Carrots, Sticks, and International Externalities

Abstract:     
Dispute-settlement panels of the General Agreement on Tariffs and Trade (GATT), as well as the GATT Secretariat, have condemned the use of trade restrictions by some countries to induce other countries to protect the global environment. The GATT Secretariat has recommended that countries rely on "carrots" rather than "sticks" to induce the participation of other countries in multilateral environmental agreements. This paper presents a formal model of a signaling game that suggests the type of "carrots only" regime suggested by the GATT Secretariat would create perverse incentives. Under conditions of asymmetric information, countries may seek to convince others that they bear large costs from pollution abatement by engaging in a great deal of pollution, so that other countries will offer larger "carrots" to induce abatement. In both pooling and separating equilibria, "carrots" encourage greater environmental harm pending a multilateral agreement.

JEL Classifications: F10, K32, K33

Accepted Paper Series