The Case for Free Trade
Few countries have anything approaching completely free trade. The city of Hong
Kong, which is legally part of China but maintains a separate economic policy, may be
the only modern economy with no tariffs or import quotas. Nonetheless, since the time
of Adam Smith, economists have advocated free trade as an ideal toward which trade
policy should strive. The reasons for this advocacy are not quite as simple as the idea
itself. At one level, theoretical models suggest that free trade will avoid the efficiency
losses associated with protection. Many economists believe that free trade produces
additional gains beyond the elimination of production and consumption distortions.
Finally, even among economists who believe free trade is a less-than-perfect policy,
many believe free trade is usually better than any other policy a government is likely
to follow.
Free Trade and Efficiency
The efficiency case for free trade is simply the reverse of the cost-benefit analysis of a
tariff. Figure 10-1 shows the basic point once again for the case of a small country that
cannot influence foreign export prices. A tariff causes a net loss to the economy measured
by the area of the two triangles; it does so by distorting the economic incentives of both
producers and consumers. Conversely, a move to free trade eliminates these distortions
and increases national welfare.
In the modern world, for reasons we will explain later in this chapter, tariff rates are
generally low and import quotas relatively rare. As a result, estimates of the total costs of
distortions due to tariffs and import quotas tend to be modest in size. Table 10-1 shows
one fairly recent estimate of the gains from a move to worldwide free trade, measured as
a percentage of GDP. For the world as a whole, according to these estimates, protection
costs less than 1 percent of GDP. The gains from free trade are somewhat smaller for
advanced economies such as the United States and Europe and somewhat larger for
poorer “developing countries.”
Price, P
World price
plus tariff
World price
Quantity, Q
Production
distortion
Consumption
distortion
S
D
Figure 10-1
The Efficiency Case for Free Trade
A trade restriction, such as a tariff,
leads to production and consumption
distortions.
CHAPTER 10 The Political Economy of Trade Policy 221
TABLE 10-1 Benefits of a Move to Worldwide Free Trade (percent of GDP)
United States 0.57
European Union 0.61
Japan 0.85
Developing countries 1.4
World 0.93
Source: William Cline, Trade Policy and Global Poverty (Washington, D.C.: Institute for International
Economics, 2004), p. 180.
Additional Gains from Free Trade1
There is a widespread belief among economists that such calculations, even though they
report substantial gains from free trade in some cases, do not represent the whole story.
In the case of small countries in general and developing countries in particular, many
economists would argue that there are important gains from free trade not accounted for in
conventional cost-benefit analysis.
One kind of additional gain involves economies of scale, which were the theme of
Chapters 7 and 8. Protected markets limit gains from external economies of scale by
inhibiting the concentration of industries; when the economies of scale are internal, they
not only fragment production internationally, but by reducing competition and raising
profits, they also lead too many firms to enter the protected industry. With a proliferation
of firms in narrow domestic markets, the scale of production of each firm becomes inefficient.
A good example of how protection leads to inefficient scale is the case of the
Argentine automobile industry, which emerged because of import restrictions. An efficient
scale assembly plant should make from 80,000 to 200,000 automobiles per year, yet in
1964 the Argentine industry, which produced only 166,000 cars, had no fewer than 13
firms! Some economists argue that the need to deter excessive entry and the resulting
inefficient scale of production is a reason for free trade that goes beyond the standard
cost-benefit calculations.
Another argument for free trade is that by providing entrepreneurs with an incentive to
seek new ways to export or compete with imports, free trade offers more opportunities for
learning and innovation than are provided by a system of “managed” trade, where the government
largely dictates the pattern of imports and exports. Chapter 11 discusses the experiences
of less-developed countries that discovered unexpected export opportunities when
they shifted from systems of import quotas and tariffs to more open trade policies.
A related form of gains from free trade involves the tendency, documented in Chapter 8,
for more productive firms to engage in exports, while less productive firms stay with the
domestic market. This suggests that a move to free trade makes the economy as a whole
more efficient by shifting the industrial mix toward firms with higher productivity.
These additional arguments for free trade are difficult to quantify, although some economists
have tried to do so. In general, models that try to take economies of scale and imperfect
competition into account yield bigger numbers than those reported in Table 10-1.
However, there is no consensus about just how much bigger the gains from free trade really
are. If the additional gains from free trade are as large as some economists believe, the costs
1The additional gains from free trade that are discussed here are sometimes referred to as “dynamic” gains,
because increased competition and innovation may need more time to take effect than the elimination of production
and consumption distortions.
222 PART TWO International Trade Policy
of distorting trade with tariffs, quotas, export subsidies, and so on are correspondingly
larger than the conventional cost-benefit analysis measures.
Rent-Seeking
When imports are restricted with a quota rather than a tariff, the cost is sometimes magnified
by a process known as rent-seeking. Recall from Chapter 9 that to enforce an import
quota, a government has to issue import licenses, and that economic rents accrue to whoever
receives these licenses. In some cases, individuals and companies incur substantial
costs—in effect, wasting some of the economy’s productive resources—in an effort to get
import licenses.
A famous example involved India in the 1950s and 1960s. At that time, Indian companies
were allocated the right to buy imported inputs in proportion to their installed capacity.
This created an incentive to overinvest—for example, a steel company might build more
blast furnaces than it expected to need simply because this would give it a larger number of
import licenses. The resources used to build this idle capacity represented a cost of protection
over and above the costs shown in Figure 10-1.
A more modern and unusual example of rent-seeking involves U.S. imports of canned
tuna. Tuna is protected by a “tariff-rate quota”: A small quantity of tuna (4.8 percent of U.S.
consumption) can be imported at a low tariff rate, 6 percent, but any imports beyond that
level face a 12.5 percent tariff. For some reason, there are no import licenses; each year, the
right to import tuna at the low tariff rate is assigned on a first come, first served basis. The
result is a costly race to get tuna into the United States as quickly as possible. Here’s how
the U.S. International Trade Commission describes the process of rent-seeking:
Importers attempt to qualify for the largest share of the TRQ [tariff-rate quota] as possible
by stockpiling large quantities of canned tuna in Customs-bonded warehouses in late
December and releasing the warehoused product as soon as the calendar year begins.
The money importers spend on warehousing lots of tuna in December represents a loss
to the U.S. economy over and above the standard costs of protection.
Political Argument for Free Trade
A political argument for free trade reflects the fact that a political commitment to free
trade may be a good idea in practice even though there may be better policies in principle.
Economists often argue that trade policies in practice are dominated by special-interest
politics rather than by consideration of national costs and benefits. Economists can sometimes
show that in theory, a selective set of tariffs and export subsidies could increase
national welfare, but that in reality, any government agency attempting to pursue a sophisticated
program of intervention in trade would probably be captured by interest groups and
converted into a device for redistributing income to politically influential sectors. If this
argument is correct, it may be better to advocate free trade without exceptions even though
on purely economic grounds, free trade may not always be the best conceivable policy.
The three arguments outlined in the previous section probably represent the standard
view of most international economists, at least those in the United States:
1. The conventionally measured costs of deviating from free trade are large.
2. There are other benefits from free trade that add to the costs of protectionist policies.
3. Any attempt to pursue sophisticated deviations from free trade will be subverted by the
political process.
Nonetheless, there are intellectually respectable arguments for deviating from free
trade, and these arguments deserve a fair hearing.
CHAPTER 10 The Political Economy of Trade Policy 223
Case Study
The Gains from 1992
In 1987, the nations of the European Community (now known as the European Union)
agreed on what formally was called the Single European Act, with the intention to create
a truly unified European market. Because the act was supposed to go into effect within
five years, the measures it embodied came to be known generally as “1992.”
The unusual thing about 1992 was that the European Community was already a customs
union, that is, there were no tariffs or import quotas on intra-European trade. So,
what was left to liberalize? The advocates of 1992 argued that there were still substantial
barriers to international trade within Europe. Some of these barriers involved the costs of
crossing borders; for example, the mere fact that trucks carrying goods between France
and Germany had to stop for legal formalities often resulted in long waits that were
costly in time and fuel. Similar costs were imposed on business travelers, who might fly
from London to Paris in an hour, then spend another hour waiting to clear immigration
and customs. Differences in regulations also had the effect of limiting the integration of
markets. For example, because health regulations on food differed among the European
nations, one could not simply fill a truck with British goods and take them to France, or
vice versa.
Eliminating these subtle obstacles to trade was a very difficult political process.
Suppose France decided to allow goods from Germany to enter the country without any
checks. What would prevent the French people from being supplied with manufactured
goods that did not meet French safety standards, foods that did not meet French health
standards, or medicines that had not been approved by French doctors? Thus the only
way that countries can have truly open borders is if they are able to agree on common
standards so that a good that meets French requirements is acceptable in Germany and
vice versa. The main task of the 1992 negotiations was therefore one of harmonizing
regulations in hundreds of areas, negotiations that were often acrimonious because of
differences in national cultures.
The most emotional examples involved food. All advanced countries regulate
things such as artificial coloring to ensure that consumers are not unknowingly fed
chemicals that are carcinogens or otherwise harmful. The initially proposed regulations
on artificial coloring would, however, have destroyed the appearance of several
traditional British foods: Pink bangers (breakfast sausages) would have become white,
golden kippers gray, and mushy peas a drab rather than a brilliant green. Continental
consumers did not mind; indeed they could not understand how the British could eat
such things in the first place. But in Britain, the issue became tied up with fear over the
loss of national identity, and loosening the proposed regulations became a top priority
for the British government, which succeeded in getting the necessary exemptions. On
the other hand, Germany was forced to accept imports of beer that do not meet its
centuries-old purity laws, and Italy to accept pasta made from—horrors!—the wrong
kind of wheat.
But why engage in all this difficult negotiating? What were the potential gains from
1992? Attempts to estimate the direct gains have always suggested that they are fairly
modest. Costs associated with crossing borders amount to no more than a few percent
of the value of the goods shipped; removing these costs adds at best a fraction of a percent
to the real income of Europe as a whole. Yet economists at the European
Commission (the administrative arm of the European Community) argued that the true
gains would be much larger.
224 PART TWO International Trade Policy
Their reasoning relied to a large extent on the view that the unification of the
European market would lead to greater competition among firms and to a more efficient
scale of production. Much was made of the comparison with the United States, a country
whose purchasing power and population are similar to those of the European Union,
but that is a borderless, fully integrated market. Commission economists pointed out
that in a number of industries, Europe seemed to have markets that were segmented:
Instead of treating the whole continent as a single market, firms seemed to have carved
it into local zones served by relatively small-scale national producers. The economists
argued that with all barriers to trade removed, there would be a consolidation of these
producers, with substantial gains in productivity. These putative gains raised the overall
estimated benefits from 1992 to several percent of the initial income of European
nations. The Commission economists argued further that there would be indirect benefits,
because the improved efficiency of the European economy would improve the
trade-off between inflation and unemployment. At the end of a series of calculations,
the Commission estimated a gain from 1992 of 7 percent of European income.2
While nobody involved in this discussion regarded 7 percent as a particularly reliable
number, many economists shared the conviction of the Commission that the gains would
be large. There were, however, skeptics who suggested that the segmentation of markets
had more to do with culture than with trade policy. For example, Italian consumers
wanted washing machines that were quite different from those preferred in Germany.
Italians tend to buy relatively few clothes, but those they buy are stylish and expensive,
so they prefer slow, gentle washing machines that conserve their clothing investment.
Now that a number of years have passed since 1992, it is clear that both the supporters
and the skeptics had valid points. In some cases there have been notable consolidations
of industry. For example, Hoover closed its vacuum cleaner plant in France and
concentrated all its production in a more efficient plant in Britain. In some cases old
market segmentations have clearly broken down, and sometimes in surprising ways,
like the emergence of British sliced bread as a popular item in France. But in other
cases markets have shown little sign of merging. The Germans have shown little taste
for imported beer, and the Italians none for pasta made with soft wheat.
How large were the economic gains from 1992? By 2003, when the European
Commission decided to review the effects of the Single European Act, it came up with
more modest estimates than it had before 1992: It put the gains at about 1.8 percent of
GDP. If this number is correct, it represents a mild disappointment but hardly a failure.
Few countries have anything approaching completely free trade. The city of Hong
Kong, which is legally part of China but maintains a separate economic policy, may be
the only modern economy with no tariffs or import quotas. Nonetheless, since the time
of Adam Smith, economists have advocated free trade as an ideal toward which trade
policy should strive. The reasons for this advocacy are not quite as simple as the idea
itself. At one level, theoretical models suggest that free trade will avoid the efficiency
losses associated with protection. Many economists believe that free trade produces
additional gains beyond the elimination of production and consumption distortions.
Finally, even among economists who believe free trade is a less-than-perfect policy,
many believe free trade is usually better than any other policy a government is likely
to follow.
Free Trade and Efficiency
The efficiency case for free trade is simply the reverse of the cost-benefit analysis of a
tariff. Figure 10-1 shows the basic point once again for the case of a small country that
cannot influence foreign export prices. A tariff causes a net loss to the economy measured
by the area of the two triangles; it does so by distorting the economic incentives of both
producers and consumers. Conversely, a move to free trade eliminates these distortions
and increases national welfare.
In the modern world, for reasons we will explain later in this chapter, tariff rates are
generally low and import quotas relatively rare. As a result, estimates of the total costs of
distortions due to tariffs and import quotas tend to be modest in size. Table 10-1 shows
one fairly recent estimate of the gains from a move to worldwide free trade, measured as
a percentage of GDP. For the world as a whole, according to these estimates, protection
costs less than 1 percent of GDP. The gains from free trade are somewhat smaller for
advanced economies such as the United States and Europe and somewhat larger for
poorer “developing countries.”
Price, P
World price
plus tariff
World price
Quantity, Q
Production
distortion
Consumption
distortion
S
D
Figure 10-1
The Efficiency Case for Free Trade
A trade restriction, such as a tariff,
leads to production and consumption
distortions.
CHAPTER 10 The Political Economy of Trade Policy 221
TABLE 10-1 Benefits of a Move to Worldwide Free Trade (percent of GDP)
United States 0.57
European Union 0.61
Japan 0.85
Developing countries 1.4
World 0.93
Source: William Cline, Trade Policy and Global Poverty (Washington, D.C.: Institute for International
Economics, 2004), p. 180.
Additional Gains from Free Trade1
There is a widespread belief among economists that such calculations, even though they
report substantial gains from free trade in some cases, do not represent the whole story.
In the case of small countries in general and developing countries in particular, many
economists would argue that there are important gains from free trade not accounted for in
conventional cost-benefit analysis.
One kind of additional gain involves economies of scale, which were the theme of
Chapters 7 and 8. Protected markets limit gains from external economies of scale by
inhibiting the concentration of industries; when the economies of scale are internal, they
not only fragment production internationally, but by reducing competition and raising
profits, they also lead too many firms to enter the protected industry. With a proliferation
of firms in narrow domestic markets, the scale of production of each firm becomes inefficient.
A good example of how protection leads to inefficient scale is the case of the
Argentine automobile industry, which emerged because of import restrictions. An efficient
scale assembly plant should make from 80,000 to 200,000 automobiles per year, yet in
1964 the Argentine industry, which produced only 166,000 cars, had no fewer than 13
firms! Some economists argue that the need to deter excessive entry and the resulting
inefficient scale of production is a reason for free trade that goes beyond the standard
cost-benefit calculations.
Another argument for free trade is that by providing entrepreneurs with an incentive to
seek new ways to export or compete with imports, free trade offers more opportunities for
learning and innovation than are provided by a system of “managed” trade, where the government
largely dictates the pattern of imports and exports. Chapter 11 discusses the experiences
of less-developed countries that discovered unexpected export opportunities when
they shifted from systems of import quotas and tariffs to more open trade policies.
A related form of gains from free trade involves the tendency, documented in Chapter 8,
for more productive firms to engage in exports, while less productive firms stay with the
domestic market. This suggests that a move to free trade makes the economy as a whole
more efficient by shifting the industrial mix toward firms with higher productivity.
These additional arguments for free trade are difficult to quantify, although some economists
have tried to do so. In general, models that try to take economies of scale and imperfect
competition into account yield bigger numbers than those reported in Table 10-1.
However, there is no consensus about just how much bigger the gains from free trade really
are. If the additional gains from free trade are as large as some economists believe, the costs
1The additional gains from free trade that are discussed here are sometimes referred to as “dynamic” gains,
because increased competition and innovation may need more time to take effect than the elimination of production
and consumption distortions.
222 PART TWO International Trade Policy
of distorting trade with tariffs, quotas, export subsidies, and so on are correspondingly
larger than the conventional cost-benefit analysis measures.
Rent-Seeking
When imports are restricted with a quota rather than a tariff, the cost is sometimes magnified
by a process known as rent-seeking. Recall from Chapter 9 that to enforce an import
quota, a government has to issue import licenses, and that economic rents accrue to whoever
receives these licenses. In some cases, individuals and companies incur substantial
costs—in effect, wasting some of the economy’s productive resources—in an effort to get
import licenses.
A famous example involved India in the 1950s and 1960s. At that time, Indian companies
were allocated the right to buy imported inputs in proportion to their installed capacity.
This created an incentive to overinvest—for example, a steel company might build more
blast furnaces than it expected to need simply because this would give it a larger number of
import licenses. The resources used to build this idle capacity represented a cost of protection
over and above the costs shown in Figure 10-1.
A more modern and unusual example of rent-seeking involves U.S. imports of canned
tuna. Tuna is protected by a “tariff-rate quota”: A small quantity of tuna (4.8 percent of U.S.
consumption) can be imported at a low tariff rate, 6 percent, but any imports beyond that
level face a 12.5 percent tariff. For some reason, there are no import licenses; each year, the
right to import tuna at the low tariff rate is assigned on a first come, first served basis. The
result is a costly race to get tuna into the United States as quickly as possible. Here’s how
the U.S. International Trade Commission describes the process of rent-seeking:
Importers attempt to qualify for the largest share of the TRQ [tariff-rate quota] as possible
by stockpiling large quantities of canned tuna in Customs-bonded warehouses in late
December and releasing the warehoused product as soon as the calendar year begins.
The money importers spend on warehousing lots of tuna in December represents a loss
to the U.S. economy over and above the standard costs of protection.
Political Argument for Free Trade
A political argument for free trade reflects the fact that a political commitment to free
trade may be a good idea in practice even though there may be better policies in principle.
Economists often argue that trade policies in practice are dominated by special-interest
politics rather than by consideration of national costs and benefits. Economists can sometimes
show that in theory, a selective set of tariffs and export subsidies could increase
national welfare, but that in reality, any government agency attempting to pursue a sophisticated
program of intervention in trade would probably be captured by interest groups and
converted into a device for redistributing income to politically influential sectors. If this
argument is correct, it may be better to advocate free trade without exceptions even though
on purely economic grounds, free trade may not always be the best conceivable policy.
The three arguments outlined in the previous section probably represent the standard
view of most international economists, at least those in the United States:
1. The conventionally measured costs of deviating from free trade are large.
2. There are other benefits from free trade that add to the costs of protectionist policies.
3. Any attempt to pursue sophisticated deviations from free trade will be subverted by the
political process.
Nonetheless, there are intellectually respectable arguments for deviating from free
trade, and these arguments deserve a fair hearing.
CHAPTER 10 The Political Economy of Trade Policy 223
Case Study
The Gains from 1992
In 1987, the nations of the European Community (now known as the European Union)
agreed on what formally was called the Single European Act, with the intention to create
a truly unified European market. Because the act was supposed to go into effect within
five years, the measures it embodied came to be known generally as “1992.”
The unusual thing about 1992 was that the European Community was already a customs
union, that is, there were no tariffs or import quotas on intra-European trade. So,
what was left to liberalize? The advocates of 1992 argued that there were still substantial
barriers to international trade within Europe. Some of these barriers involved the costs of
crossing borders; for example, the mere fact that trucks carrying goods between France
and Germany had to stop for legal formalities often resulted in long waits that were
costly in time and fuel. Similar costs were imposed on business travelers, who might fly
from London to Paris in an hour, then spend another hour waiting to clear immigration
and customs. Differences in regulations also had the effect of limiting the integration of
markets. For example, because health regulations on food differed among the European
nations, one could not simply fill a truck with British goods and take them to France, or
vice versa.
Eliminating these subtle obstacles to trade was a very difficult political process.
Suppose France decided to allow goods from Germany to enter the country without any
checks. What would prevent the French people from being supplied with manufactured
goods that did not meet French safety standards, foods that did not meet French health
standards, or medicines that had not been approved by French doctors? Thus the only
way that countries can have truly open borders is if they are able to agree on common
standards so that a good that meets French requirements is acceptable in Germany and
vice versa. The main task of the 1992 negotiations was therefore one of harmonizing
regulations in hundreds of areas, negotiations that were often acrimonious because of
differences in national cultures.
The most emotional examples involved food. All advanced countries regulate
things such as artificial coloring to ensure that consumers are not unknowingly fed
chemicals that are carcinogens or otherwise harmful. The initially proposed regulations
on artificial coloring would, however, have destroyed the appearance of several
traditional British foods: Pink bangers (breakfast sausages) would have become white,
golden kippers gray, and mushy peas a drab rather than a brilliant green. Continental
consumers did not mind; indeed they could not understand how the British could eat
such things in the first place. But in Britain, the issue became tied up with fear over the
loss of national identity, and loosening the proposed regulations became a top priority
for the British government, which succeeded in getting the necessary exemptions. On
the other hand, Germany was forced to accept imports of beer that do not meet its
centuries-old purity laws, and Italy to accept pasta made from—horrors!—the wrong
kind of wheat.
But why engage in all this difficult negotiating? What were the potential gains from
1992? Attempts to estimate the direct gains have always suggested that they are fairly
modest. Costs associated with crossing borders amount to no more than a few percent
of the value of the goods shipped; removing these costs adds at best a fraction of a percent
to the real income of Europe as a whole. Yet economists at the European
Commission (the administrative arm of the European Community) argued that the true
gains would be much larger.
224 PART TWO International Trade Policy
Their reasoning relied to a large extent on the view that the unification of the
European market would lead to greater competition among firms and to a more efficient
scale of production. Much was made of the comparison with the United States, a country
whose purchasing power and population are similar to those of the European Union,
but that is a borderless, fully integrated market. Commission economists pointed out
that in a number of industries, Europe seemed to have markets that were segmented:
Instead of treating the whole continent as a single market, firms seemed to have carved
it into local zones served by relatively small-scale national producers. The economists
argued that with all barriers to trade removed, there would be a consolidation of these
producers, with substantial gains in productivity. These putative gains raised the overall
estimated benefits from 1992 to several percent of the initial income of European
nations. The Commission economists argued further that there would be indirect benefits,
because the improved efficiency of the European economy would improve the
trade-off between inflation and unemployment. At the end of a series of calculations,
the Commission estimated a gain from 1992 of 7 percent of European income.2
While nobody involved in this discussion regarded 7 percent as a particularly reliable
number, many economists shared the conviction of the Commission that the gains would
be large. There were, however, skeptics who suggested that the segmentation of markets
had more to do with culture than with trade policy. For example, Italian consumers
wanted washing machines that were quite different from those preferred in Germany.
Italians tend to buy relatively few clothes, but those they buy are stylish and expensive,
so they prefer slow, gentle washing machines that conserve their clothing investment.
Now that a number of years have passed since 1992, it is clear that both the supporters
and the skeptics had valid points. In some cases there have been notable consolidations
of industry. For example, Hoover closed its vacuum cleaner plant in France and
concentrated all its production in a more efficient plant in Britain. In some cases old
market segmentations have clearly broken down, and sometimes in surprising ways,
like the emergence of British sliced bread as a popular item in France. But in other
cases markets have shown little sign of merging. The Germans have shown little taste
for imported beer, and the Italians none for pasta made with soft wheat.
How large were the economic gains from 1992? By 2003, when the European
Commission decided to review the effects of the Single European Act, it came up with
more modest estimates than it had before 1992: It put the gains at about 1.8 percent of
GDP. If this number is correct, it represents a mild disappointment but hardly a failure.
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