Understanding Free Trade

Why trade?

The following video will discuss the advantages for consumers and producers (i.e. society as a whole) as a result of the promotion of free trade between countries. Free trade can promote global allocative efficiency through specialisation. Free trade and specialisation can lower prices for goods and services for consumers and allow for higher profits for firms able to expand their production and revenues due to ability to expand sales into foreign markets.

Free Trade and Protectionism Pt1.mp4

Benefits of Free Trade

As we have seen from the video above both consumers and producers can gain as a result of free trade (however domestic producers can be made worse off as a result of more efficient foreign producers being able to produce at a lower cost of production). Some more of the benefits of Free Trade are:

Specialisation and benefits from factor endowment (Absolute and Comparative Advantage)

As every country has different factor endowments (that is common access resources, marketable commodities or other resources that can be used in the production of goods and services) free trade enables economies to be able to focus and specialise in the production of goods and services that they are most efficient at. This specialisation should enable an increase in quality and lowering of prices of goods and services. Free trade allows countries to harness the concept of comparative advantage, which refers to the ability to produce goods and services at a lower opportunity cost. By focusing on industries where they have a comparative advantage, countries can specialize in those sectors and trade with others, maximizing their production efficiency and benefiting from the differences in resource endowments.

Economies of Scale

As firms are able to export more of their goods due to free trade, this can increase the output firms are able to produce (and sell). This can allow firms to benefit from Economies of Scale (being able to produce more of a good at a lower Long Run Average Cost per unit). If firms were only able to sell to domestic markets, this would limit the amounts firms can produce and sell, limiting firms ability to achieve economies of scale and therefore being able to produce at a lower Long Run Average Cost. This could translate into lower prices for consumers

Increased competition leads to increased efficiency

Free trade can increase the overall levels of competition in a market and number of firms. This increased competition can lead to an increase in investment by firms in innovation, R&D and product differentiation as firms are encouraged to either lower prices (therefore improving productive and allocative efficiency) or encourages product differentiation, which in turn can improve consumer choices.

Ability to acquire raw materials

Free trade enables firms to be able to acquire materials or components from other foreign producers, either due to factor endowment or specialisation in the production of a components. As a result, firms that require these components or raw materials, can import these at the lowest cost and therefore this lowers their cost of production, which in turn can translate into lower prices for consumers for the goods and services made using these raw materials or components, and therefore maximising social welfare as more consumers would be willing and able to consume goods at a lower price.

Overall more global allocative efficiency

Free trade promotes the efficient allocation of resources. It allows countries to specialize in producing goods and services in which they have a comparative advantage, meaning they can produce at a lower opportunity cost compared to other countries. This specialization leads to increased productivity, efficient resource allocation, and overall economic efficiency.

Interdependence of free trade can reduce hostilities and violence between countries

Free trade can foster cooperation and peaceful relations between nations. When countries engage in trade, they become economically interdependent and have a vested interest in maintaining good diplomatic and economic relations. This interdependence can promote stability, reduce the likelihood of conflicts, and encourage peaceful resolutions to disputes.

Free Trade (due to the above reasons) can lead to higher levels of growth

Free trade stimulates competition and fosters innovation. When domestic industries face competition from international counterparts, they are motivated to improve efficiency, develop new technologies, and innovate to remain competitive. This leads to productivity gains, technological advancements, and overall economic growth. As well as this, Free trade often attracts foreign direct investment, as companies seek to access new markets or benefit from cost advantages in other countries. FDI brings capital, technology, and expertise, which can boost domestic production, create jobs, and stimulate economic growth.

Benefits of Free Trade: Absolute and Comparative Advantage

If the above situation, lets assume 1 unit of coffee is traded for 1 unit of cars. Lets say that the UK consumes 100 units of cars domestically and trades 100 units with Colombia. In return the UK recieves 100 units of Coffee. As a result of the specialisation, the combinations of goods that can be consumed in both countries are:

UK = 100 Cars & 100 units of Coffee

Colombia = 900 units of coffee & 100 units of Cars.

In this situation, both countries are able to consume beyond their PPC or what they could if they just consumed what they produced domestically. By specialising and trading both countries are able to benefit more by trading.

Comparative Advantage

In the above example, we assumed both countries are better at producing one good compared to the other and therefore they should simply focus on what they are good at and trade. However, what about if a country is good at producing both goods. Should the two countries still trade with each other?

Let's look at a hypothetical example between China and India.

We can see that in our example, China has the absolute advantage in the production of both Wheat and Potatoes. That is, it can produce both more Wheat and more Potatoes compared to India.

Therefore, in this situation, does it make sense for China to trade with India?

In order to understand this question, we need to calculate the opportunity costs for China having to give up the production of one in order to produce the other good.

To calculate this, we need to calculate how much of one good must be foregone in order to produce the other good. Once we have these figures, we can see which country has the lower opportunity cost in which goods and therefore which good they should specialise in.

First of all, we need to calculate the opportunity cost:

China and India make both wheat and potatoes.
China can produce either 100 kilograms of wheat or 200 kilograms of potatoes
As a result, 100kg of wheat = 200kg of potatoes
So for each 1kg of wheat, China must forego 2kg of potatoes.
The opportunity cost is therefore what the nation foregoes to produce the other product.
So its opportunity cost of producing wheat would be 2 ÷ 1 = 2.
By contrast, the opportunity cost of making potatoes is much smaller: 1 ÷ 2 = 0.5

By contrast, India can produce either 80 kilograms of wheat or 100 kilograms of potatoes.

So 80kg of wheat = 100kg of potatoes.
And for each 1kg of wheat, India must forgo 1.25 kg of potatoes.
Therefore, the opportunity cost to India of producing wheat would be 1.25 ÷ 1 = 1.25
By contrast, the opportunity cost of making potatoes is 1 ÷ 1.25 = 0.8

We can tell this by first looking at the product and then comparing the opportunity cost to each country. So in this example, the opportunity cost of making wheat in China is 2 potatoes. By contrast, it is only 1.25 in India. Therefore, the country that has the lowest opportunity cost has the comparative advantage. So in this case, India would have the comparative advantage in Wheat production and should focus on this.

If we now look to the production of potatoes, China has an opportunity cost of 0.5. In other words, it must sacrifice 0.5 wheat. At the same time, India has an opportunity cost of 0.8. So when we look at the nation with the lower opportunity cost, it would be China that has the comparative advantage. Therefore China should focus on producing potatoes, whilst India focuses on wheat.

So how does this benefit both countries. Well, let's say China is going to produce 200 kg Potatoes and India Produces 80 kg wheat. Of the 200kg Potatoes, China consumes 170kgs domestically and trades the remaining 30kgs for 30kgs of Wheat. The total combination of potatoes and wheat each country can consume is now:

China: 170kg Potatoes and 30kg Wheat

India: 30kg Potatoes and 50kgs Wheat.

Both countries are now able to consume beyond their domestic production capabilities.

Boyce, J. (n.d.). Comparative Advantage Definition. Boycewire. Retrieved from https://boycewire.com/comparative-advantage-definition/

Real World issues with the theory of absolute and comparative advantage

Comparative Advantage Assumes the following that limit the application of the theory:

FOPs are immobile between countries. That is, they can't move freely between countries.
Technology is fixed at a certain level.
Markets are perfectly competitive. They take the market price and do not differentiate their goods.
Countries are producing at their PPCs (or Potential output)
Exports = Imports
There is free trade
In our example, we assumed a trade of 1:1, which is highly unrealistic.

Ignores transportation costs - Whilst costs of production may be lower, the overall costs including transport may be much higher and so the specialisation gains are offset by higher transport costs, limiting the argument.

Over Specialisation - As the theory focuses on the idea of specialisation, this can cause countries to become over specialised in the production of a few goods, leaving them exposed to risks if prices become volatile or decrease over the long term.

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