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they have undergone while passing through the hands of the exporter before reaching their final
destination.

In a free trade area, members may set different tariffs and thus may have different internal
prices. As discussed above, firms located in the FTA have an incentive to transship products
imported from the rest of the world by a low tarif member to a high tarif FTA partner. Rules of
origin must be chosen to prevent the duty-free transshipment of goods originating in the rest of
the world among FTA member countries. Next we describe tarif policy and rules of origin that
jointly insure consistency between transshipment and independent member tarifs.

2.1 Tariffs

Assumption 1 (Choice of Tariffs) Each FTA member chooses tariffs so that its trade with
the rest of the world (country W) is unchanged between the initial pre-union situation
0 and the
post-union-formation situation
1.

Assumption 1 has the effect of preventing welfare losses to the rest of the world upon FTA
formation by freezing external trade flows. Recording of production and trade follows the usual
general equilibrium convention. For example, which country did the shipping matters in the
recording of production and trade flows. Thus, assume that good
WWk (good of type к origi-
nating in W and entering into commerce there) is placed on W’s ship and transported to country
H. The description of production in W would refect this transportation activity and would record
~Vwwk as an input and y^Hk as an output. Aggregate production, of course, would involve
netting out commodity fows. The superscript W indicates that country W did the producing of
good
yWHk Country H would receive y^Hk and record this quantity in its import vector as y!kllk.

2.2 Rules of Origin

Trans-shipment allows a producer to import a product from location α and re-export it to
location
b. Rules of origin that prevent trans-shipment distinguish between transformations that
change a commodity’s description
k and not merely the good’s location.

Assumption 2 (Rules of Origin) A good or service may enter duty free to one FTA country
from the other only if it contains strictly positive value added of the sending FTA country. Ifthe
good is “new” (neither produced nor consumed at the initial pre-FTA situation
0), it may pass



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