one market only if all other markets are working properly. If one market fails to work properly, a government intervention may actually increase welfare.
Infant industries argument: The infant industries argument states that developing countries have potential comparative advantages in manufacturing and they can initialize this potential through an initial period of protection. The best policy to protect domestic industries is to use tariffs or import quotas as temporarymeasures to get industrialization started. One ofthe most important reasons for this strategy is that capital markets are imperfect in most developing countries in their initial development stage. If a developing country does not have a set of financial institutions that would allow savings from traditional sectors (such as agriculture) to be used to finance investment in new sectors (such as manufacturing), then growth of new industries will be restricted. Furthermore, firms in a new industry generate social benefits for which they are not compensated (e.g., start-up costs of adapting technology). In practice, infant industries argument was supported by the import substituting industrialization policy in many developing countries during the 1960s and the 1970s, and many less developed countries pursued this strategy.
International Negotiations
International integration increased from the mid-19308 until about 1980 because advanced countries gradually removed tariffs and non-tariff barriers to trade, and the removal of tariffs became politically possible through international trade negotiations.
It is easier to lower tariffs as part of a mutual agreement as a unilateral policy because it helps mobilize exporters to support freer trade, and it can help governments avoid getting caught in destructive trade wars. Since World War II, the multilateral tariff reductions have taken place under the General Agreement on Tariffs and Trade (GATT), which was established in 1947 as a provisional international agreement, and then in 1995, it was replaced by a more formal international institution called the World Trade Organization (WTO). The GATT-WTO system is a legal organization that embodies a set of rules of conduct for international trade policy. The GATT-WTO system prohibits the imposition of (1) export subsidies (except for agricultural products), (2) import quotas (except when imports threaten “market disruption”), or (3) tariffs (any new tariff or increase in a tariff must be offset by reductions in other tariffs to compensate the affected exporting countries).
Their negotiations address trade restrictions in at least three ways: (1) reduction of tariff rates through multilateral negotiations, (2) binding: a tariff is “bound” by having the imposing country agree not to raise it in the future, and (3) prevention of non-tariff barriers: quotas and export subsidies are changed to tariffs because the costs of tariff protection are more apparent.
Preferential trading agreements are trade agreements between countries in which they lower tariffs for each other but not for the rest of the world. There are three types of preferential trading agreements in which tariff rates are set at or near zero: (1) a free trade area: an agreement that allows free trade among members, but each member can have its own trade policy towards nonmember countries: an example is the North America Free Trade Agreement (NAFTA); (2) a common market is a customs union with free factor movements (especially labor) among members; and (3) a customs union: an agreement that allows free trade among members and requires a common external trade policy towards nonmember countries: an example is the European Union.
Free trade-related negotiations can also be linked with regional integration, which is believed strengthens structural reforms, provides economic transformation, attracts foreign direct investment, emphasizes the importance of geopolitics, and helps corporations to function. Key regional blocs that pursue free trade agreements are EU (European Union), NAFTA (North American Free Trade Agreement), Merco-sur/Mercosul (Southern Cone Common Market), ASEAN (Association of South-East Asian Nations), CACM (Central American Community), and FTAA (Free Trade Area of the Americas).
Compared to previous decades, the proliferation of regional trade agreements (RTAs) during the last 10 years took place at an unprecedented rate and eventually became a very prominent feature of the multilateral trading system (MTS). Some 380 RTAs have been notified to the GATT/WTO up to July 2007. Of these, 300 RTAs were notified under Article XXIV of the GATT 1947 or GATT 1994; 22 under the Enabling Clause; and 58 under Article V of the GATT. At that same date, 205 agreements were in force. If we take into account RTAs that are in force but have not been notified, those signed but not yet in force, those currently being negotiated, and those in the proposal stage, we arrive at a figure of close to 400 RTAs that are scheduled to be implemented by 2010.
Of these RTAs, free trade agreements (FTAs) and partial scope agreements account for over 90 percent, while customs unions account for less than 10 percent. While the greatest concentration of RTAs is in Europe, more than 100 RTAs are in force. The main focus of RTA activity has shifted away from Europe in the last two years toward Asia Pacific. The Asia Pacific Economic Cooperation (APEC) members, in particular, have been among the most active participants in RTAs.
In fact, RTAs are a fundamental departure from the principle of nondiscrimination of the WTO. Two broad questions raised by the formation of RTAs are (1) welfare effects: How does the creation, expansion or merger of RTAs affect the welfare of member and nonmember countries? and (2) stability: When is a trade arrangement stable? Are RTAs “stepping stones” or “stumbling blocks” toward global free trade. Welfare effects of RTAs are in particular very important because of static allocation effects (trade creation/diversion, terms of trade effects, pro-competitive, and product variety effects); accumulation effects (medium and long run growth effects), and location effects (spatial allocation of resources as economic geography studies the location of production in space). RTAs can also have growth effects. Economic integration may raise the incentive to innovate, and therefore may improve the economic growth performance of members through research and development and technological spillovers.