Firm Behavior and Market Access in a Free Trade Area with Rules of Origin

Abstract

While it is tempting to think of Free Trade Areas (FTAs) as liberalizing, they need not be. One reason for this is a relatively less studied feature of FTAs, namely Rules of Origin (ROOs) which determine when products are eligible for preferential treatment. We develop a model to study the behavior of firms in a Free Trade Area with Rules of Origin and the consequences of this behavior on the market equilibrium and outcome. We have a number of interesting and counter intuitive results to offer. First, we show that firms will choose to specialize: some firms will choose to meet rules of origin, and thereby obtain zero tariffs, while others will choose to ignore the possibility of obtaining preferential treatment. Second, we look at the effects of an FTA on market access. We show that an FTA with strict ROOs on the intermediate good raises imports and hence improves market access in the final good market, but reduces imports and hence harms market access in the intermediate good market. Third we look at the effect of more restrictive ROOs in the final good market. A consequence of our specialization result is that more restrictive ROOs on the final good first raise and then lower imports of the final good, but first lower then raise imports of the intermediate good. Their turning point is common so that imports of the final good are maximized and imports of the intermediate good are minimized at a common level of restrictiveness of the rules of origin. Lastly, we show that our model can be reinterpreted to show that more restrictive ROOs on the final good first improves and then harms the fortunes of labor, and to cast light on a particular policy to improve market access. Other problems with a similar structure could also be analyzed using our techniques with, we expect similar results.