What is a Free Trade Agreement (FTA)?

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Definition:

Free trade is international trade that occurs with minimal barriers, such as tariffs or quotas.

🤔 Understanding free trade

Free trade is international trade that is subject to few or no restrictions. Countries often sign agreements with one another or as part of a group to reduce trade barriers. These remove or reduce things like tariffs (taxes on imports), quotas (limits on imports), and subsidies (incentives for local producers of a product). Free trade agreements make it easier for goods and services to flow across borders. Proponents of free trade argue that it promotes efficient markets and results in lower prices for higher-quality goods. Critics of free trade promote some degree of isolationism, which involves protecting domestic industries from foreign competition. They argue that free trade can reduce wages and eliminate jobs at home.

Example

An example of a pact that promoted free trade was the North American Free Trade Agreement (NAFTA). Signed in 1993, NAFTA was an agreement between the US, Canada, and Mexico to reduce trade restrictions and allow business travelers to move freely between the countries, among other things. Many companies approved of the deal, which reduced the cost of doing business between the countries involved. Critics argued that it led to some jobs leaving the US for Mexico, where workers make less. NAFTA was replaced with the United States-Mexico-Canada Agreement (USMCA) in 2020. USMCA shares many characteristics with NAFTA while aiming to reduce the number of jobs outsourced from the US.

Takeaway

Free trade is like what happens at a yard sale…

When you host a yard sale, anyone can come over and buy things. You probably won’t charge taxes, and there aren’t any government restrictions on how much or what you sell. Free trade is similar — The government reduces or eliminates barriers to trade between countries, making it easier and cheaper to do business across borders.

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What is a free trade agreement?

A free trade agreement is a deal between two or more countries that reduces or removes barriers to trade between them.

Many countries have regulations surrounding trade with foreign nations. For example, a government may impose tariffs, taxing imports from abroad. It could also impose quotas for foreign imports, limiting the quantity or value of goods that other countries can sell within its borders. Other barriers to trade can include subsidies for domestic producers.

Free trade agreements cut back or eliminate restrictions like these. Some remove barriers entirely and immediately, while others only relate to specific goods or take months or years to fully go into effect. Free trade agreements can also unify standards, such as safety requirements for products.

Proponents of free trade argue that it helps consumers and businesses by reducing the cost of goods and improving their quality. Detractors believe it can lead to companies outsourcing to regions with cheaper wages and inputs, eliminating jobs.

What is the purpose of a free trade agreement?

The main purpose of a free trade agreement is to boost imports and exports by reducing barriers to trade between one or more countries. The theory is that free competition ultimately makes companies and markets more efficient and reduces prices.

Free trade also lets countries focus on their comparative advantages — goods and services they can produce at a lower opportunity cost than other nations.

Free trade agreements can also cover other important aspects of international business, such as regulation and standards. For example, they can create a framework for handling intellectual property disputes between companies in different countries. Or they can establish common safety or design standards. This can make it easier for businesses to make a product that meets all requirements for sale in multiple countries.

According to their proponents, the ultimate goal of free trade agreements is generally to benefit consumers. Advocates of free trade argue that the agreements can increase consumer access to high-quality products while reducing prices.

Free trade agreements can also help some domestic businesses by increasing their access to foreign markets. If a company can export more of its products, it can increase its revenues and profits. On the other hand, some domestic industries are hurt by foreign competition.

How does a free trade agreement work?

Free trade agreements make it easier for goods and services to flow across borders. They do this by reducing trade barriers, such as tariffs and quotas, and imposing standards for things like safety.

Tariffs, which are taxes on imports, make it more expensive for businesses to import goods or sell them in other countries. By reducing or eliminating tariffs, free trade agreements let businesses sell their products in another country at a lower price. This can help them gain access to new markets and take in more revenue.

Differing standards across countries can force companies to design multiple products for sale in different markets. Imagine one country requires hard hats to have an eighth of an inch of padding, while another country requires half an inch. Hard hat manufacturers would have to produce two different versions of the same product, which raises costs. Creating a shared standard across countries would mean manufacturers could make a single product. This can reduce costs due to economies of scale (costs falling as a company produces more of a product), which can mean lower prices for consumers.

Free trade agreements can also set rules around how freely individuals can travel and work between different countries. In the European Union, for example, citizens of member countries have the freedom to live and work in any other EU country.

Who does the US have free trade agreements with?

The US has free trade agreements with 20 countries as of May 2020. Each agreement has different provisions and may apply to different goods.

As of January 2021, the US has trade agreements with:

  • Australia
  • Bahrain
  • Canada
  • Chile
  • Colombia
  • Costa Rica
  • Dominican Republic
  • El Salvador
  • Guatemala
  • Honduras
  • Israel
  • Jordan
  • Korea
  • Mexico
  • Morocco
  • Nicaragua
  • Oman
  • Panama
  • Peru
  • Singapore
  • USMCA

What are the pros and cons of free trade agreements?

Free trade agreements are controversial, and people disagree over their benefits and drawbacks.

Proponents argue that free trade benefits both consumers and businesses in a country. Lower tariffs increase foreign competition in a market, which can drive up product quality and reduce prices for consumers. Domestic businesses can also take advantage of lower tariffs in other nations, expanding their potential customer base and contributing to economic growth.

Free trade also encourages innovation, advocates say, as businesses have to improve products and processes in the face of higher levels of competition. Reduced trade barriers can also help local firms that rely on raw materials from other countries. Reducing the cost of inputs allows those companies to earn higher profits or charge consumers less.

Another argument, which can be a pro or a con, is that manufacturers need to produce goods to the highest safety standards required by countries involved in a free trade agreement if they want to sell their goods everywhere. This can increase safety, but also hike costs.

Those who argue against free trade agreements often point out that they can hurt domestic industries and cause workers to lose their jobs. They claim that fewer tariffs and restrictions make it cheaper for companies to produce goods overseas, which can cause manufacturing and other jobs to move to areas with cheaper labor and materials, increasing unemployment in places like the US.

Some also argue that provisions for standardizing regulations reduce a nation’s sovereignty (ability to govern itself), because it has to work with other governments before passing new laws.

What are the effects of free trade agreements?

Economists debate the effects of free trade agreements. There is little question that the agreements lead to higher levels of trade between the countries involved. The subject of debate is the effect that increased trade has on the economies of each country.

Between the signing of the North American Free Trade Agreement in 1993 and 2016, trade between Canada, the US, and Mexico increased from around $290B to more than $1.1T.

While researchers estimate NAFTA caused the net loss of about 15,000 jobs a year from the US, experts believe that it helped create 200,000 jobs a year that paid an average of 15% to 20% more than the jobs lost.

Some experts argue that free trade also promotes closer relationships between the countries involved in agreements. As countries exchange more goods and adopt similar laws, they can establish closer diplomatic ties and reduce the chances of conflict.

The immediate negative effects of free trade agreements are often easier to see than more long-term, spread-out benefits.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.