The importance of free trade – and how to derive its full benefits
31 July 2019
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Welfare
29 July 2019
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31 July 2019
Tax and Fiscal Policy
19 November 2024
The gains in economic activity derived from free trade are well established. Adam Smith and David Ricardo, who respectively discussed the importance of specialisation and comparative advantage, are often cited as the first to have formally illustrated the benefits of trade. However, the benefits of specialisation have long been well-understood: writing in the 1st century AD, St Clement of Rome said “the great cannot subsist without the small, nor the small without the great. There is a kind of mixture in all things, and thence arises mutual advantage”.
But comparative advantage also exists at the firm and individual level, and in the trillions of voluntary individual interactions that occur every day. A firm’s comparative advantage depends on its ability to produce a good or service at a lower opportunity cost than its competitors. Therefore, it makes sense for firms to trade with each other even if one firm is better at producing goods or services than the other, as long as one has a comparative advantage in the production of one of the goods or services. This simple principle lay behind the liberalisation of British trade in the nineteenth century, and economists have since found a direct correlation between openness to trade and economic growth.
The process works because exposure to international trade and investment provides incentives for domestic firms to innovate, which is amplified by exposing those firms to potentially more efficient foreign competitors. These firms will then be encouraged to specialise in those areas where opportunity costs are lowest. These forces combine to generate gains in welfare, which are shared with consumers, who enjoy new, cheaper, or better products.
However, even if the advantages of free trade have long been recognised, they have not always been put into practice. In the first half of the twentieth century, this process of comparative advantage was significantly interfered with by trade barriers. The signing of the General Agreement on Tariffs and Trade (GATT), in 1947, was a reaction to the economic and social costs of this mercantilism.
Unfortunately, the GATT and World Trade Organisation (WTO) system, which helped to produce dramatic growth through trade liberalisation in the post-war period, has been in stasis since the launch of the Doha Development Agenda in 2001. In the meantime, we have seen a torrent of regional and bilateral trade agreements. In order to be compliant with WTO rules, these should apply to all trade, or substantially all trade, and should be trade-creating rather than trade-diverting. However, many of the trade agreements negotiated today fail this test and are, technically, illegal. It’s worth noting, for instance, that the EU often eliminates barriers in agriculture slowly, reserves some categories of agriculture entirely, and is very inflexible on non-tariff barriers.
A further problem has been the issue of “gatekeeping” in insufficiently competitive markets. In order for the gains from trade to yield actual benefits to consumers, import competition must not only cross borders, but markets must also be competitive inside national borders. Where this does not happen, the immediate beneficiaries of trade opening — local distributors and other intermediaries — pocket the gains of liberalisation, and domestic consumers do not see the benefits. The result has been the growing belief that globalisation simply functions as a racket for the well off or politically connected.
This, however, need not be the case. While Ricardo applied the law of comparative advantage to the special case of international trade between nations, Ludwig von Mises — in his 1949 book Human Action — conceived of this rule more broadly by applying it to all interactions. The conclusion to be drawn is that free trade, while necessary, is not a sufficient condition for the broad advancement of prosperity within society. We must also remove domestic barriers to trade and competition. Put another way, trade and competition are two sides of the same coin. Adam Smith recognised this when he argued in The Wealth of Nations that “monopoly was the sole engine of mercantilism”.
Now, it is inevitable that some producers will lose out as both domestic and international competition increase. However, the lowering of entry barriers, whether in foreign markets or at home, allows the spread and growth of innovation, as new products can be brought to market and existing layers are challenged. Moreover, exporting producers and importing consumers gain from competition, not only in the market that is opening up to trade but also in global markets, as more efficient production leads to a reduction in prices worldwide. The biggest winners here are undoubtedly the global poor, who are most vulnerable to price fluctuations in energy and food. Lower prices in energy inevitably lead to lower prices for foodstuffs and heating — two of the most basic human needs.
As a result, we should recognise that a true commitment to free trade starts at home in the elimination of anti-competitive barriers and distortions, whether they affect domestic or international market entrants. At the same time, we can embrace positive, wealth-creating free-trade agreements as engines of growth both inside and outside their boundaries. Opening up to trade opens up a country to the knowledge held by its trading partners, with a more efficient flow of goods leading to a more efficient flow of information. Because of this, productivity has been shown to increase when trade with highly knowledgeable partners increases.
After Brexit, the UK could therefore look to strike trade-creating agreements with the innovative economies of the world, while simultaneously opening domestic markets to the world’s poorest producers, involving them more deeply in the same process of specialisation and exchange that lifted the UK to prosperity. Finally, if we want these gains to be shared and amplified, both at home and abroad, then we need to be serious about removing the barriers at home that favour incumbents over new entrants, and allow for “rent seeking” by intermediaries.
This post was originally published on the FREER blog, as part of a collection of essays on economic freedom.
But comparative advantage also exists at the firm and individual level, and in the trillions of voluntary individual interactions that occur every day. A firm’s comparative advantage depends on its ability to produce a good or service at a lower opportunity cost than its competitors. Therefore, it makes sense for firms to trade with each other even if one firm is better at producing goods or services than the other, as long as one has a comparative advantage in the production of one of the goods or services. This simple principle lay behind the liberalisation of British trade in the nineteenth century, and economists have since found a direct correlation between openness to trade and economic growth.
The process works because exposure to international trade and investment provides incentives for domestic firms to innovate, which is amplified by exposing those firms to potentially more efficient foreign competitors. These firms will then be encouraged to specialise in those areas where opportunity costs are lowest. These forces combine to generate gains in welfare, which are shared with consumers, who enjoy new, cheaper, or better products.
However, even if the advantages of free trade have long been recognised, they have not always been put into practice. In the first half of the twentieth century, this process of comparative advantage was significantly interfered with by trade barriers. The signing of the General Agreement on Tariffs and Trade (GATT), in 1947, was a reaction to the economic and social costs of this mercantilism.
Unfortunately, the GATT and World Trade Organisation (WTO) system, which helped to produce dramatic growth through trade liberalisation in the post-war period, has been in stasis since the launch of the Doha Development Agenda in 2001. In the meantime, we have seen a torrent of regional and bilateral trade agreements. In order to be compliant with WTO rules, these should apply to all trade, or substantially all trade, and should be trade-creating rather than trade-diverting. However, many of the trade agreements negotiated today fail this test and are, technically, illegal. It’s worth noting, for instance, that the EU often eliminates barriers in agriculture slowly, reserves some categories of agriculture entirely, and is very inflexible on non-tariff barriers.
A further problem has been the issue of “gatekeeping” in insufficiently competitive markets. In order for the gains from trade to yield actual benefits to consumers, import competition must not only cross borders, but markets must also be competitive inside national borders. Where this does not happen, the immediate beneficiaries of trade opening — local distributors and other intermediaries — pocket the gains of liberalisation, and domestic consumers do not see the benefits. The result has been the growing belief that globalisation simply functions as a racket for the well off or politically connected.
This, however, need not be the case. While Ricardo applied the law of comparative advantage to the special case of international trade between nations, Ludwig von Mises — in his 1949 book Human Action — conceived of this rule more broadly by applying it to all interactions. The conclusion to be drawn is that free trade, while necessary, is not a sufficient condition for the broad advancement of prosperity within society. We must also remove domestic barriers to trade and competition. Put another way, trade and competition are two sides of the same coin. Adam Smith recognised this when he argued in The Wealth of Nations that “monopoly was the sole engine of mercantilism”.
Now, it is inevitable that some producers will lose out as both domestic and international competition increase. However, the lowering of entry barriers, whether in foreign markets or at home, allows the spread and growth of innovation, as new products can be brought to market and existing layers are challenged. Moreover, exporting producers and importing consumers gain from competition, not only in the market that is opening up to trade but also in global markets, as more efficient production leads to a reduction in prices worldwide. The biggest winners here are undoubtedly the global poor, who are most vulnerable to price fluctuations in energy and food. Lower prices in energy inevitably lead to lower prices for foodstuffs and heating — two of the most basic human needs.
As a result, we should recognise that a true commitment to free trade starts at home in the elimination of anti-competitive barriers and distortions, whether they affect domestic or international market entrants. At the same time, we can embrace positive, wealth-creating free-trade agreements as engines of growth both inside and outside their boundaries. Opening up to trade opens up a country to the knowledge held by its trading partners, with a more efficient flow of goods leading to a more efficient flow of information. Because of this, productivity has been shown to increase when trade with highly knowledgeable partners increases.
After Brexit, the UK could therefore look to strike trade-creating agreements with the innovative economies of the world, while simultaneously opening domestic markets to the world’s poorest producers, involving them more deeply in the same process of specialisation and exchange that lifted the UK to prosperity. Finally, if we want these gains to be shared and amplified, both at home and abroad, then we need to be serious about removing the barriers at home that favour incumbents over new entrants, and allow for “rent seeking” by intermediaries.
This post was originally published on the FREER blog, as part of a collection of essays on economic freedom.
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The case for competitive markets, both inside national borders and across borders, expertly made.
Competition is at the very heart of enterprise and free market capitalism. Unlike the market in consumer goods and services which is the subject of this blog, government markets are not only some the most closed in the world with significant barriers to entry, but they are also seriously uncompetitive with public procurement contracts often handed out on a preferential basis.
Consider, for a moment, the market for defence equipment.
The government’s default policy is to procure military equipment for the Armed Forces through fair and open competition – the only exceptions being off-the-shelf purchases and uncontested, single-source development contracts, the latter to be handed out on a preferential basis (to the Select Few).
Indeed, in its most recent policy statement on defence procurement expressed in the Defence Industrial Policy published in December 2017, the government says (on page 23):
“We strive to provide our Armed Forces with the capabilities they need at the best value for money, obtaining this through open competition in the global market, wherever possible. Competitive tension is the greatest driver for innovation, productivity and earning power in any economy.”
Yet, in the very next sentence, the government goes on to make this frank admission:
“In 2016/17, 58% of new MoD contracts by value were placed on a non-competitive basis. This has grown from 36% in 2010/11 ……”
So, it seems that less and less use is being made of the market-based instrument of fair and open competition – which happens to be the government’s preferred policy on defence procurement. There is a suspicion that senior executives seconded from the defence industry and embedded within MoD, who remain in the pay of their employers, may have exercised their maligned influence to interfere with implementation of policy to serve their narrow business interests. Or is this a clear-cut case of the senior civil servants subverting the will of the party of government, and policy set by Ministers? What Trump calls the “deep state” which is out to frustrate his administration. One thing is for certain – there is reluctance on the part of some people in the pay of the State to use the instrument of competition as a tool, because it creates winners and losers – reflecting their deep-seated socialist tendencies.
It is entirely understandable why the government would want to hand out uncontested, single-source development contracts to selected defence contractors on a preferential basis, but the downside is that there is a price to be paid for this government largesse – and it is not only in pounds sterling!
Over the last 45 years or so, the UK’s top defence contractors who have monopolised the market in military equipment, have become seriously uncompetitive – largely because they have enjoyed unbridled protection from government on national security grounds. Which means that they are ill-equipped to contribute towards the government’s vision of a thriving and globally competitive defence sector trading freely with countries beyond the EU, post-Brexit.
Indeed, since joining what was then the European Economic Community, successive governments including that of Margaret Thatcher – the original champion of free markets – have gone out of their way to shield domestic equipment manufacturers from the full rigours of the free market, that is to say, “feeling the heat” of competitive market forces, by denying continental rivals the opportunity to bid for UK defence equipment acquisition programmes, which is allowed under Article 346 of EU procurement regulations on war-like goods.
The results are entirely predictable. The defence industry has become grotesquely inefficient on the back of endless subsidies from government, which it expects to receive in perpetuity – cultivating an entitlements culture. As a consequence, it has failed time and again to deliver equipment to the Armed Forces which is fit for purpose, adequately sustained in-service and constitutes value for money through-life.
Additionally, it has got away with not investing in innovation, product research and development, creating intellectual property or upskilling employees – despite quietly hoarding mountains of cash and putting it to no particular use.
These are the same producer interests that are secretly lobbying the governing elite right now to remain in the Single Market and the Customs Union, so that they can continue to be protected from being exposed to the full rigours of the free market.
@JagPatel3
To fully understand the advantages and limitations of free trade you must not only study the works of the great economists that have written on it, but also pay attention to the circumstance around them, and their country, when the pen their thoughts. you will also need to understand their audience and what they were trying to achieve by their writing.
After all these, you will agree with me that: free trade within a borderless geographical space would uplift that geographical space more than otherwise;, while for free trade amongst nations with different custom borders, the nation that would benefit most is the one that exports more.
Free trade , on a long term basis , never benefits a net importer. Adam Smith, Ricardo and others that promoted free trade had the growth of the wealth of their nation on their mind, at a time when UK/England was the major producer for all nations in the world, a Net exporter.
For the progress of your nation in the current state of affairs: free trade need not be your preoccupation, but rather the growth of your home production and the reduction of the negative impact of government authority and policies on enterprise,; the true understanding that almost all government controls cause more havoc to economies; That you all should understand that the laws of enterprise must be so simple that owners of institutions must be made to pay for the loss that they cause other people; this would remove the need for most regulatory authorities that are the cause of bloated government and undynamic business environment. If you are able to make this adjustments your country would become the new destination for all great minds and potentially great enterprises. I stop here till I hear from you.