# Free Trade Agreement (FTA): Definition, How It Works, and Example

> **Definition**
>
> A free trade agreement between two or more countries reduces or eliminates certain costs and obstacles in order to more freely facilitate the exchange of goods and services.

## What Is a Free Trade Agreement (FTA)?

A free trade agreement is an arrangement where two or more countries commit to opening up their markets to one another by lowering or removing tariffs, quotas, and other trade barriers, making it easier for goods and services to move between them.

The concept of free trade is the opposite of trade [protectionism](https://www.investopedia.com/terms/p/protectionism.asp) or economic isolationism.

### Key Takeaways

*   Free trade agreements reduce or eliminate barriers to trade across international borders.
*   When implemented, these agreements come with regulations and oversight in the U.S. and the E.U.
*   Free trade can be applied based on two models: mercantilism and comparative advantage.

![Free Trade Agreement](https://www.investopedia.com/thmb/aystd_YH78pZEF-daf4r71fZY-Q=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/FTA-0375c877e1f24dd693adeca4b653131c.jpg)

*— Investopedia / Julie Bang*

## How a Free Trade Agreement (FTA) Works

Free trade policy is often implemented by a formal and mutual agreement of the nations involved. A free-trade policy may simply be the absence of any trade restrictions, however.

A government doesn't have to take specific action to promote free trade. This hands-off stance is referred to as “[laissez-faire](https://www.investopedia.com/terms/l/laissezfaire.asp) trade” or trade liberalization.

Governments with free-trade policies or agreements in place don't necessarily abandon all control of imports and exports or eliminate all protectionist policies. Few free trade agreements (FTAs) result in completely free trade in modern international trade.

> **Important**
>
> The benefits of free trade were outlined in "On the Principles of Political Economy and Taxation," published by economist David Ricardo in 1817.

For example, a nation might allow free trade with another nation, with exceptions that forbid the import of specific drugs not approved by its regulators, animals that have not been vaccinated, or processed foods that do not meet its standards.

It might also have policies in place that exempt specific products from tariff-free status to protect home producers from foreign competition in their industries.

### The Economics of Free Trade

Free trade on the international level is no different from trade between neighbors, towns, or states. It allows businesses in each country or location to focus on producing and selling the goods that best use their resources. Other businesses import goods that are scarce or unavailable domestically. This mix of local production and foreign trade allows countries to experience faster growth while better meeting the needs of their consumers.

This view was first popularized in 1817 by economist David Ricardo in his book, "On the Principles of Political Economy and Taxation." He argued that free trade expands diversity and lowers the prices of goods available in a nation while better exploiting its homegrown resources, knowledge, and specialized skills.

## Free Trade Models

Free trade can be applied based on two models.

### Mercantilism

Global trade was dominated by the theory of mercantilism before the 1800s. This theory placed priority on having a favorable balance of trade relative to other countries and accumulating more gold and silver.

Countries would often place trade barriers like taxes and tariffs to discourage their residents from purchasing foreign goods to attain a favorable balance of trade. This incentivized consumers to purchase locally-made products and support domestic industries.

### Comparative Advantage

Ricardo introduced the law of [comparative advantage](https://www.investopedia.com/terms/c/comparativeadvantage.asp), which states that countries can attain the maximum benefits through free trade. Ricardo demonstrated that countries would be able to produce more goods in total than they would by limiting trade if they prioritized producing the goods that they could produce more cheaply than other countries, and where they have a comparative advantage.

## Advantages and Disadvantages of Free Trade

Free trade comes with both pros and cons.

### Rapid Development

Free trade has allowed many countries to attain rapid economic growth. Many countries have been able to attract foreign investment capital and provide relatively high-paying jobs for local workers by [focusing on exports](https://www.investopedia.com/terms/e/export-incentives.asp) and resources where they have a strong comparative advantage.

### Lower Global Prices

Free trade creates a competitive environment for consumers where countries strive to provide the lowest possible prices for their resources. This, in turn, allows manufacturers to provide lower prices for finished goods and ultimately increases the buying power of all consumers.

### Unemployment and Business Losses

There are, nonetheless, some economic losers when a country opens its borders to free trade. Domestic industries might be unable to compete with foreign competitors, causing local unemployment. Large-scale industries might move to countries with lax environmental and labor laws, resulting in child labor or pollution.

### Increased Dependency on the Global Market

Free trade can also make countries more dependent on the global market. The prices of some goods may be lower in the world market, but there are strategic benefits for a country that produces those goods domestically. The country might be forced to rebuild these industries from scratch in the event of a war or crisis.

### Free Trade Pros and Cons

Pros

*   Allows consumers to access the cheapest goods on the world market.
    
*   Allows countries with relatively cheap labor or resources to benefit from foreign exports.
    
*   Under Ricardo's theory, countries can produce more goods collectively by trading on their respective advantages.
    

Cons

*   Competition with foreign exports may cause local unemployment and business failures.
    
*   Industries may relocate to jurisdictions with lax regulations, causing environmental damage or abusive labor practices.
    
*   Countries may become reliant on the global market for key goods, leaving them at a strategic disadvantage in times of crisis.
    

## Public Opinion on Free Trade

Research suggests that economists in the U.S. support free-trade policies at significantly higher rates than the general public.

American economist [Milton Friedman](https://www.investopedia.com/terms/m/milton-friedman.asp) said, “The economics profession has been almost unanimous on the subject of the desirability of free trade.”

Free-trade policies haven't been as popular with the general public. The key issues include unfair competition from countries where lower labor costs allow price-cutting and a loss of good-paying jobs to manufacturers abroad.

> **Fast Fact**
>
> The call on the public to "Buy American" may get louder or quieter with the political winds, but it never goes silent.

## The View From Financial Markets

The financial markets see the other side of the coin. Free trade is an opportunity to open another part of the world to domestic producers. It's an integral part of the financial system and the investing world. American investors have access to most foreign financial markets and a wider range of securities, currencies, and other financial products.

Completely free trade in the financial markets is unlikely in our times, however. There are many supranational regulatory organizations for world financial markets, including the [Basel Committee on Banking Supervision](https://www.investopedia.com/terms/b/baselcommittee.asp), the [International Organization of Securities Commissions (IOSCO)](https://www.investopedia.com/terms/i/iosco.asp), and the Committee on Capital Movements and Invisible Transactions.

## Examples of Free Trade Agreements

The U.S. and the European Union provide notable examples of free trade.

### European Union

The member nations of the [European Union](https://www.investopedia.com/terms/e/europeanunion.asp) form an essentially borderless single entity for trade, and the adoption of the euro by most of those nations smooths the way further.

It should be noted that this system is regulated by a central bureaucracy that must manage the many trade-related issues that come up between representatives of member nations.

### U.S. Free Trade Agreements

The United States has several free trade agreements in place. They include multi-nation agreements such as the [United States-Mexico-Canada Agreement](https://www.investopedia.com/usmca-4582387) (USMCA), which covers Canada and Mexico, and the Central America-Dominican Republic Free Trade Agreement (CAFTA-DR), which includes Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, and Nicaragua. There are also separate trade agreements with nations from Australia to Peru.

These agreements mean that about half of all industrial goods entering the U.S. come in free of tariffs, according to government figures. The average import tariff on industrial goods is 2%.

> **Important**
>
> President Donald Trump signed an executive order on April 5, 2025, that implemented a 10% global tariff on all U.S. imports. He then instituted a 90-day pause on some aspects of the order, but he imposed a 125% tariff on China. The situation has undergone several shifts and changes since then, and it does not yet appear to be resolved.

These agreements collectively still don't add up to free trade in its most laissez-faire form. American special interest groups have successfully lobbied to impose trade restrictions on hundreds of imports, including steel, sugar, automobiles, milk, tuna, beef, and denim.

## Why Were Free Trade Zones Created in China?

China began establishing free trade zones around key ports and coastal areas in 2013. These were areas where national regulations were relaxed to facilitate foreign investment and business development.

## What Is a Free Trade Area?

A free trade area is a group of countries that have agreed to mutually lower or eliminate trade barriers for trade within the area. This allows participating countries to benefit from reduced tariffs while maintaining their existing protections for trade with countries outside the area.

## What Are the Arguments Against Free Trade?

Opponents often assert that free trade invites foreign competition with domestic industries, causing job loss and harming key industries. Free trade causes manufacturers to move their operations to countries with fewer regulations, in some cases, rewarding companies that cause pollution or use abusive labor practices. Countries with weak intellectual property laws may steal technology from foreign companies.

## The Bottom Line

Free trade refers to policies that permit inexpensive imports and exports without tariffs or other trade barriers. A group of countries agrees to lower their tariffs or other barriers in a free trade agreement to facilitate more exchanges with their trading partners. This allows all countries to benefit from lower prices and gives them access to each other's resources.

> **Article Sources**
>
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>     
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>     
> 3.  Kansas State University. "[Landon Lecture (April 27, 1978) Free Trade: Producer Versus Consumer](https://www.k-state.edu/landon/speakers/milton-friedman/transcript.html)."
>     
> 4.  European Union. "[The European Union, What It Is and What It Does](https://op.europa.eu/webpub/com/eu-what-it-is/en/)."
>     
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>     
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>     
> 7.  U.S. Customs and Border Protection. "[U.S. Comprehensive Free Trade Agreement and Other Trade Agreements](https://www.cbp.gov/trade/priority-issues/trade-agreements/free-trade-agreements?language_content_entity=en)."
>     
> 8.  U.S. Customs and Border Protection. "[U.S. - Mexico - Canada Agreement (USMCA)](https://www.cbp.gov/trade/priority-issues/trade-agreements/free-trade-agreements/USMCA)."
>     
> 9.  Office of the United States Trade Representative. "[Industrial Tariffs](https://ustr.gov/issue-areas/industry-manufacturing/industrial-tariffs)."
>     
> 10.  Yahoo! Finance. "[Trump Tariffs Live Updates: Possible Tech, Auto Exemptions in Focus As Trump Team Sows Confusion](https://finance.yahoo.com/news/live/trump-tariffs-live-updates-possible-tech-auto-exemptions-in-focus-as-trump-team-sows-confusion-191201321.html)."
>      
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