When Free Trade is Good for Growth

From the growing concern over Donald Trump’s imposing tariff hikes against Chinese goods and Britain’s ministers negotiating trade deals with the EU, reflects a resurgence of old arguments about the benefits of free trade. This debate has been ongoing for centuries because the advantage of free trade is often diffuse and indistinct, while the gain from shielding specific countries against foreign competition are often immediate and visible. Whilst this illusion fuels the common perception that free trade is detrimental to a country’s economic growth, many research and studies have shown that fewer barriers to international trade results in greater wealth and economic wellbeing which will spur the country’s economic growth. According to John Stuart Mill we can classify the gains from trade into three principals; direct economic advantages of trade, indirect effects of trade and the promotion of intellectual and morals, or otherwise can be referred to the Doux Commerce.

The “direct economic advantages” is the standard gains that arise through specialization of a country from a mutually beneficial trade. They are able to utilize their limited productive resources (land, labour and capital) more efficiently through exporting some of its domestically produced goods in exchange for imports earning them a higher real national income as compared in the absence of trade. The improvements in allocative and productive efficiency result in a static gain for the country with a greater capital accumulation which they are able to invest in infrastructure, human development and improving the quality of life translating to an economic growth. A classic illustration of the static gains from trade comes from China’s opening to the world economy. Although foreign trade existed prior to the economic reform, but it was generally limited in only obtaining goods that could not be made or have access in China. However, after the year 1979 China decided to fully open its economy aimed to increase foreign trade and investment. The gains from trade can be estimated by examining prices of goods in China before and after the opening of trade. For example, the price of grain and cotton on the world market was much higher than in China prior to the opening of trade. Once trade was introduced, China is able to export these crops fetching a higher price increasing their profit margins. As a result, this development has dramatically boosted its economy producing them a real GDP growth rate of 9% from 1979 to 1997 in comparison to 4.4% from 1953 to 1978 based on Economist Angus Maddison research.

Free trade allows a country to specialise in a range of goods and services with comparative advantage- a concept by Alan Deardorff “The general validity of the law of comparative advantage”. This concept basically means that trade encourages a country to specialise in goods and services that they can produce more effectively, efficiently and at the lowest opportunity cost than others. A country’s comparative advantages are ultimately determined by domestic factor endowments based on its initial conditions in terms of their resources, population and geographical location. For example, New Zealand has a comparative advantage in producing butter and cheese due to its climate and large supply of land for breeding dairy cows in comparison to countries like Singapore who have limited land and unfavorable climate in producing the products. Additionally, Ricardio suggest that nation should then narrow its focus of activity to these goods and services, even abandoning certain industries that have a higher domestic opportunity costs compared to other nation, to fully utilize its resources. This is evident for New Zealand, as of 2018 the country is the world’s largest exporter of butter making up of 17.7% of the world’s export. As a result of economies of scale, the country’s export and overall productivity will grow enhancing its prosperity.

There is also an overwhelming evidence that free trade boost economic performance by creating a more dynamic business climate in the domestic market. With trade available, consumers have a wider range of goods and services to choose from the domestic and foreign market. Therefore, domestic firms will face a greater competition from abroad diminishing its market power. This gives them a continuing incentive to make their production more efficient, to adopt new technologies and innovate to gain that competitive edge. Overtime, the more productive firms will increase their market share at the expense of the less productive firms and may even lead them to exit the market. This result in the country to operate at a high productivity rate which progresses the economy. A study by the World Bank measures the correlation of economic growth rates of a country with their level of domestic competition. Using data from over 100 countries over a ten-year period from 1986 through 1995 indicates that there is a strong correlation between the effectiveness of a rapid per capita economic growth with the higher level of competition within the domestic market.

Free trade improves the economic performance not only by allocating a country’s limited resources into their most efficient use, but also promotes productivity usage of the resources.