Self-Enforcing Trade Agreements and Private Information

Abstract

This paper considers self-enforcing trade agreements among privately informed governments. A trade agreement that uses weak bindings (i.e., maximal tariff levels) is shown to offer advantages relative to a trade agreement that uses strong bindings (i.e., precise tariff levels). Consistent with practice, the theory also predicts that governments sometimes apply tariffs that are strictly below their bound rates. When private information is persistent through time, an enforcement "ratchet effect" is identified: a government reveals that it is "weak," and thus that it is unlikely to retaliate in an effective manner, when it applies a low tariff. This effect suggests that a government with a low type may "pool" at an above-optimal tariff, in order to conceal weakness. It also suggests a new information-based theory of gradualism in trade agreements.