What’s it: A free trade area is a regional economic integration in which members remove barriers to trade in goods between them. However, each member has different policies when trading with non-member countries.
The free trade area is the initial economic integration stage before moving to the customs union, the common market to the economic union.
Examples of free trade areas
Citing from Wikipedia, some examples of free trade area agreements are:
- African Continental Free Trade Area
- Andean Community
- ASEAN Free Trade Area (AFTA)
- ASEAN – Australia – New Zealand Free Trade Area (AANZFTA)
- Asia-Pacific Trade Agreement (APTA)
- Central American Integration System (SICA)
- Central European Free Trade Agreement (CEFTA)
- Common Market for Eastern and Southern Africa (COMESA)
- Greater Arab Free Trade Area (GAFTA)
- East African Community (EAC)
- Eurasian Economic Union (EAEU)
- Gulf Cooperation Council (GCC) – 1981
- North American Free Trade Agreement (NAFTA)
- Pacific Alliance Free Trade Area (PAFTA)
- South Asian Free Trade Area (SAFTA)
Differences in free trade areas, customs unions, common markets, and economic unions
Free trade areas are the simplest form of regional economic integration. A more advanced stage of the free trade area is the customs unions.
Under a customs union, member countries adopt a uniform policy when they transact with non-member countries. For example, they set a single tariff when trading with non-members. This cooperation is usually to eliminate the effect of trade deflection, in which non-member countries take advantage of tariff differences between members of the free trade area to their benefit.
Furthermore, suppose the members agree to remove barriers to the flow of factors of production. In that case, they move towards common market cooperation. Under this agreement, capital and workers move freely between member countries, not only goods and services.
The more advanced stage of the common market is the economic union. In addition to eliminating barriers to goods, services, and production factors, members agree to build a common economic policy. They form joint institutions to integrate fiscal and monetary policy. An example is the European Union.
If later, an economic union member agrees to use the single currency, that is a monetary union. An example is Eurozone.
Advantages of the free trade area
The free trade area offers several advantages, including:
- Stimulating economic growth. Companies have greater market access. They have a more significant opportunity to sell more products, increase production, and absorb more labor. As a result, the economy grows higher and creates more jobs and incomes.
- Increased efficiency. The free trade area increases competition between companies. They will have to strive harder to increase efficiency and be more innovative to stay competitive.
- Specialization. Tighter competitive pressures force member states to specialize in the most efficient products.
- Reducing monopoly power. Goods and services flow freely between member countries, increasing competition.
- Fairer competition. Member countries agree to remove various trade protection forms that benefit their domestic industries and businesses, such as subsidies. It makes the competitive field fairer for companies in member countries.
- Price reduction. Because it removes trade protection, cheaper and better quality goods should dominate the market due to high market demand. It forces non-competitive producers out of the market.
- Varied goods and services. Competition forces companies to develop higher quality products to attract consumers. Also, free flow allows consumers to have more choices to meet their needs and wants.
- Technology transfer. Producers can import technology from member countries more cheaply. It indirectly contributes to technology transfer.
- Reducing subsidy spending. Often, governments subsidize their industries to make their products more competitive in international markets. By removing subsidies, the government will save more on the budget.
Disadvantages of the free trade area
The free trade area also has several drawbacks, including:
- Reduced income. Member countries can no longer earn revenue from tariffs.
- Threats to intellectual property. Manufacturers can easily copy other member countries’ products. When law enforcement is weak, the threat to intellectual property is also higher.
- Exploitation of natural resources. Free trade can lead to exploitative behavior. Member countries seek to increase exports to other members to take advantage of the free flow of goods and services.
- Decreasing employment in the service sector. Companies are trying to take advantage of zero protection to outsource some non-core business services to member countries with lower wage rates. That reduces the absorption of domestic labor.
- Get rid of the domestic industry. Increased competition forces non-competitive industries to die and raises unemployment. The effect is even more significant if most industries are uncompetitive.
- New industries are difficult to grow. Before becoming mature, some industries need government protection. That won’t happen in a free trade area.
