Free Trade in the Modern World - Essay Example

Free Trade refers to the open transactions between two countries without any form of interference from the government of these two nations in the form of tariff, quotas or other form of trade restrictions. Many countries have understood the importance of free-trade's necessity in terms of efficient consumption and production, economic growth and other economic benefits that are brought about by the trading between two or more countries. Many people consider free-trade leads to efficiency and their claim can be assessed by seeing the affect of tariff or import tax on imports. Here it must be kept in mind that imposing tariff on international trade is complete opposite of free trade and hence we are going to look what difference does the imposition of tariff poses on the supply and demand. D Price Y2 Y Y1 SW SW + TARIFF SW + TARIFF Quantity Y3 Figure : Impact of Free Trade vs. Charging of Tariff Source: Brue and McConnell Suppose that at first no trade was occurring as a result of which the original demand and supply curve, D & S respectively are the country's demand and supply. At the point equilibrium occur at point Y at the interaction of two points. However, if a country indulges in free trade SW curve becomes its supply curve and new equilibrium occurs at Y1. The result why the equilibrium quantity of supply is lower than for the demand curve S is because some countries can produce these products at a lower price than others because of comparative and absolute advantages discussed below and as a result our country will stop the production of this good citing that other countries can produce it cheaply. This is a point of controversy among supporters of free trade and people who are against free trade. The people who oppose free trade argues that domestic production will reduce from Y to Y1 as result of free trade and hence this implies closing down of factories, downsizing and unemployment of local factors of production. They say that free trade is an evil that should be stopped from penetrating a local market for the reasons discussed above. However, the supporters say that this leads to more efficient use of global resources as efficiency as more products are being produced where they can be produced cheaply. Although it might be beneficial on the global basis, it should be discourage in the developing economies which are seeking to maximize employment rate and implementing policies for the growth of local industries. Faced with this problem many countries often charge a tariff on imports which increase it's price and hence reduces the impact of imports on local industry and market. This increase reduces the local supply from Y to Y2 which is creates a lesser impact on domestic supply but still it is large enough to affect domestic industry and hence receives criticism from people who suffer from unemployment etc. However, once a a high tariff is charged raising the price of imported goods above what is being incurred in local market, it does not affect the local industry, in theory. This is the right amount of tariff and completely against the free trade, but people who oppose free-trade are appeased by this as local industry is not harmed. Similarly, supporter of free-trade argues that this is against the economic teachings of productive and allocative efficiency as the benefits of low-cost are not being enjoyed by the people resulting in less demand and people who want to consume the products at lower prices are not being catered i-e allocative inefficiency. Before coming at the conclusion whether free-trade should be allowed or not, let's look at absolute and comparative advantages. Absolute advantage occurs when one country can produce one commodity better than other i-e the production cost in one country is lower than other or requires far less resources and hence efficient. Following assumptions are necessary for the use of absolute advantage theory: There are only two countries in the world There are only two products demanded by consumers of these countries i-e butter and guns. Each country is blessed with a fixed number of resources, let's say 10. These resources can be anything that is necessary in the production process. Let's look at the production schedule or table of production for these countries: Countries: Guns Butter X 30 15 Y 10 20 Fig 1. Production Schedule in Country X & Y Source: John D. Sloman, 2001 We can clearly see from the above table that production of guns and butter can be done in two countries namely X and Y. Let's now suppose that out of available 10 resources that each country has, 5 resources are used to produce each of butter and guns. Let's now look at the average number of commodities produced by each resource to arrive at what commodity should these countries produce. For Country X: Guns = 30/5 = 6 Guns/ Resources, Butter 15/ 5 = 3 Butter/ Resources For Country Y: Guns = 10/5 = 2 Guns/ Resources, Butter= 20/5 = 4 Butter/Resources This lower production cost is one argument that is used by the supporters of free trade to argue that it is a good thing and should be encouraged. However, this implies that local resources in the production of these goods will become unemployed in the country which is indulging in free-trade and importing these goods. Comparative advantage: Comparative advantage is when you measure the advantage of producing in one country in terms of opportunity costs or other products that will have to be forgone by producing one units of a chosen product. Let's relate this with the data in fig 1. Let's first look at the number of product produced by each resource by dividing each column of fig 1, by five. Countries: Guns Butter X 30/5 = 6 15/5 = 3 Y 10/5 = 2 20/5 = 4 Fig 2: Productivity of each resource employed Source: John D. Sloman, 2001 This will ease our numerical and logical analysis if we assume that diversion of resources is possible from one product to another. Let's now look at the opportunity cost table of each resource that is being used in the manufacturing of butter and guns. Countries: Guns Butter X 6/3= 2 3/6 = 0.5 Y 2/4 = 0.5 4/2 = 2 Fig 3 : Opportunity Cost in Production of X & Y Source: John D. Sloman, 2001 From the above table we can conclude that for X to produce Guns it will have to forgo 0.5 units of butter, whereas to produce half-unit of butter it would have to forgo two guns. So, it is better that X produces guns as less output of butter is being lost and more is gained, so that society is benefiting by 1.5 units of the commodity. In the light of the same reasoning, it is better for Y to produce butter rather than guns. (McConnell and Brue, 2001) This comparative advantage leads to international specialization and the benefits of comparative and absolute advantage could only be enjoyed if there is free trade. These benefits include: Efficient-use of resources and hence more goods are produced which increased the welfare of the world in terms of material physical goods Low production costs lead to higher consumption and better standard of living It also makes the transfer of technology and capital easier and many companies chose to produce in those countries in which they can enjoy economic benefits and then export those goods through out the world without any fear of taxes or tariffs Free-Trade can be vital for the development of the world as it allows every country to focus on its core-competencies which is necessary for innovation and invention of new products Free-Trade leads to international specialization which is a basic theory in economics and hence all the benefits of specialization is gained such as more production, more employment, increased productivity of the resources etc. From Social point of view it is also good as Trade Alliances between various countries are formed which reduces the risk of wars due to interdependence of countries on each other and thus they cannot afford to indulge in wars with each other and this saves the world from destruction. Free-Trade also leads to transfer of culture and projection of better ideas. Given all these advantages of free-trade it becomes very difficult for the people who oppose free-trade to get their views justified. However, it is a fact that free-trade is not beneficial for developing countries and most of the times it is used by developed countries to gain from it and to exploit developing countries. Free-Trade is not beneficial because it creates a lot of pressure on infant industries of a country. With the influx of foreign goods coming in at cheap prices it is very difficult for infant industries to build their market or attract customer and hence they die out leaving little chance for developing countries to become self-sufficient. Similarly, when an infant industry is closed down, many people are made redundant and unemployment in the country rises. As a result of this many countries are banning free-trade charging heavy tariffs and imports on foreign trade. Same argument is used not only for infant industry but overall industrial base. If free-trade is allowed local industry is destroyed and hence unemployment, loss in GDP, current account deficit etc. occurs. Many supporters of free-trade argue that it is not necessarily bad as it may lead local industries into becoming more efficient but more often or not weather and climate plays huge part in production and countries with favorable climate enjoy benefits of low cost. These natural factors make it necessary for some countries to ban free trade and charge tariffs so that local industry do not lose and continues to develop, employ more people and play vital role in economic prosperity. Free-Trade is also bad because it creates interdependence on other countries and a country also suffers if other country is having a bad time. For example, if because of free-trade and efficiency one country only produces technological good while it imports agricultural or food from other countries. If these countries face a period of bad harvest, then all the countries who are dependent on free trade will suffer because of interdependence and that is why it is considered as an evil and not beneficial because its disadvantages outweigh it advantages. References Campbell McConnell and Stanley Brue. Economics. McGraw-Hill Companies; 15th edition (October 15, 2001) Richard Lipsey and Alec Chrystal. Oxford University Press; 10th Revised edition (28 Aug 2003) John Sloman. Economics. Prentice Hall; 5 edition (19 Dec 2002) Robin Pindyck and Daniel Rubinfield. Microeconomics. Prentice Hall; 7 edition (June 21, 2008) Read More