A ‘New Trade’Theory of GATT/WTO Negotiations Ralph OssayLondon School of Economics & Princeton UniversityOctober 10, 2007(PRELIMINARY AND INCOMPLETE)AbstractI o¤er a new explanation for why GATT/WTO negotiations have been so suc-cessful in achieving trade liberalization by providing new rationales for the fun-damental GATT/WTO principles of reciprocity and nondiscrimination. Relativeto the standard terms-of-trade theory, my theory makes three main contributions:First, it builds on a ‘new trade’model rather than the neoclassical trade model andthereby closes an important gap in the literature on GATT/WTO negotiations.Second, it does not rely on the terms-of-trade e¤ect and therefore avoids a mech-anism whose real-world relevance many observers doubt. Third, it is immediatelyconsistent with the fact that GATT/WTO regulations do not constrain export taxesand therefore o¤ers a solution to the puzzle identi…ed by Ethier (2002).JEL classi…cation: F12, F13Keywords: Trade negotiations; GATT/WTO; New trade theory Special thanks go to my thesis advisor Stephen Redding for p roviding outstanding guidance andsupport. I would also like to thank Pol Antras, David At kin, Daniel S turm, Frederic Robert-Nicoud,Dani Ro drik, and seminar participants at the London School of Economics and Princeton Universityfor very helpful comments and discussions. The usual discla imer applies.yInternational Economics Section, Department of Economics, Fisher Hall, Princeton University,Princeton, NJ 08544-1021, United States; [email protected]; +1 609 258 4815.11 Introduction“Without cooperation, we will be lost. Without institutions there will be little coopera-tion. And without a knowledge of how institutions work – and what makes them workwell – there are likely to be fewer, and worse, institutions than if such knowledge iswidespread”. Robert O. Keohane (1988: 393)International trade has been libe ralized dramatically during the past half-century.Since the end of World War II, the average ad valorem tari¤ on manufacturing goodshas been reduced from ove r 40 percent to below 4 percent, making this undoubtedlyone of the most important ever acts of economic policy making.It is widely appreciated that this liberalization was largely the result of a sequenceof successful rounds of trade negotiations governed by the General Agreement on Tari¤sand Trade (GATT) and later its successor the World Trade Organization (WTO).1TheGATT/WTO is an institution regu lating trade negotiations through a set of prenegoti-ated articles. The principles of reciprocity and nondiscrimination are usually consideredto be the ess enc e of these articles. Generally speaking, the f ormer requires that tradepolicy changes keep changes in import volumes equal across trading partners and thelatter stipulates that the same tari¤ must be applied against all trading partners forany given traded product.2In this paper, I o¤er a new explanation for why GATT/WTO negotiations havebeen so successful in achieving trade liberalization by providing new rationales for thefundamental GATT/WTO principles of reciprocity and nondiscrimination. I considerGATT/WTO negotiations in a Krugman (1980) ‘new trade’model with transport costs.1The e¤ectiveness of GATT/WTO negotiations is also documented empirically in the recent studiesof Subramanian et al . (forthcoming) and Tomz et al. (forthcoming). Both studies demonstra te thatprevious contrary …ndings by Rose (2004a, 2004b) are not robust. Accor ding to WTO statistics, in-dustrial countries have cut their tari¤s on industrial products by an average 36 percent during the …r st…ve GATT r ounds (1942-62), an average 37 percent in the Kennedy Round (1964-67), a n average 33percent in the Tokyo Round (1973 -79), and an average 38 percent in the Uruguay R ound (1986-94).2I adopt here Bagwell and Staiger’s (1999) interpretation of the rules of reciprocity and nondiscrim-ination which I will discuss in more detail later on.2The main idea is that GATT/WTO negotiations governed by the principles of reci-procity and nondiscrimination help governments escape a production relocation drivenprisoner’s dilemma: In a Krugman (1980) environment, each government has an incen-tive to impose import tari¤s since this reduces the domestic price index and therebyincreases domestic welfare. This is because import tari¤s ensure that more of theworld’s manufacturing goods are produced by domestic …rms so that less of the goodsconsumed by domestic consumers are subject to trade costs. Th is production relocationoccurs since import tari¤s make the own country a relatively more attractive location formanufacturing produ ction. In particular, a unilateral increase in import tari¤s makesforeign manufacturing goods more expensive relative to domestic manufacturing goodsin the domestic market so that domestic consumers shift expenditure towards domesticmanufacturing goods. As a consequence, domestic manufacturing …rms can sell morethus making pro…ts and foreign manufacturing …rms can sell less thus making losses.This triggers entry into the dome stic manufacturing sector and exit out of foreign man-ufacturing sectors so that more of the world’s manufacturing good s are produced bydomestic …rms. However, if all gove rnments impose import tari¤s in an attempt tohost more of the world’s manufacturing …rms, no government actually succeed s andtari¤s only push up import prices. This is why governments are stuck in a productionrelocation driven prisoner’s dilemma if tari¤s are set noncooperatively. GATT/WTOnegotiations governed by the principles of reciprocity and nondiscrimination help gov-ernments escape this prisoner’s dilemma. Essentially, the principles of reciprocity andnondiscrimination jointly ensure that tari¤ changes no longer entail production reloca-tions and thereby neutralize all trade policy externalities. This is because, under theseprinciples, tari¤-induced changes in domestic consumer expenditure towards or awayfrom domestic manufacturing goods are exactly o¤set by changes in foreign consumerexpenditure away from or towards these goods so that tari¤ changes then leave the num-ber of manufacturing …rms constant in all countries. By neutralizing all trade policy3externalities, the principles of reciprocity and nondiscrimination not only guide coun-tries away from the ine¢ cient noncooperative equilibrium in a way which monotonicallyincreases welfare in all