Free trade

The Case for “Free Trade”

Economists and policymakers have argued for centuries about whether it is better for a country to engage in free trade with other countries, or to limit trade using policy tools. Many economic theorists argue for a “free trade” position, using the Ricardian model of trade to argue that a country that engages in trade can reap significant welfare gains. David Ricardo, in On the Principles of Political Economy and Taxation (1817), presented a simple model that showed how national specialization in the production of one of two goods, followed by exchange of the two goods across national boundaries, could allow two countries to achieve levels of consumption that would be impossible on their own. In this section, we present Ricardo’s basic model, along with other arguments for free trade.

The Ricardian Model

File:Portugal’s Production Possibilities Frontier graph.gif

Ricardo used the example of two goods—wine and cloth—and two countries, Portugal and England. England has a relatively cool and cloudy climate that makes it ill-suited for grape-growing. Portugal, meanwhile, has a relatively warm and sunny climate, good for grapes.

Suppose that, given its resources, Portugal can produce a maximum of 200 units of wine, if it devotes all its resources to wine, or 100 units of cloth, if it devotes all of its resources to cloth. (A “unit” is just a specified amount, for example 1,000 bottles of wine, or 1,000 bolts of cloth – we use this terminology to keep the example numerically simple). This is illustrated in Figure 1, using a Production Possibility Frontier, along with the simplifying assumption that production has constant returns (so the frontier is just a straight line). Meanwhile, England can produce a maximum of 200 units of wine or 400 units of cloth, as illustrated in Figure 2.

File:England’s Production Possibilities Frontier graph.gif

But suppose that the Portuguese would like to be able to consume 100 units of wine and 100 units of cloth, as represented by point A in Figure 1, and the English would like to be able to consume 100 units of wine and 300 units of cloth, represented by point B in Figure 2. As we can see, if each relies only on its own production possibilities, points A and B are unachievable.

But suppose that Portugal specialized in producing wine, while England specialized in cloth production. This production combination is illustrated in the Production section of Table 1 and by points C and D in Figures 1 and 2. Total production would be 200 units of wine, and 400 units of cloth.

Further, suppose that Portugal and England were to agree to trade 100 units of Portuguese wine for 100 units of English cloth, as listed in the Exchange section of Table 1. The costs of imports relative to exports are called the terms of trade. In this example, when England and Portugal exchange 100 units of wine for 100 units of cloth, the terms of trade are 1:1.

Table 1: Production, Exchange, and
Consumption of Wine and Cloth
Production Wine Cloth
Portugal 200 0
England 0 400
Total 200 400
Exchange
Portugal sell 100 buy 100
England buy 100 sell 100
Consumption
Portugal 100 100
England 100 300
Total 200 400

Now Portugal and England could each consume the quantities listed in the Consumption section of Table 1. Note that their total consumption does not exceed the total amount produced of each good; but Portugal can now consume at point A, and England at point B—the desired points that they could not each reach on their own!

The “magic” behind this result is that Portugal and England differ in their opportunity costs of production. For every unit of cloth Portugal produces, it must give up the production of 2 units of wine. For every unit of cloth England produces, it needs to give up production of only half a unit of wine. England has a comparative advantage in cloth production, since cloth costs less in terms of the other good (wine) in England than in Portugal. Portugal, likewise, has a comparative advantage in production of wine. An additional unit of wine comes at the cost of ½ a unit of cloth when produced in Portugal, but requires giving up 2 units of cloth when produced in England, as noted in Table 2.

Table 2: Opportunity Cost and
Comparative Advantage
Country Opportunity Cost of
1 Unit of Cloth
Opportunity Cost of
1 Unit of Wine
Portugal 2 units of wine ½ unit of cloth
England ½ unit of wine 2 units of cloth

The principle of comparative advantage says that you should specialize in what you do (relatively) best. Even if it turns out that one of the countries is more efficient at producing both goods, it still pays to specialize. Only if both countries have the same opportunity costs will there be no possible gains from trade.

In the case of Ricardo’s story, the source of comparative advantage was climate and other resource endowments that differed between England and Portugal. It’s not hard, by extension, to understand why bananas are currently exported by Ecuador, while Sweden finds it advantageous to import bananas rather than grow them in greenhouses.

But comparative advantage can also be created by human action. Countries can become more efficient in producing particular goods by investing in the physical capital needed to produce them. Sometimes technological advances or changes in the social organization of work can change the pattern of comparative advantage, and the evolution of comparative advantage over time may thus be unpredictable.

Economists often like to make a distinction between countries which are thought to be more suited for labor-intensive production processes, such as stitching clothing or making handicrafts, and others that specialize in relatively capital-intensive production, such as the manufacture of airplanes or automobiles. The fact that the United States has more manufactured capital per worker than does Bangladesh, for example, is considered to be an explanation of why Bangladesh exports clothing. Bangladesh presumably has a comparative advantage in relatively labor-intensive industries. Clothing production, meanwhile, has nearly disappeared from the United States.

The economic theory of factor-price equalization predicts that free trade should tend to equalize the returns to capital and labor across countries. For example, to the extent that the United States is rich in capital, and relatively lacking in labor power, returns to capital are theorized to be relatively low and returns to labor relatively high, in the absence of trade. (The logic of this is that a scarce factor will command a higher return — higher demand for a factor, relative to available supplies, increases the price that must be paid for it.) Since factor endowments in Bangladesh are the opposite, capital investments there would be expected to receive high returns in the absence of trade, while workers receive low wages compared to those in the U.S.

Once the two countries start to trade, however, the demand for capital in the United States should rise (because the country now has a larger market for selling its capital-intensive goods), increasing the return on investments there. The demand for labor, however, will fall, since the U.S. now imports labor-intensive goods from Bangladesh. Meanwhile, the demand for labor in Bangladesh should rise (because it now exports labor-intensive goods), putting upwards pressure on wages in that country, while returns to capital there fall. According to this theory, in a (hypothetical) world of perfectly free trade, we would expect wages to eventually converge, so that workers in the United States and Bangladesh would be paid about the same. Returns to capital investments would also be equalized.

These simple categories of “labor intensity” and “capital intensity" and the theory of factor-price equalization can be misleading, however. One reason is that investments in human capital—health, skills, and education—blur the distinction between “labor” and “capital.” Some studies suggest that the United States' comparative advantage is now tilted towards goods that require production by an educated and skilled workforce, and away from production that involves merely heavy machinery (as well as away from lower-skilled work). When production is intensive in human capital, the earlier two-way classification is harder to apply. Meanwhile studies of factor prices are mixed in their support of the theory of factor-price equalization. Ongoing changes in technology, skills, and the composition of production, as well as deliberate government policies that limit and shift patterns of trade, make it difficult to test the theory.

Other Arguments For Free Trade

Specialization and trade can lead to improvements in economic efficiency, as the “gains from trade” story points out. Trade allowed Portugal and England, in Ricardo’s story, to more efficiently organize the use of their resources to produce wine and cloth. The result was a more highly valued level and combination of outputs than the countries could have achieved without trade. Ricardo’s result is the main justification behind some economists’ advocacy of free trade – international trade that is not regulated or restricted by governments in any way. Many commentators have also pointed to additional advantages international trade could have, in theory.

One of these desirable outcomes is technical. A production process is characterized by economies of scale if the cost per unit of production falls as the volume of production rises. With trade, the volume of a country’s production of a good can be substantially higher than what its internal (domestic) market can use, increasing the opportunity for economies of scale to be realized. A larger market means that goods can be produced more cheaply.

Other advantages are related to what some economists see as positive attributes of free opportunities for trade or exchange, in general. Free trade gives countries the incentive to produce goods that have high value on the world market. This may encourage competition and innovation, to the ultimate benefit of all. In addition, some argue, countries with thriving trade relations are more likely to remain at peace, since war would eliminate all the benefits of trade.

International Trade Agreements

Up through the early decades of the 20th century, many countries remained quite closed to trade, charging high tariffs or imposing strict quotas on imported goods. After World War II this began to change. Countries rarely reduce their barriers to trade unilaterally, since a country that lets in more foreign imports usually also wants its products likewise to be welcomed abroad. But, starting in the 1940s, many countries became more interested in negotiating mutual reductions in tariffs and quotas.

Some trade agreements are “bilateral,” meaning that two countries negotiate directly with each other. Other agreements are “multilateral,” involving a group of countries. In 1948, 23 countries joined the General Agreement on Tariffs and Trade (GATT), which sought to set out rules for trade and enhance negotiations. Eight subsequent negotiation “trade rounds,” some of which led to significant reductions in average tariff rates among participating countries, were sponsored by GATT. In 1995, the Uruguay Round of GATT trade negotiations led to the creation of a new forum for multilateral negotiations, the World Trade Organization (WTO). Currently, the WTO includes 149 member countries. Besides being a forum for trade negotiations, the WTO attempts to set out rules about trade and is charged with investigating and making judgments when countries have trade disputes.

Meanwhile, some countries have entered into regional trade agreements with their neighbors. Leading examples of such attempts to integrate trade within a regional area include the European Union (EU), formed in 1992, containing 25 European countries as members; the North American Free Trade Agreement (NAFTA) entered into in 1994 by the United States, Canada, and Mexico; and Mercosur in Latin America. There is some debate about whether such regional agreements promote “free trade” or retard it. Regional integration promotes both trade expansion (within the region) and trade diversion (away from trade with other regions). It is not clear whether the benefits of trade expansion always outweigh the losses from trade diversion.

Why Nations Often Resist “Free Trade”

The Ricardian arguments for “free trade” emphasize efficiency, increased production and consumption, and the possible benefits of an integrated global economy. This leads some economists to argue that free trade is always best. But the “free trade” arguments may also neglect issues of institutional, political, social, and environmental context that can drastically reduce the possible “gains from trade”—or even make free trade work against national or global well-being. An examination of contemporary real-world issues and policies shows how complex the picture is.

The Health of Nations, Regions, Industries and Jobs

One very important reason that many policymakers have, historically, restricted trade is that they feel this is necessary to “protect” domestic industries and jobs from foreign competition. Countries have frequently engaged in protectionist policies to discourage imports and/or encourage exports of specific goods. The United States, for example, still engages in protection of a variety of industries including Southern cotton, Northwestern timber, and Midwestern sugar beets. Without government protection, these industries would lose market share to lower-cost foreign producers. Such adjustment to global competition can be very painful. When United States automakers began to lose out to foreign competition, for example, a swath of the Midwest became so economically depressed that it became known as the "rust belt."

Sometimes protectionism is called a “beggar-thy-neighbor” approach, since each country is, in effect, trying to gain at the expense of other countries. Each country wants to raise its own production levels while simultaneously reducing the access of foreign producers to its market. If protection is successful, does it actually make a country better off? Since the Ricardian model demonstrates the benefits of trade, you might think that anything other than mutual free trade must yield lower benefits. But, in fact, other theories in economics demonstrate that an individual country may be able to do better than “free trade” if, while engaging in some amount of trade, it can use tariffs to turn the terms of trade in its own favor. A country that can force another country to be open to its exports, while selectively putting some level of duty on imports from that country, may be able to gain relative to the “free trade” case. The other country loses out. Yes, trade can yield benefits—but the selective use of protectionist policies can be used to distribute these benefits to the advantage of the more powerful parties.

“Beggar-thy-neighbor” policies can only work if other countries do not retaliate with their own protective policies. But this is often not the case. During the Great Depression, for example, the United States enacted the Smoot-Hawley tariff in an attempt to support domestic agriculture and industry. This tariff bumped up average tariff rates to a high of nearly 60%. Other countries responded with retaliatory tariffs, creating what is sometimes called a “trade war.” As a result, the volume of global trade declined by two-thirds between 1929 and 1934. The Smoot-Hawley tariff decreased imports, as it was intended to—but it also ended up dramatically decreasing the ability of U.S. producers to sell their goods abroad. While the trade war did not, itself, cause the Great Depression, the contraction of international trade that it created certainly did not help the major countries involved escape it, either.

Even after decades of trade negotiations—and encouragement by economists to “liberalize” their trade regimes—many countries continue to have protectionist policies, at least of a modest, piecemeal sort. While simple economic theory ignores issues of power differentials between countries, and assumes that labor and capital resources can immediately and smoothly adjust to new patterns of commerce, in real life things can be quite different. Trade relations continue to be an arena where countries try to exert dominance over each other. Policymakers continue to be concerned about the job losses and industrial dislocations that global competition can cause. Policies to ease structural unemployment may help, but there is no sign that—at least in democratic countries—policymakers will completely abandon protectionist tendencies anytime soon.

Revenue

Another historically important reason for tariffs is that they may be an important source of government revenue. Until 1913, for example, the United States had no income tax, and the federal government relied heavily on tariffs to run its operations. In many poorer countries today, it is still very difficult to collect taxes on incomes and property. People may be spread over wide geographical areas and much of the economy may not be monetized. In contrast, taxes on monetized transactions at harbor facilities or airports may be relatively easy to collect. Thus tariffs can be an important source of revenue for health, education, defense, and other governmental activities.

Industrial Policy as a Strategy for Growth

Ricardo’s two-country, two-good model is a “static” model that doesn’t take into account the passage of time. But patterns of comparative advantage can change. Should a country simply follow whatever comparative advantage it happens to have at a given time, or should it explore policies that might change its comparative advantage? If the country could end up better off in the long run by deliberately changing its mix of productive capabilities, it might achieve “dynamic efficiency” overall—that is, efficiency-based welfare gains over a sustained period of years—even if “static efficiency” is sacrificed over the short run.

In fact, many countries that have achieved high rates of industrialization—including the United States, United Kingdom, Japan, South Korea and others—did so behind substantial tariff barriers. If these countries had stayed with their natural comparative advantages as they existed in the past, the U.S. might still be known mostly for its production of wheat and raw cotton and the U.K. for its wool, while South Korea and Japan would still import all their cars. Policies that excluded foreign imports of manufactured textiles or automotive parts helped these countries to shift their economies away from less-processed goods towards a more industrial economic base. Now they all compete in global markets for sophisticated manufactured goods.

The infant industry argument asserts that sometimes industries can take a while to get established in a country, and that “learning by doing” helps industries get more efficient over time. Governments adopt an infant industry approach when they use trade policies to protect selected domestic industries from foreign competition until the industries become able to compete on world markets. The main drawback to an infant industry approach is that, for these policies to work well, governments also have to stop protecting or subsidizing industries that do not achieve sufficient levels of efficiency. This can be politically difficult if these industries have in the meantime become entrenched and powerful. If inefficient industries get government help for too long—as some believe has happened in India and parts of Latin America—the policy can encourage dependence on government subsidies and protection, rather than encourage innovation and competitiveness.

While poorly designed support of specific industries can be harmful, the historical record suggests that the deliberate manipulation of trade in order to encourage particular industries has played an important role in the economic development of many countries. Countries that have not engaged in the encouragement of specific industries have often remained “locked in” to patterns of trade in which they specialize in only raw materials (such as minerals or crops) or labor-intensive manufactures. Concerns about global inequality might suggest that poor countries should be allowed to practice more protection, while countries that have already achieved a high standard of living should be especially encouraged to open their markets to imports from poorer countries.

Military and Food Security

Countries often limit trade for security reasons. In the United States, for example, some of the same people who argue for “free trade” in most goods also argue for increased development of domestic petroleum (or other energy) resources, on the grounds that excessive reliance on imports decreases economic self-sufficiency and military preparedness. The United States also bans the export of weapons, certain strategic materials, and technology to countries thought of as potential enemies.

Food security is also an issue for many countries. Japan, for example, is heavily dependent on food imports, and some worry that this could make the country very vulnerable in the case of a war or other disruption in trade. Japan has long used quotas and tariffs to limit rice imports, providing protection for its domestic rice producers.

One of the arguments for free trade mentioned above was that trade should encourage cooperative behavior and peace. However, to the extent a country becomes dependent on other countries for vital resources such as oil, water, or food, this may also become a cause for war. Some commentators interpret United States military actions in the Middle East, for example, as primarily motivated by a desire to assure a steady supply of imported petroleum.

Diversification in an Unpredictable World

While specialization for trade has clear advantages, it may also have a significant downside. A country that has specialized becomes more vulnerable to certain kinds of problems. Two of these have already been mentioned: “lock-in” to a dynamically disadvantageous mix of production capabilities, and security problems related to military and strategic goods. Because the future is uncertain, it is hard to know whether a current choice to specialize will be wise in the long run.

Another especially important source of uncertainty is variation in the terms of trade. Changes in terms of trade can occur as a result of changes in international supply and demand. When a bumper crop occurs, or a new country starts to export a good, or people’s tastes change, the terms of trade may fluctuate in unforeseen ways. The structure of international prices can also be subject to deliberate manipulation through the exertion of political and military power. Lastly, terms of trade may also be manipulated by large corporate international traders, some of whom have gained substantial market power in their field of commerce.

Variations in the terms of trade have created serious problems in many countries. In Ethiopia, for example, producing coffee for export currently provides the means for life for about one-quarter of the population. When the price of an important export is high in international markets, economies that reply on one or a few exports for a good deal of their income do well. But when prices weaken—or plummet, as coffee prices did in 1989—economies dependent on specialized exports are subjected to major crises that are outside of their control. Countries that specialize in a particular crop also become very vulnerable to ecological events such as droughts or plant diseases. While the "gains from trade" story emphasizes the benefits of specialization, these kinds of considerations suggest that some degree of diversification may be wise. Countries may use trade policies such as tariffs, quotas, and subsidies to try to encourage more variety in the range of goods and services they produce.

Labor, Environmental, and Safety Standards

Traditionally, democratic governments have been able to enact policies perceived to be in the public good, even though they are not always in the perceived self-interest of business actors. Minimum standards for pay and safety on the job, for example, as well as reasonable environmental standards and safety standards for consumer products are widely considered necessary for a healthy, just society. Yet such policies are often resisted by some in business community because they may increase costs and decrease profits.

With capital increasingly mobile, multinational corporations are able to move their operations to countries with lower labor and environmental standards. Countries that want to hold on to their business base may therefore find themselves drawn into a "race to the bottom", in which they compete to attract businesses based on their country’s lack of attention to social and environmental concerns. Such competition has the potential to create quite a different relationship between states and businesses than has been assumed in the past: rather than governments shaping business and macroeconomic conditions, large corporations are now playing an increasing role.

One way in which countries can try to avoid such a "race to the bottom" is to ban both the domestic manufacture and importation of goods that are considered hazardous to consumers, or have been made under labor standards that are considered inhumane, or made using production processes that cause serious damage to the environment. In this way, at least the domestic market is reserved for producers who follow higher standards. The setting of standards may also encourage potential trading partners to raise their environmental, labor, or safety standards, so that their goods can be admitted.

When is Limiting Trade “Unfair”?

When should a limitation of trade be considered legitimate, and when should it not be? This is a complicated question that is a topic of vigorous, ongoing debate. Most countries will staunchly defend their right to restrict trade for purposes such as military security or consumer safety, so international trade agreements tend to stop short of banning all restrictions.

But beyond agreement on a few principles, debates become heated. Consider three examples:

GMO products. The European Union has banned the importation of GMO (genetically-modified organism) products, on the grounds that they present threats to public health and the environment. The United States and other grain-producing countries have contested this at the World Trade Organization (WTO), arguing that GMO products are safe and the real reason for the ban is that the EU simply wants to protect its farmers. (The WTO recently ruled that the ban was illegal—but the ruling is unlikely to end the debate.)

Dumping. The United States has accused China of subsidizing the production of many of its products and dumping them on United States markets. "Dumping" is the selling of products on foreign markets at prices that are unfairly low (that is, below the cost of production), and is forbidden in international agreements. The United States argues that it has the right to retaliate by putting quotas and tariffs on Chinese goods. But China, of course, can argue that it simply is blessed with a low-cost production environment, and that the United States is engaging in protectionism.

Labor standards. In some extreme cases, such as the use of slave labor, restrictions on trade are usually considered permissible. But should countries be allowed to use trade restrictions to punish unfair labor practices? Some poorer countries have accused richer countries of imposing unreasonably high labor standards. Under the pretext of trying to protect global workers, they say, the richer countries are just trying to protect their workers from fair competition.

Questions of what will be ruled "fair" or "unfair" by the WTO—and whether such rulings can be enforced—often come down to questions of political economy. Large, powerful countries and corporations use the WTO negotiations and dispute resolution mechanisms as ways to advance their own interests. Smaller and less powerful groups have a more difficult time getting their voices heard. Many labor, environmental, and social justice groups, for example, charge that the WTO primarily serves the interests of powerful multinational corporations. They worry that WTO negotiations have served to speed up the "race to the bottom" and reduced national sovereignty. Observers concerned about economic development believe that WTO rules disadvantage countries that are still relatively poor, by forbidding the use of the sorts of industrial policies that helped other countries achieve economic growth at an earlier time.

In 2001, the WTO officially launched the Doha Round of negotiations, which was, in its official statements, intended to take special account of the needs and interests of poorer countries. At the time of this writing, however, the Round is at a stalemate. Many poorer countries pushed for richer countries to reduce their tariffs and subsidies, particularly on agricultural goods. On the other hand, top priorities for richer countries included getting poorer countries to open their service industries (such as banking and airline transportation) to foreign companies and to abide by stricter rules on intellectual property (for example, to stop making less expensive versions of patented drugs). With the wealthier nations showing little willingness to reduce protection of their domestic agricultural industries, Doha Round talks were suspended in July 2006.

Further Reading



Disclaimer: This article is taken wholly from, or contains information that was originally published by, the Global Development And Environment Institute. Topic editors and authors for the Encyclopedia of Earth may have edited its content or added new information. The use of information from the Global Development And Environment Institute should not be construed as support for or endorsement by that organization for any new information added by EoE personnel, or for any editing of the original content.

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Goodwin, N., & Institute, G. (2006). Free trade. Retrieved from http://www.eoearth.org/view/article/152856

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