Abstract
In this paper, we study the impact of the rule of origin (ROO) requirements accompanied by free trade agreements (FTAs), which specify the minimum portion of supplies that should satisfy the origin requirement, on a multinational firm’s production decisions. We consider a multinational firm who exports its product to multiple countries and analyze its production decision in the presence of multiple free trading agreements (FTAs). The ROO requirements in FTAs not only refer to the origin of supplies but are also involved with an environmental regulation of a country of the supplies. As such, meeting multiple ROO requirements can be costly since it may be involved with an adjustment of production facility and suppliers according to different environmental standards. We investigate a multinational firm’s choice of the ROO level in its production decision under multiple FTAs. It is well known that, in the presence of overlapping FTAs, the firm may strategically choose not to comply with the minimum ROO requirements in the FTAs. Instead, the firm may choose to comply with an ROO level that is higher than required, or pay the tariff instead without enjoying tariff exemption by the FTA in the new country. Such unintended outcomes in the FTAs are called the Spaghetti Bowl Effect. We characterize and quantify two types of such Spaghetti Bowl Effects with the optimal production decisions of a multinational firm under multiple ROO requirements and derive policy implications.
Highlights
Free trade agreements (FTAs) have become increasingly popular among countries that seek strong economic ties in a region
This paper studies a multinational firm’s operational decision in the presence of multiple Rules of Origin (ROO) in FTAs
We investigate the unintended outcome of overlapping FTAs: an effect called the Spaghetti Bowl Effect
Summary
Free trade agreements (FTAs) have become increasingly popular among countries that seek strong economic ties in a region. Due to the cost associated with changing the production system to satisfy the ROO level, the firm may choose not to comply with the minimum required ROO level of the new FTA, and choose a different ROO level instead. The conversion cost tends to increase as the difference in the two ROO levels under overlapping FTAs gets larger [38] We consider this conversion cost to be the cost required to change the production process to comply with the new ROO requirement. Since the firm is assumed to already comply with the ROO already Country 1, the firm’s optimal choice of compliance level is e1 to minimize its unit production cost, which yields Πf1 e1. We analyze the firm’s optimal choice in Country 2 based on the above models
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