Economic Theory and the Interpretation of GATT/WTO

1. Economic Theory and the Interpretation of GATT/WTO Kyle Bagwell and Robert Staiger Presented by Bonnie Palifka

2. Economic Model • Two countries • Trade in two goods, x and y • Normal goods • Perfect competition • Increasing opportunity costs

3. Economic Model x natural import good of the home country y natural import good of the foreign country p = px/py relative price facing home consumers and producers p* = p*x/p*y relative price facing foreign consumers and producers

4. Economic model t home ad valorem tax t* foreign ad valorem tax  = (1+t) [> 1 if import tax, < 1 if import subsidy] * = (1+t*) pw = p*x/p*y foreign terms of trade 1/ pw home terms of trade p = pw p* = pw/*

5. Production possibilities frontier y slope = px/py y0 x x0

6. Equilibrium tariffs world price production consumption import export tariff revenue local prices

7. Figure 1 pw(C)  pw(A) p(C) C p(A) ’ D B p(C) A pw(C)  p(A) pw(A) *

8. Game Theory • Each country sets its tariff given the other country’s tariff level. • The resulting Nash equilibrium is inefficient. • Only a trade agreement can establish a more efficient equilibrium.

9. Prisoner’s dilemma • two thieves captured • each questioned separately • confess or deny

10. Prisoners’ dilemma Burt deny confess Ernie confess deny confess deny 1 year 5 years 5 years 1 year 3 years 3 years 2 years 2 years

11. Prisoners’ dilemma

12. Trade dilemma Brazil open tariffs Mexico tariffs open tariffs open $6 $1 $1 $6 $3 $3 $5 $5

13. Trade dilemma

14. Role of GATT/WTO • GATT 1947 • WTO 1994 • WTO includes a dispute settlement system • Trade agreements can help move from the Nash equilibrium to the better equilibrium. • This result requires “repeated games”. • reciprocity (constant trade volumes and terms of trade)

15. Trade dilemma

16. Bibliography • Bagwell, Kyle and Robert W. Staiger. 2002. “Economic Theory and the Interpretation of GATT/WTO,” American Economist 46,2: 3-19.