where we used the identity ^i,t = yl,t + ωl,t + zl,t for situations t = {0,1}. Term 1 describes
substitution in consumption effects; Term 2 represents the production efficiency effects due to
prices and technology; and Term 3 summarizes tarif revenue and terms of trade effects.6
Term 1 ≥ 0 because consumers minimize the cost of achieving a given level of utility subject
to their budget constraints. Term 2 ≥ 0 by the Assumption of perfect competition which implies
producer efficiency under constant production choices (firms maximize the value of aggregate
output). Term 3 = 0 because the trade of a good produced and consumed in the same country is
zero; the export of one member country corresponds to the import of the other for goods traded
between FTA members; and trade between country W and an FTA member is frozen. ■
The rule in equation (2) describes necessary and sufficient transfers to spread the gains from
the formation of FTAs satisfying Assumptions 1 and 2 in the following sense. Terms 1 and 2 can be
as little as equal to zero if economic agents maintain their pre-FTA choices under the new vector
of prices that prevails in the FTA. In this case, the fair sharing distribution rule is necessary to
guarantee that every household is not worse-off after the FTA is formed. If each member country
is responsible for the application of the fair sharing distribution rule on its households, then cross
country transfers are required to implement this income distribution arrangement. The reason
is that external-trade-freezing tarifs keep constant the terms of trade between each member
country and the rest of the world but do not keep constant the terms of trade between member
countries. Grinols and Silva (2007) discuss at length the necessary and sufficient cross-country
transfers to spread the welfare gains from FTA formation.
The key term for rules of origin is Term 2. If Assumptions 1-2 are satisfied then quantities
of goods which were imported indirectly through the partner country in the pre-FTA situation
can continue to be imported indirectly as long as the tarifs levied on goods originating in the
rest of the world continue to be paid. Goods that contain strictly positive value added of the
sending member country in the pre-FTA situation are traded among member countries without
restrictions. Thus, producers located within the FTA have the production choice yi,° available in
the pre- and post-FTA situations.
More restrictive rules of origin than Assumption 2 can reduce social welfare in conjunction
with the formation of FTAs based on Assumption 1 because they diminish the range of production
choices of firms located within the union with respect to their pre-FTA levels, Y*’° D Y4 In this
case, Term 2 can be negative (yi,° may no longer be available) and assurance of a Pareto superior
FTA allocation fails. An example may clarify why this is true. Suppose that a firm in country
6See Grinols and Wong (1991).