Dispute Settlement Mechanism The role of dispute settlement

Dispute Settlement Mechanism • The role of dispute settlement mechanism – information gathering and dispatching, not enforcement of trade arrangements • Main results: – multilateral enforcement is better than bilateral enforcement in enforcing freer trade – multilateral enforcement cannot be replicated by a set of bilateral enforcements

Voluntary Participation • Starting point: – Participation in a multilateral agreement is voluntary. – The worse thing a country will face from failing in fulfilling the agreement is losing the privilege of being a member – [Compare with this: you borrow money from a bank using your flat a collateral and you fail to repay— then the bank can take your flat and sell it!] • Design of a multilateral agreement – It should be designed so that member countries want to stay in and abide by it on a voluntary basis

Nash equilibrium • A Nash equilibrium is a profile of strategies (one strategy for each player) so that no player can gain from a unilateral deviation. • In a dynamic setting, we have a more refined concept of subgame perfect equilibrium, which itself is a Nash equilibrium. • We hope that participation and abiding by the rules is a (nash or subgame perfect) equilibrium.

A one shot game between two countries • Assumptions: a one shot game, each country is maximizing its own welfare • Both playing “protection” is a Nash equilibrium. • Each will defeat even if a free trade agreement has been signed. Country B Free trade Country A Protection Free trade 10, 10 3, 15 protection 8, 8 15, 3

Repeated Game • Now change the game, assume that it is played indefinitely • Consider the following strategies – Always choose free trade so long as protection has not been chosen – Always choose protection if protection has been chosen • Clearly, given that both countries abide by these strategies, there will be perpetual free trade. • This is indeed a subgame perfect equilibrium if countries are patient enough, i. e. , if they do not discount future payoffs too much.

Repeated Game • • Common discount factor: 0<σ<1 One dollar arriving next period is worth σ dollars now. If cheating now, it brings the country a gain of 15 -10=5. Next period on, the country suffers a loss of 10 -8=2 each period. • The loss’s present value is which is greater than 5 if σ>5/7. Hence cheating is not worthwhile.

Imbalance Trade Country B Free trade protection Country A 10, 10 3, 15 • In an infinitely repeated scenario, as in a one shot scenario, it is optimal for country B to choose protection. • Country A is unable to punish B! • Imbalance trade between two countries make it difficult to sustain free trade even in a repeated environment

Multilateralism • Consider a world with three countries cars B C apparels A computers

Multilateralism • In a repeated scenario, as in a one shot scenario: – Even if a bilateral free trade agreement has been signed between A and B, B will defeat against A – Even if such one has been signed between B and C, C will defeat against B – Even if such one has been signed between C and A, A will defeat against C

Multilateralism • Think of a multilateral free trading agreement: • Each country adopts free trade so long as protection has not been used • Each country adopts protection so long as protection has been used • The above strategies constitute a subgame perfect equilibrium so long as σ high enough

Multilateralism • Without loss of generality, consider country B. If nobody cheats, B will have a payoff of 10 (from trade with A) and 10 (from trade with C). Hence a total of 20. • If country B cheats now, its current payoff will be 15 (w. r. t A) +10 (w. r. t C). Hence a gain of If you cheat now, you gain 25 -20=5 now. • In the next period, B’s payoff will be 15 (w. r. t. A) + 3 (w. r. t. C) = 18. Hence a loss of 20 -18=2. • If σ>5/7, then the loss exceeds gain because

Multilateralism • Hence, a multilateral agreement is not just a summation of several bilateral agreements. • It achieves something that a bunch of bilateral agreements cannot. • But why are we sure that country C will be aware of country B’s cheating against country A? • We need a dispute settlement mechanism (DSM) to give verdicts to trade dispute raised by complainant countries • The DSM doesn’t need to have enforcement power!