The Economic Case for Free Trade

Comparative advantage, trade and technology

The standard economic argument offered in support of free trade is straightforward. Free trade is beneficial because it induces countries to produce according to their comparative advantage. [This model of trade is usually called the Ricardian Model and is named after the famous nineteenth-century classical economist, David Ricardo. See Ricardo 1817.] When countries specialize in the production of goods at which they have a comparative advantage, the value of national income is maximized. Trade enables countries to sell these goods on the world market and exchange them for other goods which domestic consumers value but are not particularly good at producing. Hence, by encouraging domestic producers to specialize in the production of those goods at which the country has a comparative advantage, free trade creates more wealth than would be possible if the country had to produce everything on its own. With this greater wealth, domestic consumers are able to consume more of both domestic and foreign goods. This raises overall economic welfare.

An important insight that can be derived from this standard model of international trade is that no country loses as a result of free trade. When a country moves from autarky to a free trade regime, national income rises and consumers are able to buy more of all goods. [Autarky is a situation where there is no international trade.] These gains from trade will arise even when one country is, in absolute terms, less efficient in the production of all goods (Pomfret 1991). The fact that all countries, regardless of their productivities will gain from trade is a powerful endorsement of the potential for free trade to raise real incomes in all nations.

Another way of thinking about trade is to view it as simply another technology for the production of goods. [This approach to understanding trade is taken from James Ingram (1966).] To understand this idea, consider the following example. There are two technologies available for the production of cars in Canada. The first technology involves the physical production of cars in factories in south-western Ontario. The second technology involves growing wheat in Saskatchewan and exporting wheat to Japan in exchange for cars produced in Japanese factories. While the two technologies may differ in terms of the "inputs" used, the net result is the same: Canada gets the cars. Whether Canada should use the first or second technology should depend only on which one enables Canadians to get more cars.

Most people would probably agree that technical progress—being able to produce more goods and services with fewer inputs of labour, capital, and other factors of production—is desirable because it enables us to use scarce resources more efficiently, Indeed, most economists would argue that technical progress is what drives economic growth and the creation of wealth (Lipsey 1996). Yet it is curious that while most people would be in favour of using the most efficient methods of production available, many of these same people object to free international trade. This is illogical because free trade is simply another technology for the production of goods and services, and, in some cases, it is the most efficient technology available. If technological progress is desirable because it drives growth and prosperity, then so is free trade.

More sophisticated trade models

Of course, the standard economic model of trade discussed above is not the only way economists think about free trade. Although the Ricardian classical trade model is certainly the most intuitive international trade model, it has generally not been the model of trade preferred by academic economists. For a variety of reasons, most neoclassical international trade economists have, until quite recently, preferred to think about trade in terms of the more sophisticated Heckscher-Ohlin-Samuelson Model.  [The Heckscher-Ohlin-Samuelson Model is sometimes called the Factor Proportions Model of Trade.] While the motivation for trade in this model is somewhat different than in the simple Ricardian model,  [What distinguishes the Ricardian model from the Heckscher-Ohlin-Samuelson model is that in the Ricardian model trade is driven by technological differences across countries while in the Heckscher-Ohlin-Samuelson model all nations are assumed to have the same technology. The motivation for trade in this model is differences in factor (i.e. resource) endowments. See Pomfret 1991.] the general conclusions about trade policy are the same: the welfare of all nations rises as they move from autarky to free trade (Pomfret 1991; Jones 1987). Hence, the case for free trade remains intact even in the more complicated Heckscher-Ohlin-Samuelson Model.

In the last 20 years, trade theorists have developed alternative models of trade that, at least at a theoretical level, have called into question the optimality of a free trade policy. The distinguishing feature of these models is that they depart from the standard assumptions about perfect competition and allow for imperfectly competitive market structures and scale economies. According to the "new trade theory," it is possible under particular circumstances for nations to raise their welfare by introducing protectionist policies. For instance, in two very influential papers, Brander and Spencer (1983, 1985) demonstrate that export subsidies and import restrictions can, under certain conditions, deter foreign firms from competing in profitable domestic markets. This approach to understanding international trade has been refined by other authors and is generally called "strategic trade theory." Other scholars have noted that, when there are significant externalities associated with a particular industry—particularly knowledge-based externalities resulting from research and development expenditures—a policy of protection can raise national welfare (Cordon 1974). While there are many variants of the new trade theory, the general conclusions call into question the optimality of free trade as an economic policy.

Is free trade still optimal?

Demonstrating that free trade may not be the theoretically optimal policy does not necessarily discredit free trade as a rule of thumb to good international trade policy in the real world. In fact, Paul Krugman, one of the major contributors to the new trade theory, argues that it is so difficult to implement successful state intervention that we would be foolish to follow any policy other than free trade (1987, 1993a). In Paul Krugman's view, practical considerations—informational constraints on the part of policy makers, general equilibrium concerns, the possibility of retaliatory trade wars, and rent-seeking domestic politics—may result in a strategic trade policy causing more harm than good. Krugman writes:

If the potential gains from interventionist trade policies were large, it would be hard to argue against making some effort to realize these gains. The thrust of [my] critique . . . is that is that the gains from intervention are limited by uncertainty about appropriate policies, by entry that dissipates the gains, and by the general equilibrium effects that insure that promoting one sector diverts resources from others. The combination of these factors limits the potential benefits of sophisticated interventionism. Once the expected gains from intervention have been whittled down sufficiently, political economy can be invoked as a reason to forego intervention altogether. Free trade can serve as a focal point on which countries can agree to avoid trade wars. It can also serve as a simple principle with which to resist pressures of special-interest politics. To abandon the free trade principle in pursuit of the gains from sophisticated intervention could therefore open the door to adverse political consequences that would outweigh the potential gains (1987:143).

Hence, in spite of recent theoretical developments, the practical case for free trade remains strong. Sophisticated intervention, according to Krugman, may ultimately cause more harm than good. Therefore, the principle of free trade should remain the cornerstone of a sound international economic policy.

GATT versus the FTA and NAFTA: multilateralism versus regionalism

Broadly speaking, there are two processes by which countries can liberalize trade. The first approach, usually called multilateralism, involves the gradual reduction of trade barriers among a very large set of countries. The GATT process and the various round of trade reductions which occurred under the Kennedy, Tokyo, and most recently, Uruguay Rounds are examples of multilateralism.

The other approach to trade liberalization involves the reduction and/or elimination of trade barriers among smaller groups of nations that are, typically, geographically contiguous. This approach to trade liberalization is called regionalism. The Canada-United States Free Trade Agreement (FTA), the North American Free Trade Agreement (NAFTA), the Australia-New Zealand Free Trade Agreement, and the European Union (EU) furnish examples of regional trade liberalization.   [It is important to distinguish among different types of regional trade initiatives. A "free trade area" is formed when a group of countries agrees to reduce tariffs amongst themselves but each country is allowed to set its own tariff level with other (non-member) countries. NAFTA, for instance, establishes a free trade areas among Canada, the United States, and Mexico. A "customs union" occurs when a group of countries not only reduces trade barriers amongst themselves but also agrees to set common external tariffs. The European Union is an example of a customs union.] Nations that belong to the GATT are permitted to engage in such regional trade initiatives under the GATT Article XXIV.  [For a succinct discussion of regionalism versus multilateralism and the GATT rules, see Bhagwati 1991.]

Given the choice, most international trade scholars would prefer trade liberalization to occur on a multilateral as opposed to a regional basis. The preference for multilateral over regional trade liberalization stems from concerns about the possible "trade diverting" effects of regional trade agreements.  [The potential for regional trade agreements to cause trade diversion was first identified by Viner 1950 and was later expanded by Lipsey 1957.] To illustrate the concept of trade diversion, consider the following example. Suppose Canada, as a result of NAFTA, eliminates its tariff on Mexican textiles but not on Indonesian textiles. Since a tariff is eliminated, domestic textile prices fall and Canadian consumers will buy more textiles. However, because the tariff structure now favours Mexico, it is likely that textile imports to Canada will be "diverted" from Indonesia to Mexico. If Mexico is at least as efficient as Indonesia in the production of textiles, then economic welfare is improved: consumers get more textiles and they purchase them from the producer having lower costs. However, if Mexico is a less efficient textile producer than Indonesia, then economic welfare is diminished because Canada is importing from a producer having higher costs. If Canada had reduced tariffs on both Indonesian and Mexican textiles (i.e. if Canada had pursued multilateral as opposed to regional trade liberalization), then this problem would be avoided: consumers in Canada would get more textiles and they would purchase them from the most efficient producer. Hence, because regional free trade agreements can result in trade diversion that could reduce economic welfare, most economists prefer multilateral to regional trade liberalization.

Of course, whether or not regional trade initiatives like the FTA or NAFTA are the cause of significant trade diversion is ultimately an empirical matter. Unfortunately, on this particular issue, there is little empirical evidence. It is interesting to note, however, that while all economists recognize the potential for regional trade agreements to cause trade diversion, many are skeptical about its empirical relevance. For instance, in a recent symposium on regional trade blocs, Lawrence Summers, a Harvard economist and now Deputy Secretary of the United States Treasury, writes that he "find[s] it surprising that this issue [i.e. trade diversion] should be taken so seriously—in most other situations, economists laugh off second best considerations and focus on direct impacts" (1991: 299). Summers also argues that since trade blocs such as the FTA, NAFTA, and the EU are usually formed amongst countries that are natural trading partners in the sense that the bulk of their trade would be with each other regardless of the trading regime, the likelihood of trade diversion is minimal:

Are trading blocs likely to divert large amounts of trade? In answering this question, the issue of natural trading blocs is crucial because to the extent that the blocs are created between countries that already trade disproportionately, the risk of large amounts of trade diversion is reduced (1991: 297).

In a similar vein, Paul Krugman writes:

If a disproportionate share of world trade would take place within trading blocs even in the absence of any preferential trading arrangement, then the gains from trade creation within blocs are likely to outweigh any possible losses from external trade diversion (1991: 21).

Hence, there are reasons to believe that the costs of pursuing a regional as opposed to a multilateral trade liberalization strategy are likely to be small relative to the potential gains.  [Jagdish Bhagwati remains skeptical. See Bhagwati and Panagariya 1996: ch. 1; see also Bhagwati 1991.] Without question, Canada, the United States, and, to a lesser extent, Mexico qualify as "natural trading partners." Even before the FTA, the overwhelming bulk of Canada's international trade was with the United States. Likewise, exports to Canada represented a very significant portion of America's international trade. Hence, the likelihood that a North American free trade bloc would result in significant trade diversion appears to be small.

A final point to be made about regional versus multilateral trade liberalization is that regional free trade liberalization need not be inconsistent with the pursuit of broader multilateral free trade.  [Bhagwati 1991 argues the opposite.] In fact, as noted earlier, regional trade agreements are fully consistent with the GATT rules. Certainly, the ultimate objective of any sound international economic policy must be free trade among all nations. Nonetheless, it is important to note that Canada's membership in NAFTA does not preclude the attainment of this larger objective. Seen in this light, pursuit of regional free trade may be a positive first step towards achieving freer trade among all nations. Indeed, given the slow pace of multilateral trade negotiations, regional free trade may represent a viable way to accelerate the process of multilateral trade liberalization.