Free Trade (Encyclopedia of Business)
Free trade refers to the absence of restrictions on international trade between two nations. As a commercial policy affecting international trade, free trade is the opposite of protectionism. Where protectionism calls for tariffs and duties on imports to "protect" a country's domestic producers, free trade is a policy of allowing imports and exports to flow freely between nations without any restrictions.
In the 18th century, Scottish economist Adam Smith (1723-1790) wrote The Wealth of Nations to explain the benefits of free trade. What he proposed has come to be called unilateral free trade. That is, he called on nations to unilaterally practice free trade by allowing unrestricted free access to their domestic markets. In addition, he recommended a nation neither hold back nor subsidize its own exports. His response to the practice of dumping, for example, would have been to welcome foreign goods that were being sold below cost or fair market value, rather than to impose antidumping duties on them. He argued that domestic industries would respond to dumping by shifting their resources to the production of different goods that would benefit the nation's economy.
The doctrine of free trade holds that interventions in international trade, such as tariffs and duties, serve only to reduce the overall wealth of all nations. In practice, 19th-century Victorian England has been the only country where unilateral free trade was an official policy. It has never been the policy of the United States. The imposition of tariffs and duties has always been a source of revenue for the U.S. government. In the mid-19th century, for example, tariffs on imports accounted for more than 90 percent of total federal revenue. In the mid-20th century it was less than 1 percent, due in large part to other sources of federal tax revenue.
It was English economist David Ricardo (1772-1823) who put forth the doctrine of comparative advantage, which showed how free trade between nations benefits each nation involved. Though one nation may enjoy an absolute advantage over another nation in terms of being able to produce goods more inexpensively, Ricardo demonstrated that such an absolute advantage is irrelevant in determining whether trade can benefit two trading partners. He showed that even when one country enjoys an absolute advantage over another country in two industries, for example, each nation will have a comparative advantage in only one of the industries.
On that basis, both nations can enjoy benefits from exchange and from specialization. That is, the nation that enjoys a comparative advantage in one industry benefits by exporting more goods from that industry and also by shifting more resources to producing goods in that industry. In addition, the reallocation of labor and other resources increases the overall production of goods in those industries by both nations. As a result, nations are economically motivated to engage in international trade.
U.S. commercial policy has always been a mixture of free trade and protectionism. After tariffs and duties reached a peak in the early 1930s, the United States began to reduce tariffs and duties on imports substantially by negotiating bilateral trade agreements with other countries. In the years following World War II, the General Agreement on Tariffs and Trade (GATT) took effect. It provided for multilateral trade agreements to be negotiated in a series of "rounds," the most recent of which was the Uruguay Round that concluded in 1993.
The principles of free trade form the basis for regional free trade agreements and economic communities. In the European Union (EU), for example, member nations enjoy a form of free trade when trading with other member nations. The North American Free Trade Agreement (NAFTA) has reduced and, in many cases, eliminated duties and tariffs on goods flowing between Canada, Mexico, and the United States. Such agreements and economic communities have given rise to the phenomenon of large trading blocs, which may act collectively to impose restrictions on imports from nations who are not part of the trading bloc. For example, the EU (and its predecessor, the European Community) have generally increased tariffs and duties on imports from non-EU countries since 1975.
Trade wars can erupt when nations believe that the principles of free trade have been violated. Protectionist measures may be taken to reduce imports and protect a nation's industries. Such measures are usually met with retaliatory measures. If one country imposes an unusually high tariff on the exports of another country, it is likely that additional tariffs will be levied on some of the exports of the first country. International trade agreements, such as GATT, are designed in part to prevent the escalation of such trade wars and ensure that international trade is conducted for the benefit of all nations.
[David P. Bianco]