On the Welfare Effect of FTAs in the Presence of FDIs and Rules of Origin
This paper investigates the welfare effect of forming free trade agreements (FTAs) in an international oligopoly model with cost heterogeneity. To receive tariff-free treatment, firms must comply with the rules of origin (ROO) that require them to use a certain fraction of the parts and intermediates produced within the FTA. Firms producing outside of the FTA could undertake either market-oriented or export-platform foreign direct investment (FDIs). The presence of ROO has the following potential effects: (i) making an initially infeasible FTA become feasible by deterring outside firms from undertaking FDI, (ii) inducing an export-platform FDI of a less efficient firm to replace a market-oriented FDI of an efficient firm, or (iii) discharging FDIs made before the FTA was formed and deterring all possible FDIs. These potential effects complicate the welfare effect of FTAs and could decrease consumer surplus in member countries.
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