Analysis of Free Trade and Free Trade Agreements

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In 1776 Adam Smith published “The Wealth of Nations”, in which he introduced the proposition that free trade among nations improves overall economic welfare. The concept of “free trade” has since become a generally accepted principle. A considerable number of economists assume that free trade is beneficial for countries involved in and raises overall economic welfare. Free trade, generally explained as the elimination of tariffs, quotas, or other governmental restrictions on international trade. This allows each nation to specialize in the production of goods that it can produce relatively cheaper and more efficient than other countries, which eventually results in higher real income. In spite of free trade’s benefits, it sometimes hurts the domestic industry, because the removal of tariffs makes it difficult for domestic firms to compete with the cheaper imports of that good coming from partners.

Free trade agreements among countries are set up multilaterally, bilaterally or regionally. Multilateral agreement involves a number of countries, which is currently promoted by World Trade Organization (WTO) that also permits implementation of bilateral (involves two countries) and regional (involves two or more countries in a region) arrangements. WTO website reports that 462 bilateral and regional trade agreements are in force up to February 2010.

In this report, the theory of free trade agreements is analyzed on the basis of economics along with their practice in real life taking into account the examples of North American Free Trade Agreement (NAFTA) and the European Union (EU). Furthermore, given empirical evidence related to free trade agreements provides a clear picture of the pattern of those agreements.

Economic Integration

Free trade agreement (FTA) is a negotiated treaty among a designated group of countries that have accepted to eliminate trade barriers between them. As a consequence, member countries allow one another preferential consideration in trade. In order, this results in closer economic integration between nations. Economic integration is materialized under several associations. First of those is free trade areas (FTAs), under which tariffs and non-tariff barriers on trade have been eliminated between members, nevertheless, each country preserves its private trade policies outside the region. The second preferential trade institution is customs union, in which countries create free trade among members and keep hold ofcommon tariffs and other policies outside the organization. Common markets, the third type of preferential trade, is a further step of customs union, which not only promotes elimination of tariffs and non-tariff barriers with common tariffs for non-members, but also free movement of capital and labour across internal borders within the market. The last form of arrangement in terms of preferential treatment is economic union, in which countries go further beyond by bringing together their economies with setting up a common currency, in order a unified monetary policy, at the same time as other economic institutions. The most essential example of such a group of member countries is the European Union, which initially started as a customs union and eventually reached to an economic union.According to Cooper (2005), majority of recent FTAs comprise rules oneconomic activities along with trade in goods, including foreign investment, intellectualproperty rights protection, treatment of labor and environment, and trade in services.The dimension and complexity of the FTA will predominantly demonstrate the size and difficulty ofthe economic relations.

Economics of Free Trade

Free trade agreements are believed to bring economic growth to member countries with respect to the volume of trade. According to Trentmann (1998:226), “thedoctrine of free trade, that provides unrestricted commodity exchange between places is the best way to advance their mutual prosperity”. To explain the benefits of free trade, economists use David Ricardo’s theory of comparative advantage and basic tariff or quota analysis. In 1817 Ricardo presented the concept of comparative advantage, which is regarded as one of the most significant laws of economics. It refers to, for a country,producing a good or a service at a lower cost compared to another good within an economy. Therefore, the comparative advantage ability of a nation contributes to trade with its partner. Even if a country has an absolute disadvantage in producing any good than the other nation, there is still a foundation for joint beneficial trade. According to the theory, bearing in mind two goods, the first nation should specialize in production and exportation of the good, in which it has smaller absolute disadvantage and importationof the item in which its absolute disadvantage is greater.As a result, specialization among nations, allows them to allocate their scarce resources to the production of the certain goods and services, in which that country has a comparative advantage. Since free trade grants specialization among countries, this expands worldwide output level. The welfare of specialization with economies of scale, which is the fall in costs because of output increases, makes the global production possibility frontier to enlarge. This displays the fact that under free trade the quantity of produced goods and services is higher than the previous level, which leads to international economic prosperity.

Another method of describing the advantage of free trade is using a basic tariff analysis. A tariff is a tax on imports, which simply raises the price collected by domestic producers of that good. Figure 1 shows the benefit of free trade with the example of tariff assumption.

The above graph illustrates the imposition of an import tariff on a made-up good. Previous to tariff, Pworld is the price of the good in the world market. However, the levied tax on the good increases the domestic price from Pworld to Ptariff. As a consequence of higher prices, the domestic production grows from Qs1 to Qs2 at the same time domestic consumption shrinks from Qc1 to Qc2. The increase in price due to introduced tariff has significant effects on the welfare of the society. This ultimately leads to a decrease in consumer surplus with the new border of Ptariff level, a rise in producer surplus up to Ptariff level, and additional revenue for the government (the blue area). Nevertheless, the consumer loss is considerably more than the profits of producers and the government together. The size of societal loss is shown by the two triangles. Hence, imposition of tariff makes society worse off, vice versa; free trade would provide a net gain for society.

The similar analysis of export tariffs, import and export quotas all generate practically very same results. This makes consumers occasionally better off and producers worse off or sometimes consumers worse off and producers better off, yet establishing trade barriers create a net loss to trading countries as the amount of losers from trade limitations is greater than winners from those restrictions. Landsburg (2004), based on empirical evidence, states that free trade also produces winners and losers; nonetheless, the volume of gains from free trade is bigger than the losses. Hence, being under free trade positively affects nations’ economic welfare.

Economic impact of free trade

Formation of free trade agreements throughout the world raises notions about their impact on member countries and nonmembers. The issue has been discussed by economists and separated them into those who are strongly against the free trade and find it economically inefficient, and those who are in favour of it and believe that it creates freer trade. To build their analysis on the impact of the free trade, economists use the theories of trade creation and trade diversion. Jacob Viner first introduced these theories in 1950, whose work later has been mostly applied for free trade agreements. The concept of trade creation is based on the assumption that a member country substitute domestic production of a good with imports of that good from another member, since launch of free trade makes it more profitable to import rather than produce domestically. This is also described as a shift from a higher cost domestic zone to a lower cost partner source.

Trade creation with an example of a European Union (EU) member. A member country should import from a EU partner, which charges a lower price thanks to termination of tariffs and this leads to a rise in consumer surplus. The creation of trade contributes to economic welfare within the member countries as resources are utilized more efficiently.

Trade diversion is implemented when a member country shifts its import of a good from an efficient nonmember to a less efficient partner in view of the fact that elimination of tariffs among the members and imposition of tariffs on imports from nonmembers make it more affordable to do so. It is a shift from lower cost international territory to a higher cost regional partner source.

The graph of trade diversion again using the example of EU. In view of the fact that, EU is a customs union, it has a common external tariff on products coming from nonmember countries. This raises the price of imports from the rest of the world, which at the same time brings inefficiency by reducing consumer surplus. Consequently, costs are higher for a EU country if it formerly had entry for a lower cost producer. The graph also shows the deadweight losses as a result of trade diversion. Trade diversion is meant to lower economic welfare as a less efficient producer now uses resources rather than an efficient one.

In general, creation of free trade agreements are subject to both trade creation and trade diversion. When countries are forming a freer trade among themselves, with respect to pattern of the agreement, they could be economically and financially deteriorated. This would be a result if diversion of trade exceeds its creation according to Lipsey and Lancaster’s (1956) general theory of the second best principle. Therefore, forming a FTA does not always improve efficiency or bring prosperity, but sometimes moving to it may reduce the national welfare of the nations involved.

Empirical Evidence

Foundation of General Agreement on Tariffs and Trade (GATT) in 1947, significantly affected expansion of world trade by reducing tariff barriers on manufactured goods. Over the years, average tariffs have fallen from around 40 percent to about 5 percent currently. GATT became World Trade Organization (WTO) in 1995 and now involves world’s 153 countries. Although WTO’s success on world trade, it still has the problem of maintaining and extending liberalism in the global trading system. Multilateral negations, which include many trading partners, over trade liberalization move very slowly. Besides this, it has not had a great success in liberalizing trade in agriculture, textile, or apparel industries. For this reason, rather than multilateral negotiations, bilateral or regional trade agreements has become a preference for a number of countries.


The rapid increase in the regional trade agreements from the 1950s hitherto. It is indicated that around 450 RTAs have been notified to the WTO, of which almost 250 are currently in force.



In its early years, implementation of a free trade agreement was subject to free trade of only goods, however, currently trade agreements involves trade in services as well. According to the UNESCAP (2009), out of current 246, 171 RTAs cover trade in goods, 61 trade in services and 15 are accessions to existing RTAs. Besides this, 70% of RTAs being reached an agreement but not yet in force, provides free movement of services on trade.


The above chart displays that the majority of trade agreements with 82% are free trade areas, whereas only 11% of those account for customs union and the remaining part belongs to partial scope. Slow progress on the multilateral agenda has led to many countries to attain more efficient negotiations for the deeper regional integration.One of these agreements is North American Free Trade Agreement (NAFTA).


NAFTA is a trilateral free trade treaty that came into force in January 1994 involving three countries-United States, Canada, and Mexico. The fundamental object of the agreement was to put an end to the huge majority of trade barriers among the members. The formation of NAFTA led to the instant removal of tariffs on US-Mexico business transactions, whereas nearly all US-Canada trade was already tax-free. According to Hufbauer and Schott (2005), NAFTA was created to boost economic growth by stimulating competition in domestic markets and promoting investment through national and international sources. They also state that this has worked and consequently has brought efficiency and productivity to North American Firms. Currently, they can benefit from economies of scale in production and intra-industry specialization.

NAFTA at a Glance

NAFTA Partners





Population (2008 est.)

33.3 million

304.1 million

106.7 million

444.1 million


English and French



GDP (2008)

1,501 billion

14,441 billion

1,087 billion

17.0 trillion

Trade with NAFTA

570.8 billion

919.9 billion

393.5 billion

946.1 billion

Inward FDI (2008)

240.0 billion

229.8 billion

156.0 billion

— _1

Jobs created (1993-2008)





Employment Level, 2008






Establishment of NAFTA has contributed significantly to the trade relations between Canada, Mexico, and the United States. Although, economists disagree whether the growth is a direct outcome of the agreement, the expansion is proved by the facts from the office of the U.S. Trade Representative (USTR). USTR (2008) reports that trade within the members more than tripled between 1993 and 2008, from $297 billion to $946.1 billion. Besides this, business investment in the United States has risen by 117 percent between the same years, as compared to a 45 percent rise in the fourteen years prior. Trade with NAFTA members, currently, makes up more than 80 percent of Canadian and Mexican trade, and more than a third of U.S. trade. NAFTA has allowed North American businesses to have a better entry to sources including materials, technology, investment and human capital accessible within the partners. This brings competitiveness to the businesses in the North America as a consequence of trade liberalization. In order, trade liberalization makes an important role in promoting economic growth. Since NAFTA came into force, the economy of member countries has more than doubled in size. As it is shown in the Figure 4, in 2008, the combined gross domestic product (GDP) for partners exceeded US$17 trillion, up from US$7.6 trillion in 1993.

Both Mexico and Canada have experienced economic growth since the formation of NAFTA. Being a member of this institution caused a rapid increase in trade with the United States for these economies. Thanks to trade liberalization, a substantial reduction in prices for Mexico and Canada’s consumers occurred as a result of tariff removals along with bringing up efficiency in business relations.In case of United States, NAFA countries became top two largest export markets in 2008. USTR (2009) reports that the value of U.S. exports to NAFTA was $412.4 billion in 2008, up 7.2 % ($27.6 billion) from 2007, and up 190% from 1993 (the year before NAFTA). The top export categories (2-digit HS) in 2008 were: Machinery ($63.5 billion), Vehicles (parts) ($59.5 billion), Electrical Machinery ($49.2 billion) and Mineral Fuel and Oil ($27.9 billion), and Plastic ($22.3 billion) (USTR. 2009). U.S. exports to NAFTA evaluated 32.0% of total U.S. exports in 2008, down slightly from 32.2% in 1994. Whereas U.S. imports from NAFTA accounted for 26.4% of overall U.S. imports in 2008, down from 26.9% in 1994. NAFTA countries – Canada ($339.5 billion) and Mexico (215.9 billion) are totaled the largest and third largest importers for U.S. respectively in 2008. U.S. goods imports from NAFTA accounted for $554.4 billion in 2008, up 5.2% ($27.7 billion) from 2007, and up 268% from 1993 (USTR, 2009). The five largest categories in 2008 were Mineral Fuel and Oil (crude oil) ($157.8 billion), Vehicles ($79.7 billion), Electrical Machinery ($63.5 billion), Machinery ($46.5 billion), and Special Other (returns) ($14.3 billion).

It is very obvious that NAFTA has become very successful in soaring trade between its member nations. Yet, it is not very clear to understand whether the increase is really contributed to world trade or whether the increase actually symbolizes trade diversion. Just like any other free trade area, NAFTA members are subject to hold their own external tariff for third countries. This behavior of FTAs features Rules of Origin (ROO) concept. Its intention is to prevent trade deflection, i.e. goods or services accessing the member country with the lowest tariff for the object of trans-shipment. Although a product, coming from a member, has an access of free entry, if it contains material or processing from a third country it is then necessary to set which such inputs are permitted (Augier). A quite number of negative effects are attributed to ROO in economic literature. It could be said that these rules are protectionist and leads to negative economic welfare.Krueger (1997) states that even where the purpose of ROO is not protectionist, they provide a great amount of cost for producers and administrators. NAFTA possesses restrictive rules of origin procedure as well.Hufbauer and Schott (2005:23) comment that “in a few industries, most notably textiles and apparel where ‘yarn forward’ rules of origin were imposed specifically to make US textile firms the preferred suppliers for Mexican apparel manufacturers, NAFTA has indeed fostered trade diversion”.The rules of origin have possibly brought about trade diversion for certain industries under NAFTA.

European Union

European Union (EU) is the world’s largest trading bloc. The Treaty of Rome established the foundation of the EU in 1958. This treaty created a supranational institution called European Economic Community (EEC) between six countries (France, Western Germany, Italy, Belgium, Netherlands, and Luxembourg). The primary purpose of the EEC was to create a customs union and an incomplete common market. Customs Union has entailed free trade between members with the protection of the union against the rest of the world. Merging markets brought up rapid progress in the 1960s and early 1970s. The following objective was to implement an economic union by setting up common policies. In 1993, the Maastricht Treaty implemented the single market and the European Union was formally established. Currently, the EU involves 27 countries with over 500 million population.

The advantages from free trade predicted by theory encouraged the founders of EU to adopt removal of barriers on trade. In the 1970s and 1980s the new partners – both those, which joined in 1972 (the UK, Ireland and Denmark) and those, which joined in the 1980s (Spain, Portugal, and Greece) eliminated all tariffs and quotas in intra-EU trade. After the completion of the customs union, the EU has picked a common external tariff (CET) in their relation with the rest of the world. The CET principle applies generally to all manufactured products. Until recently it did not apply to agricultural products market, which is protected by the EU. Nonetheless, being under a customs union has had a favorable influence on the EU members so that trade among member states overweighs the trade with the third countries. Between 1958 and 1972, the trade among the six original EU members had increased by nine times, whereas goods trade with the third countries grew by three times (Molle, 2006). This was attributed to the trade creation effect of the EU.

In 1993, the completion of single market provided removal of all trade barriers and free movement of goods, services, capital and people within the EU. It is believed that the single market actually benefits the union with reducing the business costs along with stimulating competition and increasing efficiency for the advantage of consumers. BIS reports that in 2006 the EU’s GDP was 2.2% higher than it would have been in the absence of the Single Market, which benefited consumers by an average increase of €518 per capita. Furthermore, an extra 2.75 million jobs have been created as a result of the single market across Europe.

Molle (2006) states that in the period 1960-2000 intra-EU trade has expanded by almost 7 per cent annually, which is considerably in excess of GDP growth. The main factors of this growth were the EU integration and ongoing liberalization of world trade. After the enlargement of Austria, Finland, and Sweden in 1995, original members’ trade with the three new partners increased significantly, indicating an effect of integration.

In 2004 and 2007, EU experienced its biggest enlargement by the join of 12 Central and Eastern European countries (CEECs). This resulted in changes in the EU’s trade pattern because enlargement made the new partners as a part of intra-EU trade, which used to be considered as an extra-EU commerce. As a result, EU’s internal trade accounted for nearly two thirds of the EU’s total foreign trade, summing approximately €4.9 trillion in 2006 (Panorama of European Union Trade). David (2009) based on his research, states that the enlargement led to a net trade creation caused by notable gross trade between the EU and CEECS. Although exports from older 15 members to new eastern European members surpass their imports, this in general increases liberalized trade between partners and creates overall positive impact.

Free Trade Area vs Customs Union

Both of these two major forms of economic integration have a distinctive behavior that has notable implications. For an FTA, with every single country possessing its own external tariff, the ROO is the typical feature. In terms of a CU, the distinguishable factor is the common external tariff (CET), which is related to third countries. When a common external tariff is the case, imports into the union’s area meet the same tariff in each member country; therefore there is no incentive for trans-shipment of imports among members. Mirus and Rylska statethat the once CET established, it remains non-negotiable, although this may result in increase in non-tariff barriers, common commercial and trade policies would limit such attempts. The administrative simplicity in a CET makes it easy to implement, promoting efficiency and competition as a result of lowered input costs.

Taking into account FTA’s ROO feature, Krueger (1995) has revealed that an FTA does not cause more net trade creation than a CU for the same partners. Besides this, an FTA will not be economically more successful than a CU for the same members, if the CET is placed below the level of the high cost country. In this situation, trade is created when the high cost nation lowers production because of tariff cuts, in contrast an FTA would maintain the tariff and creates less trade. Considering the protectionist (trade-diversion) effect of ROO, this accounts for more trade creation and less trade diversion for a CU. Bearing in mind the borders and separate customs operation under an FTA, a CU resembles a larger single market, in which the power of interest groups compared to an FTA is significantly low and scale economics along with competition effects are importantly greater. Furthermore, a fairly large CU will have a remarkable influence on the prices of globally traded products, compelling non-member countries to undertake the existed prices inside the CU. As a result, non-members will export to the CU at prices that contains CET and transport costs, granting an aspect of monopsony power to the CU. This effect is not that clear for an FTA with similar partners. Hence, the welfare-enhancing benefit of a CU is greater than those of an FTA.


This report provides analysis of free trade and free trade agreements with their economic implications including economic integration, comparative advantage, trade creation and trade diversion effects. Moreover, the practical impacts of NAFTA, the world’s largest free trade area, alongside the European Union, which is the world’s biggest customs union, are surveyed. The results reveal that formation of both of these institutions has enormously increased the dimensions of trade among members. In addition, a rise in investment, competition and closer economic integration has contributed economic welfare of the countries involved. Welfare enhancing characteristic of free trade as a consequence of elimination of trade barriers stimulate nations to implement free trade agreementsacross the world. This was primarily undertaken by GATT/WTO, however, inefficiency and inadequacy of this institution in trade liberalization required countries to move towards the bilateral and regional trade agreements preferred to multilateral trade negotiations. Under regional trade agreements, Bhagwati (1992) states that trade diversion is more likely to prevail trade creation in most cases. Besides this, the dominant view among mainstream economists is that regionalism is disadvantageous for the multilateral trading system because they bear discriminatory features in their nature. In contrast, Krugman favors regional agreements and states that contemporary trade barriers are much more complicated to agree on multilateral level, whereas, negotiating in regional forums is really easy to cope with. Moreover, he does not find regional trade agreements to have any kind of negative effect on multilateral structure. Recent studies demonstrate that,under regional and bilateral trade agreements, trade diversion effects are limited and a significant amount of trade creation effects dominate under those treaties (Urata and Okabe, 2007).Both the cases of NAFTA and the European Union show that the trade creation effects prevail, as a result, this generates economic welfare.

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