that knowing that an equilibrium that has features A (related to rules of origin and tariffs) will
also have features B (everyone’s welfare rises) shows that features B can be attained only if
existence of the original equilibrium A is proved.
Thus, let countries H and F form an FTA that satisfies Assumptions 1 and 2 and apply the
Gale and Mas-Colell Theorem (see appendix for details) to establish the following proposition.
Gale and Mas-Colell (1975) apply the same standard as this paper, def ning goods by characteristic
and location. Theirproofisverygeneraland maintains the treatment of goods initiated by Debreu.
Proposition 1 Let Assumptions 1 and 2 hold, then a welfare-enhancing FTA equilibrium involv-
ing H and F exists where consumers in countries H, F, and W are not worse off post-agreement.
The proof follows a similar strategy to that used by Kemp and Wan (1976), Grinols (1981),
and Hammond and Sempere (1995) for welfare-enhancing customs unions. The difference is
incorporating rules of origin.
An example highlights the way the theorem works. Consider that the world is partitioned
into the US, Mexico, and the rest of the world. Suppose that the US and Mexico form an FTA
that satisfies Assumptions 1 and 2, and assume that the price of textiles in the US is higher
than in Mexico. Suppose that in FTA equilibrium Mexico exports textiles to the US but both
countries imported textiles from the rest of the world before the FTA was formed. Would that
trigger an increase in the amount of textile exports from Mexico to the US large enough to make
independent tarif setting inconsistent?
Let’s verify what Mexican textile exporters could do in this case. One option would be to
import textile products and re-export them to the US. In this case, Mexican exporters would pay
duties based on Assumption 2, making prices in the two countries consistent. Another option
would be to import larger quantities of inputs (yarn, fabric and etc.), add value to them, and
export the textile products to the US. But this is not possible since Mexico applies external tarifs
to freeze trade of all inputs with the rest of the world at the pre-FTA levels. The combination
of the choice of external tarifs (Assumption 1) and the setting of rules of origin (Assumption 2)
guarantees price consistency of welfare-enhancing FTAs.
4 Rules of Origin and Welfare
The main types of rules of origin applied in practice require that at least one of the following
criteria be fulfilled to grant duty-free access to member countries’ markets: (i) minimum regional