Free trade is the voluntarily exchange of goods and services between two parties without government policies impacting the price at which the exchange takes place or the amount of products permitted to be exchanged.
When politicians and the media discuss free trade, typically they are referring to trade between parties that reside in different countries – international free trade. On an international level free trade is the free flow of goods and services across international borders without any government erected obstructions to the exchange.
Obstructions to Free Trade
Governments erect several types of obstructions to free trade including tariffs, quotas, and subsidies that are explicitly designed to: (1) benefit exporters or (2) benefit domestic producers who directly compete against importers.
A tariff is a tax that is imposed on goods that are imported into a country. Tariffs make imported goods more expensive to domestic consumers relative to domestically produced goods. Tariffs on foreign goods discourage domestic consumers from purchasing foreign products.
Proponents of tariffs on imported goods argue that domestic producers need protection from foreign competition because: (1) a foreign government is providing subsidies to the importers (e.g. there is currently unfair competition); or (2) the domestic industry requires support for reasons of national security or national interest.
However, such protection for domestic producers limits consumer choice and raises prices. Higher prices reduce consumers’ purchasing power (e.g. effectively lowering their income).
Quotas are justified on the same grounds as tariffs; however, instead of simply raising the price of imported goods, quotas set a quantity limit on the number of imports that can enter the country. Because quotas restrict the quantity of the imports, domestic producers are insulated from foreign competition – any demand above the established quota can only be met by domestic producers. Consequently, prices for the goods or services protected by quotas tend to rise. The economic consequence of quotas is similar as tariffs – the profits of domestic producers are subsidized at the expense of consumers, who face reduced choice and lower purchasing power.
Subsidies are funds that a government directly pays a business. Subsidies are used to support companies or industries that are experiencing economic difficulties in the marketplace because consumers are not willing to purchase enough of their products at unsubsidized prices.
Governments use subsidies to effectively pay for a portion of the operating costs of domestic businesses and industries. With lower effective operating costs (some of the expenses are now paid by the government) a subsidized domestic firm can lower their prices without reducing their income or losing money. Therefore, the subsidized firm is better positioned to compete with businesses from other countries.
Subsidies can either benefit those firms competing against imports in the domestic market or those firms exporting goods or services to international markets.
On the surface, subsidized goods appear less expensive to consumers. However, domestically subsidized goods are more expensive than they appear. The true cost of the subsidized good is equal to the price paid by the consumer plus the cost of the subsidy, which is funded by the taxpayer.
Ultimately, tariffs, quotas, and subsidies distort market prices and impose rather large costs on an economy. When any or a combination of these policies are used, the result is economic protectionism.
Free Trade or Protectionism
The benefits from free trade were understood from the inception of the field of economics. Both Adam Smith and David Ricardo argued that free trade makes people better off. And, this theorem holds for individuals, for companies, and for countries.
Take the simple case of a 2-person economy. In this economy, assume that one person is a much better weaver than farmer; the other person is a better farmer than weaver. If both people had to produce their own food and their own clothes, then they each would be spending time doing both activities. But, there is a loss in potential output from this arrangement.
Every hour the first person spends farming he could have been weaving. And, if he were weaving, he would have been more productive – he would be producing more clothes in this hour than the amount of food he produced in that same hour. The reverse is true for person 2. Every hour person 2 spends weaving she is giving up more potential food production relative to the amount of clothes she is able to produce.
Without trade, there are lost opportunities to create more of both goods. The result is less clothes and less food than would be possible if both people spent their time doing what they do best.
Free trade allows individuals to specialize in what they do best (what economists call their comparative advantage) and then trade with one another to get all of the goods and services they need or desire. Specializing also generates its own efficiencies. As people spend all of their time on one task they learn how to do that task better – that is why, generally speaking, professional plumbers can fix a sink faster than a homeowner can. Specialization allows people to learn how to produce more efficiently and creates even greater productivity gains.
Inside of the United States, individuals benefit from free trade every day. It is virtually unheard of for anyone in the United States to produce all of the goods and services he/she consumes. Instead people specialize. Computer programmers specialize in creating computing technology; farmers specialize in farming; and, veterinarians specialize in keeping animals healthy. We then sell the goods and services we produce via specialization; and then use the money we earn to purchase the goods or services we desire.
The potential benefits from trade do not change simply because one participant lives in a different country. Global adherence to free trade principles replicates the benefits created at the local level, and would help foster an era of global prosperity.
However, claims about “fair trade” rather than “free trade” dominate the headlines periodically. Fair trade claims that trade has benefits, but only if countries are not subsidizing their industries – one of the potential obstructions to free trade discussed above. Fair trade advocates claim that if a country provides subsidies to its industries, the industries from the subsidizing country will have an unfair advantage relative to the industries from countries that do not offer the subsidy.
The fear is that the industry from the subsidizing country will be able to charge lower prices relative to the industries from countries that do not offer the subsidy, unfairly stealing market share and profits. The impact could be greater unemployment in the non-subsidizing country. The cure, from fair traders, is to only pursue free trade policies if certain criteria are met. Otherwise, counterbalancing protectionist measures are necessary.
While the protectionism advocates paint a convincing picture, there is no evidence the protectionist theory holds in practice. Countries that subsidize their industries are effectively using their citizens’ money to pay consumers from other countries to purchase their products. It is effectively a wealth transfer from taxpayers from the protectionist country to consumers of the importing country. Such a wealth transfer cannot continue forever. Additionally, the economic data in the U.S. illustrates that domestic industries prosper, employment growth accelerates, and income growth accelerates during periods of freer trade, regardless of the policies pursued abroad.