Multinational Firm's Production Decisions under Overlapping Free Trade Agreements: Rule of Origin Requirements and Environmental Regulation

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.