Explain the costs of free trade.

Intro

Free trade occurs when governments do not discriminate against imports or interfere with exports by applying tariffs or quotas to imports or subsidies to exports.

There are several costs when countries engage in free trade. These include a fall in economic growth and worsening of the Balance of Payments (BOP) due to increased vulnerability to external shocks, structural unemployment due to loss of comparative advantage and imported inflation.

Body

With free trade, problems in one part of the world can spread like a contagion to other parts. For example, a recession in the US will result in a fall in income of consumers in the US. US consumers will not only consume fewer domestically produced goods, but also reduce their consumption of imported products. This results in a fall in net exports of the affected countries.

The fall in net exports will result in a fall in aggregate demand (AD). As seen in figure 1, the AD shifts to the left from AD0 to AD1 resulting in a surplus. Eventually, there will be a multiple fall in national output from Y0 to Y1.

This increased exposure to external shocks due to free trade will therefore result in a fall in economic growth and worsening of the BOP.

Free trade results in countries specialising and producing goods and services which they have a comparative advantage (CA) in. Due to trade, developed countries such as Singapore might lose their CA in labour-intensive manufacturing to emerging economies such as China due to its abundance of labour resulting in a lower labour cost. Due to the presence of better technology and sound infrastructure, Singapore move up to higher value-added manufacturing (e.g. biomedical) which they have a CA in. Workers who lack the necessary skills to work in such industries will be unemployed due to the mismatch of skills. This loss of CA can therefore result in structural unemployment.

Countries depend on one another for final goods and services as well as raw materials for production. The rise in general price level in a country could directly result in imported inflation in its trading partners as prices of imported final goods and services rise. With free trade, import-price-push inflation might occur due to supply shocks. The Middle Eastern crisis during the 1990s resulted in a fall in supply of crude oil which resulted in prices of imported crude oil to soar in oil importing countries such as Singapore. Being an essential input of production, the soaring oil prices will result in higher cost of production which in turn caused the prices of manufactured goods to rise. Hence, another cost of free trade is that it could bring about a rise in imported inflation.

Conclusion

In conclusion, free trade could have a negative impact on the internal (i.e. economic growth and inflation) and external (i.e. BOP) stability of an economy.