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

Sung Lee, Kun Park, Yong Seo
2016 Sustainability  
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
more » ... 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. Sustainability 2017, 9, 42 2 of 16 Trades between two countries under different levels of environmental regulations, however, require additional efforts to abide by reciprocal compliance to the rule of counterparts. As a consequence, it is observed that (a) firms in low-regulating countries try to meet international regimes or rules of high-regulating countries; or (b) firms in high-regulating countries maintain higher competitiveness in markets. Since environmental regulations are major concerns of ROOs, a sustainable management of international trades considering environmental and economic dimensions is required [5] . The level of ROO restriction plays a significant role in an FTA [1,6], especially on making production decisions when a firm is entering a member country's market. Usually, meeting ROO requirements under an FTA usually incurs additional costs and efforts for a firm. For example, ROO requirements call for documentation to ensure the origins of all intermediate products satisfy the ROO conditions [2] . Estevadeordal et al. [7] pointed out that the administrative and production costs associated with meeting these requirements can be considerable, hence, the average ROO compliance cost exceeds the average tariff cost in the case of NAFTA [8] . Furthermore, meeting the ROO requirements can also be costly since it may be involved with an adjustment of a firm's production processes or facilities. The above stream is in line with non-tariff barriers to trade (NTBs, or called non-tariff measures (NTMs)) in the literature, which are trade barriers that restrict trading through quasi-regulatory measures and have appeared frequently with the technical barrier, standards [9,10]. Presently, many countries belong to different overlapping FTAs simultaneously. For example, in the Americas, each country belongs to an average of four different FTAs [11] . Firms that are involved in multiple FTAs face the complicated ROO requirements and cumbersome procedures in complying with the requirements. The additional costs associated with these activities related to complying with ROO may discourage the firms from utilizing the FTA, resulting in paying the traditional tariffs instead. Many papers in the literature, such as [12] , have studied this protective nature of ROO. Kim et al. [13] also illustrated that the effort to comply with the required ROO level incurs additional compliance costs. Consider a firm that currently exports to one country under an FTA by complying with the required ROO. When this firm considers exporting to a new country under a different FTA, regardless of whether the new ROO is stricter than the existing ROO or not, changing the production process to satisfy the ROO level can be costly to the firm. 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. Such unintended outcomes in the presence of overlapping FTAs have been widely observed in practice. The Economist [14] indicates that: "Bilateral deals come laden with complicated rules about where products originate-rules which impose substantial costs of labelling and certification on firms. The more overlapping deals there are, the more complex the rules are and the higher the costs are. Those who follow Asia's FTA mania refer to this as the 'noodle bowl'. No wonder few firms actually want to use FTAs. An ADB survey of exporters in Japan, South Korea, Singapore and Thailand in 2007-2008 found that only 22% took advantage of them". In the literature, this downside effect of overlapping FTAs is called the Spaghetti Bowl Effect [15] [16] [17] [18] [19] [20] . Such an effect is also empirically supported by related literature, such as [21, 22] . Bhagwati [17] drew an analogy between numerous trading relationship involving criss-crossing FTAs and tariff rates affected by multiple sources of origin and strands of spaghetti tangled in a bowl (see Figure 1 ) [23, 24] . As is mentioned before, the Spaghetti Bowl Effect reduces the applicability of FTAs and increases the costs of participating firms, calling for due attention from both the academic and the practical sides.
doi:10.3390/su9010042 fatcat:x47tvhc3wrbxjc2avqzkh326wa