The importance of free trade – and how to derive its full benefits
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.