Enforcing International Trade Agreements with Imperfect Private Monitoring: Private Trigger Strategies and a Possible Role for the WTO

Abstract

International trade disputes often involve the WTO as a third party that generates impartial opinions of potential violations when countries receive imperfect and private signals of violations. To identify the role that the WTO plays in enforcing trade agreements, this paper first characterizes what countries can achieve alone in a repeated bilateral trade relationship in which they can secretly raise their protection levels through concealed trade barriers. In particular, countries adopt "private trigger strategies (PTS)" under which each country triggers a punishment phase by imposing an explicit tariff based on its privately observed imperfect signals of such barriers. This paper identifies the condition under which countries can restrain the use of concealed barriers based on simple PTS, where each country imposes its static optimal tariff in all periods under any punishment phase: The sensitivity of private signals rises in response to an increase in concealed protection. Any equilibrium payoff under almost strongly symmetric PTS will be identical to the one under simple PTS, as long as the initial punishment is triggered by a static optimal tariff, justifying the paper's focus on simple PTS. With countries maximizing their expected payoffs under the optimal PTS, they will not push down the cooperative protection level to its minimum attainable level, thus not setting it to the free trade level even when it is attainable. To analyze a possible role of the WTO, this paper considers "third-party trigger strategies (TTS)" under which the WTO allows each country to initiate a punishment phase based on the WTO's judgment (signals) about potential violations. The WTO changes the nature of punishment-triggering signals from private into public, enabling countries to use punishment phases of any length under TTS, which in turn facilitates a better cooperative equilibrium. The optimal TTS will involve an asymmetric and minimum punishment if the probability of a punishment phase being triggered is low enough, but it will entail punishments involving a permanent Nash tariff war if the probability of a punishment being triggered is high enough. A numerical comparison of the optimal TTS and optimal PTS indicates that the contribution of the WTO is likely to be significant when the signals of potential violations are relatively accurate. The WTO enables countries to adopt a more efficient punishment, such as the asymmetric and minimum punishment, which in turn enables countries to be less tolerant of potential violations and attain a higher level of cooperation as a result.