The Significance of Free Trade: Realizing a greater level of satisfaction throughout society as a whole

Faculty Fellow, RIETI

The subject of free trade is being actively discussed, at least in part due to the U.S. presidential election. But to what extent do people actually support import liberalization? A questionnaire survey on the subject conducted by Professor Eiichi Tomiura (Hitotsubashi University) and others received a significantly higher proportion of positive than negative responses (See Figure).

Figure. A Questionnaire Survey on Import Liberalization
(The survey was conducted in October 2011.)
Figure. A Questionnaire Survey on Import Liberalization
Source: Tomiura, E., B.Ito, H. Mukunoki, R. Wakasugi, H. Kuwahata."Trade Policy Preferences and Individual Characteristics: Descriptive report of a survey on approximately 10,000 individuals," RIETI Discussion Paper 13-J-049

If we limit our focus to economists, the rate of support is even higher. According to Gregory Mankiw's textbook, Principles of Economics, 93% of economists agree that tariffs and import quotas reduce the general economic welfare (the level of satisfaction in society as a whole). This article will discuss the grounds for supporting free trade from an economic perspective.

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In the traditional international trade theory, a situation in which the government does not intervene in the market, i.e., free trade based on comparative advantage, is desirable from the perspective of the allocation of resources, and maximizes global welfare. However, there are several reservations.

First, while free trade is the most desirable form of trade for the world as a whole, it also generates winners and losers. For example, if free trade leads to cheap imports of wheat, domestic consumers will gain, but domestic producers will lose. In other words, free trade does not necessarily benefit every individual in the country in question. If the winners from free trade were to pay appropriate compensation to the losers, then everyone would enjoy the benefits of free trade.

We must also be aware of the fact that free trade is not necessarily good for consumers and bad for producers. For example, if scallops were exported as a result of free trade, their price overseas would fall, but their domestic supply would decrease, and the price therefore would increase. In this case, domestic consumers would lose, but domestic producers would gain.

The traditional theory is also based on the hypothesis that there is no market failure. It is based on the assumption that the market is omnipotent and flawless; it assumes, for example, that the market is perfectly competitive with all economic activities conducted therein. In actuality, however, such assumptions are rarely satisfied.

What should the approach be, then, when there are market failures? Economics states that where there are market failures, governments should directly correct them. Accordingly, for example, if the domestic supply of beef fell below the socially optimal level through some failure in the market, the government should directly boost domestic production by providing production subsidies rather than indirectly boosting it by applying tariffs to protect dairy farmers from overseas competition.

What is not generally understood is that the effect of tariffs is equivalent to the combined effect of production subsidies and a consumption tax. Production subsidies benefit producers, but tariffs simultaneously benefit producers and hurt consumers by increasing the prices not merely of imported goods, but also of the domestic goods that compete with them. The limited awareness among consumers that they bear the burden of tariffs represents an issue. Ultimately, given that tariffs have the side effect of disadvantaging consumers, if the goal is to expand production, it would be preferable to provide production subsidies.

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Even when the market is not perfectly competitive and firms have some market power, free trade still offers benefits. When firms have the ability to control the domestic market because they are protected from foreign competitors, free trade promotes domestic competition. This results in products diversifying and giving consumers a greater range of options

Focusing on intra-industry variations in the productivity of firms, Professor Marc Melitz (Harvard University) pointed out that by forcing low-productivity firms to exit from the market, free trade raises the productivity of industry as a whole, thus increasing overall economic welfare.

The market could be imperfectly competitive because of economies of scale, which is the decline in average production costs as the scale of production increases. When economies of scale work, small companies are not able to match large companies in terms of average production costs, and therefore the latter survives and can control the market. Free trade expands the market for producers, but when production volume increases as a result, industries in which economies of scale work reap even greater benefits.

Some technologies and knowledge diffuse through paths other than market transactions such as licensing contracts. Free trade promotes the diffusion of superior foreign technologies and knowledge. For example, new technologies are often employed in import products, and importing countries can gain access to and absorb these new technologies. This effect is particularly important for developing nations. In Japan as well, if free trade promotes industrial agglomeration in export industries, there will be greater spillover of technologies and knowledge among companies, and productivity will increase.

To take a fresh perspective, I would also like to note that import liberalization will lead to the promotion of exports. As the trade barriers to intermediate goods are eliminated and the cost of procuring foreign intermediate goods is reduced, the cost of producing final goods becomes lower, promoting their exports. In addition, the ships and airplanes used to transport goods would return with fresh cargo after delivering their export cargo. For the sake of efficiency, transport companies seek to ensure full loads on both outbound and inbound journeys, and import promotion would therefore result in export promotion.

In my joint research with Professor Nori Tarui (University of Hawaii at Manoa), we rigorously demonstrated this possibility in a theoretical model. Further joint research with Kazunobu Hayakawa (Institute of Developing Economies, Japan External Trade Organization (IDE/JETRO)) using data from the Organisation for Economic Co-operation and Development (OECD) and others showed that the lowering of a country's import tariffs not only increased its imports but also its exports.

There are also advantages from the perspective of political economy. If a government advocates free trade, there will be less room for rent seeking. The activities of politicians advocating for specific industries or interests would be curbed, and waste of resources would be prevented.

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Finally, I would like to touch on the advantages of the Trans-Pacific Partnership (TPP). The negotiation of large-scale FTAs—so-called "mega-FTAs"—has proceeded apace recently, and the TPP is one of these. Other examples include the Regional Comprehensive Economic Partnership (RCEP), the Japan-EU Economic Partnership Agreement, the Japan-China-Republic of Korea FTA, and the Transatlantic Trade and Investment Partnership (TTIP).

Professor Richard Baldwin (The Graduate Institute, Geneva) indicated that the development of information and communications technologies since the 1980s has produced global production networks in which production processes transcend national borders, i.e., global value chains (GVCs).

GVCs entail costs for dividing and relocating production processes (in particular, costs related to foreign direct investments), costs for linking geographically dispersed production processes (trade- and communication-related costs, etc.), and production costs (wages, etc.). To reduce these costs, it is important to conduct comprehensive institutional reform and adjustment in non-tariff areas, encompassing investment protection, trade facilitation, protection of intellectual property rights, competition policy, dispute settlement, and service trade.

It will be necessary to integrate systems and rules, institute cross certification, and ensure consistency and transparency. These tasks are on the agenda of mega-FTA negotiations.

If mega-FTAs are created, the barriers represented by national borders will be lowered simultaneously across entire regions, which will result in the creation and reorganization of GVCs. The TPP in particular, encompassing as it does a mix of advanced and developing nations, has the potential to maximally exploit the characteristics of GVCs. For example, it would be comparatively simple to establish a vertical distribution of procedures in which research and development (R&D) is conducted in advanced nations and actual production is conducted in developing nations, where wages and rents are lower. Against the background of stalled global trade negotiations under the World Trade Organization (WTO), mega-FTAs will help form efficient fragmented production networks.

>> Original text in Japanese

* Translated by RIETI.

August 25, 2016 Nihon Keizai Shimbun

October 21, 2016