The name is absent

duty free to one FTA country from the other only if it contains IOO percent value added of the
sending FTA country.

Notice that Assumption 2 does not impose any minimum fraction of value that must be
added by the sending FTA partner to grant the commodity duty-free access. A good is deemed
to contain strictly positive value added of the producing (or trans-shipping) country only if its
type (not merely its final location) is different from the description of each of its inputs. If good
WHk is an input, for example, any transformation to some other good HFk^ where к ψ k^
suffices.¹ Notationally, a good produced in country W of type к that is re-exported by H to
country F (WWk → WHk → WFk ) ultimately becomes good WFk (a different economic
product than WWk or WHk to be sure), but is not allowed to pass duty free by FTA partner
F because it is still a good of the original type “k ” and retains the same description as one of
its inputs. The 100% rule for new goods prevents evasion. If an H importer, for example, sought
to avoid the positive value added (change-of-product-type) requirement for duty free access by
importing a good WHk, trivially repackaging it, and claiming it to be a “new” good HHk where
k₁ is a never-before-seen product type, then it would fall under the 100% local content rule and
be prevented from duty free access.

Assumption 2 rules are the weakest (“most generous”) that prevent trans-shipment of pre-
existent commodities. We show in Section 4 that more restrictive rules are inconsistent with
Pareto improvement.

3 FTA Equilibrium

We are now ready for our first result. An existence proof verifies for an FTA that a chosen
combination of external tarifs and rules of origin support the implementation of a Pareto superior
allocation. General existence proofs have been available for customs union theory² but not for
free trade areas.³ In general, we show that for an arbitrary initial trade equilibrium, a free trade
area Pareto superior equilibrium exists that is consistent with the simultaneous and possibly price-
dependent assignment of purchasing power so that no one is worse of. This solves the problem
¹What if country H produces a good that uses many intermediate inputs from different origins? Ifthe good’s
final description ‰ differs from each of the comparable input descriptions, the good contains value-added of
country H and is deemed to originate (be produced) in location H.

²See Kemp and Wan, 1976.

³Examples can be constructed showing that the set of results for FTAs is not empty. For example, Feenstra,
2004, writes “While Krishna and Panagariya [2002] do not provide a general existence result, we can certainly
construct examples where [the described conditions hold]” (p. 195).

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