Rules of origin and technology spillovers from foreign direct investment under international duopoly

•We analyze the optimal choice of rules of origin (ROO) in FTA.•A simple three-country model of international duopoly is employed.•Firms from outside the FTA must undertake FDI to comply with the ROO.•FDI causes technology spillovers, depending on the stringency of ROO.•We predict the level of ROO is positively correlated with the average MFN tariffs.

Using a simple three-country model of international duopoly, this study analyzes the optimal choice of rules of origin (ROO) in a free trade area/agreement (FTA) when firms from outside the FTA must undertake foreign direct investment (FDI) in FTA countries and conduct part of their production process within the FTA to comply with the ROO. FDI causes spillovers of the superior production technology from a non-FTA firm to its competitor within the FTA, depending on how much of the production process is shifted to the FTA area. In this situation, this study predicts that as the degree of multilateral trade liberalization before formation of the FTA is higher, the optimal ROO tends to be less stringent.