Limits of the WTO as a Self-Enforcing Institution

By Renee Bowen
November222010| Working Paper No. 2071

Is there a limit to trade cooperation that the WTO can facilitate? In this paper I present a theory of the WTO in which the WTO is an equilibrium outcome of multiple bilateral repeated prisoners’ dilemma games among countries. The equilibrium mimics an important feature of the WTO’s Dispute Settlement Mechanism (DSM) - trading partners withhold retaliation during the DSM process. I call this property of the DSM forbearance. I show that when a sufficient number of countries participate in multilateral sanctions under the WTO, the threat of these sanctions provides incentives to allow forbearance(i.e. use the DSM). This causes countries to obtain outcomes that improve joint welfare. I also show that there are limits to forbearance that can be sustained by this mechanism - the fraction of simultaneous deviations against a single country that can be part of an equilibrium approaches a finite number as the number of countries participating in multilateral punishments becomes arbitrarily large. The results provide a theoretical basis for the DSM to offer prospective punishments rather than retroactive punishments and suggests a critical role for renegotiation.

political economy of trade policy