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. Free trade stands in contrast to trade protectionism or economic isolationism.
Key Takeaways
- Free trade agreements reduce or eliminate barriers to trade across international borders.
- Free trade is the opposite of trade protectionism.
- Regulations and oversight still exist within the context of free trade agreements, particularly in areas like the U.S. and the E.U.
How a Free Trade Agreement Works
In the modern world, free trade policy is often implemented via formal agreements among nations. However, it can also exist through the simple absence of trade restrictions. This hands-off approach is known as laissez-faire trade or trade liberalization.
Governments involved with free trade do not completely relinquish control over imports and exports or eliminate all protective measures. Few FTAs result in completely free trade without some exceptions, like forbidding certain non-approved drugs, unvaccinated animals, or non-compliant processed foods.
The Economics of Free Trade
Free trade on an international level allows businesses to focus on producing and selling goods that best utilize their resources, while other businesses import goods that are not readily available domestically. This balance of local and foreign trade boosts economic growth and caters to consumer needs more effectively. David Ricardo, in his 1817 book “On the Principles of Political Economy and Taxation”, showed that free trade also increases the variety, lowers the costs of goods, and better exploits a country’s native resources and skills.
Free Trade Models
Mercantilism
Before the 1800s, mercantilism dominated global trade. This theory emphasized maintaining a favorable balance of trade by limiting imports and encouraging exports, thus accumulating wealth. Barriers like taxes and tariffs were used to discourage foreign goods and promote local industry.
Comparative Advantage
David Ricardo introduced comparative advantage, demonstrating that countries could maximize benefits through free trade by prioritizing the goods they can produce more efficiently. This leads to a net increase in global production compared to limited or no trade.
Advantages and Disadvantages of Free Trade
Rapid Development
Free trade promotes rapid economic growth by enabling countries to leverage export-focused strategies and attract foreign investment, creating high-paying jobs in the process.
Lower Global Prices
Consumers benefit from lower prices due to a competitive global market, which helps manufacturers offer affordable goods, thus increasing purchasing power worldwide.
Unemployment and Business Losses
However, domestic industries may struggle against international competitors, leading to unemployment. Moreover, processes may shift to countries with lax regulations, causing potential labor abuses and environmental harm.
Increased Dependency on the Global Market
Reliance on global markets can be a downside, particularly during crises when domestic production becomes crucial. This dependency may pose strategic risks during blockades or conflicts.
Free Trade Pros and Cons
Pros:
- Access to the cheapest goods on the world market.
- Boosts the economic benefits for countries with cheap labor or resources.
- More efficient global production based on comparative advantages.
Cons:
- May cause local unemployment and business failures due to foreign competition.
- Risk of industries relocating to countries with lax regulations.
- Strategic disadvantages in times of crisis due to dependency on global markets for key goods.
Public Opinion and Markets
Opinions on free trade vary widely. Economists generally favor free trade, while the general public is more skeptical due to concerns about job loss and unfair competition from countries with lower labor costs. Financial markets view free trade as an avenue to expand into global markets, offering greater access to foreign investment opportunities and a variety of financial products, although this remains regulated.
Real-World Examples of Free Trade Agreements
European Union
The E.U. exemplifies contemporary free trade, offering a near borderless environment for member countries to trade freely. While the euro enhances this system, a central bureaucracy manages trade-related matters.
U.S. Free Trade Agreements
The United States holds several free trade agreements, including the North American Free Trade Agreement (NAFTA) with Canada and Mexico. The Dominican Republic-Central America Free Trade Agreement (CAFTA-DR) includes Central American nations and the Caribbean. These agreements result in about half of all U.S. imports coming in tariff-free, though special interest groups have imposed restrictions on many products.
China’s Free Trade Zones
Since 2013, China has established free trade zones around critical ports and coastal areas to attract foreign investment and bolster business development through relaxed regulations.
What Is a Free Trade Area?
A free trade area consists of countries coming together to lower or eliminate tariffs among themselves while maintaining the freedom to set their tariffs against non-member countries. This allows member countries to benefit from reduced tariffs within the area.
Arguments Against Free Trade
Opponents argue that it can harm domestic industries, result in job losses, and encourage companies to move operations to countries with fewer regulations. Concerns also include countries with weak intellectual property laws stealing technology from foreign firms.
The Bottom Line
Free trade policies allow for inexpensive imports and exports by minimizing tariffs and trade barriers. Through free trade agreements, participating countries lower tariffs and foster increased trade, benefiting from lower prices and better access to global resources.
Related Terms: laissez-faire, mercantilism, comparative advantage, trade liberalization.
References
- McMaster University. “On the Principles of Political Economy and Taxation”.
- The Wilson Center. “Chapter 3: Trade Agreements and Economic Theory”.
- Federal Reserve Bank Of St. Louis. “Free Trade: Why Are Economists and Noneconomists So Far Apart?”
- Kansas State University. “Landon Lecture (April 27, 1978) Free Trade: Producer Versus Consumer”.
- European Union. “The European Union, What It Is and What It Does”.
- European Union. “Trade”.
- European Union. “Types of Institutions and Bodies”.
- U.S. Customs and Border Protection. “Free Trade Agreements”.
- U.S. Customs and Border Protection. “North American Free Trade Agreement”.
- Office of the United States Trade Representative. “Industrial Tariffs”.
- Government of Canada. “Free Trade Zones in China”.
