A Change in The Volume of Final Goods Import

The impacts of the FTA with rules of origin on the final goods preferential trade flows can be studied via a change in the volume of final goods import from

RoW, between, before and after implementing the FTA. Now let consider the

final goods demand and supply in A and B

Since the final goods price in B remains unchanged, so the demand for the final goods in B is not affected, or:

DB_X(pB_x∗1) =DB_X(pB_x∗0)

The higher final goods price inAencourages the final goods firms inBto produce more the originating final goods and export under the preferential treatment to A; causes a decrease in the final goods price in A. However, if the final

goods price in A falls to pB_x∗0, none of the final goods firms in B export the originating final goods to A. At the same time, country A can import the final goods from RoW at price pA0

x∗; therefore, the originating final goods inA will be p_xB_∗0 ≤p_xA1 ≤pA_x∗0.

For simplification, assume that the originating final goods from B is not sufficient to meet the whole demand in A. The final goods price and demand in

A remain unchanged,11 then:

D_XA(pA_x∗1) =DA_X(pA_x∗0)

11_{On the contrary, if then final goods firms in B can supply all originating final goods}

demands fromA, the final goods price inAfalls to belowp1

The final goods price inB is lower than the price in A, which is assumed to

be unchanged. Then none of the final goods firms in A choose to produce the originating final goods and the final goods supply in A remains unchanged, or:

S_XA(pA_x1, pA_y∗1) =N_XAsA_x∗(pA_x1, pA_y∗1)

Where NA

X is the fixed number of final goods firms in country A.12

While the formation of the FTA affects neither the final goods demand in

A and B nor the final goods supply in A, it directly affects on the final goods supply in B. With pB1

y∗ < p1_y < p˜_y(α∗),13 all final goods firms in B produce the

originating final goods and export to A. Their supply increases with the price of the originating final goods but decreases with the price of the originating intermediate goods. Under the homogeneous regime, the final goods supply in

B can be written as:

S_XB(pA_x1, pB_x∗1, ϕ(.), pB_y∗1) = N_XBsB_x(pA_x1, ϕ(.))

If the price of the originating intermediate goods increases to p1

y = ˜py(α∗),

some final goods firms in B produce the originating final goods while others do

12_Ni J= n

i j+n

i

j∗ where i ∈ {A, B}, J ∈ {X, Y} and j, j∗ indicate originating and non-

originating goodsj respectively.

13_{Where ˜py(α) is the originating intermediate goods price in which makes the final goods}

firms inB are indifferent between exporting the originating final goods toAand selling their products in domestic market with the same price as the final goods from RoW.

not.14 _{Under the heterogeneous regime, the final goods supply in B is:}

S_XB(pA_x1, pB_x∗1, ϕ(.), pB_y∗1) = nB_xs_xB(pA_x1, ϕ(.)) +nB_x∗sB_x∗(pB_x∗1, pB_y∗1)

Now a change in the volume of final goods import from RoW can be shown as: V Ix∗ =DA_X(p_xA1)−DA_X(pA_x∗0 + D_XB(pB_x∗1)−D_XB(pB_x∗0) − N_XAsA_x∗(p_xA1, pA_y∗1)−N_XAsA_X(pA_x∗0, pA_y∗0) − sB_x(pA_x1, ϕ(.))−s_xB(pB_x∗0, pB_y∗0) nB_x − s_xB∗(p_xB∗1, pB_y∗1)−sB_x∗(pB_x∗0, p_yB∗0) nB_x∗ (5)

Only the final goods supply inB is affected by the FTA. Therefore, the impacts of the restrictiveness of the final goods rules of origin on the change in the volume

of final goods imported from RoW can be examined by differentiating the final goods supply in B with respecting to the final goods rules of origin, or ∂SXB

∂α .

For the homogeneous regime, all final goods firm in B choose to produce

and export the originating final goods, the tightening of the final goods rules of origin causes a decrease in the final goods supply in B. Therefore, the volume of final goods import from RoW increases with the restrictiveness of the final

14_{In contrast, if p}1

y >py˜ (α∗), none of the final goods firms in B produces the originating

final goods; therefore, the final goods supply in B is the same as before forming an FTA, or:

goods rules of origin. On the contrary, if some final goods firms in B produce

the originating final goods whereas the others do not, the heterogeneous regime, the result is different. The more restrictive final goods rules of origin increases the number of firms that choose not to produce the originating final goods and

reduces the price of the originating intermediate goods. As a result, the final goods supply inB increases when the rules of origin are tightened. These results are consistent with Ju and Krishna (2005).

Proposition 1 If rules of origin are not binding, the formation of an FTA reduces the volume of final goods import from RoW. If rules of origin are bind- ing, a tightening of the final goods rules of origin increases the volume of final

goods import from RoW under the homogeneous regime but decreases it under the heterogeneous regime.

Proof. See Appendix.

As already mentioned, a drop in the volume of imports from RoW implies an increase in preferential trade flows among the member countries. Hence,

Proposition 1 implies that the higher the degree of restrictiveness of the final goods rules of origin is, the more likely that the preferential trade flows of final goods among the member countries decrease.