Implementing Free Trade Areas: Rules of Origin and Hidden Protection

This paper focuses on the effects of rules of origin in Free Trade Areas. We first point out that even rules of origin which are not restrictive, namely those which do not raise costs of production, have very pronounced effects on trade and investment flows. We then look at some different ways of specifying rules of origin (ROOs) under perfect competition. We compare price and cost based ROOs and show that even if they are equivalent in the 'long run', they are not equivalent in the short run where capacity constraints can exist. We also show that some kinds of ROOs can be ranked in terms of their implications for producer profits. We also show that welfare is likely to be non monotonic in the restrictiveness of the ROO, so that making a ROO more stringent could raise welfare. Finally, we show that in the presence of imperfect competition, ROOs may raise output and reduce prices as they become more stringent.