Understanding the Proposed Benefits of Free Trade

This theory, known as import substitution industrialization, is largely considered ineffective for currently developing nations. 3] Disadvantages of tariffs[edit] The pink regions are the net loss to society caused by the existence of the tariff. The chart at the right analyzes the effect of the imposition of an import tariff on some imaginary good. Prior to the tariff, the price of the good in the world market (and hence in the domestic market) is Pworld. The tariff increases the domestic price to Ptariff. The higher price causes domestic production to increase from QSI to QS2 and causes domestic consumption to decline from QCI to This has three main effects on societal welfare.

Consumers are made worse off because the consumer urplus (green region) becomes smaller. Producers are better off because the producer surplus (yellow region) is made larger. The government also has additional tax revenue (blue region). However, the loss to consumers is greater than the gains by producers and the government. The magnitude of this societal loss is shown by the two pink triangles. Removing the tariff and having free trade would be a net gain for An almost identical analysis of this tariff from the perspective of a net producing country yields parallel results.

From that country’s perspective, the ariff leaves producers worse off and consumers better off, but the net loss to producers is larger than the benefit to consumers (there is no tax revenue in this analysis, export tariffs, import quotas, and export quotas all yield nearly identical results. [l] Sometimes consumers are better off and producers worse off, and sometimes consumers are worse off and producers are better off, but the imposition of trade restrictions causes a net loss to society because the losses from trade restrictions are larger than the gains from trade restrictions.

Free trade creates inners and losers, but theory and empirical evidence show that the size of the winnings from free trade are larger than the losses. [l] Trade diversion[edit] According to mainstream economic theory, the selective application of free trade agreements to some countries and tariffs on others can lead to economic inefficiency through the process of trade diversion. It is economically efficient for a good to be produced by the country which is the lowest cost producer, but this does not always take place if a high cost producer has a free trade agreement while the low cost roducer faces a high tariff.

Applying free trade to the high cost producer (and not the low cost producer as well) can lead to trade diversion and a net economic loss. This is why many economists place such high importance on negotiations for global tariff reductions, such as the Doha Round. [l] Opinion of economists[edit] The literature analysing the economics of free trade is extremely rich with extensive work having been done on the theoretical and empirical effects.

Though it creates winners and losers, the broad consensus among economists is that free trade is a arge and unambiguous net gain for society. [6][7] In a 2006 survey of American economists (83 responders), “87. 5% agree that the U. S. should eliminate remaining tariffs and other barriers to trade” and “90. 1% disagree with the suggestion that the U. S. should restrict employers from outsourcing work to foreign countries. “[8] Quoting Harvard economics professor N.

Gregory Mankiw, “Few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards. “[9] Nonetheless, uoting Professor Peter Soderbaum of Malardalen University, Sweden, “This neoclassical trade theory focuses on one dimension, i. e. , the price at which a commodity can be delivered and is extremely narrow in cutting off a large number of other considerations about impacts on employment in different parts of the world, about environmental impacts and on culture. [10] Most economists would agree that although increasing returns to scale might mean that certain industry could settle in a geographical area without any strong economic reason derived from comparative dvantage, this is not a reason to argue against free trade because the absolute level of output enjoyed by both “winner” and “loser” will increase with the “winner” gaining more than the “loser” but both gaining more than before in an absolute level.

In the classic text An Inquiry into the Nature and Causes of the Wealth of Nations (Wealth of Nations), namely, in the passage “Of Restraints upon the Importation from Foreign Countries of such Goods as can be Produced at Home” economist Adam Smith describes reasons for allowing free trade.