H imports fabric from country W and uses it to produce textile products that are exported to
country F in the pre-FTA equilibrium. Suppose that rules of origin differ from Assumption 2
and require the use of fabric produced by FTA members in order to be granted duty free access
to member countries’ markets after an FTA formed by H and F that satisfies Assumption 1 is
created.7 This constrains the production decision of country H’s firm relative to the pre-FTA
equilibrium.8 We therefore have:
Proposition 3 Assumption 2 is the most restrictive rule of origin that remains consistent with
a fair sharing distribution of income and choice of tariffs such that FTA member country trade
with the rest of the world is unchanged between the initial pre-union situation 0 and the post-
union-formation situation 1.
The intuition can be given in terms of the theory of the second best. If each FTA member
freezes its trade flows with the rest of the world at pre-FTA levels, setting tarifs to zero on
trade among members eliminates a distortion that is present in the economy described by the
FTA. However, rules of origin consistent with independent tarif setting introduce distortions into
the economy if they do not satisfy Assumption 2. Of course, the welfare gains in Proposition
2 can be even greater if the necessity for rules of origin is eliminated. This explains the static
efficiency superiority of customs unions relative to free trade areas.9 In customs union formation,
the trade with the rest of the world of the entire union needs to be frozen at situation 0 levels so
that the preferential trade agreement collapses to a customs union. The rules of origin defined in
Assumption 2 are the only ones that eliminate the possibility of welfare losses due to the formation
of FTAs where each member freezes its trade flows with the rest of the world at pre-formation
levels.
5 Comments on the Literature
The concern of this paper is guaranteeing and spreading gains from improved trade. The
study of preferential trading agreements covers a body of results involving external tarifs, cross-
7Note that the example is close to NAFTA’s rules of origin on textile products which require a “triple trans-
formation” to grant duty free access to member countries’ markets.
8In practice, custom agents may find it difficult to distinguish a claimed new final product from its inputs,
inviting evasion of rules of origin by claiming a product new. Assumption 2 rules of origin require that new goods
have their entire value added in the FTA. This analytically-based rule, therefore, has the practical benefit that it
discourages exporters from trying to fool custom agents.
9See Grinols and Silva (2007) for a proof of general superiority of customs unions over free trade areas.