Free Trade Agreement: The Ultimate FAQ Guide

If you’re in the import and export business, probably you have come across the term free trade agreement.

In this guide, I will answer all your questions on free trade agreement (FTA).

So keep reading to learn more.

What Is The Meaning Of FTA (Free Trade Agreement)?

Free trade agreement is a settlement between two or more countries to lessen trade barriers between them.

This protocol allows the trading nations to move goods and services across their borders with less government restrictions, subsidized quotas, tariffs, etc.

Nations that do not have FTA, practice trade protectionism.

How Does A Free Trade Agreement Work?

Free trade agreement can be achieved by either formally signing a mutual agreement or by eliminating trade border barriers.

Most governments choose the “laissez-faire trade” which is French for “leave alone”.

This hand off economic philosophy believes that businesses are better off without government involvement.

Countries with FTA in place do not completely abandon across border trade restrictions.

They still have regulations on imports and exports as well as oversight on FTA.

This has resulted in few FTA being successful.

Countries with FTA still prohibit import of certain drugs, processed food below their standards or endangered animal species.

Some countries will impose tariffs on specific goods to protect domestic products from foreign competition.

What Is The Purpose Of FTAs In International Trade And Economics?

Free trade agreements are mainly to facilitate frictionless trade between member nations by reducing or abolishing trade barriers.

It also encourages diversity, gives access to global markets, lower prices of goods in the domestic country while better utilizing homebased resources.

What Is The Difference Between FTA (Free Trade Agreement) And FTZ (Free Trade Zone)?

FTA is a treaty between countries to reduce or remove tariffs and trade barriers, to ease trade between them.

Free trade zone (FTZ) is an area within or near a port where goods are exempted from tariffs, taxes, re-export payments to encourage global business

How Many Types Of Trade Agreements Are There?

There are three types of trade agreements namely, unilateral, bilateral, and multilateral.

Unilateral Trade Agreement

Unilateral trade agreement is where only one country lessens its border restriction in order to boost economy of another country.

A country may also restrict trade across its border with the other country not reciprocating.

A country only lessens trade restrictions to a country that is less threatening to its economy.

This is done by developed states as a form of foreign aid to help strengthen emerging markets grows their economy.

United states practice unilateral trade agreement as a way of creating new markets for its exporters.

Bilateral Trade Agreement

Unlike unilateral trade agreement, bilateral trade agreement involves two governments that agree to lessen their trade restrictions to their advantage.

The two nations agree to subsidize their tariffs and grant themselves their preferred trade status.

This FTA agreement is always on government protected domestic products such as oil, food producing industries, etc.

One such example was the Transatlantic Trade and Investment Partnership (TTIP) which was between U.S and the EU.

Multilateral Trade Agreement

This is a free trade agreement involving three or more countries and is always very difficult to agree on.

This is because each member country has specific needs and request that want met.

Multilateral trade agreement is advantageous because they cover large geographical area giving member states competitive advantage.

The member states confer a “most-favored-status” thus enjoy the excellent mutual agreement and lowest tariffs.

An example of the largest multilateral trade agreement is the United States-Mexico-Canada Agreement (USMCA) between United States, Mexico and Canada.

This FTA was formerly known as North American Free Trade Agreement (NAFTA).

What Is The History Of International Free Trade Agreements?

Between 16^th century and the end of 18^th century, nations adopted the Mercantilism doctrine in their trade engagements.

This trade policy encouraged countries to import fewer goods and services and export more to increase their economic value.

It forbade foreign traders from taking part in local trade for instance only British ships could access coastal trade in England.

This doctrine was later shunned by Adam Smith and David Ricardo who promoted trade liberalization in their writing.

In 1823, Reciprocity of Duties Acts was passed and it assisted the British to carry out bilateral trade with other nations.

Corn Law was thereafter repealed in 1850 thereby allowing corn trade.

Come 1995, World Trade Organization was formed to take over from General Agreement on Tariffs and Trade (GTT).

WTO included policies on services, intellectual property, and investments.

To date, WTO is the oversight body that ensures free trade agreement is adhered to.

What Is The Role Of WTO (World Trade Organization) In Free Trade Agreements?

World Trade Organization is a global body mandated with regulation on trade agreements between its member states.

WTO comes when the FTA involves nations from different geographical regions.

It performs three main functions namely; regulates multilateral agreement, control dumping and dispute resolution and oversee ongoing negotiations.

World trade organization ensures that the policies in the trade agreement are implemented and followed by countries involved.

These nations are granted “Most Favored Status” and lower trade tariffs.

Its second primary function is ensuring that countries involved do not export goods at prices lower than their production cost.

This is known as dumping and it puts other countries at a competitive disadvantage for the same products.

Anti-dumping policies and duty are implemented by WTO upon investigating and proving that a member state has been involved in dumping.

WTO will verify these allegations by calculating:

1. Price of the exported goods in their domestic market
2. Price of the goods in different countries by the same exporter
3. Production cost, other expenses and profit margin.

Disputing country needs to verify the normal prices for the exported goods before it can impose anti-dumping tariffs.

WTO’s major role here is to ensure smooth flow of global trade contracts by resolving such disputes.

Thirdly, WTO oversees new and ongoing trade negotiations among member states.

One such instant was the Doha Round Trade Agreement in 2006.

This would have been the largest FTA lowering agricultural and non-agricultural tariffs for its member states.

It however failed since U.S and EU refused to subsidize tariff among many other complex issues.

What Are Some Examples Of Free Trade Areas?

There are various examples of free trade agreements from bilateral to multilateral trade agreements.

NAFTA: This is North American Free Trade Agreement and its member states are; United States, Mexico and Canada.

NAFTA is currently referred to as; United States-Mexico-Canada Agreement (USMCA).

CAFTA: Central America Free Trade Agreement includes Central American States.

EFTA: European Free Trade Association comprises of Norway, Iceland, Switzerland and Liechtenstein.

SAFTA: South Asian Free Trade Agreement include; Afghanistan, Bangladesh, Bhutan, India, Nepal, Pakistan, Maldives and Sri Lanka.

Pacific Alliance: Has Chile, Colombia, Mexico and Peru as its members.

Bilateral trade agreements can be between two countries or two trading blocs such as Australia-China FTA. Others include: EU-Canada FTA, EU-Japanese FTA, US- South Korea FTA, and many more.

Who Benefits The Most From Free Trade Agreements?

Free trade agreements allow two or more countries to import and export goods and services across their borders without tariff barriers.

These less or no restrictions lead to increased trade between member states and net economic growth.

The net economic gain effect may not be felt by everyone, thus there are those who lose.

The beneficially of FTA are:

Exporters

Exporters are able to export their goods easily at a reduced cost due to removal or lessening of trade tariffs and barriers.

As a result, they are able to employ more work forces thus increasing their productivity.

Some exporters venture into specialized production in order to supply global markets.

This results into positive economic gain for the exporting company.

Increased Tax Revenue

When prices of goods are affordable due to trade liberalization, the government realizes economic growth from increased tax collection.

This generally improves society wellbeing in the country since the government has funds to fulfill public services.

Consumers Enjoy Reduce Prices

Since there are no tariffs on exports, it makes imported goods cheaper in the long run.

Consumers are advantaged as they are able to afford imports and still remain with disposable income for other use.

Additionally, domestic monopoly is reduced by the competitive prices making the prices even more cheaper for consumers.

Individual Employees

Exporting firms need workers to be able to export goods to other nations.

They range from drivers, loaders, clearance personnel, etc. Individuals who get these opportunities are direct beneficiaries of trade liberalization.

What Are The Disadvantages Of Free Trade Agreements?

Free trade agreements have not been without disadvantages. Some of them are as listed below:

Uncompetitive Businesses

Governments impose export tariffs on goods in order to protect the same goods which are produced locally though at higher cost.

Eliminating border tariffs makes domestic producers uncompetitive against foreign firms.

This in turn results into reduced demand for domestic products and high demand for imported goods. Eventually such firms go out of business due to unfair competition.

Loss Of Jobs

When local firms are unable to compete against foreign businesses due to price disparity for same products, they eventually close down.

Closing down means job loss for the employees.

Negative Multiplier Effect In The Region

Certain regions have specific industries concentrated in the same area due to free trade agreement. When uncompetitive firms close down and people lose jobs, the region is likely to feel the ripple effect of increased unemployment.

Whereas there is likelihood of increased demand and revenue for the existing firms, keeping up with new demand may be challenging.

How Do Exports And Imports Affect The Use Of Free Trade Agreements?

Exports are good and services sold to foreign countries, government or business and thus bringing money into the country.

Imports are goods and services produced abroad and bought by home country.

Imports take away money from the country hence reducing economic growth.

Imports and exports are part of international trade.

When imports exceed exports value, the resultant effect is trade deficit.

What Are Tariffs in Free Trade Agreements?

Tariffs are taxes charged on imported goods by the government at its border point.

Tariffs serve as revenue collection for government as well as protection for domestic industries and productions from unfair price competition.

There are two types of tariffs; specific tariffs and ad valorem tariffs.

Specific tariffs are charged at a fixed rate depending on the type of goods, for example; USD 30 for electronic items.

An ad-valorem is levied as a percentage on the item’s value, like 10% of car value.

Tariffs can also result into negative effects such as monopolies by companies leading to high consumer prices.

Besides, companies may become inefficient and less innovative with reduced or lack of competition.

Tariffs may also lead to trade wars within a region by rivaling countries that feel frustrated by trade favoritism.

Why Are Tariffs And Trade Barriers Used In International Trade And Do They Affect Free Trade Agreements?

Tariffs and trades barriers are a form of protection enforced by governments to protect domestic industries and production.

They are used by both new and growing economies as well as advanced economies.

Protect Domestic Industries

Tariffs are used by governments to make imported goods more expensive thereby forcing consumers to buy domestic products.

This is because having cheaper imports may push domestic industries to close down leading to job losses.

This increases a country’s unemployment rate making it a political issue than it is an economic issue.

It also affects the economy negatively as domestic firms may threaten to shift their production abroad due to cheaper production costs.

Shield Consumers

A country is likely to introduce tariffs and trade restrictions on goods they feel might harm their citizens. For instance, U.S. can impose tariff on meet from China if they believe it does not meet their health standards.

National Security

Industries of national security interest such as defense-related companies are highly protected by government through tariffs and trade barriers.

Import of such items are strictly controlled by specific arms of government.

Protect Young Industries

Developing countries or emerging markets impose tariffs and trade restriction on goods whose industries they need to grow.

This makes imported goods prices higher than domestic goods thus promoting domestic productions.

Developing economies use this approach as a way of reducing dependency on developed nations and growing their domestic industries,

Critics argue that those infant industries or markets grow without competition hence compromise on their product quality.

Weapon Of Retaliation

Member states use tariffs and trade barriers to retaliate if they feel their partnering country does not abide by trade rules.

For example, China retaliated on United States during Trump administration when he imposed tariffs on Chinese imports.

Is Free Trade Area vs. Customs Union vs. Single Market Any Different?

Yes, they are.

Free Trade Area (FTA)

This is a certain region where group of nations from that specific region sign trade agreement deal to seal their cooperation.

The main aim of FTA is to eliminate tariffs, trade barriers, and import quotas among member countries to allow free trade.

Customs Union

Like free trade area, customs union focuses on abolishing tariffs, trade restrictions, customs duties and quotas between neighboring countries.

This sort of cooperation is defined in the General Agreement on Tariffs and Trade (GATT).

Customs union is the third level of economic integration. Non-member states are required to pay standard external tariffs before trading with members of custom union.

This one-time payment is uniformly applied by member states to non-members.

European Union is one such example.

Single Market

Single market operates differently from FTA and customs union.

In such a scenario, the member state trade freely among them without any restrictions.

Goods here can be sold, distributed and consumed in any of the member states without restrictions.

This also applies to member country citizens, who are allowed to work in any of the member states without restrictions.

What Is Trade Protectionism In Relation To Free Trade Agreements?

Protectionism is a principle which aims to protect domestic industries from unfair foreign trade competition.

It is the direct opposite of free trade agreement and is often politically motivated by governments as a defense mechanism.

Protectionism can be achieved through; tariffs, subsidies, quotas and currency manipulation.

How Does Trade Protectionism Work Without Affecting Free Trade Agreements?

Governments use the following methods to enact their protectionism:

Use Tariffs In Imports

The fastest way of enacting protectionism by a country is through tax imports.

What this does is to raise the cost of imported goods, making domestic goods competitive price wise.

Since consumer are directly affected by tariffs, they naturally shift to local products hence reducing demands on imports.

Subsidies On Local Industries

Subsidy is defined as a grant offered to businesses by governments in order to promote certain activities.

Subsidies can be in form of cash, grants, tax credits or direct payment.

Subsidies usually work to the disadvantage of certain businesses, industries, etc.

Common form of subsidy is the farm subsidies which allow farmers to lower the price of their produce locally.

This also makes them competitive in the global market when they export goods.

This strategy is applied by countries that heavily rely on export for their economic growth.

Currency Manipulation

This form of protectionism involves deliberate lowering of a country’s currency value by accruing huge debts or having fixed exchange rates.

What this method does is to make your exported goods cheaper in the global market making you competitive.

The drawback on this method is retaliation from other countries, resulting to currency war.

Enforce Quota On Imports

Quotas involve restriction on the amount of goods that can be imported within a given period.

Once a country achieves its quota allocation, they can’t export more goods no matter how low the price is.

What Is The Difference Between Comparative And Absolute Advantage In Free Trade Agreements?

Comparative advantage is the ability of a company to produce same products and services than its trading partners.

Absolute advantage is whereby a company or a country can produce more of the same goods and services as another entity.

Absolute company leverages on less inputs or efficient processes than another similar entity to achieve their goal.

How Does Comparative Advantage Relate To Free Trade Agreement?

Comparative advantage leverages on lower opportunity cost in order to achieve higher profit margins. Free trade agreement borrows for the same policy when it eliminates trade barriers and tariffs for trading partners.

They achieve this by encouraging countries to produce goods and services they specialize while maximizing efficiency and output.

The home country in turn imports goods and services that are not their specialty.

Why Isn’t There Complete Free Trade In The World?

It is hard to achieve complete free trade in the world due to “rent seeking” by individual countries.

Rent seeking is whereby countries lobbies for protection from their respective governments for their own interest.

This makes it hard for trading partners to trade fairly with such conditions.

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