Free Trade Agreement (FTA) Definition: How It Works, With Example

What Is a Free Trade Agreement (FTA)?

A free trade agreement is a pact between two or more nations to reduce barriers to imports and exports among them. Under a free trade policy, goods and services can be bought and sold across international borders with little or no government tariffs, quotas, subsidies, or prohibitions to inhibit their exchange.

The concept of free trade is the opposite of trade protectionism or economic isolationism.

How a Free Trade Agreement Works

In the modern world, free trade policy is often implemented by means of a formal and mutual agreement of the nations involved. However, a free-trade policy may simply be the absence of any trade restrictions.

A government doesn't need to take specific action to promote free trade. This hands-off stance is referred to as “laissez-faire trade” or trade liberalization.

Governments with free-trade policies or agreements in place do not necessarily abandon all control of imports and exports or eliminate all protectionist policies. In modern international trade, few free trade agreements (FTAs) result in completely free trade.

For example, a nation might allow free trade with another nation, with exceptions that forbid the import of specific drugs not approved by its regulators, or animals that have not been vaccinated, or processed foods that do not meet its standards.

Or, it might have policies in place that exempt specific products from tariff-free status in order to protect home producers from foreign competition in their industries.

The Economics of Free Trade

In principle, free trade on the international level is no different from trade between neighbors, towns, or states. However, it allows businesses in each country to focus on producing and selling the goods that best use their resources while other businesses import goods that are scarce or unavailable domestically. That mix of local production and foreign trade allows economies to experience faster growth while better meeting the needs of its consumers.

This view was first popularized in 1817 by economist David Ricardo in his book, "On the Principles of Political Economy and Taxation." He argued that free trade expands the diversity and lowers the prices of goods available in a nation while better exploiting its homegrown resources, knowledge, and specialized skills.

Free Trade Models

Mercantilism

Prior to the 1800s, global trade was dominated by the theory of mercantilism. This theory placed priority on having a favorable balance of trade relative to other countries, and accumulating more gold and silver.

In order to attain a favorable balance of trade, countries would often place trade barriers like taxes and tariffs to discourage their residents from purchasing foreign goods. This incentivized consumers to purchase locally-made products, thereby supporting domestic industries.

Comparative Advantage

Ricardo introduced the law comparative advantage, which states that countries can attain the maximum benefits through free trade. Ricardo demonstrated that if countries prioritize producing the goods that they can produce more cheaply than other countries (i.e., where they have a comparative advantage) they will be able to produce more goods in total than they would by limiting trade.

Advantages and Disadvantages of Free Trade

Rapid Development

Free trade has allowed many countries to attain rapid economic growth. By focusing on exports and resources where they have a strong comparative advantage, many countries have been able to attract foreign investment capital and provide relatively high-paying jobs for local workers.

Lower Global Prices

For consumers, free trade creates a competitive environment where countries strive to provide the lowest possible prices for their resources. This in turn allows manufacturers to provide lower prices for finished goods, ultimately increasing the buying power for all consumers.

Unemployment and Business Losses

However, there are economic losers when a country opens its borders to free trade. Domestic industries may be unable to compete with foreign competitors, causing local unemployment. Large-scale industries may move to countries with lax environmental and labor laws, resulting in child labor or pollution.

Increased Dependency on the Global Market

Free trade can also make countries more dependent on the global market. For example, while the prices for some goods may be cheaper on the world market, there are strategic benefits for a country that produces those goods domestically. In the event of a war or crisis, the country may be forced to rebuild these industries from scratch.

Public Opinion on Free Trade

Few issues divide economists and the general public as much as free trade. Research suggests that economists in the U.S. support free-trade policies at significantly higher rates than the general public. In fact, the American economist Milton Friedman said: “The economics profession has been almost unanimous on the subject of the desirability of free trade.”

Free-trade policies have not been as popular with the general public. The key issues include unfair competition from countries where lower labor costs allow price-cutting and a loss of good-paying jobs to manufacturers abroad.

The call on the public to Buy American may get louder or quieter with the political winds, but it never goes silent.

The View From Financial Markets

Not surprisingly, the financial markets see the other side of the coin. Free trade is an opportunity to open another part of the world to domestic producers.

Moreover, free trade is now an integral part of the financial system and the investing world. American investors now have access to most foreign financial markets and to a wider range of securities, currencies, and other financial products.

However, completely free trade in the financial markets is unlikely in our times. There are many supranational regulatory organizations for world financial markets, including the Basel Committee on Banking Supervision, the International Organization of Securities Commission (IOSCO), and the Committee on Capital Movements and Invisible Transactions.

Real-World Examples of Free Trade Agreements

The European Union is a notable example of free trade today. The member nations form an essentially borderless single entity for the purposes of trade, and the adoption of the euro by most of those nations smooths the way further. It should be noted that this system is regulated by a central bureaucracy that must manage the many trade-related issues that come up between representatives of member nations.

U.S. Free Trade Agreements

The United States currently has a number of free trade agreements in place. These include multi-nation agreements such as the North American Free Trade Agreement (NAFTA), which covers the U.S., Canada, and Mexico, and the Dominican Republic-Central America Free Trade Agreement (CAFTA-DR), which includes the Caribbean nation and most of the nations of Central America. There are also separate trade agreements with nations from Australia to Peru.

Collectively, these agreements mean that about half of all goods entering the U.S. come in free of tariffs, according to government figures. The average import tariff on industrial goods is 2%.

All these agreements collectively still do not add up to free trade in its most laissez-faire form. American special interest groups have successfully lobbied to impose trade restrictions on hundreds of imports including steel, sugar, automobiles, milk, tuna, beef, and denim.

The Bottom Line

Free trade refers to policies that allow permit inexpensive imports and exports, without tariffs or other trade barriers. In a free trade agreement, a group of countries agrees to lower their tariffs or other barriers to facilitate more exchanges with their trading partners. This allows all countries to benefit from lower prices and access to one another's resources.