optimal design of trade agreements in the presence of...

Optimal Design of Trade Agreements in the Presence ofRenegotiation

Giovanni Maggi and Robert W. Staiger

Yale and Stanford

September 2011

Maggi and Staiger (Yale and Stanford) Property Rules and Liability Rules September 2011 1 / 25

Introduction

When govs make international commitments, what is the optimalstructure for their contract?

This question at the heart of growing debate among scholars ofinternational trade agreements.

Broadly speaking, these commitments can take one of two possiblecontractual forms.


Introduction

One type of contract assigns rights, e.g., right to protect assigned toimporter or right of free trade to exporter.

Rights can be transferred between govs only through voluntarytransaction a renegotiation.In e¤ect, assigns ownership of rights concerning trade policy: aproperty rule in the legal literature.

The second type of contract presents importer with option to practicefree trade, or to protect and pay damages.

Assigns entitlement of free trade to exporter, and while voluntaryrenegotiation can always occur,importer can also remove this entitlement unilaterally by payingdamages: a liability rule in the legal literature.

The choice between property rules and liability rules an issue offundamental importance for the design of a trade agreement.A vast law-and-econ literature on this issue in a domestic setting. Weinitiate formal analysis in context of international trade agreements.


Introduction

Evidence of both liability and property rules in real-world tradeagreements.Interesting variation across issues. For example, according toPauwelyn (2008):

Property rules the default in WTO (e.g., applying to prohibitionsagainst QRs and export subsidies);But liability rule approach for certain specic issues (e.g., provisions fortemporary and permanent escape from tari¤ bindings, rules applying toproduction subsidies).

Also evidence of contract form in a given institution evolving overtime.

For instance, broad agreement that GATT operated as system ofliability rules in early years;but in more recent times most legal scholars see GATT/WTO ashaving evolved toward property-rule system.

We seek to contribute toward an understanding of the forces thatexplain these choices.


Introduction

Intuitive appeal of a liability rule: can help govs cope withincompleteness of the contract.

Buy outallows e¢ cient adjustment of contractual obligationswithout need to specify contingencies in contract.

But a liability-rule approach has its limitations.

One stands out in context of trade agreements: gov-to-govcompensation takes form of self-help/tari¤ retaliation; ine¢ cient.

This transaction cost (ine¢ cient transfers) creates non-trivial tradeo¤between property-rule/liability-rule approaches.Formalizing and evaluating this tradeo¤ a key focus of paper.


Introduction

In evaluating property v. liability rules, important to allow forrenegotiation, especially given its empirical relevance in GATT/WTO.

Contract does not directly determine policy outcome,but w/ transaction costs it does so indirectly by shaping disagreementpoint for ex-post negotiations: hence, e¢ ciency consequences.Existing models of trade agreements abstract from renegotiation.We study optimal design of trade agreements in presence ofrenegotiation.

Considerable research more generally on optimal design of contractsin presence of renegotiation.We follow broad approach of this literature:

non-veriable information, contract designed ex-ante, can berenegotiated ex post through Nash bargaining.

But two departures:gov-to-gov transfers involve DWL, so utility is non-transferable;focus on binary policy choice; do this for tractability; but capturesmany trade-related policies that are discrete in practice.


Results

Several predictions concerning pattern and direction of renegotiation:If contract is designed optimally, renegotiation (when it occurs) resultsin trade liberalization, not protection.Renegotiation is not an extraordinary event, but rather occurs inordinary circumstances.

If a property rule is optimal, it is never renegotiated in equilibrium.Observed decline in compensation/tari¤ retaliation in GATT/WTOconsistent with evolution from liability to property rules that legalscholars claim has occurred over time.

A property rule is optimal if ex-ante uncertainty su¢ ciently low;liability rule optimal if uncertainty su¢ ciently high.

If uncertainty caused by political-economy shocks, then liability rulesbest for issues that are most politicized: ts broadly with pattern ofliability/property rules in GATT/WTO.Also, when a liability rule optimal, never optimal to set damages highenough to make injured party whole, contrary to e¢ cient breachargument, consistent with GATT reciprocity norm.


Results

Relative bargaining power of govs has interesting implications:

increasing bargaining power of importer favors property over liabilityrules; anddeveloped and developing countries naturally on di¤erent sides ofreform proposals that would move institution in one direction or other.

Finally, we introduce bargaining friction in form of xed cost ofrenegotiation.

We nd in presence of costly transfers that bargaining frictions favorproperty rules:costly transfers reverse a central conclusion of law-and-economicsliterature, namely, that bargaining frictions favor liability rules.Indicates a key di¤erence between domestic law-and-econ lit andinternational trade agreements setting.


The Model: Basic Assumptions

A single industry; importing/Home gov chooses a binary policyT 2 fFT ,Pg.b a pos/neg transfer from Home to Foreign; c(b) the DWLassociated with b (borne by Home); c(0) = 0, c(b) > 0 for b 6= 0,smoothly convex; b+ c(b) increasing in b.

Home govs payo¤ is ω(T , b) = v(T ) b c(b).Foreign gov is passive in this industry; its payo¤ isω(T , b) = v (T ) + b.

Joint payo¤ of the two govs: Ω(T , b) = v(T ) + v (T ) c(b).Home govs gain from protection: γ v(P) v(FT ) > 0.Foreign govs loss from protection: γ v (FT ) v (P) > 0.Joint (positive or negative) gain from protection: Γ γ γ.


Basic Assumptions

First bestoutcome (joint surplus maximizing): if Γ > 0, T = Pand b = 0; if Γ < 0, T = FT and b = 0.

Γ is uncertain ex-ante. Both govs observe Γ ex-post, but Γ is notveriable by the DSB, so govs cannot write a complete contingentcontract.

Assume γ is ex-ante known to all (so all uncertainty in Γ comes fromγ), and γ is not veriable.

This is the best possible scenario for the e¢ cient breachargument.

Assume γ is in the interior of the support of γ, so the rst-best is Pin some states (γ > γ) and FT in others (γ < γ).

Density h(γ) dened over γ 2 [0,∞); let γ = inffγ : h(γ) > 0g andγ = supfγ : h(γ) > 0g.Look for contract that maximizes ex-ante joint surplus.


The contracting options

Two types of contracts.

Property rule: assigns right of FT to exporter (prohibitivepropertyrule) or right of P to importer (discretionaryproperty rule).

Liability rule: a menu contract giving Home a choice between (i) FTand (ii) P and payment bD to Foreign.

Later consider possibility of transfer also associated with FT .

At formal level focus on family of liability contracts and optimize bD :

prohibitive property rule outcome-equiv to liability with bD setprohibitively high;discretionary property rule outcome-equiv to liability rule at otherextreme with bD = 0.

Note: bD can be interpreted as payment specied under explicitescape clause, or remedy for contract breach.


Timing of the game

0. Governments write the contract.

1. γ is realized and observed by the governments.

2. Governments can renegotiate the terms of the contract (b and T ).

σ is bargaining power of Home in stage-3 Nash bargain, (1 σ)bargaining power of Foreign; abstract from enforcement issues.


The No-Renegotiation Benchmark

W/out renegotiation, key tradeo¤ is conceptually simple:

a liability rule can insure against extreme realizations of γ but entailstransfer costs;a property rule avoids transfer costs but entails downside riskassociated with extreme realizations of γ.

But predictions about optimal rules somewhat ambiguous, at least w/large uncertainty:

intuitively, liability rule should be optimal, but not necessarily so;full discretion (P always) might be best, because inducing FT even forjust lowest levels of γ requires a transfer that occurs in equilibrium forall higher levels of γ, and resulting transfer costs may not be worth it.

Renegotiation complicates trade-o¤s and leads to sharper predictionsabout optimal rules.


The Optimal Agreement with Renegotiation

Given a contract specifying bD , when does renegotiation occur, andin what direction?

For any bD , no-renegotiation benchmark now provides threat pointfor any renegotiation.

Threat point gives importer option to choose between(T = FT , b = 0) and (T = P, b = bD ).

Importer indi¤erent between options when γ = bD + c(bD ) S(bD ).for γ < S(bD ) threat point is (T = FT , b = 0); for γ > S(bD ) threatpoint is (T = P, b = bD ).Figure 1.


bD

Figure 1

0

γ

γ*

γ*

S(γ*)

S(bD)

FT

P PR

FTR R(0)

S(bD)

R(bD)


Consider rst γ < S(bD ) where threat point is (T = FT , b = 0).

Renegotiation from (T = FT , b = 0) to (T = P, b = be ) requires:γ > S(be ) (for the importer) and be > γ (for the exporter);contract renegotiated toward P i¤ S(γ) < γ < S(bD ). Region PR inFigure 1.

Note: never strictly optimal to set bD > γ; Figure 1.

Implies in equilibrium contract never renegotiated towards P.

Consider next γ > S(bD ) where threat point is (T = P, b = bD ).

Renegotiation from (T = P, b = bD ) to (T = FT , b = be ) requires:S(bD ) S(be ) > γ (for importer) and γ > bD be (for exporter);contract renegotiated toward FT i¤γ < S(bD ) S(bD γ) R(bD ). Region FTR in Figure 1.

Note: renegotiation regions PR and FTR are independent of σ (whichonly a¤ects exact level of be w/in these regions).



Summary of ndings on pattern and direction of renegotiation:

Proposition 1: (i) If bD < γ, the contract is renegotiated forγ 2 (S(bD ),R(bD )), in which case the governments agree on FT and theexporter compensates the importer. (ii) If bD > γ, the contract isrenegotiated for γ 2 (S(γ),S(bD )), in which case the governmentsagree on P and the importer compensates the exporter; however, settingbD > γ is weakly dominated, and this kind of renegotiation does nothappen in equilibrium.

Note what is ruled out if damages set optimally: importers threatpoint is FT , but govs agree to a policy P and level of damages toexporter less than contractually specied level bD .

Note that renegotiation can occur in equilibrium only for intermediatevalues of γ, not extreme states of world.



Next, What allocations γ can be implemented, and what level ofbD implements a given γ?

Renegotiation limits implementable range of γ:

If no cost of transfers, only γ = γ implementable (Coase);w/ costly transfers, any γ in interval [R(0),S(γ)] is implementable(Figure 1).Still, renegotiation benecial for ex-ante joint surplus.

Lemma 1: Renegotiation limits the range of allocations γ that canbe implemented. The implementable range of γ is given byIMγ = [R(0),S(γ)]. However, renegotiation is (weakly) benecialfor the ex-ante joint surplus.

And from Figure 1, level of bD that implements a given γ isbD (γ) = R1(γ).


bD

Figure 1

0

γ

γ*

γ*

S(γ*)

S(bD)

FT

P PR

FTR R(0)

S(bD)

R(bD)


Finally, How does be change with bD?

Intuitively, increasing bD strengthens the bargaining position of theexporter and hence decreases be in absolute size.

Lemma 2: For (bD ,γ) in the FTR region, where governmentsrenegotiate to FT and be < 0, an increase in bD leads to a decreasein (the absolute size of) the equilibrium transfer: ∂jbe j

∂bD < 0.

Now ready to study optimal level of bD :

property rules (bD = 0, or bD bprohib where bprohib determined byS(bprohib) = γ); vs. liability rules (bD 2 (0, bprohib)).

Notice tradeo¤s relative to no-renegotiation benchmark:

policy outcome no longer rigid under property rules;renegotiation imposes limit on implementable policy allocations;level of bD a¤ects equilibrium payments under renegotiation.


bD 0

γ

γ*

γ*

S(γ*)

FT

P PR

FTR R(0)

Figure 2

bprohib

S(bD)

S(bD)

R(bD)

bD

Figure 1

0

γ

γ*

γ*

S(γ*)

S(bD)

FT

P PR

FTR R(0)

S(bD)

R(bD)


Small uncertainty:Property rule not renegotiated, hence no equilibrium transfers; Figure 2.A liability rule can make policy contingent on γ, but benet smallwhen uncertainty small, cost not small; Figure 2.Hence property rule optimal for small uncertainty: bD = 0 if Eγ > γ

and bD bprohib if Eγ < γ.

Large uncertainty: Suppose γ < R(0) and γ > S(γ); refer back toFigure 1.bprohib > γ, so bD bprohib cannot be optimal by Proposition 1;Figure 1.What about bD = 0?

For γ > R(0), contract not renegotiated, outcome is (P, b = 0),increasing bD slightly from zero entails second-order loss;But for all γ < R(0), contract renegotiated when bD = 0, exporter

pays sizable be , and hence with ∂jbe j∂bD < 0, increasing bD slightly from

zero gives rst-order benet. Figure 1.

Liability rule optimal for large uncertainty.Maggi and Staiger (Yale and Stanford) Property Rules and Liability Rules September 2011 19 / 25


Proposition 2: (i) If the support of γ is su¢ ciently small, a propertyrule is optimal (specically, the optimum is bD = 0 if Eγ > γ andbD bprohib if Eγ < γ). (ii) If the support of γ is su¢ ciently large(on both sides of γ), the optimum is a liability rule, and in particularthe optimal bD satises 0 < bD < γ < bprohib .

Opt. liability rule never makes injured party whole, i.e., bD < γ.Intuition: when compensation is ine¢ cient (counter-retaliation), use itsparingly; a feature consistent with GATT reciprocity norm.

Empirical prediction if uncertainty primarily about political-economyshocks: liability rules for issue areas where political-economy shocksmore intense; property rules where political-economy less important.

Tarrication channeled political pressures from QRs to tari¤s; exportsectors less politically active than import-competing sectors.Hence, broadly in line with what we observe in GATT/WTO: exportsubsidies/QRs prohibited by property rule; tari¤s and productionsubsidies regulated through liability rules.



Two predictions that derive from underlying pattern of equilibriumrenegotiation:

Proposition 3: When a property rule is optimal, it is neverrenegotiated, and therefore entails no equilibrium transfers.

Prohibitive property rule (bD bprohib) implies threat point of FT forall γ in support, and Proposition 1 says no renegotiation from FT to P;Discretionary property rule (bD = 0) renegotiated only for γ < R(0),but if γ < R(0) then liability rule optimal by Proposition 1.

Note: frequency of renegotiation/compensation in GATT/WTO hasdiminished through time; GATT/WTO has evolved towards system ofproperty rules through time; Proposition 3 links these observations.

Evolution of GATT/WTO towards property rules may account fordecline in frequency of renegotiation/compensation over time.



Role of bargaining powers for the optimal choice of contract.

Proposition 4: As σ rises, the optimum can switch from a liabilityrule to a property rule, but it cannot switch from a property rule to aliability rule.

By Proposition 1, equilibrium renegotiations always entail transfer fromexporter to importer; so as σ rises expected transfer as a result ofrenegotiations goes up; and σ has no impact on the equilibrium policy.Finally, no equilibrium renegotiations when property rules are optimal(Proposition 3); so increase in σ favors property rule over liability rule.

If power imbalances between developed/developing countries:developing countries disadvantaged by reforms that move system awayfrom property rules and toward liability rules;implies bargaining positions broadly in line with those taken byWTO-member govs over proposed institutional reforms that would haveelevated the role of compensation as buy outof ones obligations.



How does a xed cost K of renegotiation impact the choice betweenproperty rules and liability rules?

Proposition 5: As K increases, the optimum may switch from aproperty rule to a liability rule, but not vice-versa.

By Proposition 3, when a property rule is optimal, it is neverrenegotiated; and when renegotiation occurs it increases joint surplus.Hence, the introduction of renegotiation can only increase the relativeattractiveness of a liability rule.

If inability to renegotiate interpreted as extreme ex-post bargainingfrictions, then in presence of costly transfers bargaining frictions favorproperty rules:

costly transfers reverse a central conclusion of law-and-economicsliterature, namely, that bargaining frictions favor liability rules.Indicates a key di¤erence between domestic law-and-econ lit andinternational trade agreements setting.


A More General Class of Contracts

Consider more general class of menu contracts (P, bD ), (FT , bFT ).Is it desirable in the presence of a liability rule to introduce as well acarrotbFT attached to the choice of FT?And if it is optimal, can a property rule still be optimal when a carrot isavailable for use with a liability rule?

Proposition 6: Consider menu contracts of the type(P, bD ), (FT , bFT ): (i) If the support of γ is su¢ ciently small, aproperty rule is optimal; (ii) If the support of γ is su¢ ciently large(on both sides of γ), it is optimal to use a carrot (bFT < 0) togetherwith a liability rule/stick (bD > 0), and in particular the optimal bD

satises 0 < bD < γ < bprohib .

A small carrot for good behavior can destroy ability of importer toexploit bargaining power (σ > 0) and hold out for big carrot for goodbehavior in some states of world.But Proposition 2 and all others extend to this more general class ofcontracts.


Conclusion

Argued that renegotiation and ine¢ cient gov-to-gov transfers gureprominently in the GATT/WTO and other trade agreements.

Derived predictions concerning the optimal form of the agreement, theconditions under which the agreement will be renegotiated in equilibrium,and the form that such renegotiation will take.

Forged a link between the theory of trade agreements and thelaw-and-economics theory of optimal legal rules.

Extensions: harm not perfectly veriable, DSB can observe noisy signal(ongoing work); private information; continuous policies; enforcement.

Finally, in a multi-country setting, all propositions extend. But newquestion: How does expansion of membership a¤ect tradeo¤ betweenliability/property rules? If more members increases bargaining frictions,then property rules favored by expanding membership. Could help explainevolution of legal rules in GATT/WTO.


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