Rules of origin and uncertain cost of compliance

To consider the role of uncertain production cost resulting from complying with rules of origin (ROO), we formulate a Cournot oligopoly model of a free trade area (FTA). If exporters do not comply with ROO, they must pay an external tariff, and if they comply, they enjoy zero tariff but suffer an uncertain production cost. Because compliers must source a certain ratio of the inputs from within the area, they face input-price fluctuations in that area; this yields an uncertain production cost for compliers. This uncertain cost provides a benefit to compliers owing to its variance. Therefore, for an intermediate external tariff, strategic substitution emerges in exporters' choice. We show that the coexistence of compliers and non-compliers is seen among symmetric exporters. We also discuss the endogenous rate of ROO-compliers in the coexisting equilibrium of compliers and non-compliers. We show that if the variance of the uncertain production cost is small, the rate of ROO-compliers in the coexisting equilibrium increases with the number of total exporters inside the FTA.