C o n d it io n a l Pol icie s in Gen e r al E q u ilib r iu m:FTAs with ROOs Revisited.1Kala KrishnaApril, 20041Extremely preliminary. Please do not quote without p erm ission.AbstractA large number of trade policies are “conditional” in so much as they can beinvoked only if certain prerequisites are met. Hence, the benefits accruing fromthem can come at a cost. For example, meeting the Rules of Origin (ROOs) ina Free Trade Area (FTA) or under the generalized system of preferences (GSP)may have a cost, but on the other hand, firms are rewarded for complyingwith them by facing zero or lower tariffs. This paper analyzes the effects ofsuch restrictions in a general equilibrium setting using FTAs with ROOs as anexample.Keywords: General Equilibrium, Trade Policy, Factor Price Frontier, FreeTrade Areas, Rules of Origin.JEL Classification: F13, F15, F16.1IntroductionTrade Policies are often conditional in practice. Only if certain conditions aremet are a set of benefits obtained. In a Free Trade Area (FTA), for example,producers become eligible for zero tariffs (when exporting to a partner in theFTA) if the product is deemed to have domestic origin. Under the GeneralizedSystem of Preferences (GSP) poor developing countries obtain preferential tariffsif the product is deemed to originate in the developing country1.Indevelopingcoun tries, producers obtain preferential access to inputs if they export theirproducts. What is the effect of such policies in a general equilibrium setting?This question has been by and large ignored. This paper looks at a particularsuch policy, namely, the creation of an FTA with Rules of Origin (ROOs).Previous work on this subject has taken a partial equilibrium approach.Early work by McCulloch and Johnson (1973), Grossman (1981), Mussa (1984),and Krishna and Itoh (1988), lay the foundation for recen t work on contentprotection and preference. See Krishna (2003) for a recent survey on FTAs withR OOs. In an FTA, members maintain their own external tariffs. As such , tariffsmay differ between member countries. ROOs, therefore, assume a functionadditional to that under customs unions: ROOs prevent deflection. This occurswhen imports enter through the country (whic h gets the tariff revenue) with thelowest duty on the item in question and are re-exported to other countries in theFTA. Without ROOs, an FTA could be highly liberalizing, both because at giventariffs, the lowest tariff would apply to each category of imports2, and becausethe possibility of such deflection makes it in the interest of all other countries toreduce their own tariffs in order to attract imports to their ports! Only whenthe lowest tariff is zero is this not an issue, suggesting that in equilibrium, all1Most pro ducts, other than arms and numerous agricultural goo ds, are covered by theGSP.2Such re-exp orts need not b e a go o d thing as resources are wasted in doing so.1external tariffs would be competed down to zero3!ROOs can also provide an incentive for regional producers to buy interme-diate goods from regional sources, even if their prices are higher than thoseof the identical import from outside the FTA, in order to make their product“originate" in the FTA and qualify for preferential treatment. This, in effect,protects FTA suppliers, a point first made by Krueger (1999)4.Asaresult,trade patterns and investment flows needed to sustain them can be profoundlyaffected by a FTA as pointed out in Krishna and Krueger (1995).That ROOs may be protectionist does not prove that they are. However,recent work by Estevadeordal (2000) suggests that ROOs are being used toprevent trade deflection as the sectors which have large differences betweentariffs between the partners are the ones where ROOs are strongest. The workof Cadot et. al. (2002) on NAFTA also suggests that ROO are negating theeffects of tariff reductions due to an FTA. They show that while the severity ofR OOs reduced Mexican exports, tariff preferences raised them and that the neteffect was close to zero.In addition, it is worth pointing out that ROO are often quite expensiveto document. As a result, even if a product satisfies origin, an importer mayprefer to pay the tariff rather than bother with the documentation needed.Some idea of how extensive this is might be gleaned from the prevalence ofoutward processing trade (OPT) between the EU and the Central and EasternEuropean countries5. The latter have duty free access to the EU but insteadof proving origin is met, EU firms use the OPT provision instead suggesting3See Richardson (1995) for more on this. It is interesting to note that this seems to haveactually happened in America during the Articles of Confederation p eriod (1777-1789). SeeM c Gilliv ray (200 0 ).4The Conference at which this pap er was presented was in 1992.5OPT encourages pro cessing overseas by EU firms as the duty that would have b een paidon the exported inputs to be pro cessed abroad is deducted from the duty owed on the impo rtedproduct.2that the cost of proving origin exceeds the duty paid using the OPT provision.For example, as documented in Breton and Manchin (2002), when Albanianexports of clothing to the EU are considered, OPT provisions were used over90% of the time. However, Turkey, which is part of the customs union (hence itdoes not have any ROO to meet) used these provisions only .5% of the time6.Herin (1986) also shows that the cost of proving origin seems to have led over aquarter of EFTA exports to pa y the MFN tariff.The work closest to this paper is Ju and Krishna (1998) and (2003). Theypoint out an essential non monotonicit y that occurs in suc h settings when thelink between final and intermediate goods markets is modelled. If the require-ment that has to be met is easy to meet, all firms choose meet it. In this regime,one set of comparative statics results obtain. At some point however, firms willbecome indifferent between meeting and not meeting the restriction and at thispoint, a regime change occurs. Some firms meet it and some do not and thecomparative statics results are reversed. Their setting may be interpreted as asp ecific factors model and hence valid in the short or medium run when laboris mobile between sectors while other factors are not. Despite their work, ageneral understanding of such situations is still lac king and the current paperdevelops a way of looking at the effect of ROOs in a general equilibrium settingunder perfect competition.The