Trade Liberalization: Definition, How It Works, and Example

What Is Trade Liberalization?

Trade liberalization refers to the removal or reduction of restrictions or barriers on the free exchange of goods between nations. Such barriers could include tariffs, such as duties and surcharges, and non-tariff barriers, such as licensing rules and quotas. Economists often view the easing or eradication of these restrictions as steps to promote free trade.

Understanding Trade Liberalization

Trade liberalization is a controversial topic. Critics of trade liberalization claim that the policy can cost jobs because cheaper goods will flood the nation's domestic market. Critics also suggest that the goods can be of inferior quality and less safe than competing domestic products that may have undergone more rigorous safety and quality checks.

Proponents of trade liberalization, however, claim that it ultimately lowers consumer costs, increases efficiency, and fosters economic growth. Protectionism, the opposite of trade liberalization, is characterized by strict barriers and market regulation. The outcome of trade liberalization and the resulting integration among countries is known as globalization.

Advantages and Disadvantages of Trade Liberalization

Trade liberalization promotes free trade, which allows countries to trade goods without regulatory barriers or their associated costs. This reduced regulation decreases costs for countries that trade with other nations and may, ultimately, result in lower consumer prices because imports are subject to lower fees and competition is likely to increase. 

Increased competition from abroad as a result of trade liberalization creates an incentive for greater efficiency and cheaper production by domestic firms. This competition might also spur a country to shift resources to industries in which it may have a competitive advantage. For example, trade liberalization has encouraged the United Kingdom to concentrate on its service sector rather than manufacturing.

However, trade liberalization can negatively affect certain businesses within a nation because of greater competition from foreign producers and may result in less local support for those industries. There may also be a financial and social risk if products or raw materials come from countries with lower environmental standards.

Trade liberalization can pose a threat to developing nations or economies because they are forced to compete in the same market as stronger economies or nations. This challenge can stifle established local industries or result in the failure of newly developed industries there.

Countries with advanced education systems tend to adapt rapidly to a free-trade economy because they have a labor market that can adjust to changing demands and production facilities that can shift their focus to more in-demand goods. Countries with lower educational standards may struggle to adapt to a changing economic environment.

Trade Liberalization Example

The North American Free Trade Agreement (NAFTA) was signed on Dec. 17, 1992, by Canada, Mexico, and the United States. It entered into force on Jan. 1, 1994. The agreement eliminated the tariffs on products that were traded among the three countries. One of NAFTA's goals was to integrate Mexico with the highly developed economies of the United States and Canada, in part because Mexico was considered a lucrative new market for Canada and the United States. The three governments also hoped that the trade deal would improve Mexico's economy.

Over time, regional trade tripled, and cross-border investment increased among the countries. However, Former President Donald Trump considered the agreement detrimental to U.S. jobs and manufacturing. On Sept. 30, 2018, the Trump administration concluded negotiations on an updated pact, the U.S.-Mexico-Canada Agreement (USMCA), which entered into force on July 1, 2020. 

Most economists agree that NAFTA was beneficial to the Canadian and U.S. economies. According to a Council on Foreign Relations report, regional trade increased from $290 billion in 1993 to over $1.1 trillion in 2016, and U.S. foreign direct investment (FDI) stock in Mexico increased from $15 billion to more than $100 billion. However, economists also say that other factors may have contributed to these outcomes, such as technological change and extended trade with China.

Critics of NAFTA argue that the agreement caused job losses and wage stagnation in the United States because companies moved their production to Mexico to take advantage of lower labor costs. It remains to be seen how the USMCA will affect these factors.

The Bottom Line

Trade liberalization refers to policies and programs that reduce barriers to trade among countries. This can include free trade agreements that eliminate tariffs and duties. It can also mean the elimination or adjustment of rules, such as domestic production quotas or licensing restrictions.