The Economics of GATT/ WTO

1. The Economics of GATT/ WTO

2. The GATT / WTO • The membership has grown from 23 countries at the creation to around 150 countries. • The tariffs of industrial goods fall from over 40% to below 4%.

3. The objectives • Trade liberalization is not the explicit objective of the GATT/WTO. GATT was created to assure that trade should be conducted in the way that raise standards of living, ensuring full employment, and a large growth of volume of real income and developing the full use of the resources of the world.

4. The objectives • The WTO adds up the objective to promote sustainable development and the environment issues, so as extend the scope to trade in both goods and services. • The GATT/WTO rules provide a legal framework for incorporating the result of negotiations. The central frameworks are reciprocity and non-discrimination (MFN).

5. The objectives • In summary, the GATT/WTO objectives are to be served by securing non-discriminatory and substantially freerer trade on a reciprocal basis.

6. How do economists think about this? • Paul Krugman has the idea called “GATT-think”. GATT creates a simple set of principles that is entirely consistent, explains most of what goes on in negotiations, but makes no sense in terms of economics.

7. GATT-Think • There are three simple rules about the objectives of negotiating countries: 1) Exports are good 2) Imports are bad 3) Other things equal, an equal increase in imports and exports is good. • GATT-think is enlightened mercantilism.

8. Two problems that the GATT has to solve • Terms of trade externality

9. Renegotiation in Trade Agreements: The Case of Private Political Shocks

10. Research Question • Does the renegotiation process lead to an efficient trade agreement? (when private political shocks occur in one country.)

11. Article XXVIII, The modification of Schedules • Allows WTO members to modify or deviate from the tariff agreement previously negotiated. • Limits the retaliatory withdrawal of concessions to satisfy the principle of reciprocity. • Under principle of reciprocity, a change in tariffs must bring about equal changes in trade volume in each country. • If the renegotiation is unsuccessful, a member proposing renegotiation is free to withdraw or modify the tariff agreement but members involved are allowed to withdraw tariff agreements which bring about equal changes in trade volume.

12. The basic model • Two countries (Home and Foreign), three goods (numeraire, and • Two countries are ex-ante symmetric • Quasi-linear utility function • The linear demand function: • Home is the net importer of good , Foreign is the net importer of good . • Home variables denotes with no *. Foreign variables denote with an *.

13. The basic model • One instrument case • The government welfare function Baldwin (1987) Suppose that , before the presence of political shocks,

14. The basic model • The best-response tariffs( , ) such that: and • Suppose that the trade agreement brings about the politically optimal tariffs, . (the tariffs that governments choose when they do not take term-of-trade effect into account.)

15. Reciprocity • A balance of concessions or mutual changes in tariff policy that bring about equal changes in trade volume of each country. • Formally, suppose that ( , ) is the new tariff proposal, reciprocity restriction implies that: • Since The reciprocity restriction implies that =

16. The structure of the renegotiation game • The renegotiation game can be formally defined as follows: Stage 0: Home decides: - does not use Article XXVIII  Commit to free trade (previous) agreement  Trigger trade wars - use Article XXVIII  Go to Stage 1 Stage 1: Home offers modified tariffs. Principle of reciprocity is required so that .

17. The structure of the renegotiation game Stage 2: Foreign updates its prior belief and chooses whether to: - accept  the game ends. - reject  go to Stage 3. Stage 3: Home and Foreign simultaneously choose: - commit to the free trade agreement - trigger trade wars.

18. The tariff renegotiation game (complete information) • Suppose that there is an unanticipated change in . It can either change to (low type) or (high type). • Solve the game using backward induction. • The game in the last stage is the repeated prisoner-dilemma game. Cooperative Best-Response Cooperative Best-Response

19. The tariff renegotiation game (complete information) • Assumption 1: The low type commits to the free trade agreement if the discount rate is sufficiently high; however, the high type always triggers trade wars. • Assumption 2: the discount rate is sufficiently high.

20. The tariff renegotiation game (complete information) • Define be the tariff that maximize Home’s welfare function under the reciprocity restriction.

21. The tariff renegotiation game (complete information) Proposition 3: The outcome of the tariff renegotiation game in a complete information environment is that: i) The low type never uses Article XXVIII. It continues to commit the previous agreement. ii) If is low enough , the high type offers and Foreign accepts. iii) Otherwise, the high type does not use Article XXVIII and triggers trade wars.

22. The tariff renegotiation game (complete information) Proposition 4: The efficiency of the tariff renegotiation game (complete information) i) The tariff outcome from the renegotiation game is not politically optimal ii) The tariff outcome is pareto-efficient constrained with the reciprocity condition.

23. Complete information – two instruments • Consider when governments can set both import tariffs and export subsidies. Proposition 6: The tariff outcome when there are two instruments i) Home always offers efficient tariff agreements regardless of its type. ii) If Home is of low type, Foreign gains welfare equal to the welfare from the reciprocal free trade. If Home is of high type, Foreign gains welfare equal to the welfare from the Nash tariff policy.

24. The tariff renegotiation game (Home possesses private information) • = with probability and = with probability , where . Foreign does not know the new value of . • Solving the game by backward induction.

25. The tariff renegotiation game (Home possesses private information) Proposition 7:Recall that is the tariff that maximizes Home’s welfare under the reciprocity restriction; the perfect Bayesian equilibrium of the tariff renegotiation game is that will always be rejected by Foreign. Therefore, i) If is high enough , both types use Article XXVIII and offer . Foreign accepts.

26. The tariff renegotiation game (Home possesses private information) Proposition 7 (continue): ii) If is not high and Home is impatient, both types do not use Article XXVIII. The low type continues to commit previous agreement. The high type immediately defects and plays the best-response tariff which triggers trade wars from next period on. iii) If is not high but Home is patient enough, the low type does not use Article XXVIII and continues to commit previous agreement. The high type uses Article XXVIII and offers .

27. The tariff renegotiation game (Home possesses private information) Proposition 6: The efficiency of renegotiation game i) The tariff outcome from the renegotiation game is neither politically optimal . ii) The tariff outcome from the renegotiation game is not pareto-efficient.

28. The tariff renegotiation game (Home possesses private information) • Suppose that there are two policy instruments (tariffs and export subsidies) Proposition 9: The outcome of the renegotiation game when there are two instruments i) The high type always offers the efficient tariff proposal that binds Foreign’s participation constraint. ii) If is low enough, the low type offers the efficient tariff proposal that has Foreign’s welfare equal to a reciprocal free trade agreement. Otherwise, the low type pretends to be the high type and offer the same tariff agreement as the high type.

29. The tariff renegotiation game (International Transfers) • International transfers are allowed • Suppose that the tariff proposal from type i is ( = if reciprocity restriction is required), then the international transfer is given by: • Home’s maximization problem becomes:

30. The tariff renegotiation game (International Transfers) Proposition 7: The tariff outcome from renegotiation when international transfers are allowed is that: i) Without the reciprocity restriction, the tariff outcome is the politically optimal tariff. ii) With the reciprocity restriction, the tariff outcome maximizes the joint welfare function constrained with = .

31. The tariff renegotiation game(Foreign possesses private information) • There are political shocks on the industry in both countries. • = , publicly known. • = with probability and = with probability 1- , privately known. • Assume that

32. The tariff renegotiation game(Foreign possesses private information) The renegotiation game can be formally defined as follows: Stage 0: Home decides whether to use article XXVIII or not. Stage 1: Home offers the menu of proposed tariffs, the Foreign tariff comes from one that satisfies the principal of reciprocity mentioned in the last section, i.e., = . Stage 2: Foreign announces its type. Stage 3: Foreign chooses whether to accept or reject the tariff proposal that Home has offered. Stage 4: If Foreign chooses to reject in the third stage, Home and Foreign choose to commit to the previous agreement or to play their best-response tariffs.

33. The tariff renegotiation game(Foreign possesses private information) Proposition 8 : The following strategies construct a perfect Bayesian equilibrium. i) If both types accept , Home offers the menu ( , ). Foreign accepts. ii) If only the low type accepts , Home offers the menu ( , ). The low type accepts and the high type rejects. In the last stage, both countries trigger trade wars iii) If both type reject , Home does not use Article XXVIII but triggers trade war immediately.

34. Conclusion • With the presence of private information, the renegotiation process according to Article XXVIII cannot yield politically optimal or pareto-efficient tariffs. • If Home has private information, tariff renegotiations according to Article XXVIII are always successful. • If Foreign has private information, there might be unsuccessful tariff renegotiations. • If international transfers are allowed, the efficient tariffs constrained with the reciprocal condition are yielded from the renegotiation game. Furthermore, if the reciprocity restriction is relaxed, the renegotiation game brings about the politically optimal tariffs.

35. Do Developing Countries Benefit from GSP?

36. Research Question • Does GSP promote the welfare of developing countries.

37. The basic model: Three countries • Three countries (1,2,3) and two taxed goods (x,y). • Quasi-linear utility function • Linear demand function : D(P)= a-P • Endowment : • Country 1 : • Country 2: • Country 3: With and

38. 1 y x x y 2 3 Trade pattern

39. The basic model: Three countries • Welfare function

40. The basic model: n+2 countries • Suppose now that Country 1 and Country 2 are big countries. However, Country 3 is now partitioned into n identical countries, indexed by , where n is very large. • Country 3’s total endowment is divided equally among n small countries, • and the linear demand function for country j is given by

41. The basic model: n+2 countries • Nash Equilibrium • Efficient tariffs

42. The tariff bargaining game • We consider: • Sequential bargaining with MFN • Sequential bargaining with GSP • International transfers among countries are allowed

43. Sequential bargaining with MFN • Stage 1: Country 1 offers tariff and transfers . Country 2 either accepts or rejects. • Stage 2: If Country 2 accepts, Country 1 offers tariff and transfers , which each small country, Country 3,…,n+2, accept or reject. If Country 2 rejects, Country 1 offers and transfer which each small country, Country 3,…,n+2, accepts or rejects. If small countries rejects, it plays the best-response tariffs while Country 1 and 2 commit the agreement in the first stage, .

44. Sequential bargaining with MFN • The subgame perfect equilibrium of the sequential bargaining game with MFN is that both Country 2 and small countries accept Country 1’s offers. • If political pressure is high enough, . Small countries attain the welfare equal to the threat point of . • If political pressure is not too high, . Small countries attain the welfare equal to the threat point of .

45. Sequential bargaining with MFN • When political pressure is low, the bargaining game displays both backward stealing and forward manipulation according to Bagwell and Staiger (2004) • When political pressure is high enough, the bargaining game displays only backward stealing according to Bagwell and Staiger (2004)

46. Sequential bargaining with GSP • Stage 1: Country 1 offers tariff and transfers . Country 2 either accepts or rejects. • Stage 2: Country 1 offers the GSP proposal . Small countries accept or reject.

47. Sequential bargaining with GSP • The subgame perfect equilibrium of the sequential bargaining game with GSP is that both Country 2 and small countries accept Country 1’s offers. • Small countries attain the welfare equal to their threat point of .

48. Welfare Comparison • If political pressure is low, small countries attain higher welfare from sequential bargaining with GSP. • If political pressure is high enough, small countries are indifferent between sequential bargaining with MFN and sequential bargaining with GSP. Proposition 3: The GSP program eliminates forward manipulation from sequential bargaining.

49. Conclusion • When small countries have low political pressure, they are better off from the GSP program. Otherwise, small countries are indifferent between the two bargaining methods. • The benefit of the GSP program comes from the fact that it eliminates forward manipulation that small countries encounter in the second stage of sequential bargaining with MFN.

50. Which bargaining method gives the greatest benefit to developing countries