1 Introduction
The literature on preferential trade agreements has developed faster for the theory of customs
unions than for free trade areas, partly because members of a free trade area (FTA) can apply
different tariff schedules to goods traded with non-members and must apply rules of origin to
prevent duty-free trans-shipment of goods originating in the rest of the world. The theory of
FTAs, therefore, requires investigating the joint implementation of trade instruments and rules
of origin, making analysis more difficult. This paper contributes to the theory of free trade areas
by describing for the first time the most restrictive limit that rules of origin can enforce and
still continue to guarantee gains from trade for free trade areas in general. Second, it employs
a less restrictive framework for welfare analysis and flls a gap in the literature by proving that
starting from an arbitrary world trade equilibrium there always exists a free trade area equilibrium
involving only within-FTA transfers that provides welfare gains to FTA members and is at least
as satisfactory for every consumer worldwide as the initial equilibrium.
The paper addresses rules of origin and existence as follows. First, we describe a method-
ology that incorporates the main distinctions between FTAs and customs unions. In particular,
this methodology incorporates transportation cost considerations and allows the investigation of
different rules of origin. Second, it provides a proof for the existence of Pareto-improving free
trade areas. Third, it shows that only FTAs whose rules of origin for between-member trade allow
value added to be unrestricted in a particular way can unambiguously guarantee gains consistent
with tarifs chosen so that FTA formation is simultaneously unharmful to the rest of the world.
The methodology of these results is robust to the inclusion of factors of production in the util-
ity function—any factor may have inelastic supply or not—and to the existence of non-tradable
goods. Any commodity can be used as a final or as an intermediate good.
Section 2 describes the model. Sections 3 and 4 identify the unique rules of origin that
guarantee welfare gains and state the existence proposition. Section 5 comments on these results
relative to the related literature. Section 6 discusses the limitations of our results and the practical
significance of being able to form Pareto superior equilibria as part of the move to freer world
trade.