Implem entationofT rad e AgreementsU nd er Asymmetric
Inform ationand W elfare G ainsfrom a M ultilateralR egim e
C
»aglar OÄ z d en¤
E m ory U niversity
J uly 2 0 0 0
A bstract
T his paperaims identify e±ciency gains thatcan be provided by multilateraldispute resolution processes even though they might not have any enforcement power. U nder certain
conditions, a dispute resolution system can di®use information abouta bilateralrelationship
quite e±ciently totherestoftheworld even ifitcan notalterbehaviorex post.T henewinformationcanbevaluablebyidentifyingtheprivateinformationofplayers moree±cientlyand
a®ectthebehavioroftheplayers in laterperiods.T his willimposedisciplineon badtypes,rewardgoodbehaviorintheinitialstagesandprovidewelfaregains.H owever,wheninformational
asymmetryis onesided,weshowthatamultilateralinformation dissemination mechanism can
notprovidefurtherinformationand,thereforebene¯ts,comparedtoasimplereputationalequilibrium.O ntheotherhand,itcanbequitevaluablewhenasymmetryis two-sidedbyproviding
narrowerinformation sets abouttypes.T his is where the main bene¯ts ofthe G A T T system
arelikelytobefound.
¤
Dept. ofE c onom ic s, E m ory U niversity, Atlanta, G A 30 32 2 . e-m ail:c oz d en@em ory.
ed u. Iw ould like to thank
Anne K rueger f
or suggesting the generalarea ofresearc h inmy d issertation, Avner G reif
, Steve T ad elis, R ob ert
Staiger f
or initialf
eed b ac k.Iw ould also like to thankthe partic ipantsat the InstitutionalDesign, Dispute Settlement
and InternationalT rad e c onf
ereence at Harvard U niversity,espec ially M arc h B usc h,Lisa M artin,P etrosM avroid is,
E ric R einhard t f
or c om m entsand the sta® ofthe W orld T rad e O rganiz ationf
or their hospitality d uring my visit
w hic h led to som e ofthe id easinthispaper.Allm istakesare my ow n.
1
1
In
trod uc tion
Internationaltreaties,especiallytradeagreements,areplagued bymanyproblems from acontract
theorypointofview.Firsttherearenointernationalcourts orpolicetoenforcethem whichmeans
they have to be self-enforcing. Second, they are incomplete in the sense there are many issues
thatare notveri¯able and/ortoo costly to be included in the contract. T hird, there are many
informationalasymmetries which cause moralhazard and adverse selection problems thatresult
in welfare losses.In lightofthese problems, any mechanism thatcan improve the outcomes and
provideP aretogains becomes extremelyvaluable.
O uraim inthis paperis toidentifye±ciencygains thatmightbeprovidedbydisputeresolution
processes ofmultilateralinstitutions suchas theW orld T radeO rganization(W T O /G A T T ).T hese
gains willberealizedthroughsolvingsomeoftheproblemslistedabove.EventhoughW T O /G A T T
does nothaveanyformalenforcementpower,its involvementinmanystages ofatraderelationship
(especially during the resolution ofdisputes)is an evidence ofthe high demand forits services
(Jackson [1 997]
).
T hegains from multilateralism is notanewideain theliterature.M aggi [1 999]
,forexample,
argues thatmultilateralpunishmentcan increasethee±ciencylevels oftradeagreements through
higherlevels ofpunishment(as opposedtounilateralpunishment)whencheatingoccurs.InO zden
[1 999]
, we argued thatmultilateralnegotiations can improve the P aretoe±cientfrontierthrough
exchange ofpolicies.In this paper, we willbe addressingan anotherpotentialbene¯tfrom multilateralism.W e willarguethat,undercertain conditions,adispute resolution system can di®use
information aboutabilateralrelationship quite e±ciently tothe restofthe world.T his information can be valuable by identifying the private information ofplayers more e±ciently and a®ect
thebehavioroftheplayers inlaterperiods.T his expostdisputeresolutionmechanism willimpose
disciplinein theinitialstages againstcheatingand willbemain avenueforwelfaregains.
T o explore these idea we willconstructa series ofmodels. In the ¯rstmodel, there are two
countries and one ofthem has private information about her type. A fterthe initialtrade liberalization agreementis signed, both countries need to undertake certain investment/actions for
liberalization to bearfruits. T hese can be costly politicaland economic policies such as worker
relocation programs orelimination oftrade-prohibitive domesticpolicies.T he importantpointis
2
thatthesearetoonumerous andcostlytobeincludedintheinitialtradeagreement.T his situation
is thestandard hold-up problem thatis closelyidenti¯ed with Klein,Crawford and A lchian [1 978]
andthatarises from incompletecontracts.Ifthe¯rstcountryis a\ bad"type,thenshewillbehave
opportunistically and renege on herpromises. T he second country, withoutperfectinformation
aboutthe type ofthe trading partner, willundertake the socially e±cientinvestmentonly ifthe
probabilityofabad typeis lowenough.
A multilateralenvironmentcanimposedisciplineontheopportunisticbehaviorof\ bad"types
ifits actions became public information and othercountries would refuse to even sign the initial
agreement. Fearing such retaliation, a bad type willbe more reluctant to renege on a promise
and have the incentive to establish a good reputation. H owever, we willassume that the rest
ofthe world can only observe ifthe agreement failed (via lowertrade volume)ornot, but not
speci¯c actions. In short, the threatofnon-cooperation in the future provides P areto gains. In
this framework,wecanintroduceavoluntarydisputeresolutionprocess towhichthetwocountries
agree beforehand. T his resolution process simply identi¯es initialactions, determines the guilty
party and requests compensation, but can not enforce the judgement. T he surprising result is
thatthis does notimprove welfare since, in the world ofone-sided informationalasymmetry, all
actions canbeperfectlyinferredfrom theoutcomes.A nextramechanism does notrevealanyextra
information and can notimproveupon theinitialequilibrium.
Fortunately,conclusions arenotas pessimisticwhenthereis two-sidedasymmetricinformation.
T his can beduetothepossibilityofboth countries havingtwotypes orduetothepresenceofan
externalshock thatcan lead toalowertrade volume.In this case, the restofthe world can not
perfectly identify thecountries'types from theoutcomes sincethetypespaceis multidimensional
and there is no one-to-one correspondence between types and actions. T he dispute resolution
process willrevealnewinformation thatwillenable the restofthe world to update theirbeliefs
aboutthe types ofthese twocountries more e±ciently.T his causes thereputation mechanism to
workbetterbyrewardinggoodtypesandpunishingbadtypes moree®ectively.T heresultisfurther
P aretogains.
W hatdo these results imply forthe W T O /G A T T system? A ta theoreticallevel, itenables
us to see the limitations of the dispute resolution process. T he information di®usion can not
providefurtherP aretogains undereverycircumstance.FortheretoexistP aretogains,thereneeds
3
tobe multidimensionaluncertainty.Furthermore, there needs tobe mechanisms thatcreate the
incentives toestablish and maintain reputation.T his motivation can beoneofthereasons ofthe
slow nature ofthe liberalization process since ittakes time to di®use information and establish
reputations.T herefore, itbecomes crucialforW T O /G A T T to have an open environmentwhere
information is transmitted immediately and clearly.Finally, the factthatG A T T can notenforce
its decisions does notmean itdoes notpreform ausefulservice.B y providingbetterinformation
aboutplayers'truetypes,G A T T canenabletherestoftheworldtoprovidethenecessarydiscipline
and punishment.
T henextsection willprovidethemotivation forthepaperand Section 3 introduces theinitial
model. Section 4 establishes the P areto superiorreputationalequilibrium. Section 5 introduces
a multilateraldispute resolution process that can di®use information and shows the absence of
P aretogains.Section 6 modi¯es modelby introducingtwo-sided informationalproblems.Section
7provides areputationalequilibrium and shows theexistenceoffurthergains from G A T T in this
case.Conclusions follow.
2
T he Story
T he motivation forthe modelcomes from a typicaldispute thatis broughtto the G A T T /W T O
forsettlementunderA rticleX X III.T hesetwocountries willhavesigned an agreementin thepast
which called forreciprocalloweringoftari®s and othertradebarriers.T hechallengerclaims that
the initial bene¯ts that she expected to receive from the agreement never materialized mainly
duetocertain prohibitivedomesticpolicies the defendingcountry enacted (orfriendly policies he
failed toenact)afterwards (Y arbrough and Y arbrough [1 987]
).T hesepolicies can includelaboror
healthstandards,extrataxes thatmainlytargetimportsorcompetitionpoliciesthatfavordomestic
import-competing¯rms.InthelanguageoftheG A T T ,theconcessions thatthechallengerreceived
are\ nulli¯ed and/orimpaired"atthe outcome.Itis importanttonote thattheactualbreach of
legalobligations is neithernecessary norsu±cientunderthe G A T T rules to initiate the dispute
settlementprocess (Jackson [1 997]
).In an importantcase, G A T T panelstated thatnulli¯cation
orimpairment can be caused by actions that \ could not reasonably have been anticipated" by
the plainti® at the time of negotiations (H udec [1 975]
). In otherwords, G A T T recognizes the
4
incompletenatureoftradeagreements andaddresses theimportanceofresolvingthedisputes that
arisefrom this.
Inmostcircumstances,thechallengerrequeststocanceltheinitialconcessionsthatsheprovided
ortoenactotherprotectivemeasures (probablyinanothersector)tocompensateforherloss.T he
defenderclaims thathe complied with the initialagreementand lowered his trade barriers.T he
domestic policies in question have been in place at the time or were never part of the initial
negotiations ordonotcausethedamagethatthechallengerclaims toexist.T heclaim canevenbe
that,as asovereign country,thegovernmenthas therighttoimplementanypolicyitdeems tobe
inthebestinterestofits people.T hetradeconcessions arestillin placeandtheyarenotnulli¯ed.
T hus thecaseis withoutmeritand should bedismissed.
T heimportantpointis thatboth sides arelikelytobecorrectin theirclaims.W hen atrading
partnerlowers hertari®barriers,theincreaseinexports tothis marketand,therefore,welfaregains
arenotguaranteed.T heimportingcountrycaneasily\ undo"theloweringofprotectionism through
a multitude of\ opportunistic" domestic policies, even though these mightbe less e±cientthan
directtari®s (Y arbrough and Y arbrough [1 987]
).Forexample, an increase in portfees, subsidies
todomestic production, excessive the technicalrequirements thatforeign goods willhave a hard
time to match would limit the expected increase in trade volume. Some otherpolicies can be
more complicated. A llowing domestic producers to controldownstream distribution channels to
limitthe foreign companies'access tothe consumers is one ofthe favorite criticisms ofA merican
tradenegotiators againstJapan.A completelydi®erentpossibilityis thatstructuralchanges inthe
economy need to take place forthe liberalization and the increase in the trade volume to occur.
T heremightbeneedtohaveworkers shiftedfrom theimport-competingsectortotheexportsector
orto have certain infrastructure projects completed. R elocation of workers is rarely a smooth
process, both in economic and politicalterms.Itmightrequire extensive retrainingprograms at
greateconomiccosts and possiblecon° icts with laborunions with signi¯cantpoliticalcosts.Since
all of these changes are costly, especially in the short run, governments might be reluctant to
undertakethem which would lead \ nulli¯cation"ofconcessions and disappointmentofthetrading
partners.
A lloftheabovecases would providelegitimacytothechallengingcountry'
s case.D espitethe
claims tothecontrary,thedefendingcountrymightactually haveimplemented thecostly policies
5
andresistedthepressure(orthetemptation)toimplementotherprotectionistpolicies.Sincethese
actions arealreadysunk,thechallengermight wanttotakeadvantageofthesituation and refuse
toimplementherown costly policies orrenegotiatetheirinitialagreementtoobtain furthergains
thatwere notavailable in the initialnegotiation stage. In short, the true realization ofthe full
bene¯ts ofaliberaltrade agreementrequires both parties toundertakefurtheractions and/orto
promise nottoimplementcertain policies.In return, tradingpartners need tocommittonotto
engagein post-contractualopportunism.G A T T disputesettlementprocess is keenly awareofthe
factthatsimple lowering oftrade barriers is a ¯rststep in the rightdirection to reach a P areto
superioroutcome,butis rarelythecompletejourney.
T his is themain scenariowewillanalyzein this paper.W ewillassumethatthetwocountries
have already signed a treaty thatlowers tari®s.H owever, they need to undertake costly actions
forthe true bene¯ts ofthe treaty to be realized and forthe trade volume to increase above the
pre-treatylevel.T heuncertainties aboutthemotivationoftheotherpartywillcausethecountries
torefrainimplementingthesepotentiallypro¯tableactions.T herestoftheworldonlyobserves the
tradevolume(nottheactions)and willtry toinfertheirtypes from theoutcome.G A T T dispute
resolution process simplyannounces whatactions each partytotherestoftheworld.
3 T he M od el
A crucialobservation forthemotivation ofthis paperis thefactthatthedispute in this scenario
would neveroccurin a world ofperfectinformation and complete contracts.A llofthe problems
associated governments who implement domestic policies that favor local producers or do not
undertake the required investments can be easily resolved by an explicittrade agreement.O nce
thecontractlists theactions thatareallowedand/orprohibited,alloftheclaims for\ nulli¯cation"
willbe preempted.P revention ofpost-contractualactions by opportunistictradingpartners after
certain sunk investments are made is more problematic.Ifthe othergovernmentis known tobe
opportunistic (i.
e. a bad type), then the treaty would eitherspecify excessive penalties against
opportunism (ifitenforceable)oritwould notbe signed in the ¯rstplace.In short, in a world
of perfect information, parties would sign a complete contract that would anticipate all future
contingencies.Even ifthe economic environmentincluded uncertain events thatwillbe resolved
6
aftertheinitialnegotiationstage,thecontractcanspecifyactions tobetakenforeachpossibility1.
T herefore, thedispute resolution process ofthe G A T T aims toresolve contractualproblems that
ariseex-post,mainlycausedbyasymmetricinformationorincompleteness ofcontracts.T hemodel
wepresentherewilladdress theseissues.
T here are two trading partners, A and B , who realize thatthere are welfare gains to be obtained from reciprocalloweringoftheirtradebarriers.T hefullrealization ofthebene¯ts toboth
countries from lowtari®s requirethem undertakecostlyactions which wewillcallinvestments for
theremainderofthepaper.A s westatedabove,thesemightincludepoliticalcosts (suchas ¯ghting
thepreviouslyprotectedsectors andresistingtheirdemands fordomesticpolicies thatdiscriminate
in theirfavor)oreconomic costs (such as retraining workers who willlose theirjobs during the
restructuringoftheeconomyandinvestments ininfrastructure.
)T hesecosts cannotbecontracted
uponinthetradeagreementbut,intheG A T T terminology,countries havereasonableexpectations
thattheywillbeimplemented2 .
In the ¯rstmodel, there is no uncertainty aboutB who is a good type.T he payo®forB is
represented by v(a;b)where a is the action ofA and bis the action ofB . A ction a takes two
values:itis equaltoc(\ cooperate")ifinvestmentis undertaken and is equalto0 otherwise.T he
same holds foraction b.Ifa = c, then B prefers toinvestas well.O n the otherhand, ifa = 0 ,
then B willnotwanttoinvest.A lso,B prefers thatboth investand obtain thebene¯ts oftrade
liberalization ratherthan noneofthem investing.Finally,sheprefers thatatleastA investifB is
notgoingtoinvest.T herefore,herpreferenceorderingis thefollowing:
v(c;c)> v(c;0 )> v (0 ;0 )> v (0 ;c)
T hepayo®stogovernmentA from di®erentinvestmentoutcomes depends onits type(forexample,howstrongthedomesticanti-freetradelobbies are)and whetherB performed theinvestment
T hestrength ofthegovernmentis denotedbyL whichcanbestrong,s,orweak,w.A stronggovernmentcan withstand pressures from lobby groups and aims tomaximizetotaldomesticwelfare
ratherthan thepayo®s ofanarrowinterestgroup.A weakgovernmentcan notresistthepolitical
1
W e are ignoring the prob lem sassoc iated w ith the enf
orc em ent ofc ontrac t w henthere are no c ourtsor polic e.
eveninthe w orld ofc om plete c ontrac ts.T hisob viously isa seriousprob lem f
or internationaltrad e agreem entsb ut
it isb eyond the sc ope ofthispaper.See Dixit [19 87]f
or anintrod uc tion.
2
inthe next sec ion,w e w illsee that the good type w illim plem ent these polic iesinequilib irum .
7
pressures forprotectionism attheexpenseofdomesticwelfareT hetruevalueofL is known by A
while governmentB only has information on its probability distribution.W e willassume thatB
knows thatthegovernmentis strongwithprobabilityp where0 ·p ·1 andA knows thesebeliefs
as well.T his featureforms theasymmetricinformation in themodeland itcan notbecontracted
upon directly in the model.T he payo®s forA willbe denoted by u(L ;a;b)where L is hertype
anda;baretherespectiveactions ofthegovernments.Foranylevelofstrength andforanyaction
byA ,governmentA prefers thatB invests:
u(L ;a;c)> u(L ;a;0 )
forallL 2 fs;wg and a2 fc;0 g
IfthegovernmentofA is weak,sheprefers nottoinvestregardless oftheinvestmentby B .A lso,
weakA prefers lowtari®s withinvestmenttohigh tari®s with noinvestment.T hus,thepreference
orderingbyaweaktypeofA is given bythefollowing:
u(w;0 ;c)> u(w;c;c)> u(w;0 ;0 )> u(w;c;0 )
O ntheotherhand,ifsheis strong,A prefers toinvestonlyifB invests.T hepreferences ofastrong
typearegiven bythefollowingordering:
u(s;c;c)> u(s;0 ;c)> u(s;0 ;0 )> u(s;c;0 )
W ewillalsoassumethatinvestments aresocially e±cientregardless ofthetypeofA .
H avingestablishedthepreferenceorderingsoftwogovernments,nowwecansetup thestructure
ofthegame.W eassumethattheyinitiallymetinperiod1 tolowertheirtari®sfrom theirinitialhigh
levels andundertakeinvestments.T hetari®s areimplementedimmediatelyandbuttheinvestment
decisionbyB canonlybeundertakenatperiod2.T heinvestmentlevelis observablebyA butisnot
contractibleatperiod1 sothetextofthetreatycanonlyincludethetari®level.A fterobservingB '
s
investmentdecisioninperiod2,A decides whethertosticktotheinitialagreementandimplement
herinvestmentortorenegeon thetreatyand neverimplementthepromised investment.A tthat
point, the investmentby B is a sunk costand the decision is irreversible. T he initiallowtrade
volumewillincreaseand providewelfarebene¯ts ifand onlyifboth sides implementinvestments.
T his is thevariablethattherestoftheworld can observe.T heactualinvestmentdecisions ofthe
countries arenotobserved by anybodyelse.
8
B eforeweproceedto¯ndtheequilibrium outcomeofthis game,wewillmakesomeobservations
thatwillsimplifytherestoftheanalysis considerably.T heagreementoflowtari®s is irrelevantif
one ofthe countries does notinvest.Since both countries actually knowtheircontingentactions
(ortheirstrategies)fortherestofthegame,wewillnotincludeaformalbargainingovertari®s in
this stage.W ithoutloss ofany generality,wecan assumethatboth sides agreetolowtari®s even
though theymightknowtheywillnotinvestsincethis does nota®ecttheirpayo®s.
W ecan¯ndtheequilibrium ofthis simplegamebybackwardinductionarguments.Inperiod3,
aweakA willrenegeon theinitialagreementand notinvestwhetherregardless ofB '
s investment
decision in the previous stage. O n the otherhand, ifshe is strong, A willinvest only ifB did
implementthe investments in period 2. In otherwords, ifthere was no investmentin period 2,
therewillbenoinvestmentbyA regardless ofhertype.Iftherewas aninvestment,onlythestrong
typewillinvest.
G iven the equilibrium strategies for both type of A in period 3, B will invest only if the
probability ofinvestmentbyA is high enough.T heexpected payo®from investmentis pv(c;c)+
[1 ¡p]v(0 ;c)whilethepayo®from notinvestingis v(0 ;0 ).T hereforeB willinvestifand onlyif
p ¸p¤ ´
v(0 ;0 )¡v(0 ;c)
v(c;c)¡v(0 ;c)
wherep¤ is theminimum probabilitylevelofweaklobbyneededforinvestment.IfB believes that
p < p¤,thensheknows thatshewillnotinvestinperiod2 regardless ofwhatmighthavetranspired
between the two governments in period 1 . L ow trade volume willoccurand no bene¯ts willbe
realized.
N ow,wecancharacterizetheperfectB ayesianequilibrium strategies ofthis game:B willinvest
in period 2 ifand onlyifp ¸p¤.A weakA willrenegeon theagreementand notinvestregardless
ofB '
s decision in period 2.A strongA willinvestonlyifB investin theprevious period3.
In equilibrium,itis possiblethatA is astrongtypebutP aretoe±cientoutcomeoflowtari®s,
positive investments and high trade volume are notreached.T here is no mechanism in place in
this scenarioforastronggovernmenttoconvinceB toinvestin period 2.A ny signalthatcan be
3
Asw e stated earlier,w henp < p 1 there are tw o other equilib ria.T he ¯rst statesthat A o®ers(l;c
) and B rejec ts
thiso®er.T he sec ond one statesthat A sim ply d oesnot m ake ano®er.Since allofthese equilib ria lead to the sam e
payo®s,w e ignore them f
or sim plic ity.
9
sentin theperiod 1 ,can costlesslybereplicated bytheweaktypes and thereforeitis notcredible
and does notrevealany information.Itis alsopossible thatA is weakand takes advantageofB
by renegingon an initialagreementafterherinvestmentand causinghertoobtain apayo®lower
thanherdefaultoption.B othoftheseequilibrium outcomes aresociallyine±cientandthereis no
way topreventthem.T he aim ofthe nextsections is to¯nd mechanisms through which we can
eliminatesomeoftheseine±cientequilibria.W ewillarguethatamultilateralenvironmentwhich
allows theestablishmentofreputation can servethis purpose.
4
T he R ol
e ofR eputation
T here are numerous models and papers on the role reputation in games and otherstrategicsituations.Forreputation to exist, we need tobe in an asymmetric information world in which the
typeofan actoris notknown with certainty byothers.Furthermore,weneed tobein arepeated
oramultistageenvironmentsothatreputation can build up and haveimpacton theequilibriaof
the games.Finally, reputation needs tobe costly toacquire and this costneeds tobe higherfor
bad types so thatitcan have signallingvalue in the future stages.A lso, the more fragile (more
easytolose)theinformationis and moreeasilyitcan betransmitted torelevantparties,themore
valuableitbecomes.
In thefamous chain-store paradox, Kreps and W ilson [1 982]and M ilgrom and R oberts [1 982]
considera chain-storewhich faces potentialentry by competitors in anumberofmarkets in each
period. It has the option to ¯ght orto acquiesce when entry occurs. Fora tough monopolist,
the optimalchoice is to ¯ght. A weak one, on the otherhand, willpreferto acquiesce ifentry
occurs. O fcourse the ¯rstbestfora monopolistis an entry notto occurso thatshe can enjoy
monopoly pro¯ts.Foran entrant, the optimalchoice is to enterifthe monopolistwillacquiesce
and tostay outifshe will¯ght.Ifthe type ofmonopolistis public information, the equilibrium
is obvious.Ifshe is tough,noentry occurs.Ifshe is weak, entry always occurs and she does not
¯ght.Ifhertypeis notpublicinformation and thereis onemarketforentry,then entrywilloccur
iftheprobability ofatough type is lowenough.T heinterestingequilibrium occurs ifthe typeis
unknown and there are multiple (but¯nite)periods in which a di®erententrantdecides toenter
afterobservingtheoutcomes in previous periods.T hereputation mightbevaluablehere:A weak
10
monopolistmight¯nditworthwhileto¯ghtin theinitialstages toconvincethepotentialentrants
thathe is tough to deterentry. T he shortterm price ofthe reputation willbe worth itonly if
therearehigh enough numberofpotentialentrants and theinformation about¯ghts can beeasily
disseminated tooutsiders.
T hesamelogiccaneasilybeappliedtointernationalnegotiations andrelationships suchas the
one we described in the previous section.W e willmodify the game alongthe followinglines and
see ifreputationalincentives can provide P aretogains.G overnmentA interacts with government
B
1
in the¯rststageofthegameexactly as described above.O ncetheirperiod 3 is overand they
realizedtheirpayo®s,A opensnegotiations withB 2 .T hegamebetweenA andB
previous gamebetween A andB
1
exceptwiththefactthatB
2
2
is identicaltothe
observes thetradevolumeoutcome
between A and B withoutobserving theirinvestmentdecisions.H igh trade volume implies that
bothcountries investedandespeciallyA didnottakeadvantageofthesunkinvestmentofB 1 .L ow
trade volume, on the otherhand, mightimply thateitherB
1
did notinvestorA took advantage
ofthesituation despitetheinvestment4 .T his observation oftradevolumeis stillvaluablesinceit
willenableB
2
toupdateherbeliefs aboutA '
s typeandpossiblychangeherbehaviorinthefuture.
T hechangein thebeliefs ofB
B
2
2
is equivalenttoareputation forA .A high volumeobservation by
wouldstrengthenherbeliefs thatA is astrongtype(anincreaseinp)andwouldmakehermore
likely toinvestwhen itis herturn.T his would give a weak A an incentive nottorenege against
B
1
which is thesource oftheP aretogains wearelookingfor.T he actions ofA in the¯rstgame
serveas acostlysignalofhertype.Ifothercountries could observetheinvestmentdecisions byB
orcould notobservethe outcomeofthegame atall,reputation would have novalue.In the¯rst
case,whentheyobservethetradevolumetheywouldautomaticallyknowthecause.Inthesecond
case,thesacri¯cebyA wouldnotbetransmittedandwouldnotcausethentoupdatetheirbeliefs.
T heequilibrium ofthis newgame again has tobeP erfectB ayesian which needs tosatisfy the
following: (i)A t each information set, when it is herturn to make decision, each playerhas a
beliefora probability distribution overthe nodes in the information set.(ii)Strategies mustbe
rationalateveryinformationset,inthesensethattheyhavetobeoptimalgiventhebeliefs andthe
4
It isc ruc ialto em phasiz e the c ontrac tualpropertiesofthe investm ent prom ised b y B .It isob servab le b y only A
and B and isnot veri¯ab le b y any other governm ent.T hisisw hy itsinclusioninthe initialtreaty w ould not have
any e®ec t.
11
hypothesized futuremoves oftheotherplayers.(iii)T hebeliefs need tobe updated usingB ayes'
ruleand otherplayers'equilibrium strategies.
A gain severalobservations are in orderbeforewe startthe formalanalysis.(1 )Ifequilibrium
calls forB
1
toinvest,then strongA willalsoinvestsincethis is theoptimalstrategy.(2)Suppose
the equilibrium strategy calls forA to investregardless ofhertype.T hen the same equilibrium
strategyneed torequireB
1
toinvestin period 2 sincethatis herbestresponseagainst(afuture)
investmentbyA .
N owwe willcharacterize an equilibrium.L etp bethe common beliefofB 1 and B
probabilityofastrongA attheverybeginningofthegame1 beforeA and B
1
2
aboutthe
play.Firstde¯ne
v (0 ;0 )¡v(0 ;c)
v (c;c)¡v(0 ;c)
p 1 ¡p¤
¼ (p) =
1 ¡p p¤
¤¤
p
= (p¤)2
p¤ =
T heequilibrium strategies aregiven bythefollowing5:
Ifp > p¤:B
1-
thesecond game,B
2
1
willinvest. A , regardless ofhertype willinvestonly ifB
1
invested.In
willinvest,ifsheobserves high tradevolumein theprevious game.Shewill
notinvestifsheobserves lowvolume.StrongA willinvestonlyiftherewas investmentbyB
2
and
weakA willneverinvest.
Ifp¤ > p > p¤¤:B
2-
1
willalways invest.StrongA willinvestonly ifB
A willinvestwith probability ¼ (p)ifB
game, B
2
1
1
invested.W eak
invested and shewillnotinvestotherwise.In thesecond
willinvestifshe observes high trade volume and does notinvestotherwise.Strong A
willinvestonlyifB
2
invested and weakA willneverinvest.
5
T here isanother sim pler equilib rium b ut the c onclusionsofthe paper d o not c hange.W e w illpresent it here f
or
c om pleteness.
1 - Ifp > p ¤:B 1 w illinvest.A,regard lessofher type w illinvest only ifB 1 invested .Inthe sec ond gam e,B 2 w ill
invest,ifshe ob serveshigh trad e volum e inthe previousgam e.She w illnot invest ifshe ob serveslow volum e.Strong
A w illinvest only ifthere w asinvestm ent b y B 2 and w eak A w illnever invest.
2 - Ifp ¤ > p: B 1 w illnot invest and strong A w illinvest ifB 1 invested w hile a w eak A w illnever invest.Inthe
sec ond gam e,B 2 w illinvest only ifshe ob serveshigh trad e volum e previousgam e.StrongA w illinvest only ifthere
w asaninvestm ent b y B 2 w hile a w eak A w illnever invest.
12
Ifp¤¤ > p:B
3-
1
willnotinvestand strongA willinvestifB
neverinvest.In the second game, B
2
1
invested whileaweakA will
willinvestonly ifshe observes high trade volume previous
game.StrongA willinvestonlyiftherewas aninvestmentbyB
2
whileaweakA willneverinvest.
T oshowthatthesestrategiesform anequilibrium,weneedtoshowthatdeviationsbyanyplayer
donotform an equilibrium and beliefs are consistent.T he formalproofis given in A ppendix A ,
butwewilllookatthecertain features oftheequilibrium moreclosely.
Iftheinitialprobabilityofastrongtype,p is high,then B 1 willalways investregardless ofthe
reputationalconcerns ofA and both B
2
and aweakA areawareofthis.SinceastrongA always
invests,lowvolumecan onlyimplyaweakA sincestrongA willalways invest.IfaweakA invests
then B
2
willnotupdate herbeliefs aboutp and shewillinvestsinceshe can nottellthem apart.
Since weakA will¯nd itoptimaltohide his true nature6, hewillinvestin the ¯rstgameagainst
B
1
nottorevealhis identitytoB 2 .Inthis case,boththevalueofgoodreputation and thecostof
abad reputation arehigh.
Iftheprobabilityofastrongtypeis in themiddlerange,weaktypes donotneed tomimicthe
strongtypes allthetime.Supposetheequilibrium required again weaktypes toinvest.A gain,B
2
only observes high tradevolume and can notdistinguish between strongand weaktypes and can
notupdateherbeliefs.H owever,herbeliefofp is stilllowerthanthethresholdlevelofp¤ soshewill
notinvest.T henaweakA '
s payo®willbeu(w;c;c)+ u(w;0 ;0 ).O ntheotherhand,ifequilibrium
requires weakA nottoinvestingame1 ,B
2
wouldalsorecognizethis andwouldneverinvestunder
lowvolumeobservation.T hetotalpayo®foraweakA wouldbeu(w;0 ;c)+ u(w;0 ;0 ).IfaweakA
weretoinvestonlywithprobability¼,thenB
2
wouldupdateherbeliefsaboutastrongA toahigher
p
leveldenotedbyb
p = p+ (1¡p)¼
.IfaweakA weretochoose¼ suchthatb
p = p¤,thenB
2
wouldinvest
and weakA '
s totalpayo®would be¼u(w;c;c)+ [1 ¡¼]u(w;0 ;c)+ ¼u(w;0 ;c)+ [1 ¡¼]u(w;0 ;0 )
which is higherthan theprevious twocases.W eshould notethatif¼ weretoohigh then p
bwould
be lowand B
2
would notinvest.T hatis why ¼ is an increasingfunction ofp.Furthermore, B
1
willinvestonlyiftheprobabilityofinvestmentinthenextperiod is highenough.T his probability
is p+ (1 ¡p)¼ which creates lowerboundarydenoted as p¤¤. A gain,in this range,B
B
1
2
knows that
is de¯nitely investing.L owvolume de¯nitely implies weak type whereas high volume implies
weaktypeonlywith probability1 ¡b
p.Inthis casetheobservation ofthetradevolumeis valuable
6
Since u(w ;c
;c
)+ u(w ;0 ;c
) > u(w ;0 ;c
)+ u(w ;0 ;0 ).
13
toacertainextentsince,as opposedtotheprevious range,highvolumeleads tobetterinformation
aboutstrongtype(higherp).
W hen the initial probability of strong type is too low, it is not possible to reveal enough
information in the¯rstgame toconvince B
B
1
2
thatthere is high enough chanceofstrongA .Since
does notinvest,noinformation willberevealed aboutthetypeofA even ifsheinvested since
trade volume willstillbe low.R eputation is toocostly toacquireand,therefore,weaktypes will
neverinvest
Itis veryclearhowthepowerreputationimproves theequilibrium andprovides e±ciencygains
compared tothe previous case.Ifthe previous section'
s gamewas simply repeated twicewith no
informationallinkages (B
B
1
2
does notobservethetradevolume)andwiththesameex-antebeliefs by
and B 2 ,the equilibrium would beidenticalin twogames.W e can summarizethe equilibrium
outcomein thefollowingtable7:
R angeforp
G amerepeated twice
B oth B
p > p¤
1
and B 2 invest
p¤¤ >
p
B oth B
1
and B 2 invest
StrongA always invests
B oth types ofA investin game1
W eakA neverinvests
O nlystrongA investin game2
N oinvestmentbyB
p¤ > p > p¤¤
R eputation G ame
1
and B
2
B
1
invests,B
2
invests w/prob.
p+ (1 ¡p)¼:StrongA invests.
N eithertypeofA invest
W eaktypes investw/prob ¼ in
in eithergame
G ame1 and neverin G ame2
N oinvestmentbyB
1
and B
N eithertypes ofA invest.
2
N oinvestmentbyB
1
and B
2
N eithertypes ofA invest.
T he equilibrium outcome is identicalforlow expectations ofa strong type. H owever, when
the expectations are really high (p > p¤), we guarantee the complete commitmentto the initial
agreementand positive investment in the ¯rstgame by weak types. T his enforcementthrough
reputation is quite valuable forB
1
and she reaps the bene¯ts by guaranteed high trade volume.
W ehaveimprovements formedium levels ofp (wherep¤ > p > p¤¤)as well.P reviously,wehad no
7
W e should m ake sure to d istinguish equilib rium strategiesand outc om es.Strategieslist the ac tionsand b elief
s
f
or allplayersat eac h nod e eventhough they m ight not b e reac hed .O utc om e sim ply statesthe ac tionsand payo®s
alongthe nod esthat are reac hed .
14
investmentin this range.N ow,wehaveinvestmentin the ¯rstgame with probability 1 and with
positive probability (p + (1 ¡p)¼)in the second game. Similarly strong types enjoy guaranteed
investmentand payo®u(s;c;c)in both games. W eak types are forced to implementinvestment
atleastsome ofthe time in game 1 notto revealtheirtrue type.T he only playerto gethurtis
B
2
since she gets payo®pv(c;c)+ (1 ¡p)v(0 ;c). T his is lowerthan whatherpayo®would be
otherwise withoutthe new information which is v(0 ;0 ). H oweverwe can show the totalsocial
welfareis higherin this reputationalequilibrium.
A s expected,weaktypes always renegein thesecond game sinceitis the lastgameand there
is novalueforreputation afterthis.Ifthis gamewas repeated manytimes,weexpectnocheating
by weak types in more games and foreven lowercuto®levels ofp.A s the shadowofthe future
gets longer, the fragility and therefore the value ofreputation increases. In short, reputation is
a valuable enforcementmechanism when there is asymmetric information which can be (atleast
partially)revealed through actions.
Finally, we should note thatthe bene¯ts ofreputation on strong types and the discipline it
provides on weaktypes improve as heplays the game with highernumberofB '
s (assumingthey
can observe the trade volumes ofallprevious games).Ifthe game is repeated enough numberof
times, then weakA willalways investin initialstages regardless ofthe value ofp.T his is simply
due to the factthatthe costofrevealing hertrue type become too high as she expects to meet
highernumberoftradingpartners.Inthelimitcasewheretherearein¯nitenumberofB '
s,wecan
showthatthereis an equilibrium in which aweakA always invest.T his is asimpleapplication of
thefamous folktheorem of¯nitelyrepeated games as in thechain-storeparadox.
5 T he R ol
e ofthe G AT T
In the previous section, we showed how repetition ofthe game and the strategic value ofinformation di®usion can provideP aretogains through reputationalmechanisms.In particular,wesee
signi¯cantimprovements in earlierstages ofagame when there are gains from establishingreputation and hidingtheirtruetypes forweakplayers.T his causes them tocooperatewith theother
players and toinvestduetothefearoffutureretaliation andloss ofcredibilitywith otherplayers.
R eputation is acquired through theobservation ofasignal(tradevolume)thatis imperfectlycor15
related with actions oftheplayers.Itis importanttore-emphasizethatB
2
onlyobserves whether
ifthere is high volume (both invested)orlow volume (at least one ofthem did not invest). If
she observes lowvolume, she does notknowwhetherthis is due to B 1 '
s orA '
s (orboth)failure
toinvest.Shecan only drive inferences from herobservations and update herbeliefs.O nemight
thinkthatabetterinformation transmissionmechanism canimprovetheequilibrium evenfurther.
T his is whereG A T T disputeresolution process willenterthepicture.
Firstweshouldexplain themainfeatures oftheprocess.A rticleX X III provides themainlegal
basis forthedispute settlementin G A T T buttheactualprocedures weredeveloped overdecades
ofpracticeand they had three main features (Jackson [1 997]
).First,as westated earlier,dispute
settlementprocedurecanbeinvokedbyaplainti®onthegrounds of\ nulli¯cationorimpairment"of
bene¯tsthatwere\ reasonablyexpected"atthetimeofinitialagreementanddoesnotrequireactual
breach oflegalobligations.T his is the recognition ofthe incomplete nature oftrade agreements
and the possibilities ofopportunistic behaviorby governments.T he second feature is aboutthe
actualprocess ofdisputeresolution.G A T T authorizes theCO N T R A CT IN G PA R T IES (members)
to investigate, recommend action and give rulings on the matter.T he main institution tocarry
out these actions is the panelofexperts who would act as representatives ofG A T T , not their
own governments. T hen their ¯ndings and recommendations would be submitted to allof the
CO N T R A CT IN G PA R T IES for¯naldecision.T hisprocessrevealstheimportanceG A T T attached
tothecredibilityofthepanelas welltheas thetothedisseminationofinformationtoallmembers
sincealloftheprocesses arehandled publicly.T hethird featureis theabilitytoauthorize(byall
CO N T R A CT IN G PA R T IES)a plainti®to \ suspend equivalentconcessions"againsta defendant
ifhe is found guilty.M embers were keenly awareofthe limited enforcementpowerofthe G A T T
decisions,butthis punishmentstagewas importantforthecredibilityofthesystem.T hefactthat
thevastmajorityofthecases wereresolved beforereachingthis stageis interpreted as evidenceof
thesuccess ofthesystem (H udec[1 975]
).
Intheprevious section,wehaveshownthatareputationmechanism can increasethee±ciency
and preventopportunisticbehavior.N ow,wewillaim toseeifaG A T T disputeresolution system
described above can provide further e±ciency gains. Suppose A and B
1
conduct their initial
agreementunderthe auspices ofthe G A T T and agree toreferalldisputes toaG A T T panel.T o
representthis process, we willmake the followingchanges tothe underlyinggame tointroduce a
16
verysimpli¯ed version oftheG A T T disputeresolution process8 .A fterperiod 3 in the¯rstgame,
A can go to the G A T T claim that the promised investment was not undertaken by B
1
which
signi¯cantlynulli¯es thebene¯ts heexpected toreceive.T his is de¯nitelytrueforboththestrong
and the weak type since u(s;c;c)> u(s;0 ;0 )and u(w;c;c)> u(w;0 ;0 ). Furthermore, A can
claim thatthis is thereason why heshould nothavetoimplementlowtari®s.A can demand B
1
toundertakeherinvestments thatwere\ reasonably expected"and promisetoimplementhis low
tari®s onlyafterthat.Similarly,ifthereis noinvestmentbyA instage3 ofthe¯rstgame,B
1
can
gotothepanel,claim thatsheful¯lledherobligations byinvestinganddemandA toinvestas well.
T he G A T T panelhas limited enforcementpowerand can notforce any governmenttoundertake
any investments orimplementany policies they donotwantto.T he only powerwithin G A T T '
s
arsenalis to revealto the restofthe members whetherifthe investmentis actually undertaken
ornot.G A T T panelcan,ofcourse,demand B 1 orA toinvesttoreceivethefullbene¯ts oftrade
liberalizationbutcannotpunishthem iftheydonotwanttofollowthejudgement.T heacceptance
ofthedecision oftheG A T T panelhas tobevoluntary.T hemain bene¯tofthemechanism occurs
when B
2
infers from the panel'
s conclusion whetherthe cause ofthe low trade volume was the
absenceofinvestmentbyA orB
1
and updates herbeliefs aboutp tochangeherbehavior.
W e willnow try to see ifthis information revelation by G A T T can improve welfare. W hen
p > p¤,B
1
investsandbothtypesofA investalongtheequilibrium pathaswestatedintheprevious
section.T hereforethereis nodispute¯led and nonewinformation revealed.If p¤ > p > p¤¤,B
1
willalways investbutthereis probability(1 ¡¼)(1 ¡p)thatweobservelowvolumesinceaweak
A invests withprobability1 ¡¼.T hen B
lowtari®s as promised.Ifp < p¤¤;B
1
1
can gototheG A T T panelandrequestA toimplement
does notinvest.N ow, there is a legitimate case fora suit
and both types ofA willgotothe G A T T .In short, we willsee a dispute ¯led by B
1
only when
p¤ > p > p¤¤ and by A when p < p¤¤.
A suit¯led by B
1
and the decision ofthe G A T T panelsimply states thatA did notinvest.
Sincestrongtypes always invest,this willtellB
2
thatA is weak.B utB
2
alreadyknows this from
theobservation oflowtradevolumeand thatp¤ > p > p¤¤!Similarlywhen p < p¤¤,asuit¯led by
8
Asstated , thism od elisintend ed to c apture the m ainelem entsofthe d ispute resolutionproc essto analyz e its
im pac t onthe e± c iency propertiesofinitialagreem ents. It d oesb y no m enasref
elct the c omplete proc ess. See
J ac kson[19 89 ] and hud ec [19 9 3]f
or extensive legaltreatm ent.
17
A leads tothe conclusion thatB
1
did notinvest.B utB
2
already knows thatB
1
willnotinvest
whenp < p¤¤ andthis does notrevealanyinformationaboutA '
s type! T hemostsigni¯cantpoint
ofthis sectionis thatthis multistagegamehas aseparatingequilibrium.B
2
knows whichactionB
1
willtakedependingon thevalueofp.T his information with theobservation oflowtrade volume
fullyreveals thetypeofA .T hereforetheG A T T panelcan notprovideanyfurtherinformation to
B
2
and improvewelfare!
A n important feature of this game is that initial beliefs of B
identical.In otherwords, B
2
exactly knows whatB
1
1
and B
2
about A 0s type are
willdoin period 2 ofgame1 and therefore
the G A T T panel'
s announcement is redundant. A n observation oflow volume when p > p¤ is
enough forB
2
toinferthatA did notinvestand shedoes notupdateherbeliefs aboutp.O n the
otherhand,lowtradeoutcomewhenp¤ > p > p¤¤,con¯rms thatA is aweaktypeandprevents B
from investingwhen itis herturn.A disputebroughtby B
whileadisputebyA tells herthatB
1
1
2
simply states thatA is aweaktype
did notinvest.T hereforethereis noadditionalinformation
provided bythedisputeresolution process .
T his interestingandstrongresultis duetoone-sidedasymmetricinformation.T hereputational
incentives can notbe made more e®ective when only one party cares aboutherreputation.T his
resultdoes notmean therearenowelfaregains created byamultilateraland independentdispute
resolution process.W ewillmodify the existinggames toprovide in thenextsection toprovidea
motivation forthepresenceofaG A T T paneland thevalueoftheinformation itcan disseminate.
6 T w o Sid ed Asym m etric Inf
orm ation
T hegamewillbealmostidenticaltotheoneintheprevious sections.FirstB willdecidetoinvest
ornotand she willbe followed by A .T he bene¯ts oflowtari®s willbe realized only when both
sides invest.H owever,thereis asymmetricinformation aboutthetypes ofboth countries.Strong
types preferhigh investmentoverlowinvestments while the reverse is true forweak types.T he
payo®s forB are denoted by v(L ;a;b)where L is hertype, b(a)is the investmentchosen by B
(A ).Similarly, A '
s payo®is given by u(L ;a;b).Investments a and bcan be positive (c)orzero.
T osimplifythemodel,wewillassumethatthetwocountries alreadyagreedon lowtari®s.Ifonly
onegovernmentinvests,tradevolumewillnotincreasebuttherearepoliticalcosts forthesidewho
18
did investand gotcheated.FirstB willchooseherinvestmentand A willrespond afterobserving
herdecision.T hepreferences ofthestrongB aresimilartothepreferences ofthesametypeofA
from theprevious section:
v(s;c;c)> v(s;c;0 )> v (s;0 ;0 )> v(s;0 ;c)
T hepreferences oftheweakB arealsosimilartothepreferences oftheweakA withaslightchange:
v(w;c;0 )> v(w;c;c)= v (w;0 ;0 )> v (w;0 ;c)
W e willassume that the weak B is indi®erent between both investing and neithergovernment
investing9 and shewillchoosethatbothinvestifthereeverwas adecisiontobemadebetweenthe
two.
Identicalrelationships hold forthe payo®s ofA as in the previous section . W e willassume
thateach governmentknows hertypeand believes thattheotheroneis strongwith probabilityq.
A gain we willuse backward induction to¯nd the equilibrium which willbethe following:IfA is
weak,his dominantstrategyis nottoinvest10 .Ifheis strong,hewillonlyinvestifB had doneso
in theprevious period as well.IfB is weak,hewillneverinvest.Ifsheis strong,shewillinvestif
q> q¤ =
v (s;0 ;0 )¡v(s;0 ;c)
v (s;c;c)¡v(s;0 ;c)
T his is verysimilartotheequilibrium ofthegamewheretherewas asymmetricinformationabout
the type ofA . T he probability ofstrong A needs to be high enough forB to take the risk of
investing.
7 R eputationand E ± c iency G ains
In this section,wewillextendthis modeltoseeifthereareanygains from reputation as wedidin
the previous section.Suppose A willmeetanothertradingpartnerB
2
in thenextstage whocan
onlytelliftherewas investmentbyboth parties sinceitshows in thetradestatistics.Ifoneofthe
9
T hisassum ptionpreventsmultiple equilib rium b y ensuringthat w eakB d oesnot invest unlessthe prob ab ility of
w eak A investingislessthan1.
10
A w eak B 1 w illinvest only ifprob ab ility ofstrong A ishigh enough.Ifw e assum e that q < 1, thenthere is2
sm allenough that w eak B 1 w illnever invest.
19
parties does notinvest,thentradevolumedoes notincreaseandB
Forsimplicity,wewillassumethatB
2
2
cannottellwhotheculpritis.
can beonly astrongtypesothatifsheis sureA is strong,
shewillinvest.O uraim is to¯nd outifreputationalpressures cancauseweaktypes ofA toinvest
which mightpromptsomestrongB 1'
s toinvestwhowould nototherwise.
Firstlet'
s look atthe region where q> q¤.In this area, a strongB
1
willinvestregardless of
the reputationalconsequences since the probability ofstrong A is high enough. A weak B 1 , on
theotherhand,willneverinvestand B
2
knows thesestrategies.IfB
1
did notinvest,neithertype
ofA willinvestsince the trade volume outcome willbe lowregardless oftheiraction and itwill
send asignalabouttheirtype.IfB
1
invested,astrongA willde¯nitely investand assumethata
weakA willinvestwithprobability¼ whichwillbefunctionofq.T henwecande¯nethefollowing
probabilities:
q
q+ (1 ¡q)¼
q
¯ = P [strongA jlowtradevolume]=
1 + q(1 ¡¼)
®
= P [strongA jhigh tradevolume]=
T hesecondprobabilitywas zeroin theprevious sectionsincelowtradevolumenecessarilyimplied
a weak A .H ere, the weak volume could be caused by a weak B
1
and G A T T dispute resolution
mechanism'
s rolein identifyingthis factwillbethesourceofthewelfaregains.Itis easy toshow
that® > ¯ foranyvalueof¼ which means highervolumeis astrongersignalofastrongtype.
In thesecond game,B
2
willinvestwhen heobserves high tradevolumeif® > q¤.SimilarlyB
2
willinvestwhen heobservelowvolumeif¯ > q¤.W ecan statethefollowing:
® > q¤ if¼ < ¼ ® ´
q 1 ¡q¤
1 ¡q q¤
H owever¼ ® > 1 forallvalues ofqsowewillalways have® > q¤.T his means wheneverB
2
observes
ahigh tradevolume,shewillinvest.Similarly
¯ > q¤ if¼ > ¼ ¯ ´1 ¡
SoifaweakA would likeB
2
1
1
+
¤
q
q
toinvestnomatterwhatthetradevolumeturns outtobe,shehas
toinvestwith probability¼ ¯ in the¯rstgameafterB
1
invests.
N ow,wecananalyzetheequilibrium strategies fortherestoftheparameterrange.Forq< q¤,
the values of® and ¯ stay the same as given above.H owever, we willhave ¼ ® < 1 forallvalues
20
ofqin this range and the maximum value ¼ can take willbe ¼ ® .Forq< q¤, we have ¼ ® < ¼ ¯
which means ¯ < q¤ and B
2
willnotinvestanymore when she observes lowtrade volume in the
¯rstgame.
Ifwelookatthedecisionfaced bystrongB 1,theprobabilityofinvestmentin thenextstageis
q+ (1 ¡q)¼ ® .StrongB
1
willinvestifandonlyifq+ (1 ¡q)¼ ® > q¤ orq> q¤¤ ´(q¤)2 .Sowecan
statetheequilibrium:
Forq> q¤ :A strongB
1-
investin the¯rstgameifB
ofA willinvestifB
1
1
1
willinvestand a weak B
1
willneverinvest.A strongA will
invested and aweakA willinvestwith probability ¼ ¯ .N eithertype
did notinvest.In the second game, B
volumefrom the¯rstgame.StrongA willinvestonlyifB
2
2
willinvestregardless ofthe trade
invested.W eakA willneverinvest.
Forq¤ > q> q¤¤: A strongB
1
willalways investand a weak B
strongA willinvestinthe¯rstgameifB
1
investedandaweakA willinvestwithprobability¼ ® if
2-
B
1
invested.N eithertypeofA willinvestifB
1
1
willneverinvest.A
did notinvest.In thesecond game,B
onlyifthetradevolumefrom the¯rstgameis high.StrongA willinvestonlyifB
2
2
willinvest
invested.W eak
A willneverinvest.
Forq¤¤ > q:R egardless ofhertypeB
3-
game only ifB
1
1
willnotinvest.A strongA willinvestin the¯rst
invested.A weak A willneverinvest.In the second game, B
thetradevolumefrom the¯rstgameis high.StrongA willinvestonlyifB
2
2
willinvestonly if
invested.W eakA will
neverinvest.
A gain itis easytoseethegains from reputation and theability ofB
2
toobserve(even ifonly
partially)theoutcomeofgame1 .Fortheregion,q> q¤ weareguaranteedthataweakA willinvest
with positive probability ifB
causes B
2
1
is strong (and had invested)which was notthe case before.T his
toinvestregardless ofwhathappens which bene¯ts strongA .Forq¤ > q> (q¤)2 , we
haveinvestmentbystrongB
1
whichwas notthecasebefore.W ealsohaveinvestmentwithpositive
probability by weak A and investmentby B
2
which again provide welfare gains.For(q¤)2 > q,
there is no change compared to the previous case.W e can create a similartable comparing the
outcomes in di®erentequilibria:
21
R angeforq
G amerepeated twice
StrongB
weakB
q> q¤
1
1
and B
2
R eputation G ame
StrongB
invest,
weakB
does not.
q>
¤¤
q > q
B
1
and B
2
invest,
does notinvest.
weakA investwith prob ¼ ¯ .
In game2,onlystrongA invests
N oinvestmentby
q¤¤
and B
In game1 ,strongA invests and
StrongA invests
W eakA neverinvest
q¤ >
1
1
B
2
1
invests,B
2
invests ifhigh vol.
In game1 ,strongA invests and
B oth types ofA
weakA investwith prob ¼ ® .
donotinvest
In game2,onlystrongA invests.
N oinvestmentbyB
1
and B
2
N eithertypes ofA invest.
N oinvestmentby B
1
and B
2
N eithertypes ofA invest.
T hee±ciency gains from the reputation mechanism areclear.First,the cuto®pointforqfor
strongB
1
toinvestgoes down sinceA is morelikely toinvest.Second,someweaktypes ofA will
invest(onlywithprobability¼ ® or¼ ¯ ,ofcourse)comparedtoneverinvestingintheprevious case.
T hird, B
2
updates herbeliefaboutqtoa higherlevelafterobservinghigh volume.T his means
she is more likely toinvest.A gain, weaktypes ofA willalways cheatin thelaststagesince they
havenoincentiveamaintain areputation.
Finally, if we compare the outcome of the two games, we can see the impact of two-sided
asymmetricinformation.First,supposethatp = qsothatthecuto®points arethesame.Forhigh
p, strongA initially invested with probability 1 butnow, he willinvestwith only probability ¼ ¯
sinceB
2
can interpretthis as weakB
1
ratherthan weakA .Formedium rangeofp and lowrange
theoutcomes arethesame.A gain,ifthegameweretorepeated moreoften (therearemoreB '
s),
the welfare gains would increase and weak A willalways investin the initialstages regardless of
thevalueofq.
8
G AT T Dispute R esol
utionP roc ess
N ow,wewillintroduceG A T T disputeresolutionmechanism as credibleinformationdisseminating
agencyas in theprevious sections.SupposeA cangototheG A T T andclaim thattheotherparty
22
didnotadheretotheinitialagreementanddidnotinvest.SimilarlyB
thatA did notcarry outhis obligation even though B
1
1
can¯leadisputeandstate
invested.Suppose,the only thingG A T T
can dois tostatewhetherifthelowtradevolumeis duetothelackofinvestmenton B 1 '
s orA '
s
part.
W hen there is uncertainty aboutboth B 1 '
s and A '
s types, low trade volume observation by
B
2
can be due to lack ofinvestmentby eitherside in game 1 when q > q¤¤. G A T T '
s dispute
resolution process and the panel'
s decision willbe valuable since itwillannounce whetherifB
invested ornotwhich is notobservable by B 2 .T his is valuable even though a weak B
1
1
willnot
changeherbehaviorupon acomplaintbyA sinceshedoes notfacefutureinteractions with other
G A T T members and G A T T decision can notbeenforced.
Ifq> q¤ andB
2
observes lowtradevolume,thenshewilllowerherbeliefs abouttheprobability
ofstrongA to¯ in theprevious section.H owever,this is stillhigh enough forhertoinvest.Ifthe
trade volume in game 1 is due tonon-investmentby weak B 1 , then A will¯le a complaint.T he
dispute resolution process ofG A T T investigates the complaintand announces whois responsible
forlowtrade volume.T his is equivalenttoannouncingthe action ofB
1
and in essencehertype.
W ith this information, theprobability ofA beingstrongstays atqratherthan goingdown to¯.
O n theotherhand,ifB
the type ofA .IfB
2
1
¯les acomplaintafterlowtradevolume,the G A T T decision willreveal
knows thatB
1
invested and A did not, then probability ofA being strong
becomes zeroinsteadof1 ¡¯ as itis intheprevious case.SinceweakA knows thathis typewillbe
perfectly revealed in thedispute resolution process, hewillinvestwith probability 1 (ratherthan
with probability ¼ ¯ )afterB
B
2
1
invests. In short, the information provided by the G A T T enables
tohavebetterinformationaboutA '
s typeand behavedi®erentlywhenherturnarrives todeal
withA .T his information,inreturn,willprovideabiggersticktopunishaweaktypeA andenable
theparties toreach aP aretosuperiorequilibrium in game.
T he bene¯ts of a G A T T dispute resolution and information dissemination process are less
valuableifq¤ > q> q¤¤.In this region,lowvolumeimplies thatthe probability ofstrongA is ¯.
IftheG A T T panelannounced thatB
1
is guilty,B
2
would increaseherbeliefaboutstrongA toq
butthis is stilltoolowtoconvincehertoinvest.O n theotherhand,ifG A T T announced thatA
is guiltythen B 2 '
s beliefwould godown tozero,butshedoes notgain anythingsinceshewas not
goingtoinvestanyway.G A T T '
s informationdoes notchangetheactions ofB
23
2
whichmeans weak
A willnotbehavedi®erently either.In short, superiorinformation from G A T T does notprovide
e±ciencygains forlowvalues ofq.
T hesameconclusions willhold iftherewereothersources ofuncertainty,otherthan thetypes
ofthe governments.Suppose, there is positive probability rsuch thattrade volume stays atlow
despiteboth governments investments.T hen B
2
would interpretthis as oneofthem notinvesting
(and A being weak type)and decide notto invest. G A T T panelcan clarify the communication
problem and enableallthreecountries toreach aP aretosuperioroutcome.
T hee±ciencygains from aG A T T disouteresolutionandinformationdisseminationemchanism
willbemorevaluableiftherearemorecountries thatA willinteractinthefuture.IN otherwords,
G A T T actually limits theability oflargecountries,such as theU S and theEU ,tocheaton their
obligations againstsmallercountries.
9
Concl
usion
T heaim ofthispaperwastoidentifyunderwhatconditionsamultilateraldisputeresolutionprocess
canprovidee±ciencygains eventhoughitdoes nothaveanyenforcementpowers.O neofthemain
bene¯ts ofamultilateralsystem can beits ability todi®useinformation and the scenariowe laid
outhas this feature.In our¯rstmodel, we have twocountries where the type ofone ofthem is
privateinformation.T heothercountryneeds totakeacostlyactionforthebene¯ts toberealized,
however,abad opponentcan takeadvantageofthesituation by renegingon an initialpromise.If
thepartywithprivateinformationrepeatsthesamegamewithotherplayersandtheseotherplayers
can (partially)observe the outcome ofthe initialgame toupdate theirbeliefs abouthertype, a
P aretosuperiorreputationalequilibrium canbesustained.In this case,someofthebad types will
behave welland higherlevels ofinvestmentwillbe undertaken. T he threatoffuture through a
bad reputation can providediscipline.N extwe added amultilateralagency whocan disseminate
information.T heimportantresultofthis sectionis thatwhenasymmetricinformationis onesided,
then a multilateralagency can not improve upon the equilibrium by furtherinformation. T he
strategies ofthe player lead to perfect separation and the rest of world can perfectly infer the
actualeventfrom theoutcome.
T his pessimisticresultdoes notmeanthereis noneedformultilateralagencies.O urnextmodel
24
hadtwo-sidedasymmetricinformationwhereplayerstakeactions withoutperfectknowledgeofeach
other'
s types.First,weshowed thatthereis P aretosuperiorreputationalequilibrium with higher
investment and lower cheating. T hen we showed how a dispute resolution process can provide
betterinformation aboutthetruetypes oftheplayers totherestoftheworld compared tosimple
observation ofthe outcome.T he reason is thatthere is noseparatingequilibrium in which each
type takes a certain action.Since both sides mix theirstrategies, identifyingthe actions ofeven
oneoftheplayers improves theinformation setofoutsiders.T his leads tobetterpunishmentand
reward mechanisms and tofurtherP aretogains.
T hemodels in this paperare extremely stylized and simplistic.T hey donotaddress many of
the importantdetails ofa dispute resolution process and its many otherbene¯ts.H owever, they
showthatthe futurestages ofagame has importantconsequences forthe e±ciency ofthe initial
agreementand dissemination ofinformation can vastly improve the outcome. Furthermore, the
nature ofthe informationalproblems is crucial.Forexample, multilateralprocesses can only improveupontwo-sidedprivateinformationproblems.Sincethesearethemorechallengingproblems,
mechanisms likeG A T T arelikelytoprovidefurthergains.
10
Append ix
p > p¤: Itis optimalforB
1
to investsince the probability ofa strong A is high enough.T hen
strongA willalsoinvest.IfaweakA does notinvest,B
2
willupdateherbeliefand setb
p = 0 and
willnotinvest.T he¯nalpayo®forweakA willbeu(w;0 ;c)+ u(w;0 ;0 ).Ifsheinvests,therewill
benochangein thebeliefs ofB
2
and shewillinvest.T hen weakA can takeadvantageofthis and
willnotinvest.his ¯nalpayo®willbeu(w;c;c)+ u(w;0 ;c)which is higher.T hus,in equilibrium,
weakA willinvestin the¯rstgame,butwillnotin thesecond game.
p¤ > p > p¤¤: If B
1
invests, strong A will invest. A ssume that weak A will invest with
probability ¼ (which we willsolve later.
) A fterobservinghigh trade volume, B
2
willupdate her
p
beliefs aboutA '
s typeandsetb
p = p+ ¼(1¡p)
andwillinvestonlyifb
p ¸p¤.G iventhis,A willchoose
¼=
p 1¡p ¤
1¡p p ¤
such thatthe condition willhold with equality.(N ote that¼ > 1 ifp > p¤ sothat
weakA willalways invest.
)T hus,B
of¼,B
1
2
willinvestonly ifsheobserves investment.G iven thevalue
willinvestiftheprobabilityofinvestmentin thenextstagep+ ¼(1 ¡p)is higherthanp¤
25
which means ifp > (p¤)2 = p¤¤.
p¤¤ > p:N owB
1
willnotinvestsostrongA willnotinvesteitherwhichtakes awaytheincentive
forweakA toimitatehim.B
2
willnotupdateherbeliefs and willnotinvestsincetheprobability
ofstrongA is toolow.T hereforenobodywillinvestalongtheequilibrium path.
26
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