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

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.