Why Free Trade Is Good For You: An Illustration

We have all heard of the term Free Trade, but what does it really mean?

Free Trade means two individuals, who happen to live in different counties, are able to exchange goods with one another without interference from their respective governments. Interference can come in the form of tariffs, quota restrictions, or other regulations.

A tariff, for example, is a tax on imported (foreign) goods. The US government allows foreign producers to sell products to American Consumers, but at a higher price than the current world market price. In other words, American Consumers have to pay more if they want to buy from foreigners. The idea is that this policy will help American Producers be more competitive with foreign producers, and thus will boost domestic production and the economy.

AND... these policies do benefit American Producers. BUT... they come at a high cost to American Consumers.

Let's walk through a graphical example:

Market with Free Trade: shows the US Domestic Supply (SUSA), along with the US Domestic Demand (DUSA) for a product. The Pink Line represents the World Supply (SWorld).

At the world price, US producers supply QUSA and US Consumers buy QUSConsumer. The difference is imported from other countries:

The Green Triangle denotes American Consumer Surplus: how much American Consumers benefit from the trade.  The Brown Triangle represents American Producer Surplus: the amount American Producers benefit from the exchange.

Now let's look at a Market with Regulations. The graph below shows the same market once the United States Government implements a tariff on the good. The tariff increases the price American Consumers have to pay. They pay PTariff instead of PWorld.

While American production (QUSA) increases, American Consumers now buys less since the good is more expensive.

American Consumer Surplus is now a much smaller Green Triangle, while American Producer Surplus is a slightly bigger Brown Triangle. The Yellow Square is the Tax Revenue the US Government receives from the Tariff.  Unfortunately, the Blue Triangles are Deadweight Loss; nobody gets this.

To recap:

Because of the tariff, American Consumers lose the GREEN (above), while the American Producers only gain the BROWN (below).

 The US Government gets the YELLOW Rectangle:

And nobody gets the BLUE:

There is Deadweight Loss because some American Consumers are no longer able to afford the product because of the price increase, but they would have been able to if there were no trade restrictions. There is also Deadweight Loss due to the fact that US producers are wasting resources making a product that could have been made more cheaply by foreign producers. 

On top of this, with Free Trade, American Consumers would have spent the entire GREEN Rectangle below on the good:

However, with the tariff, they are unable to purchase this GREEN portion of the rectangle:

They reduce their consumption since they now have to pay more for a smaller quantity; this GREEN area:

Summing up, with the implementation of a tariff:

Americans go from having gains from trade that look like this:

To having gains from trade that look like this:

Restricting Free Trade (tariffs) hurts American Consumers more than it benefits American Producers. 


Now, let's look at an extreme case: when the US Government completely bans the sale of a foreign good in the United States.  

Market without Trade shows the Domestic Market when a foreign good is ban. The price consumers pay is higher than under Free Trade, and less of the good is consumed by Americans:

American Consumer Surplus is this small Green Triangle, and American Producer Surplus is this Brown Triangle:

If we compare this to the Market with Free Trade, American Consumers have lost the entire GREEN area below:

And, American Producers have only gained the BROWN area:

And again, no one gets the BLUE triangle, which are lost gains from trade (i.e., wasted resources and reduced consumption due to higher costs and prices).

Again, American Consumers lose more than American Producers gain from such polices. Trade Restrictions hurt more than help.

So, go for Free Trade.

We could say to the rest of the world: We believe in freedom and intend to practice it. No one can force you to be free. That is your business. But we can offer you full co-operation on equal terms to all. Our market is open to you. Sell here what you can and wish to. Use the proceeds to buy what you wish. In this way co-operation among individuals can be world wide yet free.  -Milton Friedman, Capitalism and Freedom