The Economics of the WTO

Kyle Bagwell and Robert W. Staiger

I. Introduction

What is the GATT/WTO?

� History: Many failed attempts leading up to thecreation of GATT; mostly joint declarations offree-trade ideals.

� GATT was different, and seems to have worked.

� What were the objectives of the originalmember-governments in creating GATT?

� GATT Preamble: The Objectives.

�...Recognizing that their relations in the field oftrade and economic endeavour should be conductedwith a view to raising standards of living, ensuringfull employment and a large and steadily growingvolume of real income and effective demand,developing the full use of the resources of the worldand expanding the production and exchange ofgoods,...�

� ...in creating the WTO?

� WTO Preamble: The Objectives.

�...Recognizing that their relations in the field oftrade and economic endeavour should be conductedwith a view to raising standards of living, ensuringfull employment and a large and steadily growingvolume of real income and effective demand, andexpanding the production of and trade in goods andservices, while allowing for the optimal use of theworld�s resources in accordance with the objectiveof sustainable development, seeking both to protectand preserve the environment and to enhance themeans for doing so in a manner consistent with theirrespective needs and concerns at different levels ofeconomic development,

�Recognizing further that there is need for positiveefforts designed to ensure that developing countries,and especially the least developed among them,secure a share in the growth in international tradecommensurate with the needs of their economicdevelopment,...�

� How were the rules of GATT seen ascontributing to these objectives?

� GATT Preamble: The Means.

�...Being desirous of contributing to these objectivesby entering into reciprocal and mutuallyadvantageous arrangements directed to thesubstantial reduction of tariffs and other barriers totrade and to the elimination of discriminatorytreatment in international commerce,...�

� WTO Preamble: The Means.

�...Being desirous of contributing to these objectivesby entering into reciprocal and mutuallyadvantageous arrangements directed to thesubstantial reduction of tariffs and other barriers totrade and to the elimination of discriminatorytreatment in international trade relations,...�

� The GATT/WTO objectives are to be served bysecuring non-discriminatory and substantiallyfreer trade on a reciprocal basis.

� GATT/WTO rules provide a legal frameworkfor incorporating the results of negotiationsdirected toward:

� the reciprocal and mutually advantageousexchange of market access commitments ona non-discriminatory basis.

� Free trade is not an explicit GATT/WTOobjective.

� �The WTO does not tell governments how toconduct their trade policies. Rather, it�s a�member-driven� organization.� (WTOHome Page).

� �The WTO is blindly for free trade at anycost. Not true. It�s really a question of whatcountries are willing to bargain with eachother.� (WTO Home Page).

� GATT/WTO negotiations are driven by exporterinterests.

How do economists make sense of this?

� Mostly, they don�t:

�There is no generally accepted label for thetheoretical underpinnings of GATT. I like to refer toit as �GATT-think� � a simple set of principles thatis entirely consistent, explains most of what goes onin negotiations, but makes no sense in terms ofeconomics...� (Paul R. Krugman).

�To make sense of international trade negotiations,one needs to remember three simple rules about theobjectives of negotiating countries:

1). Exports are good.2). Imports are bad.3). Other things equal, an equal increase in

imports and exports is good.

In other words, GATT-think is enlightenedmercantilism.� (Paul R. Krugman).

τA

τB

pw

xMxA

~pw

M p p pxA A A w w( ( , ), )τ

E p p pxB B B w w( ( , ), )τ

II. The 2-Country Framework

p A/p A

x /p Ay ; p B

/p Bx /p B

y ; p w/p B

x /p Ay ;

; .p A�τAp w

/p A(τA,p w) p B�p w/τB/p B(τB,p w)

Market Clearing: .p̃w(τA,τB)

Balanced Trade: ; .p wM Ax �E A

y p wE Bx �M B

y

p Iw ( )

p IIIw ( )p IA ( )

p IIIA ( )τA

τBτB

τA

τA1 •

••

III

III

pw

x

MxA1

MxA0

ExB1

ExB0

~pw

~MxA0 ~Mx

A1

; .W A(p A(τA,p̃w),p̃ w) W Ap̃w<0

Governments:; .W B(p B(τB,p̃w),p̃ w) W B

p̃w>0

Reciprocity: .p̃w0[M A1x �M A0

x ]�E A1y �E A0

y

Balanced Trade .Y (p̃w1�p̃w0)M A1

x �0

– Why would governments want this?

III. Trade Negotiations�The reason why GATT-think works is...that itcaptures some basic realities of the politicalprocess.� (Paul R. Krugman).

i) A Digression to a World of Small Countries Many x-importing countries, indexed by :

; . Many y-importing countries, indexed by :

; .

Each country is �small� on world markets:

.

Unilateral Tariff Choices:

for ; for .

� No government can benefit from negotiatedtariff changes that satisfy reciprocity.

� Negotiated tariff changes that benefit allgovernments are not possible.

pw

xMx

A1Mx

A0

ExB1

ExB0

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~MxA0~Mx

A1

~ /pw

ii) Returning to a World of (2) Large Countries

Unilateral Tariff Choices:

;W Ap A

dp A

dτA�W A

p wMp̃w

MτA�0 Y W A

p A<0

.W Bp B

dp B

dτB�W B

p wMp̃w

MτB�0 Y W B

p B>0

International cost-shifting “too little trade” at .Y p̃ w

– Costs are shifted abroad when market access isunilaterally denied.

– No cost-shifting when market access isreciprocally altered.

pw

x

MxA1

MxA0

ExB1

ExB0

~pw

~MxA0 ~Mx

A1

� Find a way to eliminate international cost-shifting, and each government will desire freertrade (i.e., , ).

� A negotiated reciprocal reduction in tariffsaccomplishes this, and so is mutually beneficial.

� Trade negotiations eliminate the inefficienciesassociated with international cost-shifting (i.e.,they solve a terms-of-trade driven Prisoners�Dilemma).

� Beginning from unilateral tariff choices,Krugman�s three rules of GATT-think aresatisfied.

pw

xMxA

~pw

M s p p pxA A A A w w( , ( , ), )τ

E s p p pxB B B B w w( , ( , ), )τ

IV. Labor and Environmental Standards– Cost-shifting remains the fundamental problem

when additional policy instruments are added.

Labor/environmental standards: , . Nos A s B

international non-pecuniary externalities.

Market Clearing: .p̃w(s A,τA,s B,τB)

Balanced Trade: ; .p wM Ax �E A

y p wE Bx �M B

y

; .W A(s A,p A(τA,p̃w),p̃ w) W Ap̃w<0

Governments:; .W B(s B,p B(τB,p̃w),p̃ w) W B

p̃w>0

Externalities run through , hence market access.p̃w

The race-to-the-bottom/regulatory-chill problem.

Suppose that a government has agreed to hold itstariffs low as a result of a WTO negotiation.

Scenario 1 (Race-to-the-bottom): The governmentfaces pressure from import-competing interests to offeradditional protection from imports.

If its WTO commitments prevent the governmentfrom responding with a tariff increase, then itmight instead choose to relax a labor standard.

Scenario 2 (Regulatory chill) : The government facespressure from labor interests to introduce new andmore stringent standards that serve to enhanceworkplace safety but which also raise the costs ofproduction of its import-competing firms.

If its WTO commitments prevent the governmentfrom raising its tariff to offset the competitiveeffect of imposing the tighter standards on itsfirms, then the government might hesitate tointroduce these new and improved standards.

� If property rights over negotiated market accesslevels were sufficiently complete, the race-to-the-bottom/ regulatory chill problem would notarise.

How can these property rights be completed?

A Simple Rule.

Once a government has agreed to lower its tariffs ina WTO negotiation:

It should not be permitted to take subsequentunilateral policy actions that undercut itsimplied market access commitments; but

It should be otherwise allowed to configure itsunilateral policies in anyway it desires.

Existing GATT/WTO principles are not that faraway from approximating this simple rule.

Scenario 1: The government should not be permittedto offer protection to its import-competing industryby weakening its standards.

If it desires to provide additional protectionfrom imports, it should be required torenegotiate with its trading partners to select ahigher tariff level.

� In principle, �non-violation� nullification-or-impairment complaints can guide governmentstoward efficient renegotiations (and therebyprotect against a race to the bottom).

Scenario 2: The government should be allowed toraise its tariff as it tightens its standard.

But its tariff increase can do no more than offsetthe competitive effect of the tighter standard.

� In principle, renegotiations could involve acommitment to higher standards as�compensation� for tariffs bound at higherlevels (and thereby prevent a regulatory chill).

τA

τB

τC

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xMxA

~pw

M p p pxA A A w w( ( , ), )τ

E p p pxj j j w w

j B C( ( , ), )

{ , }τ

∈∑

V. The Many-Country Framework

MFN p j/p j

x /p jy , j0{A,B,C}; Y p w

/p Bx /p A

y �p Cx /p A

y ;

Market Clearing: .p̃ w(τA,τB,τC)

Balanced Trade:

; ; .p wM Ax �E A

y p wE Bx �M B

y p wE Cx �M C

y

; .W A(p A(τA,p̃w),p̃ w) W Ap̃w<0

Governments: ; .W B(p B(τB,p̃w),p̃ w) W Bp̃w>0

; .W C(p C(τC,p̃w),p̃ w) W Cp̃w>0

Unilateral Tariff Choices:

;W Ap A

dp A

dτA�W A

p wMp̃w

MτA�0 Y W A

p A<0

;W Bp B

dp B

dτB�W B

p wMp̃w

MτB�0 Y W B

p B>0

.W Cp C

dp C

dτC�W C

p wMp̃w

MτC�0 Y W C

p C>0

International cost-shifting “too little trade” at .Y p̃ w

pw

xMx

A1Mx

A0

~pw

~MxA0~Mx

A1

~ /pw

Exj

j B C

1

∈∑{ , } Ex

j

j B C

0

∈∑{ , }

– Costs are shifted abroad when market access isunilaterally denied.

– No cost-shifting when market access isreciprocally altered.

– Beginning from unilateral tariff choices, allgovernments gain under reciprocal multilateralliberalization (i.e., , , ).W A

p A<0 W Bp B>0 W C

p C>0

But GATT/WTO negotiations occur through time,among a subset of governments at any point in time.

� Beginning from unilateral tariff choices, A andB can reciprocally lower their tariffs and eachgain, and leave C completely unaffected.

� No Free-Rider Problem with MFN whennegotiations conform to reciprocity.

� Lerner Symmetry Theorem.

A and B can hurt C if A liberalizes less thanreciprocally with B.

� If A will negotiate with C later, this is �footdragging,� and it can lead to inefficiency.(Renegotiation opportunities may help).

� If A has negotiated with C previously, this is�concession erosion,� and it can lead toinefficiency. (Non-violation nullification-or-impairment rights may help).

A Simple Rule.

As long as bilateral negotiations abide by MFN andsatisfy reciprocity, they can be presumed to producePareto improvements across governments.

But if either MFN or reciprocity is violated, thenthis presumption may not be warranted.

� Non-MFN Example: FTAs and CUs.

; .

� Non-Reciprocity Example: Agreements to limitExport Subsidies.

Unilateral tariff choices ; .

VI. EnforcementHow can governments enforce an agreement toescape from a terms-of-trade driven Prisoners�Dilemma?

� Repeated interaction and the threat of retaliation(Statement by a drafter of Article XXIII):

�We have asked the nations of the world to conferupon an international organization the right to limittheir power to retaliate. We have sought to tameretaliation, to discipline it, to keep it within bounds.By subjecting it to the restraints of internationalcontrol, we have endeavored to check its spread andgrowth, to convert it from a weapon of economicwarfare to an instrument of international order.�

� Repositioning retaliation as an off-equilibriumthreat that enforces cooperative equilibrium-path rules.

� But a limited role for retaliation also arisesalong the equilibrium path (Articles XIX,XXVIII,XXIII).

VII. Conclusion

GATT-think makes sense in terms of economics.

� International cost-shifting incentives are key.

� Costs are shifted abroad with a unilateral denialof market access.

� A reciprocal denial of market access preservesthe balance of market access across countriesand thereby prevents cost-shifting.

GATT rules attempt to create a negotiating forum inwhich property rights over the balance of negotiatedmarket access commitments are secure.

� MFN.

� Reciprocity.

� Non-violation nullification or impairment.

� Renegotiation.