Economic Theory and the
Interpretation of GATT/WTO
Kyle Bagwell and Robert Staiger
Presented by Bonnie Palifka
Economic Model

Two countries

Trade in two goods, x and y

Normal goods

Perfect competition

Increasing opportunity costs
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
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/*
Production possibilities frontier
y
slope = px/py
y0
x0
x
Equilibrium
tariffs
world price
local prices
production
consumption
import
export
tariff revenue
Figure 1
pw(C)

’
pw(A)
p(C)
C
p(A)
D
B
p(C)

pw(C)
A
p(A)
pw(A)
*
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.
Prisoner’s dilemma

two thieves captured

each questioned separately

confess or deny
Prisoners’ dilemma
Burt
deny
confess
Ernie
confess
deny
confess
3 years
3 years
1 year
5 years
5 years
1 year
deny
2 years
2 years
Prisoners’ dilemma
Burt
confess
Ernie confess
deny
3
3
deny
5
1
1
5
2
2
Trade dilemma
Brazil
open
tariffs
Mexico
tariffs
open
tariffs
$3
$3
$6
$1
open
$1
$6
$5
$5
Trade dilemma
Brazil
tariffs
Mexico tariffs
open
3
3
open
1
6
6
1
5
5
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)

Trade dilemma
Brazil
tariffs
Mexico
open
9
tariffs
9
13
8
8
open
13
15
15
Bibliography

Bagwell, Kyle and Robert W. Staiger.
2002. “Economic Theory and the
Interpretation of GATT/WTO,” American
Economist 46,2: 3-19.