Why do trade agreements exist

Economists have had an enormous impact on trade policy, and they provide a strong rationale for free trade and for removal of trade barriers. Although the objective of a trade agreement is to liberalize trade, the actual provisions are heavily shaped by domestic and international political realities.

The world has changed enormously from the time when David Ricardo proposed the law of comparative advantage, and in recent decades economists have modified their theories to account for trade in factors of production, such as capital and labor, the growth of supply chains that today dominate much of world trade, and the success of neomercantilist countries in achieving rapid growth.

Almost all Western economists today believe in the desirability of free trade, and this is the philosophy advocated by international institutions such as the World Bank, the International Monetary Fund, and the World Trade Organization WTO.

However, economic theory has evolved substantially since the time of Adam Smith, and it has evolved rapidly since the GATT was founded. To understand U. This would allow the country to have a bigger and more powerful army and navy and more colonies. One of the better-known advocates of this philosophy, known as mercantilism, was Thomas Mun, a director of the British East India Company.

Mercantilists believed that governments should promote exports and that governments should control economic activity and place restrictions on imports if needed to ensure an export surplus. Obviously, not all nations could have an export surplus, but mercantilists believed this was the goal and that successful nations would gain at the expense of those less successful.

Ideally, a nation would export finished goods and import raw materials, under mercantilist theory, thereby maximizing domestic employment. This would enable each nation to specialize in producing the product where it had an absolute advantage, and thereby increase total production over what it would be without trade.

This insight implied very different policies than mercantilism. It implied less government involvement in the economy and a reduction of barriers to trade. Thirty-one years after The Wealth of Nations was published, David Ricardo introduced an extremely important modification to the theory in his On the Principles of Political Economy and Taxation , published in Ricardo showed that what was important was the comparative advantage of each nation in production.

The theory of comparative advantage holds that even if one nation can produce all goods more cheaply than can another nation, both nations can still trade under conditions where each benefits. Under this theory, what matters is relative efficiency. Economists sometimes compare this to the situation where even though a lawyer might be more proficient at both law and typing than the secretary, it would still pay the lawyer to have the secretary handle the typing to allow more time for the higher-paying legal work.

Similarly, if each country specializes in the products where it is comparatively more efficient, total production will be higher and consumers will have more goods to utilize. This situation is often portrayed in economics textbooks as a simplified model of two countries England and Portugal and two products textiles and wine.

In this simplified portrayal, England has relatively abundant capital and Portugal has relatively abundant labor, and textiles are relatively capital intensive whereas wine is relatively labor intensive. With these conditions, both nations would be better off if they freely traded, and under such a situation of free trade, England would export textiles and import wine. This would maximize efficiency, resulting in more total production of textiles and wine and cheaper prices for consumers than would be the case without trade.

Through empirical studies and mathematical models, economists almost universally believe that this model holds equally well for multiple products and multiple countries. In fact, economists consider this law of comparative advantage to be fundamental. The law of comparative advantage also holds equally well for many factors of production. In addition to labor and capital, other factors of production include natural resources such as land and technology, and these can be subdivided.

For example, land can be land for mining or land for farming, or technology for making cars or computer chips, or skilled and unskilled labor. Additionally, over time factor endowments may change.

Furthermore, some products do not utilize the same factors of production over their life cycle. Over time, as volume increased, costs came down and computers could be mass produced. Initially, the United States had a comparative advantage in production; but today, when computers are mass produced by relatively unskilled labor, the comparative advantage has shifted to countries with abundant cheap labor.

And still other products may use different factors of production in different countries. For example, cotton production is highly mechanized in the United States but is very labor intensive in Africa. The fact that factors of production may change does not nullify the theory of comparative advantage; it just means that the mix of products that a nation can produce relatively more efficiently than its trade partners may change.

Traditional economic theories expounded by Ricardo and Heckscher-Ohlin are based on a number of important assumptions, such as perfect competition with no artificial barriers imposed by governments. A second assumption is that production occurs under diminishing or constant returns to scale, that is, the costs of producing each additional unit are the same or higher as production increases.

For example, to increase his wheat crop, a farmer may be forced to use less-fertile land or pay more for laborers to harvest the wheat, thereby increasing the cost of each additional unit produced. Another key assumption of traditional economic theory is that basic factors of production—such as land, labor, and capital—are not traded across borders. Although Ohlin believed that such basic factors of production were not traded, he argued that the relative returns to factors of production between countries would tend to be equalized as goods are traded between the countries.

Subsequently, Samuelson argued that factor prices would in fact be equalized under free trade conditions, and this is known in economics as the factor price equalization theorem. The implications of this are important and are explored further in chapter 8. In static terms, the law of comparative advantage holds that all nations can benefit from free trade because of the increased output available for consumers as a result of more efficient production.

Many economists, however, believe that the dynamic benefits of free trade may be greater than the static benefits. Dynamic benefits, for example, include the pressure on companies to be more efficient to meet foreign competition, the transfer of skills and knowledge, the introduction of new products, and the potential positive impact of the greater adoption of commercial law.

Thus trade can affect both what is produced static effects and how it is produced dynamic effects. The terms of trade can shift, either benefiting a country or reducing its welfare. Assume that the United States exports aircraft to Japan and imports televisions, and that one airplane can purchase 1, televisions. If one airplane now can purchase 2, televisions, the United States will be better off; alternatively, its welfare is diminished if it can only purchase televisions with a single airplane.

A number of factors can affect the terms of trade, including changes in demand or supply, or government policy. A country can also adopt a beggar-thy-neighbor stance by deliberately turning the terms of trade in its favor through the imposition of an optimum tariff or through currency manipulation.

In his economics textbook, Dominick Salvatore defines an optimum tariff as. As the terms of trade of the nation imposing the tariff improve, those of the trade partner deteriorate, since they are the inverse. As a result, the trade partner is likely to retaliate. Note that even when the trade partner does not retaliate when one nation imposes the optimum tariff, the gains of the tariff-imposing nation are less than the losses of the trade partner, so that the world as a whole is worse off than under free trade.

It is in this sense that free trade maximizes world welfare. If both countries play this game, both will be worse off. The objective of reducing barriers to trade, of course, is to increase the level of trade, which is expected to improve economic well-being. Economists often measure economic well-being in terms of the share of total output of goods and services i.

GDP is the best measurement of economic well-being available, but it has significant conceptual difficulties. Although reducing barriers to trade generally represents a move toward free trade, there are situations when reducing a tariff can actually increase the effective rate of protection for a domestic industry. Removing the duty on wool while leaving the duty unchanged on the woolen cloth results in increased protection for the cloth industry while having no significance for wool-raising.

This happens for some products as a result of multilateral trade negotiations. For example, a country often reduces tariffs on products that are not import sensitive—often because they are not produced in that country—to a greater extent than it reduces tariffs on import sensitive products. In an FTA, where the end result is zero tariffs, this would not be an effect when the agreement is fully implemented.

However, during the transition period it could well be relevant for some products. Other than this exception, however, reducing tariffs or other barriers to trade increases trade in the product, and this is the intent of the trade agreement.

The benefits to an economy from expanded exports as a trade partner improves market access are clear and indisputable. And suppliers to a firm that gains additional sales through exports will likely also increase their sales to that firm, thereby increasing GDP further. The firms gaining sales through this may well hire more workers and possibly increase dividends to stockholders.

The 90 cents that is spent then becomes income for another individual, and once again 90 percent of this will be spent on consumption. The impact of trade on GDP, therefore, is the net amount that exports exceed or are less than imports. However, this is a static measure. As noted above, expanded exports also have a dynamic effect as companies become more efficient as sales increase. The economic impact of increased imports is different.

A way of looking at this is that if a U. This would suggest that the mercantilists were right, that a nation would be well advised to restrict imports. Adam Smith and many economists after him argue that the objective of production is to produce goods for consumption. From this perspective, the emphasis on the reciprocal lowering of trade barriers in most actual trade liberalization efforts. The benefits of unilateral elimination of trade barriers are particularly obvious in those cases where the country does not produce the product; in these cases, eliminating trade barriers expands consumer choice.

As noted above, however, an exception to this occurs in situations where reducing a trade barrier on a raw material or component that is not produced by the country increases the effective rate of protection for the finished product.

Even where the country does produce the product, increased competition from trade liberalization will likely lead to lower prices by the domestic firms. This makes it easier and cheaper for U. If you are looking to export your product or service, the United States may have negotiated favorable treatment through an FTA to make it easier and cheaper for you.

Accessing FTA benefits for your product may require more record-keeping but can also give your product a competitive advantage versus products from other countries. FTAs typically address a wide variety of government activity that affect your business:.

Reduction or elimination of tariffs on qualified. Detailed descriptions and the texts of many U. Skip to main content. Bilateral Investment Treaties Other Initiatives. Breadcrumb Trade Agreements. Share sensitive information only on official, secure websites. Trade Agreements can create opportunities for Americans and help to grow the U. There are many types of trade agreements, including:.

Home Trade Agreements. All trade agreements. Free Trade Agreements.