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How Does Free Trade Policy Affect the Economy?

Updated August 30, 2022

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How Does Free Trade Policy Affect the Economy? essay

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Before discussing the effects of free trade policy on a country’s economy, it is vital to understand why the idea of international trade became popular in the first place. Trade is a powerful tool to enhance the quality and quantity of goods and services of a country by means of exchange with another country. This process improves the living standard of the people in both countries when assumed that each country in the process of trade has a comparative advantage over the other country in producing the good it is trading.

When one decides to look at the history of trade, he will see dramatic increase in volume of trade taking place around the globe. Gradually we are moving away from the state of isolation as individual nation and moving fast toward an integrated world economy bringing countries of diverse culture, language and business practices together in one single world market. Advances in transportation and telecommunication technology can be given the most credit into making the globe an interdependent, integrated global economic system.

Now the question arises about the benefits of trade. At macro-level we can easily observe the rapid rise in globalisation and with that increase in volume of trade across borders but to truly comprehend the mechanism of trade and how it brings a positive effect into a specific economy, we need to analyse one specific trading relationship present in the world and how it benefits the nations involved. For the research purpose the trading relationship of UK and EU is chosen to observe how the free trade has affected UK and its trading partners in EU.

From the treaty of Rome in 1957 originated the core principle of free movement of goods, services, capital and people within the EU region. This principle adopted by the members of EU has a big implication on UK’s economy. The maintenance of such complicated economic integration across the member states has both costs and benefits for all the individual nations- some pay more than others to harmonize the laws and policies, overcoming the differences of cultures, policies and economic development of each member state.

According to economic theory of comparative advantage, it is beneficial for all nations to have free trade barrier because it creates the opportunity for them to divert their nation’s resources toward producing the goods and services in which they are more efficient. In addition to that, when the domestic market is made open to foreign companies it creates more competition encouraging the local firms to innovate and lower prices, increasing the overall public welfare.

On the other hand, producers get a larger market to sell giving them the opportunity to take advantage of economies of scale. For example, Airbus is one such multi-billion dollar company that symbolises the European dream with its operations across the globe. It produces aircrafts that are world renowned for quality product. The company takes advantage of the economic integration within the European Union to do cutting edge research on aerospace engineering and put the knowledge into use.

To manufacture such high end products as made by companies like Airbus, Mercedes or BMW, a nation needs skilled labour force. The integrated European Union provides firms the opportunity to hire workers from a diverse pool of people coming from the member states. Without laws favouring the free movement of people across states, it is tougher and more expensive for firms to hire and retain skilled workers from other countries. While critics might argue that this increases unemployment in the domestic economy, one must keep in mind that in the presence of foreign experts the local workers can be trained more efficiently which in turn increase the quality and employability of local people. In 2011, UK enjoyed the second largest inward FDI with the amount reaching $1.2tn.

According to Ernst and Young European Attractiveness survey, UK was considered the most attractive location for investment in the EU in 2013. Almost half of that FDI came from other European countries to get involved in the Greenfield investments (construction of new operational facilities) inside UK benefiting the economy directly through the creation of jobs. Moreover, the indirect benefits of FDI theoretically involve improvement in labour productivity through new work practices and transfer of new technology to local firms.

In addition to the FDI coming from other European nations, more than half of it comes from outside EU. The decision of foreign companies like Nissan, Honda, Toyota and General Motors to locate in the UK is based on the fact that establishing themselves in the UK market gives them free access to other 27 EU markets tariff-free. When a country has zero trade barrier with another nation, one macroeconomic factor plays a crucial part in the economic diagram- immigration.

The impact of migration on the living standard of the home country by GDP per capita is found to be small but positive. The effect of immigration on wages and employment at large depends on whether the skills brought by the migrant workers substitute for the ones possessed by the local workers or complement them. The more foreign workers with the same skills enter the home country the more downward pressure you see on the wages of the jobs related to the skills.

If immigration during the period of 1997-2005 is focused on, Dustmann et al found that with each 1% increase in the share of migrants led to a 0.6% decline in the wages of the 5% lowest paid workers, 0.4% decrease for the 10% lowest paid and an increase in wage of higher paid workers. Having a free trade barrier with EU has made UK an integral part of European economic system and thus must follow certain common laws. Therefore it can be easily understood that such law has an impact on commodity prices in the UK market and the government has very little control over it.

For example, the farmers in the EU are supported tremendously through the Common Agricultural Policy (CAP). They are aided in two ways: subsidies via the CAP and imposing a common external tariff on agricultural products brought from outside EU. Out of the total aid given to farmers 70% of the money is direct support to farmers with the condition that farmers will meet environmental and animal welfare standards. The rest of the aid goes towards rural development- farm modernisation, land management, etc).

the CAP also controls the output of certain products through quota system. The principal criticism of CAP is that it inflates the food prices for consumers artificially diverting resources from areas where EU might have a trade advantage. This particular policy has a negative impact on UK because it imports more and produces less agricultural products compared to countries like Italy, France and Spain. Moreover, consumer prices of a range of products imported from outside EU are increased due to external tariff- 15% tariff on bicycle, 17% on footwear and 12% tariff on clothing. This type of taxes on products actually decrease consumer welfare. After years of interdependency between UK and EU, if ‘no free-trade’ follows after Brexit this can have strong impact on the economies involved in the process.

With Brexit in the horizon, the positive side involves giving UK the opportunity to join other trade areas like NAFTA and create its own trade agreements tailored to its specific economic situation which is impossible as part of EU. The new freedom will allow UK to redirect its focus toward trade with nations with brighter prospects. It is often debated whether UK’s capacity to export outside EU, particularly new emerging economies like India and China, is held back by EU membership.

According to recent data, trade between UK and emerging economies like India and China has more than doubled in the last five years whereas the share if exports going to EU has declined from 54% to 46% in 2012. Now the focus should be directed toward how Brexit will change the business environment in the UK and what the managers of British firms are likely to encounter in the face of this uncertainty. Managers of multi-billion dollar companies like Airbus and Rolls-Royce will confront extreme challenges given their extensive network of integrated operations across the globe.

According to the manager of Airbus, they will confront substantial uncertainty because the end product that we see (plane) is the result of coordinated research and operations conducted ranging from London to Netherlands. After the Brexit, it will be extremely hard to continue the operations so smoothly, even if it is done, the cost of running the operation will increase as more restrictions and tariffs are imposed on the movement of goods and people across the continent.

This will lead to higher prices of the product, making British planes less competitive compared to its rivals like Boeing. This rise in price will lead to decrease of demand for Airbus products dragging down the profit for the company. This has a significant impact on the managers of not only Airbus but almost all managers responsible for directing international business inside the UK.

The risk of new trade barriers in goods and services resulting from an unfavourable Brexit deals caused the managers and CEOs of many multinational companies (MNCs) inside the UK to move. This restriction will stop the British firms to have access to 500 million people present in the single market if EU. For example, Panasonics is moving its headquarters located in the UK to the Netherlands ahead of Brexit.

As mentioned earlier such MNCs have their operations spread out across the glove so having restriction in free movement of people and goods will seriously hamper the smooth functioning of their operations. This prompted them to reach such a drastic decision. Another strong reason for the relocation is the workforce currently employed by the companies in the UK.

Smiffys employs over a dozen European staffs and if Brexit deal passes, these people might have to move back to their countries making it hard for companies to hire skilled labour force from inside the UK, increasing the wages and cost of operations. It has been estimated that losing access to the single market would cause the UK banks to have a loss of £27bn. It is obvious that it is a bad news for any firm manager.

However, the picture might not be so negative given the fact that after Brexit UK will have full freedom to make its own trade agreements with new economies located in Asia and Africa. The emerging economies like China and India have high level of economic growth with potential business opportunities in their growing markets. While staying inside EU, UK has limited space to trade with them on their own terms, the Brexit deal might lead to more dynamic trade process with the new trade partners from other parts of the globe.

How Does Free Trade Policy Affect the Economy? essay

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How Does Free Trade Policy Affect the Economy?. (2019, Mar 05). Retrieved from