February 16, 2006

GLOBAL FREE TRADE IN THEORY

Introduction

Over the years, a debate has raged on the benefits of free trade policy as opposed to protection issue. In fact, free trade policy is deeply located in free trade theory and today we hear terms such as liberalization, globalization and multi-lateralism. Free trade theory is opposed to protection issue in any form, whether they be tariffs or non-tariff barriers. It is generally agreed that nations engage in international free trade because they benefit from doing so. The gains from trade arise because trade allows countries to specialize their production such that all resources are allocated to their most productive use. If a country tries to produce everything itself, there would be inefficiencies in production and consumption. Citizens of that nation would be constrained to a lower standard of living. The fact that political boundaries divide the world into nation states does not alter the true potential of trade. Free trade expands output by efficiently allocating the world’s scarce resources to their most productive uses. In short, with free trade, we have “the greatest good, for the greatest number”.

Trade in Theory

The theoretical underpinnings of free trade dates back to the 17th and 18th centuries. Doctrines such as absolute and comparative advantage are critical in understanding free trade dogma. During the 17th and 18th centuries, the doctrine of Mercantalism represented the dominant theory of international trade. This period, it must be remembered, was one of nation building and consolidation of power by newly formed nations. Gold and silver (which circulated as money) symbolized a nation’s wealth and power. Therefore, countries sought to accumulate as much gold and silver as possible. One way of doing this was to export as many goods as possible and minimize imports.

When a nation’s exports proved insufficient to pay for its imports, flows of precious metals would settle the account balance. Any country that could export more than it imports could enjoy an inflow of gold and silver (or specie as it was called). The policy prescription based on this mercantalist view was to encourage exports and restrict imports. Mercantalists saw trade mainly as a way to accumulate gold.

Mercantalists also saw trade as a zero-sum game. It was not supposed to benefit all parties. Mercantalists assumed that fixed amounts of goods and gold existed in the world and that trade merely determined the distribution of goods and gold among nations. As a result, the patterns of power and hegemonic forces were created.

Towards the end of the eighteen century, the doctrine of mercantalism came under attack by leaders in political economy (which was the dominant science at that time). In 1752, David Hume pointed out two weaknesses in mercantalists’ logic:

1. Nations do not really want gold as an end in itself, but as a means to an end, i.e., gold is needed to buy goods and services.
2. An inflow of too much gold can lead to price increases and make that country quite uncompetitive.

A second political economist to question mercantalist policies was Adam Smith, writing in 1776. In his wealth of Nations, Smith rejected the mercantalist assumption that trade was a zero-sum game. Smith argued, that by each country using fewer resources than its trading partners, some commodities could be produced. Therefore all parties to international trade could benefit. This was possible, because trade improved the allocation of resources, ensuring that each good would be produced in the country where the least resources are required. The result would be increased output of goods in the world economy. This was called the Theory of Absolute Advantage.

In 1817, David Ricardo developed on the work of Adam Smith, and reasoned that “comparative advantage determined trade patterns”. The principle of comparative advantage states that it will be beneficial for a country to specialize in the production of goods in which it has a comparative advantage and to trade for the goods in which it has a comparative disadvantage. Such specialization and trade make both countries potentially better off by expanding their consumption opportunity sets, i.e., they can consume goods even which they cannot consume domestically. Later, advocates such as Hecksher and Ohlin not only supported comparative advantage, but went on to argue that a country should specialize and export the good which uses its factors of production intensely in producing a particular commodity for trade.

In short, free trade theory assumes efficiency in production and consumption. At the heart of the matter is the price system. The price mechanism is the most effective allocator of resources. Against the above background, we can summarize the benefits of free trade as follows.

Free Trade Promotes Innovation and Competition

1. It makes economic sense to buy a product from another who specialises in such production, who can make it more easily or for less cost. Specialisation allows both businesses and individuals to deploy their relative strengths, abilities and expertise. Freedom of exchange through trade lowers prices, broadens the range of quality goods and services available to firms and consumers and allows investors to diversify risks, channel resources to where returns are highest and secure access to capital at the lowest possible cost.
2. Free trade offers consumers (both individuals and firms) the most choices. Consumers benefit because lower prices and greater product diversity increase their purchasing power. Firms are able to access world markets, increase their sales potential, realize economies of scale and spread the fixed costs of research and development over a wider customer base. Firms also benefit from better access to competitive sources of materials, components and services.

Free Trade Generates Economic Growth

1. It rewards risk-taking by increasing sales, profit margins and market share.
2. Companies may use the profits from their business ventures to expand their operations, enter new market segments and create better paying jobs.
3. It encourages foreign investment, which gives the consumer more options and compels local companies to remain competitive, not only on price, but more importantly, on quality. These improvements on the quality of products, the quality of the service delivery and the techniques of production promote the development of domestic industries and provide better employment opportunities for local workers.
4. It facilitates modernization. The provision of open access in goods, services and investment exposes a country’s business institutions to internal competition and inevitably to international business standards and they in turn, require them of others.
5. Free trade internationalises an economy and the process wipes out the hold of governments, monopolies and restrictions on individual freedom and prosperity.

Free Trade Disseminates Democratic Values

1. It supports the rule of law. Companies that engage in international trade have reason to abide by the terms of their contracts and internationally agreed upon norms and laws.
2. It can reduce the opportunities for corruption. In countries where contracts are not enforced, business relationships fail, foreign investors relocate and there is capital flight. This is a downward spiral, which hinders economic growth.
3. Reinforced by the rule of law, free trade removes incentives for corruption by spurring economic growth, increasing the number of better paying jobs and ultimately increasing the level of prosperity.

Free Trade Guarantees Market Access

While the status quo today is free trade, there is no assurance that this will continue. The presence of a protective umbrella, in the form of a free trade agreement, has important consequences for business strategy. Without guaranteed market access, firms would be more conservative in their business strategy. Their increased caution would lead them to limit their market exposure and as a result their profitability.

Firms would, therefore, under-invest in trade expansion and hence the growth effects of modernization could be curtailed. By contrast, with assured access, firms can take a regional or international view of their operations, merge across borders and pursue a more ambitious strategy. This scenario leads to increases in productivity. As a result, firms are more willing to embark on the modernization of their productive plants, the fixed costs of which become more easily amortised.

In summary, advocates of free trade purport that trade promotes innovation and competition, generates economic growth, disseminates democratic values and guarantees market access. From these arguments for free trade, it follows that multilateralism and bilateralism are preferred. Tariffs and quotas should not exist, because they tend to distort. In fact, globalization and liberalization are based on free trade theory.