Background on WTO and other international agreements

1. Background on WTO and other international agreements November 1, 2007

2. Where we are going (in this set of lectures)? • Provide a brief history of international institutions for environmental management • Summarize principles on which they are based. • Then summarize functions, structure, goals and provisions of the World Trade Organization (WTO) • Explain WTO preference for tariffs rather than non-tariff barriers.

3. Brief history of international governmental environmental activity • Stockholm Conference: 1972 UN Conference on Human Environment -- one of early global environmental meetings. • Established UN Environmental Program (UNEP) • UNEP launched several International Environmental Agreements (IEAs) and has administrative responsibility for 7 of them.

4. Bruntland Report • 1985 UN established World Commission on Environment and Development. • Issued report “Our Common Future” (Bruntland Report) in 1987. • Emphasized importance of sustainable development: “meet the needs of the present without compromising the ability of future generations to meet their own needs”. • Basis for 1992 Rio UN Conference on Environment and Development.

5. Principles of Environmental Agreements • Prevention cheaper than remediation. • Precautionary Principle: lack of conclusive scientific evidence does not justify inaction. • Subsidiarity: action should be taken at “most local” level practical (local solutions for local problems). • Common but differentiated responsibilities: burdens should be different for the rich and the poor.

6. IEA Principles, continued • Openness and transparency. • Polluter pays principle (PPP). A specific assignment of property rights. Show that in a closed economy, it makes no difference whether production or consumption is taxed. (See online lecture notes “incidence of a tax). Many examples where polluters are subsidized to prevent pollution (Recent EC ag policy), contrary to PPP. The Coase Theorem shows that in some circumstances the outcome (amount of pollution) does not depend on assignment of property rights; see online lecture notes on Coase Theorem. (Mention controversy over doctrine of “regulatory takings” – a topic later this semester.)

7. Tools for achieving environmental goals • Standards on state of environment (e.g., concentrations of pollutants in air, water) • Emissions standards (Important difference between stocks and flows.) • Product standards (e.g. no lead in paint) • Markets for permits. • Taxes (remember that in some cases these “equivalent” to cap-and-trade).

8. “Trade sensitive” tools to achieve environmental goals • Standards on Process and production methods (PPMs) regulate the manner in which products are made (e.g. require use of recycled inputs) in order to regulate environmental impact. The CA bill to prohibit import of electricity produced using carbon-intensive methods is a PPM standard. • Performance standards require certain actions, such as environmental impact assessment or labor standards.

9. Dispute settlement and enforcement in IEAs • Rely primarily on consensus. • Some IEAs, such as Montreal Protocol (goal to reduce ozone-destroying substances) use limited trade restrictions against offending nation, but even this agreement relies more on carrot than stick. A major limitation Kyoto is its lack of enforcement mechanism. • Contrast to dispute settlement in WTO – the next topic. • Failure to abide by trade agreement causes direct harm to other nations. Failure to abide by IEA harms the environment, thereby only indirectly harming other nations. This difference makes enforcement somewhat easier with trade agreement compared to IEAs.

10. Description of WTO • Review history of formation (IT0—GATT—WTO after Uruguay Round) • Functions • Structure • Goals • Specific provisions Countries want to join WTO, rather than being pressured to join. China’s campaign to overcome U.S. opposition to their membership. Russia wants WTO membership. (EC dropped opposition after Russia joins Kyoto.)

11. Functions of WTO • Oversee and implement WTO agreements • Provide a mechanism to resolve trade disputes • Provide a forum for negotiations on continued trade liberalization.

12. Structure of WTO • Ministerial Conference: governing body consisting of members’ trade ministers, meets every two years (e.g. Seattle) • General Council: ambassador-level representatives make day-to-day decisions. • Trade Policy Review Body: reviews members’ implementation of WTO obligations

13. WTO Structure continued • Councils of Trade in Goods and Services oversee details of specific agreements, e.g. for ag and textiles. • Council for the Agreement on Trade-Related Aspects of Intellectual Property Rights. • Committee on Trade and Environment discusses relationship between trade rules and environment. Not a rule-maker.

14. Dispute Settlement • Dispute Settlement Body: composed of all members. 3-member Settlement Panels selected for individual disputes. • Ruling of Panel “must” be adopted. (Contrast to GATT dispute settlement.) • Country can appeal Panel decision to 3 randomly selected members of permanent Appellate Body (AB) on basis of point of law. AB decision can only be reversed by consensus of Dispute Settlement Body.

15. Dispute Settlement, continued • If country fails to implement a Panel decision, parties negotiate on compensation. • If negotiations fail, prevailing party obtains permission from DSB to retaliate by using trade sanctions (withdrawing “concessions”). Example: US won the Beef-hormone case, EU did not implement panel ruling, US imposes sanctions. • Countries cannot be forced to change laws. Losing parties have option to accept sanctions rather than changing laws (e.g. EC beef hormones).

16. Goals of WTO • Raise living standards, expand production of goods and services. • Preamble of Marrackech Agreement, which established WTO states that a goal is “…the optimal use of the world’s resources in accordance with the objective of sustainable development”. • This language is important to legal interpretation of WTO rules; it was invoked by 1998 Appellate Body ruling in Shrimp-Turtle.

17. WTO Goals, continued • Although Preamble recognizes principle of sustainable development, this is not a “core principle”. • Contrast to GATT preamble, which states objective is “a large and steadily growing volume of real income and effective demand [i.e. consumption], developing the full use of resources and expanding the production and exchange of goods.“ • The comparison illustrates increased sensitivity to environmental goals.

18. Core Principle: Non-discrimination • Article I Most Favored Nation (MFN): a concession made to any WTO member must be made to all members. (Exceptions: regional trade agreements; developed countries can impose preferential (i.e. lower) tariffs on developing countries exports, without offering the same tariff all countries). • Article III: Principle of national treatment (NT). Imported products should receive treatment that is "no less favorable" than the treatment given to "like domestic products“.

19. What are “like products”? • Are vodka and gin "like products"? Similar issue arises in anti-trust litigation. Dominant test to determine whether two goods are "like products" is to ask whether they compete against each other in market as substitutes. • Does a difference in Production and Processing Methods (PPM) imply that products are different? Are integrated circuit boards produced using a clean technology and ones produced using an ozone-depleting product “like products”? (Like products must be treated in the same way -- regardless of whether both are imported or whether one is imported and the other produced domestically.) • GATT tuna-dolphin tribunal objected to use of PPM as basis for trade restrictions. • Shrimp-turtle ruling allowed PPM as a basis for trade restrictions. • Government regulations that involve “life-cycle analysis” might contravene WTO rules.

20. Basis for environmental challenge to free trade under WTO • Article XX: (Chapeau) Provided that a national law does not constitute an "arbitrary or unjustifiable discrimination between countries.... or a disguised protection on international trade" laws are permitted that are: (several specific conditions, including) b) necessary to protect human, plant or animal life or health g) relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production and consumption.

21. Applying Article XX • To use Article XX to justify an environmental exception, need show that either b or g applies ("provisional justification", and then to show that it does not contravene the chapeau ("final justification"). • Both conditions (the specific and the general) are necessary , so either test could be applied first. The order that is actually used probably makes sense: it might be easier to determine whether the specific condition holds -- it is less of a judgment call, compared to determining whether the condition in the chapeau holds.

22. Paragraph b • Measure must be necessary to protect own environment; must show trade-impacting measure is necessary, and that this is the least trade-impacting measure. • Limitations intended to reduce trade impact of environmental provisions, and prevent disguised protectionism. Early interpretations excluded laws that protect the environment outside of the enacting country's borders. • The 1998 Shrimp-Turtle Appellate ruling required only that there by a “sufficient nexus” between the law and the environment of the enacting state. The definition of “sufficient nexus” is unclear, but it might include transboundary impacts and impacts on endangered or migratory species.

23. Paragraph g • Requires that the law relates to conservation of exhaustible resource. Shrimp-turtle case broadened this definition to include both renewable and nonrenewable resources, and living and non-living resources. • The primary objective of the law must be conservation, and there must be a close relation between means and ends.

24. Policies must not be arbitrary • A State (i.e. a country) can't require another State to adopt a specific environmental technology or measure. Must take into account differences prevailing in different countries. • In order to protect lobsters the US prohibited the sale of ‘immature’ lobsters, those under a certain size. Lobsters from colder climates become mature at a smaller size. Exclusion based on size, even though it is intended to protect lobsters, does not take into account conditions prevailing in different countries. • As a practical matter, it would be difficult to tell the “nationality” of a lobster, but easy to tell size.

25. Prohibition of quotas • Article XI: Prohibits use of quotas, import and export licenses • Exception is for ag; goal to reduce use of ag quotas. (GATT included ag exception, introduced at insistence of U.S. in the 1960s.) Textiles and Multi-Fiber Agreement, “ended” in 1/2006. • Prohibition against quotas might conflict with Basel Convention or CITES, but to date no such conflict has occurred.

26. Tariffs VS Non-Tariff Barriers (NTBs) • Long history of GATT/WTO opposition to NTBs • NTBs are less transparent and it is more difficult to negotiate reductions, relative to tariffs. • They offer more scope for corruption. • They may or may not be “less efficient” than tariffs, depending on reason for restriction. (We discussed “taxes versus quotas” comparison for environmental regulation. A similar comparison can be made for “tariffs versus quotas” in trade.) • Uruguay Round attempted to “tarrify” NTBs. Countries “cheated” by setting tariffs above the quota-equivalent level, in order to obtain a favorable basis for negotiation on tariff reductions. (This was called putting “water in the tariffs.)

27. Agreement on Technical Barriers to Trade (TBT) • TBTs include government-imposed standards on products, such as energy efficiency, or environmental, health or labor standards that a product must meet during its lifecycle (e.g. the requirement that forest products come from sustainably managed forests.) • The Agreement on TBT lays out conditions for use of TBT. There must be notification and transparency, and non-discrimination (national treatment). The Agreement encourages the use of international standards but allows a country to deviate from these when the international standard would be inappropriate (e.g. because of climatic conditions). • The objective of this Agreement is to reduce non-tariff barriers.

28. The Agreement on Sanitary and Phytosanitary Standards (SPS) • Deals with standards that are necessary to protect humans, plants and animals from hazards associated with the movement of plants, animals and foodstuffs. • Rules must be transparent, use international standards where appropriate. Allows the use of temporary measures when current science is insufficient for the adoption of permanent measures (a rare example of the "precautionary principle“ in the treaty).

29. SPS continued • All the SPS disputes to date have turned on whether the challenged measure is based on sufficient scientific evidence. The evidence requires a risk assessment. • In 1998 the WTO decided that the scientific evidence did not justify Japan's quarantine of agricultural products. • In 1998 an Appellate body ruled against the EC ban of hormone-fed beef. The hormone dispute is interesting because the EU legislation was (arguably) driven by consumer rather than producer pressure.

30. Importance of transparency and due process • WTO seeks to prevent governments from undermining agreements to liberalize trade, without preventing governments from legitimate exercise of “police powers” (defined as the right to regulate to maintain public health and safety of their population and domestic environment). • The use of transparent processes and international standards provides a means of maintaining trade agreements without infringing on a country’s “police powers”

31. Do governments need a “commitment device” against domestic consumers? • By tying its own hands (via WTO membership), a government is less susceptible to political pressure to provide protection for domestic industries. This commitment to free trade (arguably) increases domestic welfare. • If the protection is demanded by consumers, it is not clear that a decrease in protection increases welfare. Consumers might object to imports for the "wrong reason" but why give the WTO the right to make this kind of judgment?

32. WT0 goal: transparency of trade restrictions • WTO allows “bound” (i.e., capped) tariffs, but tries to prevent use of non-tariff barriers (NTBs). • For example, the Uruguay Round Agreement on Agriculture sought to replace import quotas by tariffs, and these tariffs were supposed to be reduced over time. • Simplest (and probably most important) explanation for this preference is that tariffs are more transparent and easier to negotiate, compared to NTBs.

33. Theoretical explanation for WTO “preference” for tariffs over NTBs • Ederington provides a game theoretic explanation for this preference. • This material illustrates how economists “formalize” a question. Here the question is “Why is the WTO so hostile to NTBs? If the WTO can manage negotiations over trade barriers, why not include NTBs in the allowed policy mix, rather than trying to eliminate them?” • The material is also interesting because it illustrates the use of game theory in economics.

34. A sketch of the model • In this model, countries play a “noncooperative game”. The fact that they value future welfare leads to an outcome that “resembles” limited cooperation. Their sovereignty makes them unable to make credible commitments, which would be necessary for genuine cooperation. • In this model, countries have a (rational, self-interested) reason for using trade restrictions. Those trade restrictions harm their trading partners, and lower aggregate welfare. The goal is to reduce trade restrictions.

35. What constitutes a “rational” reason for a trade restriction? • Earlier in the course I explained that a trade restriction sometimes benefits domestic producers, but lowers aggregate domestic welfare. (See notes second week of class.) In this circumstance, the trade restriction is not “rational”. That explanation assumed that the country in question is “small”, i.e. it cannot influence world prices. • If a country is “large”, a tariff can increase its welfare by improving its terms of trade (i.e. decreasing the price of its imports). • When a large country imposes a tariff, the reduction in its demand for imports leads to a fall in the price of imports, benefiting that country (in much the same way that a monopsonist restricts its own demand in order to lower the price it must pay.

36. Explanation of the three graphs • Graph 1 shows construction of “import demand curve” using domestic supply and demand curves. This graph also shows that we can measure the gains from trade using the “surplus” corresponding to the import demand curve. • Graph 2 shows how to obtain the optimal tariff for a large country: find the “marginal cost of imports” using the supply function facing home and set that marginal cost equal to the import demand function. The intersection point shows the optimal level of imports. Use this point to determine the optimal tariff. • Graph 3 shows that if Home is a large country, any tariff (provided it is not too large) will increase Home’s welfare, will decrease Rest of World’s (ROW’s) welfare, and will decrease aggregate world welfare (the sum of Home and ROW welfare). Graph 3 is simpler than graph 2. Even if you do not understand the determination of the optimal tariff (graph 2) you should be able to understand that a positive tariff (provided it is not too large) increases Home’s welfare, when Home is a large country.

37. Left panel shows Home’s supply and demand. Right panel graphs domestic demand – domestic supply = domestic imports. pa is Home’s autarchic price (where supply = demand, so imports = 0) and p’ is an arbitrary lower price. By construction, distance a the left and right panels are equal (since right panel shows demand – supply). The two triangles labeled A have the same area, since their base and their height are equal. Recall from earlier lectures that area A in left panel = gains from trade, when country trades at price p’. Conclude from this graph that we can measure the gains from trade by using the “surplus” corresponding to the import demand curve. price Home’s import demand = domestic demand – domestic supply pa A A p’ a a demand supply Home supply and demand Home import demand Graph #1

38. The “large” country’s incentive to use a tariff to lower price of imports • The next slide shows “home’s” demand for imports (the difference between home’s domestic demand and domestic supply), and the upward sloping rest-of-world (ROW) supply for those imports. • The upward sloping dotted curve is the marginal cost of imports (obtained using ROW supply). The optimal tariff is found by equating the marginal cost of imports with Home’s import demand. • The tariff leads to a lower world price and reduced imports. Home suffers deadweight loss, but the tariff revenue more than makes up for this loss, so the tariff increases Home’s welfare. • ROW suffers a welfare loss, because the price of the good that it sells has fallen.

39. Illustration of the optimal tariff for a large country The marginal cost of imports facing home price ROW supply facing home Tariff-inclusive Domestic price in home Tariff revenues World price Home’s import demand Quantity of Home Imports and ROW exports Graph #2

40. Welfare effect of a tariff t. The size of the tariff is t=a+b. Incidence on importing country (Home) is a/t; incidence on exporting country (ROW) is b/t. (Remember what “incidence” means”.) Home’s Gains from Trade falls by areas 1+3 and its tariff revenue = 1+2, so Home’s net gain is area 2 - area 3 > 0 (area 1 cancels out). ROW’s loss in welfare is areas 2 + 4. The aggregate world loss in welfare is area 3 + area 4 ROW supply facing home Tariff-inclusive Domestic price in home a 1 3 Tariff revenues 4 b 2 World price Home’s import demand Graph # 3

41. Ingredients of the model • Two large countries trade with each other. Each has an incentive to use a tariff to improve its terms of trade. • Each country also has domestic pollution. • Governments maximize domestic welfare. In a one-shot game, each country uses a tariff to improve its terms of trade, and a domestic pollution tax to achieve the optimal level of pollution. Governments’ policies are “individually rational” but their collective effect is to reduce everyone’s welfare, so the policies are “collectively irrational”. This is an example of a situation where individual pursuit of self-interest does not lead to a good outcome; compare to Adam Smith’s story of the butcher and the baker. • This outcome involves inefficient trade policies (positive tariffs) but efficient domestic pollution policies. • The objective of the WTO is to increase efficiencies by reducing the tariffs, without simultaneously causing countries to use their pollution policies inefficiently, i.e. as a substitute for the (illegal) trade policy.

42. Illustrate Basics of Game theory: Non-cooperative Nash Equilibrium (NE) • In a game, an agent’s payoff depends on it’s own and other players’ actions. The table shows how the payoffs to two countries, depend on what both countries do. First element in the ordered pair is Country 1’s payoff. • In this example, TR means “trade restriction” and FT means “free trade”. If country 2 plays FT and Country 1 plays TR, Country 1 gets 15 and Country 2 gets “2” and Country 1 gets “15”. • The “best action” for a player typically depends on what other players do. • A non-cooperative NE occurs when all players are playing their best action, given the actions that other players use. • There are no profitable “unilateral deviations” from a NE: the NE is “self-enforcing”. • In this illustration, the cooperative action is for both countries to play FT. The non-cooperative NE is for both to play TR.

43. Relate example in last slide to trade • Each large country is better off using a trade restriction than allowing free trade – regardless of what the other country does. Therefore, in equilibrium, both use trade restrictions. However, both countries would be better off if both committed to allowing free trade. But free trade is not an equilibrium in this one-shot game.

44. Why does it make sense to use a “non-cooperative” (= self-enforcing) equilibrium? • Nations’ sovereignty (paradoxically) limits their ability to make commitments (e.g. to promise not to re-impose trade restrictions) that in some states of nature (i.e. under some contingencies) they might want to repudiate. If there was a “world policeman”, that policeman could act as a guarantor of a country’s commitment. A contract between nations does not have the same force as a contract between individuals who are subject to a single nation’s laws. • This limited ability to commit to future actions makes the self-enforcement of the equilibrium more important. (Of course, nations do have some ability to make commitments, so the requirement of a Nash equilibrium might seem “too strong”). • However, we will see that in some cases, the requirement of NE does not impose substantial limits on ability to cooperate.

45. Supergames and trigger strategies • A supergame is an infinitely repeated “one-shot” game. Players discount the future. • A trigger strategy tells you (for example) to “play nice” as long as rivals have played nice in the past. • Not all trigger strategies are Nash equilibria. The temptation to “cheat” in current period may be too great to resist, even if it leads to “punishment” in the future

46. Discounting (again) • A discount rate, d converts a future flow into a “present value” (PV): d=1/(1+r) where r = “interest rate”. d<1 because r>0. • The present value of receiving $1 next year is $d. The present value of receiving $1 two years from now is dxd. The present value of receiving $1 “n” years from now is d raised to the n’th power. • The present value of receiving $1 each year from now until infinity is 1/(1-d).

47. Why do we need discounting? (review) • A dollar today is not the same thing as a dollar one year from now – they are apples and oranges. • If we have costs and benefits in different periods, we need a way to compare these, i.e. a way to “convert apples to oranges”. • By converting future dollars to their “present value” we can compare costs and benefits in different periods. • Supergames are played over infinitely many periods.

48. Example of trigger strategy applied to previous example of one-shot game • Proposed strategy: choose FT in first period and in every later period, provided that rival has used FT in every previous period. Use TR forever, if rival has ever used TR in past. • PV of following proposed strategy = 10/(1-d). • PV of cheating = 15 + d5/(1-d) • Proposed strategy is a NE in the supergame if and only if 10/(1-d) > 15 +d5/(1-d), i.e. if d > 0.5 (i.e., if r< 1)

49. Basic points of self-enforcing cooperation • Cooperation can be self-enforcing (i.e. it can be a NE) in the infinitely repeated game (the supergame). • Cooperation requires that agents place sufficiently high value on the future, i.e., they are patient (which in this context means that they have low r, or equivalently a high discount factor d). Nations must be patient if they are to resist the temptation to “cheat”. • In games with many actions, agents may not be patient enough to support complete cooperation, although they may still be able to support some cooperation, and thus get higher payoff than at non-cooperative equilibrium to one-shot game.

50. What does this have to do with the WTO? • I noted above that a “rational” (i.e. self-interested) reason for using a tariff is to restrict demand for imports in order to reduce the price of imports, i.e. to “improve the terms of trade” (lower the price of imports). • Only “large countries” are capable of lowering price of imports by means of a tariff. • Suppose that countries are “large”, so that they have an incentive to use tariffs to improve terms of trade.