Free Trade, Time-Consistent Tariff, and Market Size: The Role of GATT/WTO as Commitment Devices
We examine whether free trade is superior to tariff policy if the government of an importing country cannot precommit to an ex ante optimal tariff rate in the presence of a time lag between production and trade decisions. Based on a simple partial equilibrium model with an export monopoly, we show that the preferable choice between free trade and a time-consistent tariff policy depends on the market size of the importing country. More specifically, if the market size is larger than a certain level, the importing country prefers free trade to the time-consistent tariff policy. However, because a free trade policy is not credible in the presence of a time lag, the government of the importing country requires international organizations and rules such as GATT/WTO as commitment devices. Thus, using a game theoretic approach, we analyze under what conditions becoming a member of the international organizations is a subgame perfect Nash equilibrium and show that a free trade policy under the GATT/WTO regime is Pareto improving for the importing and exporting countries.
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