Free Trade

This quote belongs to Ngozi Okonjo-Iweala, a leader of the World Trade Organisation, which aims to open trade for the benefit of all.

To create a free trade area, members sign a free trade agreement. However, contrary to a customs union, here each country determines its own restrictions on trade with non-member countries.

An organisation that highly contributed to the development of free trade is the World Trade Organisation (WTO). The WTO is an international organisation that aims to open trade for the benefit of all.

Benefits and costs of free trade

Free trade has both advantages and disadvantages.

Benefits

• Economies of scale. Free trade allows an expansion that is associated with increased output. The increased output, however, leads to the decrease in average production cost per unit which is called economies of scale.
• Increased competition. Free trade allows enterprises to compete on a global scale. This is associated with increased competition that contributes to products' improvement and lower prices for customers.
• Specialisation. Free trade allows countries to exchange products and specialise in the production of a narrow range of goods or services to increase their efficiency.
• Reduction of monopolies. Free trade highly contributes to breaking up domestic monopolies. It allows international trade, which creates a market where many producers exist and compete with each other.

Costs

• Market dominants. Gaining more and more market share some world-leading traders dominate the market. In doing so, they do not allow any other traders to enter and develop in the market. This is particularly a threat to developing countries, which are unable to enter certain markets because of the existing market dominants.
• Collapse of home industries. When products are imported freely, they are very likely to dominate the home markets of other countries. This poses a threat to small businesses, especially those in developing countries.
• High dependence. Many countries do not manufacture their own products and simply rely on importing foreign goods and services instead. That situation poses a threat to those countries as in case of any conflicts or war, they might be deprived of the products they need.

The reasons for changes in the UK’s pattern of trade

A pattern of trade is the composition of a country’s imports and exports. The pattern of trade between the United Kingdom and the rest of the world has dramatically changed over the last few decades. For example, now the UK imports more products from China than 20 years ago. There are several reasons for these changes:

• Emerging economies. In the last few decades, Asian countries such as China and India have started to play a crucial role in international trade. They manufacture and export more products that are sold to other countries at a relatively low price.
• Trade agreements. Reduced trade restrictions between certain countries allowed the exchange of products without additional costs. For example, the creation of the European Union increased trade between the UK and countries in continental Europe.
• Exchange rates. Changing exchange rates can encourage or discourage imports and exports from/to certain countries. For example, the high rate of pound sterling makes products manufactured in the UK more expensive for other countries.

Welfare gains and losses in the free trade

Free trade can have a huge impact on the welfare of the member countries. It can cause both welfare losses and welfare gains.

Imagine a country’s economy is closed and does not trade with other countries at all. In that case, domestic demand for a certain good or service can be met by domestic supply only.

Fig. 1 - Consumer and producer surplus in a closed economy

In figure 1, the price consumers pay for the product is P1, whereas the quantity bought and sold is Q1. The market equilibrium is marked by X. An area between points P1XZ is a consumer surplus, a measure of consumer welfare. An area between points P1UX is a producer surplus, a measure of producer welfare.

Now imagine that all countries belong to the free trade area. In such a case, goods and services produced domestically have to compete with cheaper imports.

Fig. 2 - Welfare gains and losses in an open economy

In figure 2, the price of imported goods and services (Pw) is lower than the price of domestic goods (P1). Even though domestic demand increased to Qd1, domestic supply decreased to Qs1. Therefore, the gap between domestic demand and supply is filled by imports (Qd1 - Qs1). Here, the domestic market equilibrium is marked by V. Consumer surplus increased by the area between points PwVXP1 which is divided into two separate areas, 2 and 3. Area 2 presents a welfare transfer away from domestic firms to domestic customers where a part of the producer surplus becomes consumer surplus. This is caused by lower import prices and a price fall from P1 to Pw. Area 3 illustrates the increase in consumer surplus, which exceeds the welfare transfer from producer surplus to consumer surplus. Consequently, the net welfare gain equals area 3.

Impact on welfare due to tariffs and duties in free trade

Finally, imagine that a government introduces a tariff to protect domestic firms. Depending on how big a tariff or duty is, it has a different impact on welfare.

Fig. 3 - Impact of imposing a tariff

As you can see in figure 3, if the tariff is equal or bigger than the distance from P1 to Pw, the domestic market reverts to the position when there were no goods and services imported. However, if a tariff is smaller, prices of imports increase (Pw + t) which allows domestic suppliers to raise their prices. Here, domestic demand falls to Qd2 and domestic supply rises to Qs2. Imports fall from Qd1 - Qs1 to Qd2 - Qs2. Because of the higher prices, consumer surplus falls by the area marked by (4 + 1 + 2 + 3) whereas the producer surplus rises by the area 4.

Additionally, the government benefits from the tariff which is presented by area 2. The government’s tariff revenue is measured by total imports multiplied by the tariff per unit of imports, (Qd2 - Qs2) x (Pw+t-Pw). The transfers of welfare away from the consumers to domestic producers and government are marked respectively by areas 4 and 2. The net welfare loss is:

(4 + 1 + 2 + 3) - (4 + 2) which is equal to 1 + 3.