Free Trade

Free trade promotes unhindered exchange of goods and services across international borders. In this article, we will unpack the meaning behind the free trade definition, delve into the myriad benefits it offers, and take a closer look at the different types of free trade agreements that exist. Beyond that, we will assess the broad-ranging impact of free trade, exploring how it can transform economies, reshape industries, and influence our everyday lives. So, get ready for an enlightening journey into the vibrant landscape of free trade.

Get started Sign up for free
Free Trade Free Trade

Create learning materials about Free Trade with our free learning app!

  • Instand access to millions of learning materials
  • Flashcards, notes, mock-exams and more
  • Everything you need to ace your exams
Create a free account

Millions of flashcards designed to help you ace your studies

Sign up for free

Convert documents into flashcards for free with AI!

Table of contents

    Free trade definition

    Free trade is an economic principle that allows countries to exchange goods and services across their borders with minimal interference from government regulations such as tariffs, quotas, or subsidies. In essence, it's about making international trade as smooth and unrestricted as possible, promoting competition and driving economic growth on a global scale.

    Free trade refers to the economic policy of removing barriers to trade among countries, enabling the unrestricted import and export of goods and services. It's grounded in the theory of comparative advantage, which posits that countries should specialize in producing goods and services they can make most efficiently and trade for those they can't.

    For instance, imagine two countries: Country A is highly efficient at producing wine due to its favorable climate and soil conditions, while Country B excels in manufacturing electronic goods owing to its advanced technology and skilled workforce. Under a free trade agreement, Country A can export its excess wine to Country B and import electronic goods without facing any trade barriers, such as tariffs or quotas. As a result, consumers in both countries enjoy a wider variety of goods at lower prices, leading to increased economic welfare and growth.

    To create a free trade area, members sign a free trade agreement. However, contrary to a customs union, here each country determines its own restrictions on trade with non-member countries.

    - EFTA (European Free Trade Association): a free trade agreement between Norway, Iceland, Switzerland, and Liechtenstein.

    - NAFTA (North American Free Trade Agreement): a free trade agreement between the United States, Mexico, and Canada.

    - New Zealand-China Free Trade Agreement: a free trade agreement between China and New Zealand.

    An organisation that highly contributed to the development of free trade is the World Trade Organisation (WTO). The WTO is an international organisation that aims to open trade for the benefit of all.

    The WTO provides a forum for negotiating agreements aimed at reducing obstacles to international trade and ensuring a level playing field for all, thus contributing to economic growth and development.

    - World Trade Organisation

    Types of free trade agreements

    There are several types of free trade agreements (FTAs), each with unique characteristics and purposes. Here are some of the main types:

    Bilateral Free Trade Agreements

    Bilateral Free Trade Agreements are agreements between two countries aimed at reducing or eliminating barriers to trade and enhancing economic integration. An example of a bilateral FTA is the United States–Australia Free Trade Agreement (AUSFTA).

    Multilateral Free Trade Agreements

    Multilateral Free Trade Agreements are agreements involving more than two countries. They aim to liberalize trade between a group of nations by reducing or eliminating tariffs, import quotas, and other trade restrictions. An example of a multilateral FTA is the North American Free Trade Agreement (NAFTA) between the United States, Canada, and Mexico.

    Regional Free Trade Agreements

    Regional Free Trade Agreements are similar to multilateral FTAs but usually involve countries within a specific geographic region. Their goal is to encourage trade and economic cooperation within that region. The European Union (EU) is a prominent example, with member countries practicing free trade among themselves.

    Plurilateral Free Trade Agreements

    Plurilateral Free Trade Agreements agreements involve more than two countries, but not all countries in a particular region or globally. These agreements often focus on specific sectors. An example of a plurilateral FTA is the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which involves 11 countries around the Pacific Rim.

    Preferential Trade Agreements (PTAs)

    Preferential Trade Agreements (PTAs) agreements offer preferential, or more favorable, access to certain products from the countries involved. This is achieved by reducing tariffs but not abolishing them completely. An example of a PTA is the Generalized System of Preferences (GSP) in the United States, which provides preferential duty-free access for over 3,500 products from a wide range of designated beneficiary countries.

    Each type of FTA has its advantages and disadvantages, and their effectiveness often depends on the specific countries involved, the sectors covered, and other global trade dynamics.

    Benefits and costs of free trade

    Free trade has both advantages and disadvantages.


    • Economies of scale. Free trade allows an expansion that is associated with increased output. The increased output, however, leads to the decrease in average production cost per unit which is called economies of scale.
    • Increased competition. Free trade allows enterprises to compete on a global scale. This is associated with increased competition that contributes to products' improvement and lower prices for customers.
    • Specialisation. Free trade allows countries to exchange products and specialise in the production of a narrow range of goods or services to increase their efficiency.
    • Reduction of monopolies. Free trade highly contributes to breaking up domestic monopolies. It allows international trade, which creates a market where many producers exist and compete with each other.


    • Market dominants. Gaining more and more market share some world-leading traders dominate the market. In doing so, they do not allow any other traders to enter and develop in the market. This is particularly a threat to developing countries, which are unable to enter certain markets because of the existing market dominants.
    • Collapse of home industries. When products are imported freely, they are very likely to dominate the home markets of other countries. This poses a threat to small businesses, especially those in developing countries.
    • High dependence. Many countries do not manufacture their own products and simply rely on importing foreign goods and services instead. That situation poses a threat to those countries as in case of any conflicts or war, they might be deprived of the products they need.

    The reasons for changes in the UK’s pattern of trade

    A pattern of trade is the composition of a country’s imports and exports. The pattern of trade between the United Kingdom and the rest of the world has dramatically changed over the last few decades. For example, now the UK imports more products from China than 20 years ago. There are several reasons for these changes:

    • Emerging economies. In the last few decades, Asian countries such as China and India have started to play a crucial role in international trade. They manufacture and export more products that are sold to other countries at a relatively low price.
    • Trade agreements. Reduced trade restrictions between certain countries allowed the exchange of products without additional costs. For example, the creation of the European Union increased trade between the UK and countries in continental Europe.
    • Exchange rates. Changing exchange rates can encourage or discourage imports and exports from/to certain countries. For example, the high rate of pound sterling makes products manufactured in the UK more expensive for other countries.

    Welfare gains and losses in the free trade

    Free trade can have a huge impact on the welfare of the member countries. It can cause both welfare losses and welfare gains.

    Imagine a country’s economy is closed and does not trade with other countries at all. In that case, domestic demand for a certain good or service can be met by domestic supply only.

    Free Trade Consumer and producer surplus in a closed economy StudySmarter OriginalsFig. 1 - Consumer and producer surplus in a closed economy

    In figure 1, the price consumers pay for the product is P1, whereas the quantity bought and sold is Q1. The market equilibrium is marked by X. An area between points P1XZ is a consumer surplus, a measure of consumer welfare. An area between points P1UX is a producer surplus, a measure of producer welfare.

    Now imagine that all countries belong to the free trade area. In such a case, goods and services produced domestically have to compete with cheaper imports.

    Free Trade Welfare gains and losses in an open economy StudySmarter OriginalsFig. 2 - Welfare gains and losses in an open economy

    In figure 2, the price of imported goods and services (Pw) is lower than the price of domestic goods (P1). Even though domestic demand increased to Qd1, domestic supply decreased to Qs1. Therefore, the gap between domestic demand and supply is filled by imports (Qd1 - Qs1). Here, the domestic market equilibrium is marked by V. Consumer surplus increased by the area between points PwVXP1 which is divided into two separate areas, 2 and 3. Area 2 presents a welfare transfer away from domestic firms to domestic customers where a part of the producer surplus becomes consumer surplus. This is caused by lower import prices and a price fall from P1 to Pw. Area 3 illustrates the increase in consumer surplus, which exceeds the welfare transfer from producer surplus to consumer surplus. Consequently, the net welfare gain equals area 3.

    Impact on welfare due to tariffs and duties in free trade

    Finally, imagine that a government introduces a tariff to protect domestic firms. Depending on how big a tariff or duty is, it has a different impact on welfare.

    Free Trade Impact of imposing a tariff StudySmarter OriginalsFig. 3 - Impact of imposing a tariff

    As you can see in figure 3, if the tariff is equal or bigger than the distance from P1 to Pw, the domestic market reverts to the position when there were no goods and services imported. However, if a tariff is smaller, prices of imports increase (Pw + t) which allows domestic suppliers to raise their prices. Here, domestic demand falls to Qd2 and domestic supply rises to Qs2. Imports fall from Qd1 - Qs1 to Qd2 - Qs2. Because of the higher prices, consumer surplus falls by the area marked by (4 + 1 + 2 + 3) whereas the producer surplus rises by the area 4.

    Additionally, the government benefits from the tariff which is presented by area 2. The government’s tariff revenue is measured by total imports multiplied by the tariff per unit of imports, (Qd2 - Qs2) x (Pw+t-Pw). The transfers of welfare away from the consumers to domestic producers and government are marked respectively by areas 4 and 2. The net welfare loss is:

    (4 + 1 + 2 + 3) - (4 + 2) which is equal to 1 + 3.

    Free Trade - Key takeaways

    • Free trade is international trade without restrictions. Free trade reduces barriers to imports and exports of goods and services such as tariffs, quotas, subsidies, embargoes, and product standard regulations between member countries.
    • The advantages of free trade are the development of economies of scale, increased competition, specialisation, and reduction of monopolies.
    • Free trade can cause both welfare losses and welfare gains.
    • In the world of free trade, welfare is transferred away from domestic firms to domestic customers.
    • Imposing tariffs can increase the welfare of domestic producers.
    Frequently Asked Questions about Free Trade

    What is free trade?

    Free trade is international trade without restrictions. Free trade reduces barriers to imports and exports of goods and services such as tariffs, quotas, subsidies, embargoes, and product standard regulations between member countries.

    What is an example of free trade?

    1. EFTA (European Free Trade Association): a free trade agreement between Norway, Iceland, Switzerland, and Liechtenstein.
    2. NAFTA (North American Free Trade Agreement): a free trade agreement between the United States, Mexico, and Canada.
    3. New Zealand-China Free Trade Agreement: a free trade agreement between China and New Zealand.

    Why was the World Trade Organisation established?

    During World War II in the 1940s, people believed that the worldwide Depression and unemployment in the 1930s were mostly caused by the collapse of international trade. Therefore, two countries, the United States and the United Kingdom, decided to try to create a world of free trade like before the war.

    Test your knowledge with multiple choice flashcards

    Who is the precursor of the World Trade Organisation?

    How many member countries are in the World Trade Organisation?

    What type of economy do members of the world trade organisation operate in?


    Discover learning materials with the free StudySmarter app

    Sign up for free
    About StudySmarter

    StudySmarter is a globally recognized educational technology company, offering a holistic learning platform designed for students of all ages and educational levels. Our platform provides learning support for a wide range of subjects, including STEM, Social Sciences, and Languages and also helps students to successfully master various tests and exams worldwide, such as GCSE, A Level, SAT, ACT, Abitur, and more. We offer an extensive library of learning materials, including interactive flashcards, comprehensive textbook solutions, and detailed explanations. The cutting-edge technology and tools we provide help students create their own learning materials. StudySmarter’s content is not only expert-verified but also regularly updated to ensure accuracy and relevance.

    Learn more
    StudySmarter Editorial Team

    Team Macroeconomics Teachers

    • 10 minutes reading time
    • Checked by StudySmarter Editorial Team
    Save Explanation Save Explanation

    Study anywhere. Anytime.Across all devices.

    Sign-up for free

    Sign up to highlight and take notes. It’s 100% free.

    Join over 22 million students in learning with our StudySmarter App

    The first learning app that truly has everything you need to ace your exams in one place

    • Flashcards & Quizzes
    • AI Study Assistant
    • Study Planner
    • Mock-Exams
    • Smart Note-Taking
    Join over 22 million students in learning with our StudySmarter App
    Sign up with Email

    Get unlimited access with a free StudySmarter account.

    • Instant access to millions of learning materials.
    • Flashcards, notes, mock-exams, AI tools and more.
    • Everything you need to ace your exams.
    Second Popup Banner