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Economic Theory and the Interpretation of GATT/WTO Kyle Bagwell and Robert Staiger Presented by Bonnie Palifka

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Economic Model Two countries Two countries Trade in two goods, x and y Trade in two goods, x and y Normal goods Normal goods Perfect competition Perfect competition Increasing opportunity costs Increasing opportunity costs

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Economic Model x natural import good of the home country y natural import good of the foreign country p = p x /p y relative price facing home consumers and producers p* = p* x /p* y relative price facing foreign consumers and producers

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Economic model t home ad valorem tax t* foreign ad valorem tax = (1+t) [> 1 if import tax, 1 if import tax, < 1 if import subsidy] * = (1+t*) * = (1+t*) p w = p* x /p* y foreign terms of trade 1/ p w home terms of trade p = p w p* = p w / *

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Production possibilities frontier y x slope = p x /p y x0x0 y0y0

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Equilibrium tariffs world price local prices production consumption import export tariff revenue

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Figure 1 A C B D p(A) p(C) p w (A) p w (C) *

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Game Theory Each country sets its tariff given the other countrys tariff level. Each country sets its tariff given the other countrys tariff level. The resulting Nash equilibrium is inefficient. The resulting Nash equilibrium is inefficient. Only a trade agreement can establish a more efficient equilibrium. Only a trade agreement can establish a more efficient equilibrium.

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Prisoners dilemma two thieves captured two thieves captured each questioned separately each questioned separately confess or deny confess or deny

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Prisoners dilemma Burt Ernie confess deny 3 years 2 years 1 year 5 years 1 year

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Prisoners dilemma Burt confessdeny Ernieconfess3351 deny1522

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Trade dilemma Brazil Mexico tariffs open $3 $5 $6 $1 $6

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Trade dilemma Brazil tariffsopen Mexicotariffs3316 open6155

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Role of GATT/WTO GATT 1947 GATT 1947 WTO 1994 WTO 1994 WTO includes a dispute settlement system WTO includes a dispute settlement system Trade agreements can help move from the Nash equilibrium to the better equilibrium. Trade agreements can help move from the Nash equilibrium to the better equilibrium. This result requires repeated games. This result requires repeated games. reciprocity (constant trade volumes and terms of trade) reciprocity (constant trade volumes and terms of trade)

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Trade dilemma Brazil tariffsopen Mexicotariffs99138 open

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Bibliography Bagwell, Kyle and Robert W. Staiger Economic Theory and the Interpretation of GATT/WTO, American Economist 46,2: Bagwell, Kyle and Robert W. Staiger Economic Theory and the Interpretation of GATT/WTO, American Economist 46,2: 3-19.

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