Rules of Origin in Customs Unions and Global Free Trade

Abstract

In a three-country Customs Union (CU) formation game, I introduce international trade in intermediate inputs and Rules of Origin (RoO) restrictions. In the case of symmetric countries, I show that as countries become more involved in global supply chains, global free trade is less likely to be a stable equilibrium outcome. RoO can help solving this problem. In the case of asymmetry, depending on the degree of the globalization, free riding (for high) or exclusion motive (for low) prevents global free trade. Correspondingly, it is shown that RoO can have helpful or detrimental effect on attaining global free trade.