Free trade has been a long debate for centuries; they have been theories from economist that explains the benefit of free trade. The quest for free trade has its root in Adam Smith in his book the wealth of nations published in 1776, Smith stressed the importance of specialization or division of labour which in turn will benefit countries and stimulate economic growth. David Ricardo in the principles of political economy and taxation published in 1817 extended the theory further to explain the benefit that would be derived if a country has a comparative advantage in the production of one good than the other country. Two Swedish economist; Hecksher and Ohlin also came up with the theory of factor proportion. Free trade stimulates the flow of investment as firms take advantage of resources and labour from overseas, sales of goods and services across national border and in many different markets around the world. Free trade allows consumers to benefit from cheaper prices and enjoy a greater variety of products. Some critics argue that free trade will bring about high competition from overseas leading to the closure of domestic firms and unemployment of workers; they argue that free trade will cause income and wage distribution inequality and the need for government to protect domestic industries by limiting the amount of international trade (Atkinson and Miller, 1998); through trade barriers like tariff and others.
In this paper, we will be looking at theories that explain why free trade is beneficial, and also the new trade theory that emerged in 1970s, the static and dynamic gains from trade, arguments against free trade, and the various instruments of trade policy; tariffs and non tariff barriers of free trade, the evolution of the world trade and the establishment of General agreement on tariffs and trade (GATT) in 1947
International trade has been long practiced for centuries, and has been explained to be beneficial by different economist in different theories.
The Theory of Absolute Advantage
The theory of international trade has its roots in Adam Smith, in his book the wealth of nations published in 1776 in London. Smith explained that countries would benefit from trade if they specialized in the production of that good in which they have an absolute advantage than the other. By absolute advantage Smith meant if a country is more efficient in the production of one good than the other; the country can then trade with another country for the good in which they are less efficient in producing. (Hill, 1994)
The table below shows the number of units of rice and wheat that each country can produce assuming that each country has the same amount of resources and each devotes half of its resources to wine and half of its resources to cheese.
At table 1, the combined total production of the two countries amounts to 1200 units of rice and 1800 units of wheat. At table 2, country A concentrated all its resources on producing wheat while country B concentrated all its resources to rice and the total output rose to 2000 units of rice and 3000 units of wheat.(Atkinson and Miller, 1998). The above table explains that there is an increase in output when countries specialize, and can both benefit from the principle of specialization.
The Theory of Comparative cost advantage
According to krugma and Obsfeld (2009), "a country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in the other countries". The theory of comparative advantage was introduced by David Ricardo which is known as the Ricardian model. This approach in which international trade is based in the differences in the productivity of labour, Ricardo explained that countries have different endowments of factors of production; they differ in population density, labour skills, climate, raw materials, capital equipment, etc. These differences exist because factors are immobile, thus the production of goods differs between countries and the relative cost of producing goods varies between countries. To illustrate the gains according to comparative advantage, take two countries Nigeria and Ghana, Nigeria producing groundnuts and Ghana producing cocoa (both measured in bags). Nigeria has a natural advantage in producing groundnuts and Ghana has a natural advantage in producing cocoa. If Nigeria has an opportunity cost for groundnuts and cocoa as 10:1 and Ghana as 4:1, this means that if Nigeria wants to produce 1000 bags of cocoa, it would have to sacrifice 10,000 bags of groundnuts, Ghana also would have to sacrifice 1000 bags of cocoa to produce 4000 bags of groundnuts. On the other hand if Nigeria produced 1000 bags of groundnuts it would sacrifice only 100 bags of cocoa, whereas Ghana would sacrifice 250 bags of cocoa to produce 1000 bags of groundnuts. The opportunity cost of producing cocoa in Nigeria is higher than in Ghana and the opportunity cost of producing groundnuts in Ghana is higher than in Nigeria. There are static gains from trade when a country specializes in producing that goods in which it has a low opportunity cost and importing goods with high opportunity cost, it is measured by what is save from resources given up by not producing the imported goods domestically (Thirlwall and Pacheco-Lopez, 2008, P 6-7)
The Theory of Factor Proportion
This trade theory often referred to as Hecksher Ohlin theory was developed by two Swedish economists Eli Hecksher and Bertil Ohlin. They put forward another explanation for comparative advantage; they argued that comparative advantage arises from differences in nations' factor endowments. These factor endowments are resources like capital, labour, and land. And this factor endowment vary from country to country and because of this differences in factor endowment there would be differences in factor cost between countries, the less abundant a factor cost the higher the cost and the more abundant a factor cost, the lower the cost (Hill, 1994). Two factors of production 'Labour and Capital' were considered and different productions require different proportions of the two factors of production.
What this means is that the production of 1 unit of commodity A would require 4 units of labour and 1 unit of capital. At the same time to produce 1 unit of commodity B would require 4 units of labour and 2 units of capital. Commodity A would therefore require more units of labour per unit of capital (4 to 1) and B would require more units of labour per 2 units of capital (4 to 2). A is therefore a relatively labour intensive product and B is relatively capital intensive (Czinkota et al, 2009). Countries would then benefit from trade if they export those goods that use those factors that are locally abundant, whereas import those goods that make intensive use of factors that are locally scarce (Hill, 1994).
New Trade Theory
The integration of the world's economy led to the criticisms of existing theories of trade, economist questioned the diminishing returns to specialization and argued that the presence of economies of scale will lead to increasing returns to scale, in other words as output expand with specialization, economies of scale is achieved and the unit cost of production is reduced. This new trade theory is based on the fact that trade allows more economies of scale and more varieties to be consumed. Economist argued that the existence of economies of scale will give a firm a competitive advantage simply because of the fact that it was the first to enter the market (first mover advantage). The competitive position of that firm would discourage new entrant, in other words economies of scale create barriers to entry. This new trade theory has a disadvantage as some countries export will dominate the world market because their firms were the first to enter the market; this theory emerged in the 1970s. (Hill, 1994)
Static and Dynamic gains from trade
The static gains from trade are basically of the fact that countries have different resources and natural endowment and the opportunity cost of producing goods varies. This opportunity cost is measured by how much of a commodity A is sacrificed for the production of commodity B. it was argued in the theory of comparative advantage that countries will benefit from trade if they specialize in the production of those goods in which they have a low cost and export those goods while importing those goods in which they have a higher opportunity cost. The static gains from trade are measured by what is saved by not producing the imported goods domestically (Thirlwall)
There are dynamic gains from trade as free trade increases the resources of a country through the supplies of labour and capital from overseas; it also increases more efficiently the way in which a country utilizes its resources. Utilization of resources could arise from a number of factors like economies of scale, better technology from overseas available to domestic firms. Opening up an economy to competition would make domestic producers to look for ways to increase the efficiency of their operation. Generally opening up an economy to free trade will stimulate economic growth and result in a production possibility frontier to shift outward (Hill 1994). Other dynamic benefits include the acquisition of knowledge, new ideas and capital flow from foreign direct investment which may stabilize and increase the growth performance of countries (Thirlwall)
Arguments against free trade
The question here is that is free trade always desirable? In spite of the benefits of free trade, some nations still restrict international trade; various reasons have been put forward to limit international trade especially in most developing and less developed countries. The first argument is to protect infant industries; "According to this argument, many developing countries have a potential comparative advantage in manufacturing, but new manufacturing industries there cannot initially compete with well-established industries in developed countries". (Hills, 1994, P.163) Infant industries might still be In the process of achieving economies of scale and thus have high cost per unit compared to the price of their international competitors, infant industries should be protected to allow them sometime to expand in their production and take advantage of economies of scale and be able to compete equally with international competitors (Atkinson and Miller, 1998).The second argument is to prevent dumping; countries may restrict international trade when there is an unfair trade practice from their competitors like dumping, this is when countries sell it goods at a very cheaper rate even below cost price, firms in that industry will not be able to compete in the world market as other firms from other country sell at a lower price, countries seek to protect their industry as this kind of competition is unhealthy for their home firms. The third argument is to protect depressed or declining industry; countries whose firms are declining and are no longer competitive would seek to protect that firm from international competitors until it is capable to be exposed to international competitors (Atkinson and Miller, 1998). It is also argued that protectionism increases output, income and employment because it shifts demand to home products and hence save jobs at home (Eicher et al, 2009).
Generally the most common criticism of free trade is that it encourages the growth of developed Nations and the degradation of under-developed countries whose resources are being exploited. The under-developed countries tend to depend greatly on importation from the developed countries due to lack of domestic growth resulting to no economic benefits for the under-developed countries and increased profit for the developed countries, countries may consider it necessary to impose a trade policy as a source of revenue, since they find it difficult to raise revenue from other source because of the high rate of competition in international trade.
Instruments of Trade Policy
A tariff is the oldest form of trade policy; it is a tax on imported goods. The purpose of a tariff is to raise price of imported goods over domestic goods, in other to shift demands from imported goods to domestically produced goods. Tariffs might be based on a percentage of the price of import (ad valorem) or a specific charge per unit of goods imported (specific tariffs) The government gains revenue from tariffs, domestic producers gain protection from foreign producers by increasing the cost of imported goods while the consumers from importing countries will lose as tariffs may lead to inflation and inefficiency for firms who are under the protection of tariffs, unlike a quota, tariffs does not offer a monopolistic power to the domestic supplier as there is no restriction on the amount that can be imported (Atkinson and Miller, 1998).
A quota is a limit on the volume of a product that may be imported in a given period of time. Unlike tariff, quotas restrict the quantity of goods that can be imported into a country, and this is normally carried out by issuing licenses to an individual, group or firms who can only import certain amount over a period of time. This therefore reduces the availability of that product in the market. Quota does not benefit the consumers; it rather increases the domestic price of imported goods because too many people would be chasing fewer goods, which will make them bid the price up. Quotas offers a monopoly power to domestic suppliers in that suppliers will charge a higher price and supply a lower quantity, unlike tariff governments does not get revenue from quotas. (Atkinson and Miller, 1998)
Voluntary Export Restraint (VERs)
This instrument is like quota but it is arranged between countries whereby the exporting country at the request of the importing government agrees to limit the quantity of goods that would be exported to that country. The most known example of a voluntary export restraint is limitation of cars exported to the United State by the Japanese. Voluntary export restraint always raises the domestic price of imported goods because of the limited supply of those foreign goods; it is very beneficial to the Exporting country as they earn rents (Hill, 1994).
As tariff, quotas and VERs are policies to reduce the amount of imported goods, subsidy is a policy to encourage domestic producers, and to increase their level of competitiveness in home country and abroad (Griffiths and walls, 2008). This policy favors' domestic consumers by subsidizing domestic firms, prices of domestic goods would be cheaper compared to foreign goods, domestic firms also gain as consumers are encouraged to buy domestic goods.
The case for free trade goes back to the late 18th century; it was however embraced by Great Britain in 1846, when the British Parliament repealed the Corn Laws. The British Corn Laws Placed a high tariff on imports of foreign corn, the objective of the Corn Laws was to protect the British corn producers, This was successful, however it raised the price of corn too high for the poor, and workers demanded for an increase in wage, the British saw the Corn Laws no good because it caused other countries to close their economies to them. They have been motions in the parliament since in the 1820s for free trade; they push the case for trade liberalization but by 1930s however, the British attempt to embrace free trade was hindered by the Great Depression. This Great Depression was as a result of World War 1. Things got worse in 1929 as the U.S. stock market collapsed and the run on the U.S. banking system. 1930 was a period of high trade barriers throughout the world, countries raised tariffs to protect their level of employments, as response to this problems the General Agreement on Tariffs and Trade (GATT) was established in 1947 (Hill, 1994).
General agreement on tariff and trade was an agreement whose objective was to liberalize trade through the elimination or reduction of barriers to trade. Countries met periodically to negotiate and agree on the reduction in trade barriers, this was done through a process known as the 'trade rounds'. Since the establishment of GATT in 1947, only eight rounds have been completed the last of which was the Uruguay Round was completed in 1994, in this rounds mutual tariff reductions are negotiated among members who then agree not to raise tariffs above negotiated rates. GATT was successful as tariff rates reduced in most countries and the world income grew between 1950s and 1970s as a result of the move towards free trade.
There was also regional trade agreement between countries, this agreement includes a free trade area which was an agreement between member countries to eliminate tariffs barrier between each other but members are allowed to impose tariffs on countries outside the trade area, i.e. European free trade association (EFTA) and the North America free trade area (NAFTA). Another was the customs union; this was a free trade area plus a common external tariff against other non members. A common market is a customs union that allows a free movement capital and labour. GATT was replaced by the World Trade Organization in 1995 to continue its objective.
Theories from economist have shown that there are benefits from free trade; however, there have been criticisms against this theories and arguments from firms and industries against free trade as some economist believe that free trade without protection poses some threats to the developing and the under developed nations as they are often not able to compete with the foreign firms because of their high technology and market advantage. To this note, I would say that free trade is not always a desirable phenomenon.