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#### Some definitions

Before we plough into the case for free trade, it is important that we define a few terms.

A country has an absolute advantage over another country in the production of a certain good if, for a given amount of resources, it can produce more of the good than its competitor. Another way of looking at it is that the country with the absolute advantage can make the same amount of the good with fewer resources. Basically, it is when one country is better at making a given good than another country. See the next Learn-It for a numerical example.

The theory of comparative advantage takes absolute advantage a stage further. Even if a country is so bad at using a given set of resources that it is worse at making all goods than another country, it will still have a comparative advantage in the production of at least one good. This means that there will be at least one product where it is relatively better at producing, even though in absolute terms it is the worst at making everything. This might sound confusing, but all will be revealed with a numerical example in the next Learn-It.

Put simply, the terms of trade are the 'terms' (or price) agreed when two countries trade. You will see that it is important to understand this concept when we look at numerical example of trade between countries below.

Examiners often set multiple-choice questions on the terms of trade. You are expected to work out what will happen to the terms of trade if, say, the value of the pound rises. The 'terms of trade' for a country as a whole is the ratio of export prices to import prices. More formally:

The index of export prices and the index of import prices are calculated in the same way as the Retail Price Index (RPI). A weighted average is calculated using the prices of thousands of exports and imports. Remember that an index does not have any units. The series of numbers are simply used to make comparisons of the average price level (for exports and imports in this case) over different time periods (monthly or yearly).

In the example above of a rising pound (ceteris paribus) the prices of exports will rise, and the prices of imports will fall. The terms of trade, therefore, will rise (the top part of the fraction is rising and the bottom part is falling, so, overall, the fraction rises).

It should be obvious that when an economist refers to free trade he is referring to international trade without trade barriers (i.e. trade 'free' of barriers). In the final Learn-It of this topic (called 'The case against free trade') the controversial issue of protectionism is covered. Some countries feel they need to 'protect' their domestic industries (and jobs) from foreign competition. They do this by using certain trade barriers. The more well know is the tariff, which is a tax on imported goods and services. Go to the final Learn-It for more details about these trade barriers and why they are used.

#### Why is free trade a good thing?

The extensive analysis above shows how trade between countries is always a good thing. One would assume that the USA can make most things more efficiently than, say, Mexico (one of its neighbours). But the analysis above suggests that it is still in the interests of both the USA and Mexico that specialisation and trade occurs.

Surely, then, it follows that anything that disrupts free trade between countries, such as tariff and non-tariff barriers (see the last Learn It for more details) is a bad thing.

In the diagram above, DD and SD are the domestic demand and supply curves. If one assumes that this market is totally protected from foreign competition (through tariffs, for example) then the equilibrium price and output would be P1 and Q1 as expected.

Let us assume that competition on the world market means that this good is supplied at a much lower price outside the domestic economy. The 'world' supply curve is SW and is assumed to be horizontal for simplicity of analysis. If barriers were then removed, so the trade was totally free, the new 'effective' domestic supply curve would be the line FECSW. The price would be P2, quantity demanded Q3, but only OQ2 would be supplied domestically. The rest (Q3 - Q2) would be imported from the cheaper world suppliers.

The red triangle (BCE) represents the welfare gain as a result of accepting foreign imports. Before imports arrived, consumer surplus was the area ABP1 and producer surplus (which is basically profit) was the area P1BF (see the topic called 'Market failure' for a reminder of these terms). As a result of free trade, the lower price means that consumer surplus is now the area ACP2. Although the producer surplus has dropped to P2EF, the huge rise in consumer surplus more than compensates (and, let's face it, the humble consumer is more important than the profit grabbing capitalist anyway!). The net gain is the red triangle BCE.

This analysis is very simplistic but does highlight the gains of free trade, particularly for the consumer. See the Learn-It called 'The case against free trade' to see the other side of the story.

#### The World Trade Organisation (WTO)

The WTO is the world policeman for matters associated with trade. It used to be called the General Agreement on Tariffs and Trade (GATT). The major industrialised countries signed this agreement straight after the war. Its purpose, in particular, was to reduce the use of tariffs around the world. Their ultimate objective was the elimination of all tariffs resulting in free trade around the world. It was very successful, reducing tariffs (on average) from around 40% after the war to fewer than 5% in the 1990s.

GATT consisted of a number of 'rounds' where ministers and civil servants from all the important countries got together and thrashed out deals on tariff reduction. The final round (the Uruguay round) that finished in 1993 (these rounds could take a number of years to complete) was not only ambitious in terms of the elimination of tariff and non-tariff barriers, it also created a new body (the WTO) to take over from the occasional policeman that was the GATT. The WTO was to be on going. Not only would it carry on the job of setting up 'rounds' of discussions for further reductions in barriers (the attempted introduction of the 'Seattle' round at the end of 1999 was not so successful), but it would act as the adjudicator when countries had a trade dispute.

A good recent example of one such 'dispute' was between the USA and the EU (most of them are between these two huge economies) over the relatively humble banana. The EU gave preferential treatment to banana growers in African and Caribbean countries, partly due to historical colonial links, but also because they are at a huge cost disadvantage compared with the large, American owned, banana plants in Latin America. It would be no good for the EU if the poorer banana growers went bust.

The USA complained to the WTO in 1996. The WTO agreed with the USA and the EU was asked to change their banana regime. The proposed changes were not enough to satisfy the USA. It was at this point, towards the end of 1998, that the USA threatened to impose 100% tariffs on randomly selected EU products (Scottish Whiskey and French cheese to name but two). Again the WTO agreed and allowed the USA to go ahead with almost \$200 million worth of retaliation. The EU finally backed down in 1999 with changes that the USA accepted.

The long running nature of the dispute does highlight the difficulty in reaching agreement and the trouble that the WTO has in getting countries to comply with their judgements. It is a better system than the old GATT, though, which had to rely on voluntary compliance by quarrelling member countries. At least the WTO has a formal disputes procedure and can impose penalties on countries that are judged to be in the wrong.