Free Trade

I INTRODUCTION

Free Trade, interchange of commodities across political frontiers without restrictions such as tariffs, quotas, or exchange controls. This economic policy contrasts with protection or the fostering of domestic industrial or agricultural production by means of import tariffs or other legal obstacles to the movement of goods across frontiers.

II EARLY FREE TRADE DOCTRINES

Foreign trade doctrines began to develop with the emergence of dynastic nation-states during the 15th century. One early form of economic policy, known as mercantilism, dominated Western Europe from about 1500 to about 1800. Supporters of this policy worked to promote national unity and to increase the strength of the state. They considered wealth a necessary condition of power, and the accumulation of gold and silver specie a necessary condition of wealth. Countries without gold or silver mines acquired specie by maintaining a surplus of exports over imports through strict governmental control of foreign trade.

A reaction against such control occurred in France in the 18th century. This led to the formulation of the first theory of free trade by a group of economic philosophers known as the physiocrats, who were followers of the economist François Quesnay. The physiocrats maintained that the free movement of goods was in accordance with the principles of natural liberty. Although their ideas had little effect in France, they influenced the British economist Adam Smith, whose free trade theories contributed to the later development of trade policy in Great Britain.

Smith decisively refuted the protectionist conclusions of mercantilist thought. He pointed out that wealth consisted not in specie itself but in the material that specie could purchase. Governmental regulation of trade actually reduced the wealth of nations, because it prevented them from purchasing the maximum amount of commodities at the lowest possible price. With free trade, each nation could increase its wealth by exporting the goods it produced most cheaply and importing goods that were produced cheaper elsewhere.

According to Smith, each country would specialize in the production and export of goods in which it had an absolute advantage. Another British economist, David Ricardo, extended the analysis early in the 19th century to encompass the more general case of comparative advantage. Ricardo noted that some nations lack an absolute advantage in the production of any commodity. Even these nations could gain from free trade if they concentrated on those commodities in which they had a relative advantage in production. This principle has remained the theoretical basis of all argument for free trade.

Ricardo assumed that all nations would share in the gains from free trade. The British philosopher and economist John Stuart Mill later demonstrated that such gains depend on the strength of reciprocal demand for imports and exports. The stronger the demand for the exports of a country relative to its demand for imports, the greater its gain from free trade. The gain would be reflected in an improvement in the international terms of trade for the country, as expressed by the ratio of its export prices to its import prices.

III MODERN TRADE THEORY

The classical theory of trade developed by Smith, Ricardo, and Mill was concerned primarily with the analysis of the gains from trade. Modern trade theory, by contrast, takes the principle of comparative advantage for granted. It is mainly concerned with the analysis of the basis for trade and with accounting for differences in comparative advantage.

Classical theorists assumed that differences in comparative advantage resulted from differences in the productivity of resources, reflecting the unequal distribution of technologies and labour skills among nations. A more complete explanation was offered by several 20th-century economists, who noted that differences in the prices of final goods tend to reflect differences in the prices of productive resources and that the latter are accounted for mainly by differences in the availability of resources. Countries specialize in the production and export of goods requiring relatively large amounts of those resources that they possess in abundance, and they import goods requiring relatively large amounts of resources that are scarce within their borders.

IV ARGUMENTS FOR PROTECTION

Despite the conclusions of classical theory, few countries have ever actually adopted a policy of free trade. The major exception was Great Britain, which, from the 1840s until the 1930s, levied no import duties of any kind. The historical prevalence of protectionist policies reflects in part the strength of industrial vested interests fearful of foreign competition and in part the strength of various theoretical arguments for protection. Such arguments can be classified into three groups: those intended to influence the composition of production; those intended to influence the level of employment; and those intended to influence the distribution of income. Under appropriate circumstances, all three groups of arguments have theoretical validity as well as limitations.

One of the oldest arguments for protection is the so-called infant-industry argument. According to this theory, when foreign competition is reduced or eliminated by import barriers, domestic industries can develop rapidly. After their development is complete, they should theoretically be able to hold their own in competition with industries of other nations, and protection should no longer be required. In practice, however, protection frequently cannot be removed, because the domestic industries never develop sufficient competitive strength. The limitation of the infant-industry argument is its inability to identify those industries that are capable of growing to genuine maturity.

The national defence argument for protection seeks to avoid dependence on foreign sources for supplies of essential materials or finished products that might be denied in time of war. The limitation of this argument is that identification of those industries indispensable for national defence is difficult.

A third instance in which protection is advocated is to counter dumping from abroad. Dumping occurs when products are made available as imports at prices lower than the prices prevailing in the exporting country. Protection may be justified in these circumstances, but only if the clear intention of foreign suppliers is to establish a permanent monopoly by driving domestic suppliers out of business.

During periods of unemployment, protection is often urged as a means of increasing employment. With imports reduced, demand for domestic substitutes will be stimulated, expanding production at home. Economists Call this a “beggar-my-neighbour” policy: The improvement of employment at home is achieved entirely at the expense of employment elsewhere. The limitation of such a practice is that it invites retaliation from other nations suffering from similar problems of unemployment.

Protection can be used to redistribute income either within nations or between nations. For example, if a nation finds that the demand for its exports is relatively strong, it can gain income at the expense of other countries by imposing tariffs or other import barriers. Foreigners will then find it more difficult to earn the income to pay for the exports they desire. Consequently, they will be forced to reduce their prices, thus improving the terms of trade for the protectionist nation. Like the employment argument, this method invites retaliation from abroad.

V RECENT DEVELOPMENTS

Although most countries officially favour freer trade and deny protectionism, the achievement of this goal is somewhat difficult, even among highly industrialized countries. Since World War II the leading trading nations have generally made a concerted effort to promote freer trade and remove protection barriers. When economies are booming and jobs seem secure, most people tend to support free trade. When recessions occur, however, many nations become more protectionist because of national interest and pressure from organized labour and other interest groups that are adversely affected by prolonged recessions.

The integration of the world’s economies has proceeded so far that domestic economic policies now have distinct international effects. This has raised new arguments in favour of protection on the grounds that the economic policies of some foreign nations are unfair. Rules governing trade under the auspices of the General Agreement on Tariffs and Trade did not cover domestic policies, but the World Trade Organization theoretically has the power to decide disputes between trading nations.

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