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 subgame perfect equilibrium.

Mother and son son mother Go to bed by 10 Stay up after 10 kill Does not kill kill Does not kill (-1000,-1000) (20,10) (-1000,-1000) (10,20)

Mother & son The ‘strategic form game’ (Kill,Kill)(Kill, Not Kill) (Not Kill,Kill) (Not Kill, Not Kill) Go to bed on time -1000, , ,20 Stay up-1000, , , ,10

Mother & son The ‘strategic form game’ (Kill,Kill)(Kill, Not Kill) (Not Kill,Kill) (Not Kill, Not Kill) Go to bed on time -1000, , ,20 Stay up-1000, , , ,10

Mother & Son In the strategic form game, son has two strategies to choose from; mom has four strategies to choose from There are three pure strategy Nash equilibria Among them, only (stay up, (Not kill,Not kill)) is “reasonable”, and it is known as a subgame perfect equilibrium

Repeated game Prisoner dilemma (cheat,cheat) is the unique Nash equilibrium Two period repeated game—the “stage” game is played twice, previous actions assumed observable Unique subgame perfect equilibrium: cheat all the time Future cannot be used to support present cooperation Not cheat cheat Not cheat 10,103,15 cheat15,38,8

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 tradeProtection Country AFree trade10,103,15 protection15,38,8

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 =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 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 Country B Free tradeprotection Country A10,103,15

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