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WTF: Free Trade Agreements And Their Effect On Economies

In the past decade, free trade agreements have been on the rise. But what exactly do they do, and how do they affect economies?

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What is free trade? How is it intended to work?

The idea of free trade is quite simple. According to Investopedia, the definition is:

“The unrestricted purchase and sale of goods and services between countries without the imposition of constraints such as tariffs, duties and quotas.”

The goal of free trade is to foster the exchange of goods between nations around the world, but also to help those nations hone in on strengthening the areas of their economy in which they are particularly strong–this idea is called “comparative advantage.”

This concept of comparative advantage was first advocated by classic British economist, David Ricardo.

In the Ricardian theory of free trade, comparative advantage dictates that economies in a free trade agreement benefit the most if nations concentrate on manufacturing products that they are already adept at making, instead of developing weak areas.

Ideally, in this system of free trade, the manufacturing and trading of goods will allot cooperating nations enough foreign currency to purchase the products that they cannot manufacture themselves, therefore benefiting all parties involved.

By far the most important aspect of free trade is denoted in the “free” part. In order to be mutually beneficial to all parties, free trade should be, above all else, unadulterated by taxes, monopolies, and any other market distortion.

Examples

There are a number of free trade agreements which stitch together countries and continents across the world. Two of the biggest and most impactful are:

North American Free Trade Agreement (NAFTA)

A trilateral agreement between Canada, Mexico, and the US, enacted in 1994. It is meant to address a number of areas concerning trade like greater exchange of agriculture, better infrastructure to help transport goods, and increased telecommunications.

European Economic Area (EEA)

This agreement encompasses 30 European member states and provides the framework for the free movement of people, goods, services, and capital. Though many members of the EEA are in the European Union (EU), Iceland, Liechtenstein, Norway, and Switzerland also participate.

What are the impacts of free trade?

Conceptually, the idea of free trade is impeccable. By reducing economic obstacles like taxes and tariffs while simultaneously bolstering manufacturing, countries can both accentuate their economic strengths and benefit from low cost goods from other countries.

In practice, however, the efficacy of free trade is dependent, not on the ideology, but the specifics of the free trade agreement.

There are two main factors which affect the benefits derived from a free trade agreement: trade creation and trade distortion.

  • Trade creation is an increase in economic welfare as a result of a free trade agreement, while…
  • Trade diversion is when free trade agreements actually shift the cost of goods to a more expensive exporter, causing the cost of goods to go up and decreasing economic welfare.

Trade diversion can happen when large multi-lateral trade agreements force countries to divert the imports from a low-cost country to a higher one, therefore raising the price of goods and decreasing comparative advantage.

Trade diversion has become more common as free trade agreements have gotten larger, since the net effect on all countries involved has become increasingly complex.

In the US, those who champion free trade have called it a building block to trade liberalization and an economic driver.

Critics in the US, however, haven’t been quite so optimistic. With an $8 trillion trade deficit, some have begun challenging the real efficacy free trade.

Additionally, they have cited free trade agreements’ effect on labor markets in the US, pointing to widespread job losses resulting from increased foreign production.

The takeaway

There has been much debate over free trade, with two distinct camps on either side.

Pro free trade or not, economists can agree that today’s multi-lateral trade agreements have become increasingly complex, and as a result are much harder to evaluate.

Even despite a proposed framework for identifying a beneficial agreement, the sheer amount of goods, products, and services being affected by such agreements make the process muddled and liable for error.

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James Pero