According to “An Economic Theory of the GATT” by Bagwell and Staiger (1999), the main purpose of a trade agreement is to escape from a terms-of-trade driven prisoner’s dilemma. This is where all countries have a collective incentive to liberalise trade but an individual incentive to adopt protectionist measures such as tariffs. Recent econometric evidence suggests that even relatively small countries set tariffs to leverage their power on world markets, broadening the applicability of the theory. Subsequent developments of the theory argue that in an uncertain world it is efficient to write a trade agreement as an incomplete contract that does not specify the exact levels of tariffs but instead imposes tariff ceilings that allow a degree of flexibility. Recent research uncovers an intriguing empirical regularity. On average small countries, which tend to be developing nations, set their applied tariff rates further below their tariff bindings than large countries, which tend to be developed, do. The explanation proposed is that larger countries, having more power on world markets than small countries do, have a greater incentive to behave opportunistically by raising their tariffs and hence must be bound more tightly by any agreement that is reached.

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Beshkar M. and E. Bond, (2013); “Cap and Escape in Trade Agreements.” University of New Hampshire and Vanderbilt University typescript. [Working paper version]

Beshkar M., E. Bond and Y.-W. Rho, (2012); “Tariff Binding and Overhang: Theory and Evidence.” University of New Hampshire and Vanderbilt University typescript. [Working paper version]

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Horn H., G. Maggi, and R. Staiger (2010); “Trade Agreements as Endogenously Incomplete Contracts.” American Economic Review, 100(1), 394-419. [Working paper version]

Syropoulos C., (2002); “Optimal Tariffs and Retaliation Revisited: How Country Size Matters.” The Review of Economic Studies, 69 (3): 707-727.