RULES OF ORIGIN AS A STRATEGIC POLICY TOWARDS MULTINATIONAL FIRMS. Masaru Umemoto. Working Paper Series Vol November 2001

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1 RULES OF ORIGIN AS A STRATEGIC POLICY TOARDS MULTINATIONAL FIRMS Masaru Umemoto Research Assistant Professor, ICSEAD oring Paper Series Vol. -33 November The vies expresse in this publication are those of the author(s) an o not necessarily reflect those of the Institute. No part of this boo may be use reprouce in any manner hatsoever ithout ritten permission except in the case of brief quotations emboie in articles an revies. For information, please rite to the Centre. The International Centre for the Stuy of East Asian Development, Kitayushu

2 Rules of Origin as a Strategic Policy toars Multinational Firms Masaru Umemoto Research Assistant Professor, ICSEAD Abstract This paper investigates ho rules of origin impose on a vertically integrate multinational firm s subsiiary affect output an elfare uner a Cournot competition. To types of rules are investigate: one requiring the multinational firm s subsiiary a minimum ratio of expenitures on its omestic intermeiate inputs to those on its total intermeiate inputs, an the other requiring a minimum ratio of the subsiiary s expenitures on omestic components to its total revenue. It is shon that both types of rules lea the multinational firm to shift their component factories from the source country to the host country. Hoever, they may have the opposite effects on output of the final goo. Furthermore, hen the omestic firm has higher marginal cost than the multinational firm s subsiiary, the secon type of rule of origin can increase both omestic an foreign elfare. I. Introuction In aition to etermining the nationality of proucts trae in international commerce, rules of origin are frequently use to achieve trae policy objectives. hen foreign proucers increase the maret share of omestic proucers, the omestic government may impose a rule of origin to give avantage to the omestic inigenous firms an protect omestic proucers. To illustrate the point, in 988 the French government suenly announce a rule of origin such that at least 8 percent of the total cost of Japanese automobiles built in the Unite Kingom must be of locally originate components to qualify as European cars. Thus, France counte the Japanese automobiles importe from the UK toar the three percent quota on Japanese cars. Consequently, this regulation protecte French automobile

3 proucers from the expansion of maret share by the Japanese automobile maers. This is an example of a strategic inustrial policy irecte toars multinational enterprises. e investigate ho a rule of origin affects strategic conitions for the host an source country s proucers. Davison et al. (987) stuie a uopoly situation beteen a omestic firm an a foreign firm in the final goos maret. They sho that a preferential rule of origin such as a local content requirement ith the penalty tariff reuces output of the foreign firm an increases output of the omestic firm, thereby maing the omestic firm better off. Hoever, they assume that marginal cost is fixe for both proucers an they o not consier any effects of preferential rules of origin on the eman for the intermeiate goos. In orer to consier the effects of the preferential rules of origin as a strategic policy on the eman for intermeiate goos, e employ a multistage prouction moel in hich prouction is thought of as a successive processing sequence here components are combine until a final goo is prouce. Dixit an Grossman (98) introuce this moel in a competitive environment. They shoe that a content requirement as a rule of origin expans the number of stages per unit of final output in the home country but at the same time leas to a ecline in the number of units prouce. Hollaner (987) investigate the case here a final goo supplier is a foreign monopolist. He shos that it is possible for a preferential rules of origin to increase the range of intermeiate goos as ell as the quantity of the final goo prouce in a monopoly setting. James an Umemoto () also employe an extene version of this moel to assess trae iversion effects of the North American Free Trae Agreement (NAFTA) uner a three-country setting. It explains ho rules of origin on textile an apparel inustries lea elfare to orsen an supports the results by some of the earlier theoretical literatures such as Krishna an Kruger (995) an Kruger (995, 996). e consier the multistage prouction moel in a Cournot competition environment beteen a omestic inigenous firm an a multinational firm s subsiiary. e investigate the effects of to types of rules of origin. The content requirement as rules of origin is usually specifie in value-ae terms an their requirement can tae to forms. The first requires that a certain minimum spening on omestic components must be emboie in the total cost of prouction to confer omestic origin. For example, the NAFTA for automobiles use to Mason an Turay (994) provie the etail story.

4 require that 6.5 percent of the total cost of locally manufacture cars in the North American countries (Canaa, the Unite States, an Mexico) must consist of local intermeiate parts. The secon requires that a certain minimum expeniture on omestic components must be emboie in the total revenue of the proucts in orer to be recognize as omestic proucts. For example, a minimum of 85 percent of the holesale value of omestically manufacture cars in Australia must be of omestic materials an labors. e investigate the effects of these to forms of rules of origin. The remainer of this paper is organize as follos. In the next section, e evelop a multistage prouction moel for a uopoly environment an erive the Cournot-Nash equilibrium. In the thir section, e evaluate the effects of the cost-base rule of origin on the range of prouction processes an output of the multinational firm in the host country. In the fourth section, e assess the effects of an alternative revenue-base rule of origin. elfare issues are aresse in the fifth section, an conclusions are presente in the final section.. II. The Moel e consier a to-country orl: the source country, here foreign irect investment (FDI) originates, an the host country, here FDI occurs. Each country has one omestic firm proucing a commoity using constant returns to scale technology. The source country s firm, that is, multinational firm is a monopolist in its on country but also sells goos in the host country, here it competes ith the host country s firm. e assume that each firm is vertically integrate an operates a sequence of prouction stages here components are prouce an combine until a final commoity is prouce. Each stage or component is available in both countries. In reality, omestic firms lie the U.S. automotive inustry typically use a much higher ratio of omestic to importe components than foreign assemblers in the omestic country. Therefore, e assume that each firm prouces the commoity for consumers in its on country by proucing components in its on country. Hoever, the source country s firm can shift prouction processes across Vermulst et al. (994) provies information of ho the value of labor an materials of goos is calculate in Australia. 3

5 to countries to sell the commoity in the host country. Thus, some stages of the prouction are carrie out by the multinational firm s subsiiary in the host country. Ho oes the multinational firm choose the prouction stages that are carrie out by the subsiiary in the host country rather than import the components from the source country? Let us inex each stage of prouction (or the component that is prouce at a prouction stage) by a variable belonging to a continuum,;,. The unit prouction cost at the stage (or the unit cost of component ) in the host an source countries is enote by an, respectively. e assume that the firm selects the location of epening on hich of the to locations is cheaper. Consequently, the overall unit cost is ( s, s ) min s. () For simplicity e inex the components in such a ay that is increasing an continuous so that components ith a loer are relatively more cost-efficient to prouce in the host country. Moreover, e assume that < an >, hich rules out the trivial case here one country is a cheaper location for all components. Figure shos the relative unit cost function,. Uner these assumptions there exists a, such that. The multinational firm can minimizes the unit cost of prouction by choosing the inexes such that all components ith inexes belo are prouce in the host country, hile those ith inexes above are prouce in the source country. Let s of unit costs attributable to host-country proucts an s is attributable to source-country proucts.. s be the portion s be the portion that Then the unit cost of prouction is A representative consumer in the host country has a utility function: 4

6 U u Y, () here is the quantity consume of the commoity prouce by the inigenous firm an is prouce by the multinational firm. Y is consumption of a numeraire goo that is assume to be competitively supplie. The inverse eman is given by P u. e assume that eman is linear an onar sloping, so that P u < an P u. Denote the inverse eman function as P a b (3) here a an b are positive constants. To etermine the Cournot-Nash equilibrium outputs of the firms, e assume that the multinational firm perceives each country as a separate maret in maing its quantity ecisions. That means there is no trae of the final proucts beteen the to countries. Therefore, e focus on the maret in the host country. The profits of the inigenous firm an multinational firm in the host country are respectively ( ) Π P (4) an ( ) Π P. (5) Each firm maximizes its on profit by choosing output consiering the competitor s output as given. The inigenous firm has a constant marginal cost, hich is total sum of the cost at each prouction stage in the host country. Profits are maximize hen the marginal revenue equals to the marginal cost. Therefore, the profit-maximizing conition for the inigenous firm is P P ; (6) i.e., 5

7 6 ( ) b a. (6 ) Thus, the reaction function of the inigenous firm is given by a b h. (7) The profit-maximizing conition for the multinational firm is P P ; (8) i.e., ( ) b a. (8 ) The reaction function of the foreign firm is given by ( ) a b h. The equilibrium output for each firm is foun here the to reaction functions intersect. e obtain ( ) ( ) ( ) a b a b 3, 3, (9) as the equilibrium output. The equilibrium price, hich is etermine by the inverse eman function, can be ritten as ( ) { } 3 b P. () In the next to sections, e consier the case here the omestic government imposes a rule of origin for favoring the inigenous proucer. e attempt to investigate the effects of the to types of rules of origin uner the Cournot competitive environment. III. The Cost-Base Rule of Origin

8 In this section e consier the effects of one type of rule of origin. A cost-base rule of origin requires that the value of omestic components must be greater than or equal to a given proportion of total cost for components to gain recognition as a prouct of omestic ( ) origin. The cost-base rule of origin is represente as ( ) proucer in the host country., or. e assume that it ill be a constraint only for the source country s Marginal cost The multinational firm ill etermine the level of that minimizes its prouction cost subject to the rule of origin. hen >, the require ratio of omestic components is greater than the initial fraction of the cost of prouction stages in the host country to the total unit prouction cost. Uner this situation, the rule of origin oul affect the situation of this Cournot competitive environment. In response to the rule of origin, the foreign firm ill select C C ( ) C for hich the constraint is just satisfie; i.e., C C C or. Since the multinational firm has to shift more prouction stages into the host country in orer to satisfy this conition, C >. The prouction stages (, C, hich ha been carrie out at a cost of in the source country, no tae place in the host country at a cost of >. Therefore, the C C unit cost uner the cost-base rule of origin is greater than the initial unconstraine unit cost. In orer to see the relationship beteen the rule of origin an the cutoff level tae a total erivative of the origin rule constraint: C, e C C C C C ( ) ( ). () Therefore, C C C C C ( ) >. () 7

9 This result means that more restrictive rule of origin increases the value of C an expans the prouction stages in the host country, thereby leaing to the folloing proposition. Proposition : A cost-base rule of origin promotes more foreign irect investment an expans the range of prouction processes for the multinational firm in the host country. Effects on the reaction functions an output Ho oes the cost-base rule of origin affect the output of the commoity? First, e analyze the effect on the reaction function of each firm. The rule of origin oes not affect the ecision of the inigenous firm because it is not subject to the rule. Therefore, the reaction function of the inigenous firm oes not change. Hoever, the rule of origin leas to an increase in the marginal cost of the multinational firm. The profit-maximization conition for the foreign firm is C C. Thus, the ne reaction function for foreign firm uner cost-base rule of origin is C C ( ) C b h. (3) Taing the erivative of the profit-maximization conition ith respect to the requirement ratio gives Hence, C C ( ) C C. (4) C C C C C ( )( ) C C {( ) } ( C C C C C ) P P here P a < C <, (5). 8

10 The above result says that more restrictive rule of origin reuces the output of the multinational firm for each output level of the inigenous firm. In other ors, the reaction function of the multinational firm shifts to the left. This taes place ue to the increase in the marginal cost of the multinational firm. Since only the reaction function of the multinational firm shifts inar, the ne equilibrium output of the omestic proucer increases, hile the output of the multinational ecreases (See Figure ). Ho much ill they change? Since e assume a linear eman function for the final prouct, the effect of the rule of origin on the output of the inigenous firm is etermine by taing the erivative of the reaction function of the inigenous firm ith respect to the require ratio: C C C h, (6) The total change of output can be ritten as C ( ) C C. (7) Consequently, e have the folloing result. Proposition : A cost-base rule of origin loers the output of the multinational firm in the host country, hile it increases the output of the inigenous firm. The total output prouce in the host country ecreases. IV. The Revenue-Base Rule of Origin Next, e consier the case of an alternative rule of origin. A revenue-base rule of origin requires that the cost of omestic components shoul not be less than a prescribe share of total revenue to obtain recognition as a omestic prouct. The rule of origin can be ritten as P here, is the require ratio for recognition. e can rerite the constraint as 9

11 P. (8) In ors, the unit prouction cost of the omestic components shoul not be less than a certain fraction of the price. The revenue-base rule of origin affects the behavior of the multinational firm hen > P. In orer to satisfy the rule of origin, the multinational firm has to shift some prouction processes into the host country an use more components there, thereby increasing the value of inex as in the case of the cost-base rule of origin. Hoever, uner the revenue-base rule of origin, the foreign firm can shift bac some prouction processes to the source country by increasing its output. This is because an increase in output ecreases the price of the final goo. Consequently, the reuction in the price maes the rule of origin easier to satisfy; i.e., the foreign firm can reuce the number of prouction processes in the host country. Unlie the case of the cost-base rule of origin, the inex of the prouction process epens upon the output level of the multinational firm uner the revenue-base rule of origin. Uner a certain rule of origin, e tae the total erivative from the constraint to measure the effect of a change in the output of the foreign firm on the range of the prouction stages. This P yiels <. This means that an increase in quantity maes it possible to meet the rule of origin ith feer components originating in the host country. In other ors, it is possible to meet the rule of origin ith feer high-cost components originating in the host country. Marginal cost function hen the rule of origin exists, the cost function for the multinational firm is the unit cost times the quantity prouce by the multinational firm: ( ) C. (9) Hoever, uner this case the inex epens upon the output of the multinational firm in the host country. Therefore, the marginal cost can be ritten as

12 MC ( ) ( ) P ( ) ( ) ( P ) ( ) ( P ) The marginal cost is loer than the average cost ( ) () because an increase in quantity maes it possible to meet the rule of origin ith feer high cost components in the host country. Effects on the reaction functions an output The ne reaction function is etermine from the profit-maximization conition that marginal revenue equals marginal cost: ( ) ( P ). () Then the ne reaction function is here origin. R R ( ) R b h, () R R R R R is the optimal choice of the prouction stage inex uner the revenue-base rule of No let us consier the effect of a change in the require ratio on the reaction function of the multinational firm. Taing the erivative of the revenue-base rule of origin uner the conition that the expression (8) hols equality an the profit-maximizing conition given the omestic firm s output gives P P (3)

13 an ( ) ( ) ( ) P P P (4) In orer to see the relationship beteen the change in the inex an the output level, rerite equation (3) as: P P. (3 ) Substitution of (3 ) into (4) yiels: P PP (5) Hence, ( ) PP (6) an P P, (7) here ( ) { } ( ). > P R M For value at hich the rule of origin is just bining, e have R R. Thus, equations (6) an (7) can be reritten as

14 PP > (6 ) an P >. (7 ) These results suggest that a small change in the rule of origin causes the foreign reaction curve to shift outar (See a right panel of Figure ). This shift results in an increase in output of the multinational firm an a reuction in output of the inigenous firm. A more restrictive rule of origin alays leas the multinational firm to bring more prouction stages into the host country. Hoever, e cannot etermine the sign of the change in output of the multinational firm. Since the first term of (6) is positive for > an the secon term is alays negative, there can exist a value of at hich starts eclining. Hence, e have the folloing proposition. Proposition 3: A marginally restrictive change in a revenue-base rule of origin from the level that the origin rule is just bining may inuce the multinational firm s subsiiary to increase both the range of prouction processes in the host country an the quantity of final output. V. elfare Effects e no examine the elfare effects of each type of rule of origin on the host country. The elfare of the host country is the sum of the consumer surplus an the profit of the inigenous firm. It may be ritten as G P Z Z P ( ) Π, (8) here the term in the bracet represents consumer surplus an Π enotes the profit of the inigenous proucer. 3

15 To see the effects of the rule of origin on elfare in the host country, e tae the erivative of the elfare function ith respect to the require ratio of the rule of origin, hich gives ( ) ( ) ( ) ( ) P P P G P ( ) ( ) ( ) P ( P ) ( ) Π P P (9) The first term has the same sign as, implying that consumer surplus increases hen the output of the multinational firm increases. The secon term has the opposite sign from, implying that the omestic firm s profit ecreases hen the output of the multinational firm increases. e can rerite the above equation as: ( ) P G The output level of each firm epens on the marginal cost of each firm. In the case of the cost-base rule of origin, the multinational firm s reaction curve shifts inar an its output ecreases. If omestic output is initially greater than foreign output, i.e., if the marginal cost of the inigenous firm is less than that of the multinational firm, then omestic elfare increases. By contrast, elfare ecreases in the opposite case. A marginal change in a revenue-base rule of origin from the pre-regulation state increases the output of the multinational firm s subsiiary. Thus, hen omestic output is greater than foreign output, i.e., if the marginal cost of the inigenous firm is less than that of the multinational firm, omestic elfare ecreases. Similarly, elfare increases in the opposite case. Hence, e have the folloing result. 4

16 Proposition 4: hen the marginal cost of the inigenous firm is less than that of the multinational firm, the cost-base rule of origin increases the host country s elfare, hereas the marginally restrictive change in a revenue-base rule of origin from the level that the origin rule is just bining ecreases its elfare. hen the marginal cost of the inigenous firm is greater than that of the multinational firm, the cost-base rule of origin reuces elfare an the revenue-base rule of origin raises its elfare. elfare of the source country Next, e analyze the effects of the host country s rule of origin on the source country s elfare. This epens on the profit of the subsiiary in the host country because the rule of origin oes not irectly affect the maret in the source country. The effect of the rule of origin on the profit of the multinational firm s subsiiary is Π P P ( ) ( ). (3) Uner the cost-base rule of origin, the coefficient of the first term is positive from the profit-maximization conition for the multinational firm: Since the sign of ( ) > P P ( ) P P. (3) is negative, the first term becomes negative. The secon term is ( ) ( ) ( )( ) ( ) must reuce the elfare of the source country. >. Therefore, the cost-base rule of origin Similarly, uner the marginal change in a revenue-base rule of origin from the pre-regulation state, the coefficient of the first term is also positive from the profit-maximization conition. Since the sign of ( ) The secon term is zero because ( ) is positive, the first term is positive.. Hence, the marginal change 5

17 in a revenue-base rule of origin from the pre-regulation state increases the profit of the multinational firm an foreign elfare. Hoever, a rule of origin may not assure an increase in foreign elfare hen it is too restrictive. As e loo over the results of the effects of rules of origin on each country s elfare, e note the folloing proposition. Proposition 5: hen the inigenous firm has higher marginal costs than the multinational firm, the marginally restrictive change in a revenue-base rule of origin from the level that the origin rule is just bining increases both countries elfare, hereas the cost-base rule of origin ecreases their elfare. VI. Conclusion e have investigate the impact of to types of rules of origin on elfare an output in a uopoly moel. A cost-base rule of origin raises the output of the inigenous firm hile it reuces the output of the multinational firm s subsiiary in the host country. This result follos from the fact that the rule of origin increases the marginal cost of prouction for the multinational firm. Consequently, total output available for sale in the host country eclines. The marginally restrictive change in a revenue-base rule of origin from the level that the origin rule is just bining, hoever, leas to quite ifferent results. In particular, this policy inuces the multinational firm to increase the range of processing stages in the host country an the quantity of final output. This is because an increase in output maes it possible to meet the rule of origin ith a loer share of high-cost components originating in the host country. Hence, the revenue-base rule of origin loers the output share of the inigenous firm. Uner the assumption of a linear eman function, e can see clear-cut elfare effects of the to types of rules of origin. The cost-base rule of origin leas to a reuction in the host country s elfare an an increase in the inigenous firm s profit. In contrast, the revenue-base rule of origin leas to an increase in the host country s elfare an a ecrease in the inigenous firm s profit. The cost-base rule of origin reuces the source country s 6

18 elfare, hereas the revenue-base rule of origin raises it. Consequently, the marginal change in the revenue-base rule of origin from the pre-regulation state can increase both countries elfare. Hoever, the inigenous firm profit ecreases. hat are the policy implications of this paper s finings? As a type of strategic policy to protect the inigenous firm, the cost-base rule of origin is superior to the revenue-base one espite the revenue-base rule of origin may increase both countries elfare. From a strategic inustrial policy perspective, it is not critical that the former raises the inigenous firm s profit hile the latter reuces its profit. Thus, if the purpose of imposing a rule of origin is to protect the inigenous firm, it is more liely that the host-country government ill aopt the cost-base rule of origin although it might reuce both countries elfare. An extension of this research is to consier the effect of rules of origin in the event that an inigenous firm an a foreign subsiiary compete in the price of the final output, i.e., a Bertran competition. A cost-base rule of origin raises the marginal cost of the foreign firm, an it ill have the same effects as in the Cournot competition moel. Hoever, the revenue-base rule of origin may give the foreign competitor an incentive to increase prouction an reuce the final output price in fulfilling the requirement of this type of rule of origin. 7

19 References Davison, Carl, Steven Matusz, an Morechai Kreinin (985). Analysis of Performance Stanars for Direct Foreign Investments, Canaian Journal of Economics, 8: Dixit, Avinash an Gene M. Grossman (98). Trae an Protection ith Multistage Prouction, Revie of Economic Stuies, 49: Hollaner, Abraham (987). Content Protection an Transnational Monopoly, Journal of International Economics, 3: James, illiam E. an Masaru Umemoto (). NAFTA Trae ith East Asia: Rules of Origin an Maret Access in Textiles, Apparel, Footear an Electrical Machinery, ASEAN Economic Bulletin, 7: Krishna, Kala an Anne Krueger (995). Implementing Free Trae Areas: Rules of Origin an Hien Protection, in Dearorff, Levinsohn, an Stern (es.), Ne Directions in Trae Theory. Ann Arbor: University of Michigan Press. Kruger, Anne O. (995). Free Trae Agreements versus Customs Unions. NBER oring Paper no Kruger, Anne O. (996). Rules of Origin as Protectionist Devices, in Melvin, Moore, an Riezman (es.), International Trae Theory: Essays in Honour of John Chipman. Lonon: Routlege. Mason, Davi an Abul Turay (994). Japan, NAFTA an Europe. Ne Yor: St. Martin s Press. Vermulst, Ein, Paul aer, an Jacques Bourgeois (es.) (994). Rules of Origin in International Trae: A Comparative Stuy. Ann Arbor: University of Michigan Press. 8

20 Figure Relative Unit Cost Function

21 h C h h h R C h R h R Effects of Cost Base Rule of Origin Effects of Marginally Effective Revenue Base Rule of Origin Figure The Effects of Rules of Origin on Reaction Functions