Trade in Intermediate Inputs, Customs Unions, and Global Free Trade

Abstract

In a three‐country customs union (CU) formation game, I introduce international trade in intermediate inputs and rules of origin (RoO) restrictions. In the case of symmetric countries, I show that as countries become more involved in global supply chains, global free trade is less likely to be a stable equilibrium outcome. RoO can help solve this problem. In the case of asymmetry, depending on the degree of the globalization, free riding (for high degree) or exclusion motive (for low degree) prevents global free trade. Correspondingly, I show that RoO can have helpful or detrimental effects on attaining global free trade.