Free trade areas, the limit of Rules of Origin, and optimal tariff reductions under international oligopoly: A welfare analysis

Abstract

In this article we analyze the economic effects associated with preferential Rules of Origin (RoO) in a free trade area (FTA). By presenting a stylized three-country model of trade under oligopoly, we show that there exists a maximum limit of RoO below which forming an FTA is welfare-improving. In examining external tariff reductions under FTA, we take into account the constrained conditions that optimal tariffs set by member countries effectively induce the intrabloc exporters to comply with RoO. This approach rules out trade regime switches and helps identify the economic determinants of establishing an effective and welfare-improving FTA with RoO. We further examine whether an FTA with RoO increases total trade or whether the extra trade arises at the expense of nonmembers. Our simple model has implications for economic factors that foster or impede regional economic integration under imperfect completion.

Keywords:

• Free trade area
• Rules of Origin
• content ratio
• tariff reductions

JEL Classifications:

• F12
• F13
• F15

Acknowledgements

We are grateful to the editor, Pasquale Sgro, and two anonymous referees for constructive suggestions and critical insights that led to improvements in the article. An earlier version of this article was presented at the Department of Economics, National Taiwan University, the Department of Applied Economics, National University of Kaohsiung, and the Department of Industrial Economics, Tamkang University. We thank Hung-Yi Chen, I-Hui Cheng, Hong Hwang, Kuo-Feng Kao, Weng-Jung Liang, Leonard F.S. Wang, Shih-Jye Wu, and seminar participants for valuable comments. We also thank Charlie Braymen, Philip Gayle, and Tian Xia for helpful comments. The remaining errors are ours.

Notes

 1. See Krueger (1993, 1997), Krishna and Krueger (1995), and Krishna (2006).

 2. See, e.g. World Bank (2005). In their WTO report, Fiorentino, Verdeja, and Toqueboeuf (2007) indicate that FTAs constitutes more than 84% of PTAs in force.

 3. The notions of trade creation and trade diversion are due to the seminal work of Viner (1950).

 4. There are several different criteria for RoO provisions in terms of (i) domestic or regional content requirements, (ii) a change in tariff heading, (iii) particular processes that should be performed within an FTA; and (iv) a substantial transformation of a product See, e.g. Krueger (1993), Thoening and Verdier (2004), Cadot et al. (2006), and Krishna (2006). North American Free Trade Agreement (NAFTA), the European Union, and the ASEAN Free Trade Area agreement (AFTA), for example, all contain certain criteria of preferential RoO.

 5. There are contributions that examine nonpreferential RoO. For example, Falvey and Reed (1998) indicate that RoO may be used strategically as policy instruments due to the potential arbitrariness in categorizing the geographical sources of goods produced not in a single location. Falvey and Reed (2002) further show that producers may modify their production processes and input mix in response to RoO content provisions.

 6. Unless forming an FTA is politically motivated, which is beyond the scope the present article, it is plausible to assume that social welfare improvement is the goal of becoming an FTA member. Grossman and Helpman (1995) examine the political viability of FTAs when two countries negotiate a free trade agreement. Based on a political-economy framework, in which industrial interest groups attempt to influence their government, the authors show that an FTA with RoO can be an equilibrium outcome. For further contributions on FTA formation and interest group politics see, e.g. Krishna (1998), Maggi and Rodríguez-Clare (1998), Mitra (2002), and Ornelas (2005).

 7. Although the set-up and assumptions may differ, the use of a three-country model to analyze issues on FTAs with RoO can be found Anson et al. (2005), Ju and Krishna (2005), and Ishikawa, Mizoguchi, and Mukunoki (2007). FTAs may be an arrangement of two or more countries. But the prevailing FTAs are signed between two countries (World Bank, 2005).

 8. The assumption of symmetry between countries A and B implies that the prices of the regional inputs in the two countries are identical.

 9. The result of a higher input cost is in accordance with Krishna (2006, 21) who indicates that RoO can also ‘provide an incentive for regional producers to buy intermediate goods from regional sources, even if their prices are higher than those of the identical import from outside the FTA, in order to make their product originate in the FTA and qualify for preferential treatment.’

10. As in Ju and Krishna (2002, 2005), Mukunoki (2004), and Ishikawa, Mizoguchi, and Mukunoki (2007), we assume that transportation costs are relatively small or zero and hence can be ignored for analytical simplicity.

11. We rule out the case that λ > α/[(m + 1)h] because the quantities of the final good produced by outside firms in country C are negative. Also, when λ is ‘significantly high,’ there exists no interior solution for the optimal tariff.

12. See Appendix A2 for detailed derivations.

13. See Appendix A3 for detailed derivations of solving and

14. Our partial equilibrium analysis under imperfect competition complements the general equilibrium model of FTA with RoO developed by Grinols and Silva (2011). Assuming implicitly that markets are characterized by perfect competition, the authors show the general equilibrium existence of RoO that guarantees welfare gains from trade for FTA formation. They further indicate that many commonly used RoO are more restrictive than this maximum limit.

15. See Appendix A4 for detailed derivations.

16. It should be noted that the analytical framework can also be applied to the case in the absence of RoO. In this case, the optimal external tariff is given by equation (17) where λ = 0. That is, Figure 3 can be used to illustrate these results, which are consistent with Figure 1 that

17. The book by Cadot et al. (2006) contains a collection of recent studies on issues related to RoO. The authors indicate that RoO act as trade barriers and become new policy instruments. They further point out that the design and implementation of RoO should occupy the central stage in negotiation and functioning of preferential trade agreements.

18. Noting the fact that the NATFA agreement contains up to 200 pages on RoO provisions as an example, Krishna (2006) indicates that RoO might be strategically used. She further points out that documenting RoO is quite expensive for exporting firms so that they may simply pay tariffs instead of going through the more costly documentation.