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Abstract

We study the optimal design of trade agreements when governments can renegotiate after the resolution of uncertainty but compensation between them is inefficient. In equilibrium, renegotiation always results in trade liberalization, not protection. The optimal contract may be a “property rule ” or a “liability rule. ” High uncertainty favors liability over property rules, while asymmetries in bargain-ing power favor property over liability rules. Moreover, optimal property rules are never renegotiated. With a cost of renegotiation, property rules are favored when this cost is higher, reversing a cen-tral conclusion of the law-and-economics literature. (JEL C78, D86, F13, F15, K12) Trade agreements are contracts between governments that are signed in the pres-ence of considerable uncertainty over future political and economic conditions. Naturally, once the uncertainty is resolved, governments will want to renegotiate a trade agreement if it turns out to be inefficient to implement the commitments contained in the original agreement. It is therefore not surprising that renegotia