Table of Contents

The Importance of Free Trade

Written by Paul Boyce Posted in Macroeconomics
Last Updated October 31, 2022

Importance of Free Trade

True free markets don’t exist anywhere in the world. This is because free markets and free trade go hand in hand. There exists no country that has free trade with every other.

Although Hong Kong doesn’t operate a tariff regime, it is unable to export its products and services to others free of tariffs. Free market ideologies such as neoliberalism are attacked and concluded that they have failed.

The reality is that we do not have true free markets. Whilst socialism has been tested in the USSR, Cuba, North Korea, and Venezuela, free market capitalism has never truly lived. We have gone more and more towards a socialist state than that of a free market.

‘Free’ healthcare, ‘free’ education, subsidised markets, and greater regulation are notable developments that have shifted nations away from free market capitalism.

We have not seen anything like free markets since the time of the industrial revolution, which helped to propel the United Kingdom to global superpower status. Almost all tariffs were abolished, even on agricultural products. However, it must be said that the world has opened up significantly to global trade since the 1980s, as average tariff rates have collapsed.

The introduction of the World Trade Organisation (WTO) in 1995 assisted with the gradual reduction in trade barriers. Even though tariff rates have reduced, there are still a number of heavily protected industries such as agriculture and manufacturing. Furthermore, there is also an atmosphere of protectionism that is being raised as a result of President Trump’s trade war with China.

Benefits of Free Trade

So why is free trade beneficial? First of all, true free trade requires the abolishment of tariffs and quotas, as well as government subsidies. Governments put up such trade barriers to protect jobs and domestic markets from competition. This comes at the cost of the average consumer.

Higher tariffs mean that the product coming into the country faces an import tax. This is added onto the final price to the consumer — effectively acting as further taxation. In China for example, tariffs on imported motor vehicles from the US were reduced to 15% at the beginning of 2019.

Whilst tariffs declined from 40%, it means the average consumer is still paying 15% on top of the actual price of the motor vehicle. This is usually designed to protect the domestic manufacturing industry and its jobs from international competition.

Abolish tariffs and the industries fall to international competition which takes its jobs. Sounds bad? But what about the lower prices consumers will pay for motor vehicles and other products? The tariff works in a similar way as a subsidy to keep a business afloat. It uses tax-payers money to provide protection to businesses.

Lower Prices

The consumer has to pay either through tariffs or subsidies in the form of taxation, to keep domestic businesses afloat. Why is this necessary? To keep jobs? If another company is producing and selling at a lower cost, it is more efficient.

By providing the consumer with lower prices, we are able to stimulate other areas of the economy. If tariffs are removed, the consumer will have more disposable income to spend elsewhere. Those jobs that are lost will be created in markets that have a greater competitive advantage and are more efficient.

The consumer benefits as they are able to buy the initial product, but also other products and services due to the lower tariffs. The workers that are in the effected industries will inevitably face a period of frictional unemployment and may not find a job as well paid. However, what is the alternative?

Should we force millions of others to have a lower quality of life in order for a small proportion of the population to have a job? This is how economic growth stalls. Capitalism is dynamic and ever changing. It ensures that the most efficient companies survive and limits the amount of wasted resources. If we allow tariffs to reign, we also allow inefficient companies to continue.

Increased Competition

By allowing foreign competition into the market, domestic monopolies and oligopolies can be put under pressure to lower prices and provide a greater product or service. Motor vehicles are a prime example.

Ford and Chrysler of the US face competition from the Japanese in the form of Toyotas and Hondas. This competitive force ensures that Ford and Chrysler are producing a product of value. If it doesn’t, then it will go out of business due to consumers purchasing Toyotas and Hondas.

Free trade allows the consumer to choose which is of best value to them without the influence of tariffs, quotas or subsidies. Greater competition from abroad presents similar benefits as domestic competition:

Increased efficiency
Greater choice and differentiation
Higher consumption
Higher quality
Greater market awareness and product development

Economies of Scale

Free markets can actually create efficiencies for businesses. A US based company may have roughly 327 million potential customers, but once it is able to trade internationally, it is able to reach over 7.7 billion customers.

What stops the likes of Ford and Chrysler exporting to China are the extraordinarily high import tariffs which make the product all but competitive. If international tariffs were abolished then businesses would have the potential to sell to billions of customers.

Alongside this comes natural economies of scale. If business is able to produce for twice as many customers, it is able to get cheaper rates through bulk inputs, but also any efficiencies achieved during the production. If we take Apple for example. They are able to continuously manufacture iPhones on a consistent basis, making the most efficient use of labour and its capital.

Make Use of Surplus Raw Materials

Many countries have the luxury of having an abundant amount of raw materials that it would never have use of. The Middle East has excessive amounts of oil, whilst Australia has the largest iron ore reserves of any nation. Such countries are resource rich, but do not have demand for such.

Many of those countries are also developing nations that lack the ability to convert raw materials into final consumer goods. They can benefit from exporting the raw materials they do not have need of and use the income to invest in other areas of the economy.

Even resource rich countries such as Canada can benefit from free trade. They have a competitive advantage in the lumber industry, but unless it has free trade with other nations, it is unable to effectively deploy this advantage.

Conclusion

Free trade helps everyone in the long run. What it does is allow countries to focus on the industries and areas whereby they are most efficient. As a result, there are more products and services available to the world.

For example, Country A may be able to produce 30 pears at the input of 30 man hours and 70 apples at 30 man hours. By contrast, Country Z is able to produce 70 pears at an input of 30 man hours and 30 apples at 30 man hours. Each country is employing 60 man hours for a total of 100 pears and 100 apples.

If Country A focuses on producing apples, its production would increase to 140 apples. Should Country Z focus on producing pears, production would also double to 140 pears. This leaves total production between both countries at 140 apples and 140 pears. There are more products that can be distributed across borders.