Free trade is one of those concepts espoused by economists that makes perfect sense in the abstract. When one looks a bit closer, however, questions can be raised about whether we as citizens and consumers should support the implementation of free trade principles and policies. Ultimately, it depends on one’s point of view.
I. What Is Free Trade?
II. What Is Nonfree Trade?
III. Back to Basics
IV. What Are the Issues that Prompt Free Trade among Nations?
V. Where Is Free Trade?
VI. What Are the Issues?
VII. What Are the Various Perspectives?
VIII. What Are the Options?
What Is Free Trade?
Simply put, free trade is the exchange or sale of goods or services without the addition of any tariff or tax. It is common for import taxes to be levied when goods are brought into a country. Often, products that are produced outside a country are taxed, sometimes heavily, when foreign manufacturers bring these products into the home country for sale.
The notion of free trade says, for example, that there should be no additional taxes on foreign imports of cars vis-a-vis domestically produced automobiles.
What Is Nonfree Trade?
Another label for nonfree trade is protectionism. In this case, tariff s or taxes, trade restrictions, or quotas may be placed on the import of goods and services into a country. This is done to protect businesses in the home country from competitors. Opponents of free trade sometimes call this practice fair trade.
On the surface, for a resident of the home country, higher prices for imported goods means that the home country’s goods will be purchased equally if not more robustly than a foreign competitor’s products and moreover that those purchases will sustain businesses and save jobs in the home country. The truth, however, is more complicated. Adding tariff s in order to level the playing field between foreign and domestic competition actually ends up taxing consumers and causing them to pay higher prices.
Back to Basics
The fundamental laws of trade were first hypothesized in 1776 by Adam Smith in his treatise The Wealth of Nations. In this document, Smith had a simple make-buy argument: do not make at home what you can buy cheaper elsewhere. This applies to countries as well as to individuals. Th us, if one country (say, China) can make shoes cheaper than another (say, the United States), then it would make sense for Americans to buy shoes that are made in China. Smith’s argument is logical in that we can do the things that we do well and buy goods and services from other countries that do those things well. This argument makes very good sense in the abstract.
As we can see in Figure 1, country 1 has a lower cost (C1) than the cost for the product produced in country 2 (C2) for the product being made. If we presume the same profit, X, then the price (P1) of the product produced in country 1 will be lower than the price (P2) of the product produced in country 2. This should be fundamentally good for consumers. However, if a tax (T) is added to the price for the good produced in country 1, as shown in Figure 3, then consumers will pay the same amount for the product and not realize any potential savings for efficiencies, as seen in Figure 2.
Figure 1. Costs and Corresponding Prices
Figure 2. Prices under Nonfree Trade
The example begs the question of what would happen if the tax were not imposed and free trade were enabled. Figure 3 illustrates the value to the consumer of free trade. In the example, both countries produce wine and wheat. However, country 1 produces wheat at a lower cost than country 2. Likewise, country 2 produces wine at a lower cost than country 1. If a consumer was able to buy wine from country 2 and wheat from country 1 (without any interference from tariff s), she would expend less money for both products.
Figure 3. Tariff -Free Spending
What Are the Issues that Prompt Free Trade among Nations?
There are two fundamental factors that prompt nations to engage in free trade. One is buying power (or selling power), and the other is cost.
Consider the trading power of a nation. In our prior example, the more products a trading unit (i.e., a nation) has that it can produce at a low cost, the more opportunities it will have to trade. If each state in the United States were acting independently, it would have to be very efficient at organizing trades that would take a small number of products and obtain all of the products that the individual state would need. However, with all 50 states operating without trade barriers, the movement of goods and services is free flowing. Consumers do not have artificial pricing increased by taxes. Trading power is enhanced in a free trade environment.
Cost is the second issue prompting free trade. Think about the possibility that a truckload of product would need to stop at the border of each state to continue. In addition to the time lost in the stops, a tax would be charged at each checkpoint. The total cost of the product in such a scenario would be increased dramatically. In fact, at one time, the truck transportation cost was estimated to be twice as much in Europe as it was in the United States due to border checkpoints where inspections would be made and taxes levied. Therefore, we can presume that total cost in a nonfree trade environment would be higher.
Where Is Free Trade?
One of the classic examples of an implementation of free trade policies is the formation of the European Union (EU). The countries in Europe maintained separate governments, currencies, and standards over centuries. The EU was formed to enhance political, social, and economic cooperation. As an example, prior to the formation of the EU, there was no free movement of people from country to country. Licensing standards for medical and professional personnel were neither consistent nor even recognized from one country to the next. In fact, these standards were so different and so ingrained in the laws of each country that it took 17 years to reach agreement on the qualifications for an architect. Architects, like other professionals, could not move freely from one country to another. Once the EU was established, architects could move from one country to another because they would be licensed in all of the countries in the EU. Licensing standards for doctors and other medical personnel were among those that would be harmonized, or standardized.
Uniting Europe was done for two stated reasons: preventing another world war and creating an economic unit as strong as the United States. The issues in the EU were many, and the task was very daunting in the beginning. Issues included a difference in tax rates (i.e., high in the United Kingdom and low in southern European countries), government (i.e., monarchy vs. democracy), currencies (each country with its own currency), and wages (i.e., high in the heavily industrialized countries and low in other countries). The common currency, the euro, came into use officially in 1999, and many of the other issues are either unresolved or have been recently resolved. So we might say that the jury is still out on the EU’s success. (The global economic crisis of 2008–2009 caused some frayed relations but left the system intact; and even the collapse of the Greek economy in 2010 was being dealt with by means of EU policies and procedures.)
The North American Free Trade Agreement (NAFTA) was launched in 1994. Canada, Mexico, and the United States formed the world’s largest free trade area. Unlike the EU, there is no supraorganization over the independent participants. The agreement called for the elimination of duties on half of all U.S. goods shipped to Mexico and Canada immediately and for the phasing out of other tariff s over a period of 14 years. The treaty protected intellectual property and also addressed the investment restrictions between the three countries.
Several reports have been published that address the progress of the NAFTA agreement 10 years later. The Yale Economic Review reports that, during the five years before NAFTA, Mexican gross domestic product grew at 3 percent (U.S. Department of Commerce 2004). After the agreement, however, this rate increased to a high of 7 percent (prior to the global economic crisis). During the 10 years post-NAFTA, exports from the United States to Canada increased by 62 percent, and exports to Mexico increased by 106 percent. Canada’s success with NAFTA is also well established.
What Are the Issues?
There are a number of issues and questions regarding free trade. The issues concern the economy, the political situation, and social matters.
One question has to do with workers’ rights. Stories abound of child labor in foreign countries and poor wages, such as 50 cents per hour. The presumption is that these wages are slave labor rates in comparison to those of the United States. However, wherever globalization has taken hold, workers most often have seen dramatic improvements in their working conditions. Since foreign-owned companies are likely to provide similar conditions to their overseas versus domestic workers, local firms are forced to compete. Foreign-owned companies typically pay more than local businesses and provide a better environment to attract the best possible workers.
Another question relates to the environment. One view is that companies will set up shop at locations where they might avoid environmental constraints. However, this is usually a minor issue in the siting of a facility. Higher on the list of requirements are tax laws, legal systems, and an educated workforce. Infrastructure, such as transportation and packaging facilities, are also high on the list. Empirical evidence shows that the environmental standards of countries with free trade actually improve and do not deteriorate.
How does free trade affect manufacturing? Free trade, in the view of most, if not all, economists, is actually an advantage to U.S. manufacturing. Increasing productivity and decreasing costs force innovation and an increase in profitability. In fact, during the period 1992 to 1999, when the U.S. economy increased by 29 percent overall, manufacturing output increased by considerably more: 42 percent.
So we need to ask whether free trade enables movement of people across borders. Is immigration bad for the United States? The answer actually is no. Immigrants tend to fill gaps in worker shortages and often bring technical skills with them. Furthermore, a study by the National Research Council found that immigrants and their children actually pay more in taxes than they consume in services (Simon 1995).
What about the phenomenon called brain drain? This is when nations or regions lose skilled or educated workers owing to the availability of better-paying jobs elsewhere. Poor countries often educate their population in specific jobs in medical areas and other professions in the hope that they will stay, only to find that some rich countries try to attract them away. The BBC reports that one-third of doctors in the United Kingdom are from overseas (Shah 2006). The report goes on to state that African, Asian, and Latin American nations are plagued by the brain drain issue.
Finally, free trade always spurs a discussion on jobs. While imported goods may take some jobs away from a country, such jobs generally are in industries that are less competitive. More often than not, technological changes, shifts in monetary policy, and other nontrade factors lie behind the loss of jobs. Increasing imports, it is generally considered among economists, actually increases jobs and serves to make workers more productive. (Remember, however, that this effect is in the aggregate, not in specific industries.)
What Are the Various Perspectives?
The benefits to the individual consumer are well documented. As seen in Figure 3, the individual will pay less overall for goods and services under a free trade economy. Furthermore, he will be able to buy higher-quality goods at lower prices than without free trade. The downside, of course, is that, while the long-term benefit is clear, the short term presents problems, especially if one’s job is impacted by the movement abroad.
Countries that engage in free trade, or at least lower trade barriers, enjoy higher standards of living overall. As noted by Griswold (1999), trade moves to those industries where productivity and returns are higher. Thus, workers will have more job opportunities at higher wages.
There are also national implications from the value of the U.S. dollar (or the home currency). If trade barriers are imposed, imports are restricted. Americans then spend less on foreign goods, which makes its currency higher with respect to other currencies. Thus, any industry that is not protected by tariffs becomes less competitive in world markets, and the United States is less able to export. It is a vicious cycle: restricting imports creates higher currency value, which then inhibits exports.
From the corporate perspective, with free trade, raw materials may be purchased more cost-effectively, manufacturing becomes more streamlined, and lower costs make products more profitable. When we consider the changes in industries that will make one industry more profitable, we should also examine whether a change in one industry places even more pressure on another. In our steel example (see sidebar “Loss of Jobs as a Personal Issue”), if quotas are imposed once steel moves off shore, then automobiles become less competitive domestically.
Continuing with the steel example, some of the “buy American” slogans may be misleading when we examine them further. According to Blinder (2002), the estimated cost of saving jobs by implementing protectionism is staggering. He cites costs of restricting imports in the automobile industry “at $105,000 per job per year, one job in TV manufacturing at $420,000, and one job in steel at $750,000/year.” No wonder the steel industry was one of the earliest to leave U.S. shores.
What Are the Options?
One option for free trade is balanced trade. In this model, countries must provide a balance from each country. Neither country is allowed to run deficits at the risk of penalties. Some critics of this approach think that innovation may be stifled.
Another option is called fair trade. In this scenario, standards are promoted for the production of goods and services, specifically for exports from lesser-developed countries to well-developed (First World) countries.
Another alternative is an international or bilateral barter program, which would force the matching of imports and exports. Finally, establishing increased credit risk for international loans, especially those brought on by trade imbalance, would lower the volume of uneven trade and look to the economic market for discipline.
Free trade is the movement of goods, services, capital, and labor across boundaries without tariff s or other nontariff trade barriers. Arguments against it and for the use of tariff s are intended to save jobs, but actually the application of tariff s costs consumers more for final goods and services and restricts competition in a number of fundamental ways. Free trade is not a main factor in the loss of jobs. Rather, free trade helps to improve productivity and, ultimately, raise the standard of living overall.
Diane H. Parente
- Bhagwati, Jagdish, Free Trade Today. Princeton, NJ: Princeton University Press, 2002.
- Blinder, Alan S., “Free Trade.” The Concise Encyclopedia of Economics, 2d ed. 2002. http://www.econlib.org/library/Enc/FreeTrade.html
- Griswold, Daniel, “Trade, Jobs, and Manufacturing: Why (Almost All) U.S. Workers Should Welcome Imports.” Trade Briefing Paper, September 30, 1999. http://www.cato.org/publications/trade-briefing-paper/trade-jobs-manufacturing-why-almost-all-us-workers-should-welcome-imports
- Irwin, Douglas A., Free Trade under Fire, 3d ed. Princeton, NJ: Princeton University Press, 2009.
- Roberts, Russell D., The Choice: A Fable of Free Trade and Protectionism. Upper Saddle River, NJ: Pearson Prentice Hall, 2007.
- Shah, Anup, “Criticisms of Current Forms of Free Trade.” Global Issues (March 31, 2006). http://www.globalissues.org/article/40/criticisms-of-current-forms-of-free-trade
- Simon, Julian L., Immigration: The Demographic and Economic Facts. Cato Institute, December 11, 1995. http://store.cato.org/free-ebooks/immigration-economic-demographic-facts
- U.S. Department of Commerce, International Trade Administration, Office of Industry Trade Policy, “NAFTA 10 Years Later.” 2004. http://www.trade.gov/mas/ian/build/groups/public/@tg_ian/documents/webcontent/tg_ian_001998.pdf