One might ask whether free trade is economically the most effective policy, how is it that a move towards free trade by a group of countries can reduce economic efficiency? The answer is quite simple if we put the history of FTA education in the context of the theory of the second best. Remember that the second best theory suggested that if there were distortions or imperfections in a market, adding another distortion (such as trade policy) could actually increase economic well-being or efficiency. In the case of a free trade agreement, the change in policy is more the removal of trade barriers than the addition of a new trade policy. But the second best theory works in the same way. Impact of the free trade area on the government of country A. Since the initial tariffs were prohibitive and the product was not originally imported, there was no initial customs revenue. Therefore, the free trade agreement does not result in a loss of revenue. Since there are both positive and negative elements, the net national welfare effect can be either positive or negative. Figure 9.10 “Harmful Diversion” shows where the free trade agreement results in a reduction in national welfare.
Visually, it seems obvious that the area e is greater than the sum of a and b. In these circumstances, the free trade agreement with trade diversion would lead to a decline in national welfare. We assume that there are three countries in the world: countries A, B and C. Each country has the supply and demand for a homogeneous good in the representative industry. Countries A and B will constitute a free trade area. (Note that trade diversion and creation can occur whether a preferential trade agreement, free trade area or customs union is established. For simplicity, we call the Free Trade Area Agreement [FTA].) The focus of this analysis will be on Land A, one of the two members of the FTA. We assume that country A is a small country in international markets, which means that it takes international prices as indicated. Countries B and C are considered large countries (or regions). Thus, country A can export or import as much of a product as with countries B and C, at any price in these markets. In cooperation with partners such as the WTO and the OECD, the World Bank Group informs and supports client countries wishing to sign or deepen regional trade agreements.