1 An Economic Theory of the GATT : A

In a recent article in the American Economic Review, Kyle Bagwell and Robert W. Staiger (1999, hereafter B & S) have made a major contribution to answering the oft-posed puzzle (p. 215): What can governments gain from a trade agreement? Their answer is that:. .. a trade agreement is appealing provided that an inefficiency. .. exists under unilateral tariff setting.. .. Previous authors have established that the classic terms-of-trade externality creates an inefficiency in unilateral trade policies. For example, suppose a country unilaterally raises its tariff to improve its terms of trade, and its partner-faced with a resulting terms-of-trade loss-responds by raising its tariff, with both countries losing. A trade agreement that prevents such unilateral actions will allow these countries to avoid this loss. The difficulty is that B & S conclude that this terms-of-trade issue is the only reason for governments to enter a trade negotiation (p. 216, ital. added): "trade agreements are appealing to governments solely as a means to remedy the inefficient terms-of-trade-driven restrictions that arise when trade policies are set unilaterally." Specifically (p. 219, ital. added), "trade agreements are appealing to governments if and only if they serve as a means to remedy the inefficient terms-of-trade-driven restrictions in trade that arise under unilateral trade policies."