The gains and losses from free trade

Overview

Free trade, effect of trade liberalisation on employment in an economy and effect of increased import competition on the rate of inflation.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is free trade?

   Model answer

   Free trade is international exchange that takes place without government-imposed barriers such as tariffs, quotas, subsidies to domestic rivals or discriminatory regulation, so that the goods and services crossing a border face the same treatment as domestic ones. Prices then reflect underlying costs rather than policy, and buyers purchase from the cheapest source wherever it is located.

2. 2

   Explain three ways in which consumers gain from free trade.

   Model answer

   Consumers gain lower prices, because imports from lower cost producers undercut domestic supply and the increased competition also disciplines domestic firms' pricing. They gain wider choice, since goods and varieties that no domestic producer makes become available. They gain higher quality over time, because domestic firms exposed to foreign rivals must innovate and improve to keep custom. The real income of most households therefore rises for a given money income, though the size of the gain depends on how much of a household’s spending goes on the goods whose prices fall.

3. 3

   How does free trade benefit domestic producers rather than harming them?

   Model answer

   Exporting firms reach a market many times the size of the domestic one, allowing higher sales, longer production runs and lower average costs through economies of scale. Producers also gain access to cheaper or better imported raw materials, components and capital equipment, which lowers their own costs of production. Exposure to foreign competitors and foreign technology raises the pressure and the opportunity to innovate, so productivity growth tends to be faster in traded sectors.

4. 4

   Analyse the effect of trade liberalisation on employment in an economy.

   Model answer

   Employment rises in export industries and in industries using imported inputs, because both see demand or margins improve, and the extra income these workers spend supports jobs elsewhere. Employment falls in import-competing industries whose output is displaced by cheaper foreign supply, producing structural unemployment concentrated in particular occupations and regions. The net effect on total employment is usually small in the long run, since the labour force is reallocated rather than made redundant, but the transition can be long and painful where labour is immobile and the losing industry dominates a locality.

5. 5

   Analyse the effect of increased import competition on the rate of inflation.

   Model answer

   Cheaper imported finished goods enter the consumer price basket directly, so their lower prices pull measured inflation down. Cheaper imported inputs lower firms' costs of production, easing cost-push pressure on domestic prices. Competition from abroad also weakens the pricing power of domestic firms and the bargaining power of workers in exposed sectors, restraining the pace at which domestic costs rise. The effect on the price level is largely a one-off downward shift as the barriers come down rather than a permanent reduction in the inflation rate.

6. 6

   How can free trade raise an economy's long-run rate of economic growth rather than just its level of output?

   Model answer

   Trade transmits technology and management practices through imported capital goods, licensing and contact with demanding foreign customers, raising productivity. It enlarges markets so that investment in research and in specialised capital becomes worthwhile, and it forces the exit of the least efficient firms so resources concentrate in the most productive ones. It also allows a country to import capital equipment it cannot make itself, relaxing a constraint on capital accumulation. These are effects on the growth of productive capacity, not merely a one-off reallocation gain.

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