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Don’t take a backward step. Don’t shy away from taking up space in the world. Don’t assume you are too junior or that people are too busy. Reach out and network.
-Ngozi Okonjo-Iweala
This quote belongs to Ngozi Okonjo-Iweala, a leader of the World Trade Organisation, which aims to open trade for the benefit of all.
Free trade is international trade without restrictions. Free trade reduces barriers to imports and exports of goods and services such as tariffs, quotas, subsidies, embargoes, and product standard regulations between member countries.
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.
- EFTA (European Free Trade Association): a free trade agreement between Norway, Iceland, Switzerland, and Liechtenstein.
- NAFTA (North American Free Trade Agreement): a free trade agreement between the United States, Mexico, and Canada.
- New Zealand-China Free Trade Agreement: a free trade agreement between China and New Zealand.
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.
The WTO provides a forum for negotiating agreements aimed at reducing obstacles to international trade and ensuring a level playing field for all, thus contributing to economic growth and development.
- World Trade Organisation
Free trade has both advantages and disadvantages.
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:
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.
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.
Free trade is international trade without restrictions. Free trade reduces barriers to imports and exports of goods and services such as tariffs, quotas, subsidies, embargoes, and product standard regulations between member countries.
1. EFTA (European Free Trade Association): a free trade agreement between Norway, Iceland, Switzerland, and Liechtenstein.
2. NAFTA (North American Free Trade Agreement): a free trade agreement between the United States, Mexico, and Canada.
3. New Zealand-China Free Trade Agreement: a free trade agreement between China and New Zealand.
During World War II in the 1940s, people believed that the worldwide Depression and unemployment in the 1930s were mostly caused by the collapse of international trade. Therefore, two countries, the United States and the United Kingdom, decided to try to create a world of free trade like before the war.
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