Mukunoki, Hiroshi und Okoshi, Hirofumi:
Rules of Origin and Consumer-Hurting Free Trade
Agreements

Munich Discussion Paper No. 2019-1
Department of Economics
University of Munich
Volkswirtschaftliche Fakultät
Ludwig-Maximilians-Universität München

Online at https://doi.org/10.5282/ubm/epub.61759

Hiroshi Mukunoki und Hirofumi Okoshi:
Rules of Origin and Consumer-Hurting Free Trade
Agreements

Munich Discussion Paper No. 2019
Department of Economics
University of Munich
Volkswirtschaftliche Fakultät
Ludwig-Maximilians-Universität München

Online at http://epub.ub.uni-muenchen.de/61759/

Rules of origin and consumer-hurting free trade
agreements ∗Hiroshi Mukunokia Hirofumi Okoshib
March 2019
Abstract
This study examines how the rules of origin (RoO) of a free trade agreement (FTA) affectfirms’ pricing strategies. A value-added criterion (VAC) of the RoO requires firms to add
more than a certain level of values within an FTA when firms use inputs originating fromoutside the FTA. The VAC may have a collusive effect that benefits all firms if it induces
an offshoring firm to manipulate its output price. Meanwhile, a consumer-hurting FTA
formation is possible even if all firms make tariff-free exports. Furthermore, such an FTA
formation may worsen total welfare.
Keywords: Rules of origin; Free trade agreement; Pricing strategy
JEL classification: F13; F15; L11∗ We thank Carsten Eckel and Andreas Haufler for their helpful comments and suggestions.

Hiroshi
Mukunoki acknowledges financial support from the JSPS KAKENHI (Grant Numbers JP16H03620,
JP17K03706). Hirofumi Okoshi acknowledges financial support from Deutsche Forschungsgemeinschaft(German Science Foundation, GRK1928).
a Faculty of Economics, Gakushuin University, Mejiro 1-5-1, Toshima-ku, Tokyo 171-8588, Japanb Corresponding author. University of Munich, Munich Graduate School of Economics, Seminar for
Economic Policy, Akademiestr. 1/II, D-80799 Munich, Germany

1 Introduction
Economic integration has boosted worldwide fragmentation and resulted in increased
international trade over the last few decades. During this period, export prices haveincreased. Based on World Bank data, Table 1 shows the transition of export unit value from2000 to 2010 of OECD countries and BRICs.1 Similarly, according to UNCTAD statistics,
based on 2000, the unit value indexes of worldwide exports and imports were 128.7 and126.4 in 2005, respectively. These values further increased to 161.2 and 156.7 in 2010.2
Empirical research provides evidence of such an increase in trade prices.3
One of the main vehicles of economic integration is the proliferation of regional
trade agreements (RTAs).4

Understanding the effects of RTAs is an essential task forpolicy-makers. Although trade liberalization through RTAs seems to reduce trade costs,
decrease consumer prices, and benefit consumers, the effect is not as simple as it seems.5
For instance, some empirical studies investigating the impact of free trade agreements(FTAs) have cast a skeptical eye on the fruitfulness of trade liberalization because of rulesof origin (RoO). If firms export their products by utilizing preferential tariffs in an FTA,
then firms must comply with RoO and prove that the exported products are produced
within the FTA. Conconi et al. (2018) showed that RoO used in the NAFTA significantly
reduce imports of intermediate products from non-member countries relative to member
ones, which implies there is input relocation from more efficient input production countries
to less efficient ones to meet RoO. Takahashi and Urata (2010) and Hayakawa et al. (2013)
found that not all firms utilize FTA tariffs owing to RoO, which indicates that the impact of
forming an FTA is heterogeneous across firms and may be overestimated. Unfortunately,in spite of such practical importance, the complexity of RoO makes it difficult to conduct
1 See https://data.worldbank.org/indicator/TX.UVI.MRCH.XD.WD
2 See http://unctadstat.unctad.org/wds/TableViewer/tableView.aspx?ReportId=16421
3 Recent studies have found that the increase in trade prices is motivated by quality upgrading. For
example, see Amiti and Khandelwal (2013) for export data to the U.S., Bas and Strauss-Kahn (2015) and Fan
et al. (2015) for Chinese data, and Flach (2016) for Brazilian data.
4 As of May 2018, 287 RTAs were in force. The number of cumulative notifications of RTAs in 2000, 2005,
and 2010 were 94, 180, and 309, respectively. See http://rtais.wto.org/UI/charts.aspx
5 Goldberg and Pavcnik (2016, p. 164) pointed out that ‘the world may not be as liberalized as it seems and that
failure to document significant effects of trade policies may instead be due to measurement and identification challenges
rather than the absence of such effects.’ Thus, identifying the impact of trade policy correctly remains challenging
work for researchers and further appropriate research on RTAs is necessary.

1empirical research on the impact of RoO so that little empirical investigation has been
undertaken.6
Country
Australia
Austria
Belgium
CanadaChile
Czech Republic
Denmark
Estonia
FinlandFranceGermany
GreeceHungary
Iceland
IrelandIsraelItaly
Japan
Korea, Rep.
Latvia2005
152.91139.92144.07127.15155.68152.49141.37112.85133.88142.34137.73130.89130.67131.66129.51114.40148.71109.0697.58
137.302010
258.61163.53168.80153.15255.72
183.29160.97135.28161.14171.49162.15171.92148.68144.12140.75140.58185.04137.6795.80
172.44

Country
Lithuania
Luxembourg
MexicoNetherlands
New Zealand
NorwayPolandPortugal
Slovak Republic
Slovenia
Spain
SwedenSwitzerland
TurkeyUnited Kingdom
United States
BrazilChina
India
Russian Federation

2005
131.98122.83126.88133.22139.63161.58149.17135.04155.82
136.15145.93134.26139.94133.26141.33106.87120.06107.80124.34158.362010
168.85
131.62151.06160.01173.36215.83180.62161.41167.78160.49176.15
159.61
189.20155.68174.00123.12
197.06122.58159.53229.11

Source: World Bank data (The base year is 2000.)

Table 1: Transition of export unit value
This study examines how RoO affect firms’ incentives to set the prices of final goods
in an oligopoly model with one input offshoring firm and one firm using inputs produced
inside the FTA. Among several methods to check the origin of products, the valued-added
criterion (VAC) is the focus of this study. Let p denote the export value of the product andc denote the value of input materials not originating in the FTA; then, the VAC typicallyrequires that the value-added ratio,

p−c
p , is larger than the specified level. This method of

calculating the value-added content is called the “transaction value method.” Estevadeordal
and Suominen (2003) reported that among 87 FTAs they analysed, 68 FTAs employed
this method, at least in a particular product category. Because the value-added ratio isassociated with an exporting firm’s pricing as well as its input sourcing, the VAC can be a
6 Research analysing the impact of RoO on prices includes Cadot et al. (2005) and Hayakawa et al. (2019).
Cadot et al. (2005) found that RoO has a price-increasing effect while the latter showed insignificant effects.
However, they did not consider the VAC method.

2

commitment device to increase output price.
We demonstrate that there is a case in which an FTA formation with RoO increases
prices of all goods, even when all firms export tariff-free products within the FTA. This
result provides rationale for the current two trends described above. This is because a firmthat uses inputs outside the FTA has an incentive to increase its product price to comply
with the VAC of RoO. In other words, the firm can credibly commit to set high export prices
with RoO. In response, the other exporting firm, which is a rival in the product market, also
increases its export price. Because of this collusive effect, more stringent RoO can benefit
all firms. If the induced increases in export prices outweigh the tariff-elimination effect thatshould reduce the consumer price, the FTA formation hurts consumers even though tariffs
against all firms are eliminated in equilibrium. Furthermore, such stringent RoO may makean FTA formation welfare reducing for inside countries even compared to welfare before
the FTA.
Extant theoretical studies have focused on how RoO change input sourcing (Ju andKrishna, 2005), the degree of market integration inside an FTA (Ishikawa et al., 2007), andthe patterns of foreign direct investment (Mukunoki, 2017). Jinji and Mizoguchi (2016a,b)
have analysed the optimal choice of RoO. However, these studies have not considered pricemanipulation to comply with RoO. The closest research to the current study is anotherpaper of ours, Mukunoki and Okoshi (2019), which focuses on transfer-price manipulationof a multinational firm for complying with the VAC of RoO. Mukunoki and Okoshi (2019)
complements the current study in that both focus on different levels of price manipulations.
The rest of the paper is organized as follows. The next section introduces our modeland derives the optimal strategy of firms. The welfare impacts are scrutinized in the 3rd
section. Section 4 concludes.

2 ModelTwo firms (I and O) produce differentiated products only in a home country (H) and sellthem in a foreign country (F).7 Countries H and F are potential FTA partners.
7 Even if we consider the market in country H, the qualitative nature of our results remains unchanged,

as long as the two markets are segmented and firms can make independent decisions in each market.

3

The production of final products requires inputs made either in country H or incountries outside the two countries. One unit of inputs is transformed into one unit ofoutput at constant marginal cost, which is normalized to 0. The input market is under
perfect competition and the prices of the “inside inputs” produced in country H are given
by c, while the prices of the “outside inputs” produced outside the two countries are lower,
given by c − ∆ (∆ ∈ (0, c)). We assume that only firm O is an offshoring firm, which can use
inputs imported from outside the two countries. Firm I always uses the inputs producedin country H, because the firm lacks knowledge about foreign input markets and it cannot
cover the cost of searching for appropriate suppliers and matching with them.
The indirect utility of the representative consumer in country F is V ( p I , pO ) = V̄ −a ( p I + pO ) +( p I )2 +( pO )2− bp I pO + Y, where V̄ is a positive constant,2

pi is the price of

product i manufactured by firm i ∈ { I, O}, b is the degree of substitutability of products,
and Y is the consumption of the numéraire good. The utility maximization yields

xi = a − pi + bp j ,(1)

where xi is the demand for product i in country F, and j ∈ { I, O} ( j 6= i ).
A specific import tariff, τ, is imposed on both products by country F. There are no
tariffs on inputs. The FTA formation removes τ, but zero tariff is applied only if firms
comply with RoO. Firm O may use the local inputs to meet the RoO and thus, its marginal
cost is either c or c − ∆. Firm i’s profit is given by

Πi = ( pi − ci − λi τ ) xi ,(2)

where c I = c and cO ∈ {c, c − ∆}. λi is an index that takes zero if firm i meets the RoO
after an FTA formation and takes one otherwise.
For the RoO, we consider that a VAC that requires the firms to add at least α fractionof values of the exported products within the FTA countries. Since firm I never uses theimported inputs, it always meets the VAC upon the FTA formation and enjoys tariff-freeaccess to country F. However, firm O needs to use either (i) the local inputs or (ii) the4

outside inputs, and sets its export price such that the following is satisfied:α ( pO ) ≡pO − ( c − ∆ )
≥ α.
pO

(3)

Since α ( pO ) increases with pO , even if firm O procures the outside inputs, α( pO ) exceeds
the required level (α) if pO is high enough.

Equilibrium
Given that (3) is not binding, the equilibrium price of good i is obtained by maximizing (2):
(2 + b) a + 2ci + bc j + 2λi + bλ j τp̃i =( j 6 = i ).
4 − b2(4)

The equilibrium sales of good i are xei and the equilibrium profit and consumer surplus

f = V ( peI , peO ) − Y, respectively. By (4), we can characterize thee i = ( xei )2 and CS
become Π
equilibrium in the following regimes.

• No Agreement (N): Before the FTA formation, a tariff is imposed on both goods(λ I = λO = 1). Firm O uses the outside inputs, cO = c − ∆. By substituting theseparameters into (4), we obtain the equilibrium prices denoted as piN .
• Non-compliance (NC): After the FTA formation, firm O uses the outside input andthe tariff is imposed only on firm O’s product. By substituting λ I = 0, λO = 1, andcO = c − ∆ into (4), the equilibrium price becomes piNC . If τ satisfies τ ≥ τ exit ≡(2+b)( a−c+bc), firm O exits the market.
2− b2• Input relocation (IR): After the FTA formation, firm O uses the inside inputs tocomply with the RoO. With λ I = λO = 0 and cO = c in (4), the equilibrium price ispiIR .
Alternatively, suppose that firm O uses the outside inputs (cO = c − ∆) after the FTA
formation and still complies with the RoO. There are two sub-cases.

5• Unbinding RoO (UB): Both firms set the unconstrained, optimal prices pUB
given byisubstituting cO = c − ∆ and λ I = λO = 0 into (4). The VAC is unbinding if
UB − ( c − ∆ )pO(2 + b)( a − c + bc) + (2 − b2 )∆UB≡ αUB ≥ αα ( pO ) ==UB(2 + b)( a + c) − 2∆pO

(5)holds.
• Binding RoO (B): If αUB < α holds, the RoO are binding and firm O sets the price,B , such that α p B = α is satisfied. The equilibrium prices become
pO
O
B
pO
=

(c − ∆)( a + c) b(c − ∆)and p BI =+.
(1 − α )22(1 − α )If α is high enough to satisfy αexit ≡(6)(2+b)( a−c+bc)+(2−b2 )∆, then firm O exits the market,(2+b) a+bc

where αUB < αexit holds.
The profits and the consumer surplus under regime ω ∈ { N, NC, IR, UB, B} are givenby Πiω and CSω , respectively. The total welfare of member countries is given by W ω ≡ω + Πω + TRω , where TRω is tariff revenue under Regime ω.
CSω + ΠO
I

Firm’s choices of FTA use and input relocation
UB > max[ Π NC , Π IR ] holds. Thus, firm O
When the RoO are unbinding (α ≤ αUB ), ΠO
O
O

always chooses UB and both firms use the FTA without changing their pricing and sourcing
strategies. The FTA formation lowers the prices of all goods and benefits consumers andall firms.
However, when the RoO are binding (α > αUB ), firm O chooses among NC, IR, and B.
NC ≥ Π IR holds if τ ≤ ∆ while Π IR > Π NC holds if τ > ∆.8 When the
We confirm that ΠO
OOOtariff that is eliminated by complying with RoO is lower than the additional marginal costfrom input relocation, firm O prefers NC to IR, and vice versa.
B takes an inverse U-shaped form in α ∈ [ αUB , αexit ]. Specifically,
We confirm that ΠO
2
B = ΠUB at α = αUB , Π B takes the maximum at α = αmax ≡ (2+b) a+bc−(2−b )(c−∆) andΠOOO(2+b) a+bc+(2−b2 )(c−∆)
8 Given τ < τ exit such that Π NC > 0, Π NC − Π IR = ( ∆ − τ )OOONCIR ⇐⇒ ∆ T τ.
ΠO T ΠO

6

2 − b22(2τ exit − τ + ∆). This means that

Case with
Regime UB

Regime B

Regime IR0Case with
Regime UB

Regime B

Regime NC

0

Figure 1: RoO and Equilibrium Regime
B = 0 at α = αexit . This result implies that there is a unique cut-off level of the VAC, α NC ,ΠO
B > Π NC holds with αUB < α < α NC and Π NC ≥ Π B with α NC ≤ α. Similarly,
such that ΠOOOO
B > Π IR holds with αUB < α < α IR and
there is a unique cut-off level, α IR , such that ΠOOIR ≥ Π B with α IR ≤ α. Note that α IR < α NC holds if τ > ∆ holds and α NC ≤ α IRΠOO

otherwise. The following proposition summarizes the choice of firm O.
Proposition 1. After an FTA formation, (i) the RoO are unbinding (Regime UB) if α ≤ αUB
holds; (ii) firm O complies with the RoO with price manipulation (Regime B) if αUB < α <min[α NC , α IR ] holds; (iii) firm O complies with the RoO with input relocation (Regime IR)
if ∆ ≤ τ and α NC ≤ α hold; and (iv) firm O does not comply with the RoO (Regime NC) if∆ > τ and α IR ≤ α hold.
The equilibrium choice presented in Proposition 1 is depicted in Figure 1

3 Profit-enhancing RoO and consumer-hurting FTA
In the previous section, we characterize which regime becomes the equilibrium outcome.
Here, we discuss the welfare effect of forming an FTA and how it is related to the stringencyof RoO. In line with traditional models, it is easily confirmed that the total welfare ofmember countries is improved when RoO changes neither firm O’s pricing nor its input
7

0

Figure 2: RoO and Profit of Firm O
sourcing. Thus, an FTA formation always improves total welfare inside the FTA if the
post-FTA equilibrium regime is Regime UB. However, as analysed, a stricter VAC of RoO
can influence firm O’s pricing or input sourcing.
Under regime B in Figure 1, firm O sets the price to satisfy the VAC, regardless of how
UB . Then, firm I’s optimal
firm I sets the price of its product, and the price is higher than pO

reaction is to raise its own price. If α is not so high, these increases in prices raise the profits
of both firms.
Proposition 2. Under Regime B, the profits of all firms increase as the VAC becomes more
stringent for α ∈ [αUB , αmax ).
In other words, the RoO become a commitment device for firms to weaken pricecompetition. If α is very high, however, the price increase is too large for firm O and its
UB . In other words, firm O’s profits appears inverse U-shaped, which
profit falls below ΠOis shown in Figure 2 in the case of ∆ ≤ τ.
Moreover, the price-increasing effect of binding RoO substantially changes the effects of8

an FTA formation. Under non-binding RoO, input relocation, or non-compliance, an FTA
formation decreases prices and benefits consumers and firms that use the FTA. However,the price-increasing effect of the RoO might overturn the positive effect for consumers, as
the following proposition states (the proof is in the Appendix).
Proposition 3. When the post-FTA equilibrium regime is Regime B, there exists a unique
cut-off level of the VAC, α∗B , such that an FTA formation raises the prices of all goods,
benefits all firms, and hurts consumers for α > α∗B , even though all imports become tariff
free with the FTA.
From proposition 3, the overall impact of FTA formation that leads to Regime B on
total welfare is not obvious, and reduces overall welfare of member countries with α > α∗B ,even though all imports become tariff free. Even if α < α∗B holds and the FTA formation
decreases the price of good I, it can reduce overall welfare, because the negative effect of
an increase in the price of good O can dominate the positive effect of a decrease in the priceB

B
N∗of good I. Since we confirm that ∂W∂α < 0 holds, W < W at α = α B means that there is aW∗BN
cut-off level of the VAC, αW
B (< α B ), such that W < W if and only if α > α B holds under
9,10
Regime B. The level of αW
B is depicted in Figure 3 in the case of ∆ ≤ τ.

In an extreme case b = 0, there are no interactions between firms. In this case, anincrease in pO does not affect the equilibrium level of p I and an FTA formation worsens
welfare only if α is sufficiently large (shaded area of Regime B in Figure 3). As b becomes
higher, an increase in pO has a more collusive effect in the sense that it increases theequilibrium level of p I more, and an FTA formation is more likely to be welfare reducing.
The following proposition summarizes the welfare effect when the post-FTA regime isRegime B.
Proposition 4. When the post-FTA equilibrium regime is Regime B, there exists a uniqueW
cut-off level of the VAC, αW
B , such that an FTA formation worsens total welfare if α B < α <min[α NC , α IR ] holds.
ω
B
UB
∂Π̃O
∂2 Π̃O
9 From eq. (5), ∂α∗∂b > 0 is obtained. Furthermore, ∂b > 0 and ∂α∂b > 0 implies α is increasing in b.
2 B
BB
10 We confirm that ∂ ΠO < 0 holds for α ∈ [ αUB , αexit ], where ∂ΠO > 0 at α = αUB and ∂ΠO < 0 at α = αexit .
∂α
∂α
(∂α)2

The detailed calculation is available upon request.

9

1

Regime UB

Regime B

Regime IR

0

Figure 3: RoO and Welfare
We should also note that even if the post-FTA equilibrium regime is either Regime IR
or Regime NC, an FTA formation may worsen welfare. Regime IR has a similar thresholdWbW
IR such that the FTA worsens the total welfare if b ∈ ( b IR , 1]. This area is depicted in

Figure 3 as the shaded area in Regime IR.11 If τ is only slightly greater than ∆, then the
FTA formation is always harmful for the member countries (see the proof of Proposition 5for details). This is because that input relocation increases the marginal cost of productionof firm O with limited declines in consumer prices. Therefore, an FTA that leads to Regime
IR results in welfare reduction.
Proposition 5. When the post-FTA equilibrium regime is Regime IR, if the initial tariff
level is large, there exists a unique cut-off level of b, bW
IR (∈ (0, 1)), such that an FTA
formation worsens total welfare if b ∈ (bW
IR , 1) holds. If the initial tariff level is small,the FTA formation always worsens total welfare.
2IRN
11 ∂ (W −W )
2
(
∂b
)
p

< 0 and (W IR − W N )|b=1 < 0 always hold and (W IR − W N )|b=0 > 0 also holds if τ ≥{2( a − c) + ∆}{2( a − c) + 7∆} − {2( a − c) + ∆} > 0.

10

Similarly, if the post-FTA equilibrium outcome is Regime NC, there also exists a uniquelevel of the substitutability of product, bW
NC , such that an FTA formation reduces total
12 In Regime NC, the production cost of firm O is lower than thatwelfare for b ∈ (bW
NC , 1].

of firm I. Since the tariff is eliminated only for good I in this regime, the production andexports of good O decrease while those of good I increase. This “trade diversion” effectcauses inefficiency and an FTA can be welfare reducing. As the two goods become closer
substitutes, the substitution effect between the two goods becomes larger and an FTA that
leads to Regime NC is more likely to become welfare reducing.
Proposition 6. When the post-FTA equilibrium regime is Regime NC, there exists a unique
cut-off level of b, bW
NC (∈ (0, 1)), such that an FTA formation worsens total welfare if b ∈( bW
NC , 1) holds.

4 Conclusion
This study has revisited the welfare effects of an FTA when exporting firms must meeta VAC to comply with RoO. When the value-added threshold is neither very low norvery high, a firm manipulates its output price to satisfy the VAC. In this case, RoO soften
product market competition and the resulting increase in prices can hurt consumers but
benefit firms. Because of this collusive effect, an FTA formation with RoO might hurt
consumers, even though all trade within the FTA is tariff free. Moreover, the total impactof the conflicting effects may be negative if the required threshold is sufficiently high.
Furthermore, even if all firms keep the input procurement from efficient countries andenjoy tariff-free trade, the similarity of goods and the degree of restriction of the VAC playcore roles in explaining whether the FTA is harmful or not.
These results suggest that a VAC can transform a consumer-benefiting (orwelfare-improving) FTA into a consumer-hurting (or welfare-reducing) FTA. RoO of FTAs
should be designed such that they do not produce a collusive effect. One policy option isto employ the net-cost method, by which a calculation of the value-added ratio is unrelated
to output prices.
2
NCN
12 ∂ (W −W ) < 0, (W NC − W N )|NC − W N )|b=0 > 0 and (Wb=1 < 0 show this uniqueness.
(∂b)2

11

There is room for further research. This study has assumed that the prices of inputs
are exogenously given, but it would be interesting to consider how the VAC changes input
prices. Another possible extension is to consider firms’ location choices between inside andoutside the FTA. The development of empirical analysis is left as the most important futuretask.

Appendixes
Proofs
Proof of Proposition 3
B and p B are increasing in α, while p N and p N are independent of α. We haveBy (6), both pO
I
I
O

B
N
pO
− pO

p BI − p NI
4 − b2 (c − ∆) − (1 − α) {(2 + b) ( a + τ ) + 2(c − ∆) + bc},=(4 − b2 ) (1 − α )b 4 − b2 (c − ∆) − (1 − α) {(2 + b) ( ab + 2τ ) + 2b(c − ∆) + b2 c}=.
2 (4 − b2 ) (1 − α )B > p N and p B > p N hold if and only if
By these equations, pOIIO2 (c − ∆)4−bα > α′ ≡ 1 −and(2 + b) ( a + τ ) + 2(c − ∆) + bc
b 4 − b2 ( c − ∆ )∗α > αB ≡ 1 −(2 + b) ( ab + 2τ ) + 2b(c − ∆) + b2 chold, respectively.

(4− b2 ) ( c − ∆ ) τB >Since we have α∗B − α′ = {(2+b)(a+τ )+2(c−∆)+bc}{(2+b)(ab+2τ )+2b(c−∆)+b2 c} > 0, both pO
N and p B > p N hold if and only if α > α∗ holds. There is a case where this cutoff level,
pO
B
I
I

α∗B , satisfies α∗B < min[α NC , α IR ], implying that the price-increasing FTA when Regime
B becomes the equilibrium outcome. For instance, we know that αmax always satisfies
αUB < αmax < min[α NC , α IR ]. If we compare α∗B and αmax , we have
αmax − α∗B =b3 {(2 + b) a + bc − (2 − b2 )(c − ∆)} − 4(2 + b)(2 − b2 )τ
.
{(2 + b) ( ab + 2τ ) + 2b(c − ∆) + b2 c}{(2 + b) a + bc + (2 − b2 ) (c − ∆)}12Thus, as long as the tariff satisfies τ <b3 {(2+b) a+bc−(2−b2 )(c−∆)}, αmax > α∗B holds and we4(2+b)(2−b2 )have α∗B < min[α NC , α IR ] because αmax < min[α NC , α IR ] always holds.
Proof of proposition 5
The welfare comparison between regime IR and N yields:
W IR − W N =2(1 − b)(2 + b)2 Ξ − ∆{2a(2 + b)2 (3 − 2b) + (12 − 9b2 + 2b4 )∆}.
2(2 − b )2 (2 + b )2

where Ξ ≡ τ 2 + {2( a − c + bc) + ∆(1 − b)}τ + ∆(3 − 2b)c. We can confirm that2(τ − ∆){2( a − c) + τ + ∆} − ∆{2( a − c) + ∆ − 2τ },8−∆(18a + 5∆)(W IR − W N )|b=1 =< 0, and18−2(1 + b)(2 + b)4 τ 2 + Φ∂2 (W IR − W N )
< 0,
=
(∂b)2
(2 − b )4 (2 + b )4

(W IR − W N )|b=0 =where Φ ≡ −2τ {2b2 (2b3 + 15b2 + 40b + 40)c + 32( a − c) + ( a − ∆)b2 (2b3 + 15b2 + 20b +20)} − 2∆{3c(16 + 16b − 8b2 − 16b3 − 7b4 − b5 ) + 6b2 (7b2 + 8) + 16( a − ∆)} + τ {−12∆(τ −∆) − 20∆τ − 6ab2 τ (b2 + 8b + 24)} − 2ab{96τ − (40b + 40b2 + 15b3 + 2b4 )∆} < 0 (∵ τ > ∆).
The sign of (W IR − W N )|b=0 is ambiguous, and it is increasing in τ. (W IR − W N )|b=0 >p0 holds if and only if τ̃ ≡ {2( a − c) + ∆}{2( a − c) + 7∆} − {2( a − c) + ∆} < τ holds.
IR > W N holds forIn this case, there exists a unique level of b, bW
IR ∈ (0, 1), such that W
IR = W N holds at b = bW , and W IR < W N holds for b > bW .
b < bWIR , W
IR
IR
IR

N

Besides that, ∂W ∂b−W |b=0 ≥ 0 holds if and only ifτ̂ ≡∆( a + 2c)<τ2c − ∆

By substituting τ = τ̂ into (W IR − W N )|b=0 , we get(W IR − W N )|τ =τ̂, b=0 =∆{2(4c − ∆) a2 − 8(2c2 − 4∆ + ∆2 ) a + 8c2 − 12∆c2 + 14∆2 c − 3∆3 },8(2c − ∆)2which takes minimum at a = ã ≡2(c2 −4∆c+∆2 )and the minimum level is given by (W IR −
4c−∆

13

W N )|τ =τ̂, b=0, a= ã =∆(2c−∆)2 (18c−5∆)
4c−∆

IR

N

> 0. This implies that τ̃ < τ̂ and ∂W ∂b−W |b=0 < 0whenever (W IR − W N )|b=0 < 0 holds. Therefore, if τ ≤ τ̃ holds, we have W IR ≤ W N for
any b ∈ [0, 1).

Proof of proposition 6
The welfare gains from FTA formation under regime NC is computed as;
W NC − W N =τ [2{(4 − 3b2 − b3 ) a − 2(2 − b2 )b∆} − 2(1 − b)2 (2 + b)2 c + (4 − 3b2 − 2b3 )τ ].
(2 − b )2

We have[2( a − c ) + τ ] τ> 0,
8(4∆ + τ )τ(W NC − W N )|b=1 = −< 0, and18∂2 (W NC − W N )
Θτ
=−
< 0,
2
(∂b)
(2 − b )4 (2 + b )4

(W NC − W N )|b=0 =where Θ ≡ (2b5 + 9b4 + 64b3 + 56b2 + 96b + 16)τ + (4b3 + 30b2 + 86b + 80)b2 c + 32( a − c) +2b{(48 + 56b + 32b2 + 9b3 + b4 ) a − 2(20 + b2 )b2 ∆} > 0. Thus, there exists a unique cut-off
NC > W N holds for b < bW , W NC = W N holds atlevel of b, bW
NC ∈ (0, 1), such that W
NC
NC < W N holds for b > bW .
b = bW
NC , and W
NC

14

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