Free trade means that countries can import and export goods without any tariff barriers or other non-tariff barriers to trade.
Essentially, free trade enables lower prices for consumers, increased exports, benefits from economies of scale and a greater choice of goods.
In more detail, the benefits of free trade include:
1. The theory of comparative advantage
This explains that by specialising in goods where countries have a lower opportunity cost, there can be an increase in economic welfare for all countries. Free trade enables countries to specialise in those goods where they have a comparative advantage.
2. Reducing tariff barriers leads to trade creation
Trade creation occurs when consumption switches from high-cost producers to low-cost producers.
- The removal of tariffs leads to lower prices for consumers (Prices fall from P1 to P2)
- This fall in prices enables an increase in consumer surplus of areas 1 + 2 + 3 + 4
- Imports will increase from Q3-Q2 to Q4-Q1
- The government will lose tax revenue of area 3. Tax revenue from imports was T (P1-P2) × (Q3-Q2)
- Domestic firms producing this good will sell less and lose producer surplus equal to area 1
- However, overall there will be an increase in economic welfare of 2+4 (1+2+3+4 – (1+3)
- The magnitude of this increase depends upon the elasticity of supply and demand. If demand elastic consumers will have a big increase in welfare
- Essentially, removing tariffs leads to lower prices for consumers – so the price of imported food, clothes and computers will be lower. When the UK joined the EEC – the price of many imports from Europe fell.
3. Increased exports
As well as benefits for consumers importing goods, firms exporting goods where the UK has a comparative advantage will also see a significant improvement in economic welfare. Lower tariffs on UK exports will enable a higher quantity of exports boosting UK jobs and economic growth.
4. Economies of scale
If countries can specialise in certain goods they can benefit from economies of scale and lower average costs; this is especially true in industries with high fixed costs or that require high levels of investment. The benefits of economies of scale will ultimately lead to lower prices for consumers and greater efficiency for exporting firms.
5. Increased competition
With more trade, domestic firms will face more competition from abroad. Therefore, there will be more incentives to cut costs and increase efficiency. It may prevent domestic monopolies from charging too high prices.
6. Trade is an engine of growth.
World trade has increased by an average of 7% since 1945, causing this to be one of the significant contributors to economic growth.
7. Make use of surplus raw materials
Middle Eastern countries such as Qatar are very rich in reserves of oil, but without trade, there would be not much benefit in having so much oil.
Japan, on the other hand, has very few raw materials; without trade, it would have low GDP.
8. Tariffs may encourage inefficiency
If an economy protects its domestic industry by increasing tariffs industries may not have any incentives to cut costs.