Free Trade

Free trade is a market model in which trade in goods and services between or within countries flows freely without any restriction, such as tariffs, quotas, nontariff barriers, or taxes. Utilizing the argument that the free market is the best “governor” to ensure increase in wealth, free trade demands that government intervention with the “free” market be eliminated and all restrictions be removed. In history, the merit of free trade was extensively discussed by Adam Smith in 1776 in his book The Wealth of Nations, examining the gains of free trade in the context of specialization and division of labor (absolute advantage theory).

The idea of free trade was also later formulated by David Ricardo by using one factor of production with constant productivity of labor in two goods, but with relative productivity between the goods different across countries (comparative advantage theory). David Ricardo claimed that gains from free trade will be great once a policy of free trade is adopted in an institutional setting. For Jagdish Bhagwati, the classical and neoclassical schools of economic theory constantly emphasized the advantages of free trade policies for the improvement of popular living standards and the promotion of overall rates of economic growth, and the disadvantages of protectionism. The basic conclusion of classical and contemporary neoclassical economic theory is that the advantages of free international trade represent basically only a special case of the advantages of the free market system in general.

Nevertheless, in the 20th century, “New Trade Theory” manifested itself as the economic critique of international free trade from the perspective of increasing returns to scale and the network effect. Some economists asked whether it might be effective for a nation to shield infant industries until they grow to sufficient size to compete internationally. According to this theory, the optimum-tariff and infant-industry arguments constituted some grounds for protection and protectionist policies by some countries, and more importantly were seen as a departure from free trade within the framework of the traditional theory. However, the general trend in international trade is in line with the reduction of tariffs and other trade restrictions through international negotiations.

Theories

Absolute advantage in trade theory was introduced to the literature by Adam Smith, whose view of the economic system was that nations' wealth is equal to their production capacity. In his positive-sum economy it is perfectly possible to make everybody better off and [Page 720]real incomes per head are able to rise indefinitely as a policy of laissez-faire promotes economic growth. In his view, as self-interest is combined with competition, which also serves public interest, division of labor increases productivity. He fortified the idea of free trade with only one production factor, which was labor. His labor theory of value states that the value of a good is determined by the amount of labor required to produce it. Nevertheless he did not consider how to deal with capital, land, and profits.

Comparative advantage was offered by David Ricardo in order to fill gaps in Adam Smith's approach on absolute advantage of nations in trade. Ricardo, like Adam Smith, was opposed to tariff and other restrictions on international trade. The Ricardian model focuses on comparative advantage of nations. It is considered perhaps the most important approach in international free trade theory today. In a Ricardian model, countries specialize in producing what they produce best, and comparative advantage is the ability to produce a good at a lower cost, relative to other goods, compared to another country. In Principles of Economics, Ricardo states comparative advantage is a specialization technique used to create more efficient production and describes opportunity cost between producers.

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