metadata: authors: 0: author: Mattoo,Aaditya
1: author: Ruta,Michele
2: author: Staige,Robert W.
count: World
docna: 0: docna: Geopolitics and the World Trading System
docty: Policy Research Working Paper
abstracts: cdata!: Until the beginning of this century, the
            GATT/WTO system worked. Economic research provided a
            compelling explanation. It showed that if governments
            maximize the well-being of their own countries broadly
            defined, GATT/WTO principles would facilitate mutually
            beneficial cooperation over their trade policy choices. Now
            heightened geopolitical rivalry seems to have undermined the
            WTO. A simple transposition of the previous rationalization
            suggests that geopolitics and trade cooperation are not
            compatible. The paper shows that this is only true if
            rivalry eclipses any consideration of own-country
            well-being. In all other circumstances, there are gains from
            trade cooperation even with geopolitics. Furthermore, the
            WTO&#x2019;s relevance is in question only if it adheres
            too rigidly to its existing rules and norms. Through
            measured adaptation to the geopolitical imperative, the WTO
            can continue to thrive as a forum for multilateral trade
            cooperation in the age of geopolitics.
display_title: Geopolitics and the World Trading System
listing_relative_url: /research/2024/12/34440392/geopolitics-world-trading-system
topicv3: Trade Policy m1327640 776,Trade Agreements and Negotiations m1327641 779
publishtoextweb_dt: 2024-12-23T00:00:00Z
dois: 10.1596/1813-9450-11009
origu: Off of Sr VP Dev Econ/Chief Econ (DECVP)
no_of_pages: 50
author_keys: 0: author_key: 429183
1: author_key: 1245806
2: author_key: NA
model_extractions: Policy Research Working Paper 11009 Geopolitics and the World Trading System _Aaditya Mattoo Michele Ruta Robert W. Staige_ East Asia and the Pacific Region Office of the Chief Economist December 2024
Policy Research Working Paper 11009

# **Abstract**

Until the beginning of this century, the GATT/WTO system worked. Economic research provided a compelling explanation. It showed that if governments maximize the well-being of their own countries broadly defined, GATT/ WTO principles would facilitate mutually beneficial cooperation over their trade policy choices. Now heightened geopolitical rivalry seems to have undermined the WTO. A simple transposition of the previous rationalization suggests that geopolitics and trade cooperation are not compatible.

The paper shows that this is only true if rivalry eclipses any consideration of own-country well-being. In all other circumstances, there are gains from trade cooperation even with geopolitics. Furthermore, the WTO’s relevance is in question only if it adheres too rigidly to its existing rules and norms. Through measured adaptation to the geopolitical imperative, the WTO can continue to thrive as a forum for multilateral trade cooperation in the age of geopolitics.

This paper is a product of the Office of the Chief Economist, East Asia and the Pacific Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at amattoo@worldbank.org, mruta@imf.org, Robert.W.Staiger@dartmouth.edu.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
Geopolitics and the World Trading System<sup>∗</sup> Aaditya Mattoo,<sup>†</sup> Michele Ruta<sup>‡</sup> and Robert W. Staiger<sup>§</sup>

> ∗We thank John Sturm Becko, Martin Caruso Bloeck, Chad Bown, Kenneth Kang, Giovanni Maggi, Petros C. Mavroidis, Alen Mulabdic, Daniel O’Connor, Emanuel Ornelas, Ralph Ossa, Martin Sommer, Antonio Spilimbergo and seminar participants at the International Monetary Fund for helpful comments and discussion. The views expressed are those of the authors and they do not necessarily represent the views of the institutions they work for.

> †The World Bank.

> ‡The International Monetary Fund.

> §Department of Economics, Dartmouth College; and NBER.
# **1 Introduction**

The two largest trading economies in the world, the United States and China, increasingly see each other as geopolitical rivals. For both the US administration and the Chinese government, this great-power rivalry is central to their foreign and national security strategy (Wolff, 2023). While other reasons contributed to the surge in trade policy activism on both sides of the Pacific in recent years, geopolitical considerations are increasingly cited as a driver of new trade and industrial policy. For instance, data from the New Industrial Policy Observatory show that a significant number of measures imposed by China and the United States in 2023 and the first half of 2024 are motivated by geopolitical and national security concerns (Evenett et al., 2024). Irrespective of the validity of these concerns and the efficacy of new trade measures to achieve the intended goals, an increasingly commonly held view is that US-China rivalry, and the change in policies that it generates, could reshape trade flows and fragment the world trading system and the global economy more generally (Aiyar et al., 2023 and Gopinath et al., 2024).

In this paper, we study the implications of geopolitical rivalry for trade cooperation and for the purpose and design of the rules-based multilateral trading system. Our work builds from an understanding of the logic of the multilateral trading system that comes from the literature on the economics of trade agreements (see Bagwell and Staiger, 1999, for an initial statement of the framework that provides this logic, and Bagwell et al., 2016, for a review of this literature). The key findings of this body of work can be simply stated. The first is that the fundamental source of inefficiency associated with the unilateral trade policy choices of governments is the presence of cross border spillover effects in the form of a terms-of-trade externality. Second, the primary purpose of a trade agreement is to mitigate these externalities, meaning that countries agree to limit their protectionist policies thus preventing them from manipulating trade prices to their advantage at the expense of other countries. Third, the rules of the world trading system initially negotiated through the General Agreement on Tariffs and Trade (GATT) and later embedded into the Agreements under the auspices of the World Trade Organization (what we will refer to as the GATT/WTO rules) provided a governance system that allowed countries to escape from the trap of non-cooperative protectionist trade policy and promoted mutually benefical trade cooperation.

While rich in insights, the framework underpinning this body of work has been developed without explicit consideration of issues related to geopolitics. To introduce geopolitics into this framework, we turn to the literature on international relations. In particular, the so called “realist school” emphasizes the importance of rivalry among countries to improve their power, and assumes that in their rivalry governments are concerned with _relative_ rather than absolute power, in the sense that they aim to increase their power _at the expense_ of their rivals. The following quote from Mearsheimer (2003) is illuminating: Saying that states are power maximizers is tantamount to saying that they care about relative power, not absolute power. There is an important distinction here, because states concerned about relative power behave differently than do states interested in absolute power. . . . Thus states motivated by relative power concerns are likely to forgo large gains in their own power, if such gains give rival states even greater power, for smaller national gains that nevertheless provide them with a power advantage over 1
their rivals. States that maximize absolute power, on the other hand, care only about the size of their own gains, not those of other states. . . . They would jump at the opportunity for large gains, even if a rival gained more in the deal. (Mearsheimer, 2003, page 36) The focus on relative as opposed to absolute power emphasized by the realist school of international relations has important implications for the way we think about governments’ goals in setting trade policy.

We can think of a country’s absolute power as related broadly to its overall size in terms of population and real income—as Mearsheimer (2003) does—as well as its ability to maintain production in “strategic sectors” (however defined). Importantly, concern about the attributes that determine a country’s absolute power can be mapped into the country’s concerns about its own local prices (as well as its terms of trade with the world). Since the framework developed by Bagwell and Staiger (1999) specifies government objectives as a function of the country’s terms of trade and its own local prices in a way that places no restrictions on how a government assesses the attractiveness of different levels of its own local prices, these government objective functions are general enough to include the possibility that governments have concerns about their absolute power. It then follows that all the results of that literature would apply without qualification if geopolitical rivalry were about absolute power.

The focus on _relative_ power emphasized by the realist school of international relations changes things. According to this focus the absolute power levels of _both_ rivals enter into the objectives of _each_ rival. And this implies that the objective function for a country that is engaged in geopolitical rivalry will also include its _rival’s_ local prices, which (along with the rival’s terms of trade with the world) determine the _rival’s_ absolute power. Thus, for example, if each government sought to ensure that its country dominated the world ship building industry, then each government would be concerned not only about the incentives to build ships implied by the prices in its own economy, but also the incentives to build ships in the rival’s economy implied by the prices there.

Government objective functions of the form implied by the international relations literature on geopolitical rivalry therefore fall outside the framework developed by Bagwell and Staiger (1999). Hence, from the perspective of the literature on the economics of trade agreements, the impact of geopolitical rivalry is an open question. This is the focus of our paper.

We work within a two-good general equilibrium neoclassical trade model, first in a twocountry world where the two countries are assumed to be geopolitical rivals, and then in a three-country world where the third country remains neutral. As in the original Bagwell and Staiger (1999) paper, we limit our focus to tariffs. We introduce rivalry between the governments by augmenting government objective functions of the form introduced by Bagwell and Staiger with a term that is increasing in the _difference_ between the degree to which a government achieves its underlying objectives – its underlying “welfare” – and the degree to which its rival does. And we represent the rise of geopolitical rivalry by changing the weight on this term from zero to a strictly positive value in each of the rival’s objective functions.

In the two-country version of the model, we first consider whether trade cooperation is possible between geopolitical rivals. The answer is not self-evident, because as Mearsheimer (2003) notes, rival countries vying for dominance and concerned about their relative gains 2
will behave differently than other countries, and in particular they may not see the mutual gains that comprise the traditional selling point of trade cooperation as in their interests.<sup>1</sup> We show that, in all but the most extreme circumstances, the case for trade cooperation remains intact when geopolitical rivalry erupts. We do this in three steps. Our first result is that the rise of geopolitical rivalry increases the best-response (noncooperative) tariff of each rival. Intuitively, this reflects the fact that, beginning from the noncooperative Nash tariffs in the absence of rivalry, where each country’s tariff is set so that a small further increase in its tariff would leave its own welfare unchanged, rivalry makes a small increase in the tariff attractive for each country because it _hurts the rival_ . Our second result is that, except in a limiting case where each country cares _only_ about dominating its rival and cares nothing about achieving its underlying objectives for their own sake, the set of globally efficient tariffs is _unchanged_ by geopolitical rivalry. Intuitively, even if the rival countries care about the relative success with which they achieve their underlying objectives, as long as each also cares about the absolute success with which it achieves its own underlying objectives the rivals can engineer pareto gains by changing their tariffs unless their tariff choices place them on the efficiency frontier with respect to these underlying objectives. Our third result follows quickly from the first two results: Unless domination becomes the sole objective of each rival, a role for mutually benefical trade policy cooperation persists in the presence of geopolitical rivalry. In other words, just as when governments care only about their own welfare, in a geopolitical world too enlightened self-interest is the driver of trade cooperation.<sup>2</sup> The two-country setting also illuminates a tension that is created in the world trading system by the rise of geopolitics. As our first set of results indicates, with the rise of geopolitical rivalry the status quo (pre-rivalry) cooperative tariff pair will continue to be efficient, as will every other tariff pair on the original efficiency frontier; but generically the

> 1In the context of trade policy, Mearsheimer (2003) quotes from Adam Smith’s _The Wealth of Nations_ to provide an illustration of how states behave when forced to choose between wealth and relative power:

In 1651, England put into effect the famous Navigation Act, protectionist legislation designed to damage Holland’s commerce and ultimately cripple the Dutch economy. The legislation mandated that all goods imported into England be carried either in English ships or ships owned by the country that originally produced the goods. Since the Dutch produced few goods themselves, this measure would badly damage their shipping, the central ingredient in their economic success. Of course, the Navigation Act would hurt England’s economy as well, mainly because it would rob England of the benefits of free trade. “The act of navigation,” Smith wrote, “is not favorable to foreign commerce, or to the growth of that opulence that can arise from it.” Nevertheless, Smith considered the legislation “the wisest of all the commercial regulations of England” because it did more damage to the Dutch economy than to the English economy, and in the mid-seventeenth century Holland was “the only naval power which could endanger the security of England.” (Mearsheimer, 2003, page 48)

> 2Hence, according to our findings the quote from Bill Clinton cited in Mearsheimer (2003, page 23) that “Enlightened self-interest, as well as shared values, will compel countries to define their greatness in more constructive ways. . . and will compel us to cooperate” continues to be valid when the eruption of geopolitical rivalry disrupts trade cooperation. Interestingly, our results would support the conclusion of the realist school of international relations – that in the presence of geopolitical rivalry, cooperation would not emerge – only in the limit case of “pure rivalry.” In all other situations, our results indicate that the insights from the liberal school of international relations – that cooperation can emerge among countries – would apply.

3
status quo will no longer be the outcome of efficient (Nash) tariff bargaining, because the Nash threat point will change. Therefore, to maintain cooperation once geopolitical rivalry erupts, countries must find a way to move _along the international efficiency frontier_ and implement tariff changes that are neither reciprocal nor mutually beneficial relative to the status quo. And as we argue, this will confront the world trading system with a choice between two uncomfortable alternatives. In particular, adjustment to the new cooperative outcome in the presence of geopolitics requires either a temporary unraveling of existing liberal trade policies as countries move to the new Nash threat point, so that reciprocal and mutually beneficial trade liberalization can then occur from that starting point in line with the traditional features of tariff liberalization over GATT’s history; or it requires a departure from GATT/WTO’s core principle of reciprocity in negotiated tariff changes, so that countries can move in a non-pareto improving way along the efficiency frontier.

Our three-country version of the model extends the analysis to a setting where geopolitical rivalry erupts between two countries in a multilateral world. In addition to showing that our results from the two-country model extend without qualification to the three-country setting, the three-country model allows us to identify a further issue implied by the rise of geopolitics for the existing multilateral world trading system, this time related to the GATT/WTO’s core principle of nondiscrimination as embodied in the most-favored-nation (MFN) rule. The issue arises when a movement along the international efficiency frontier is desired, as our results indicate would be the case when geopolitical rivalry erupts. Such movements would naturally be facilitated if bilateral transfers between countries can be orchestrated. And if international lump sum transfer instruments are not available, tariff adjustments may provide a practical alternative. But as we observe, it is not possible for the two rival countries to make non-discriminatory MFN tariff adjustments that transfer surplus between them without also altering the surplus of the neutral third country, while this _would_ be possible if the rival countries could make use of _discriminatory_ tariff adjustments.

This leads to our final result. As we argue, the rise of geopolitical rivalry in a multilateral world will confront the world trading system with an additional choice between two uncomfortable alternatives. Adjustment to the new cooperative outcome in the presence of geopolitics requires either a temporary unraveling of existing liberal trade policies as countries move to the new Nash threat point and begin again the process of reciprocal MFN tariff liberalization; or it requires that an orderly departure from both reciprocity _and_ the MFN principle must be achieved, so that the rivals can move in a non-pareto improving way along the efficiency frontier with minimal disruption to third parties.

While the discussion above, and the modeling framework of our paper, presents geopolitics as a quest for _dominance over one’s rival_ , we believe that the framework also captures certain aspects of geopolitical concerns about _dependence on one’s rival_ (e.g. Hirschman, 1945; Becko and O’Connor, 2024; Clayton et al., 2024).<sup>3</sup> First, as long as dependence is gauged by the degree to which a country relies on imports from its rival, the country’s concerns can be mapped into the prices that prevail within its own borders, that is, its _own local prices_ . This mapping follows because the country can choose the degree of dependence on its geopolitical rival by adopting policies that alter local prices in its economy to give the desired incentives for production and consumption within its borders. Alternatively, a government may seek

> 3In his 1945 book on _National Power and the Structure of Foreign Trade_ , Albert Hirschman notes that:

4
to make _its rival more dependent_ on _it_ , in order to be in a position in the future to coerce its rival into behaviors that are more acceptable to it. These goals give a reason for the country to be concerned about its _rival’s local prices_ . The goal of diminishing own dependence through the manipulation of own prices is consistent with the quest for absolute power and included in the Bagwell and Staiger (1999) framework. And as we will show, the goal of increasing the rival’s dependence by influencing the rival’s local prices can be thought of as a reflection of the quest for relative power, which we address in this paper. These features of our modeling framework allow us to comment on the robustness of our key findings to broader interpretations of geopolitics that include government concerns about dependence in addition to the quest for dominance.

Taken together, our findings indicate that the rise of geopolitics does not obviate the need for international cooperation over trade policy. But our findings also suggest that the WTO’s relevance may be severely compromised if it adheres too rigidly to its existing rules and norms when applying those rules and norms to geopolitical rivals. In this light, it may only be through measured adaptation to the geopolitical imperative that the WTO can continue to thrive as a forum for multilateral trade cooperation in the age of geopolitics.

Our paper contributes to four branches of the economics literature. First, as discussed above, our model augments the framework used to study the purpose and design of trade agreements (especially, Bagwell and Staiger, 1999, and Bagwell and Staiger, 2005) to account for geopolitical rivalry between countries. Second, our paper relates to a literature that explores the reasons for the current crisis faced by the rules-based trading system, such as Mattoo and Staiger (2020), Staiger (2022) and Carvalho et al. (2024). Third, our paper relates to the growing literature in economics that builds on the seminal work by Hirschman (1945) on how governments can exploit trade (and, more broadly, international economic) relations to achieve geopolitical goals. Recent studies in this area include Clayton et al. (2023), Thoenig (2023), Becko and O’Connor (2024), Broner et al. (2024), Clayton et al. (2024) and Pflueger and Yared (2024). Finally, our paper relates to the literature on geoeconomic fragmentation, which studies how the recent surge in trade restrictions and return of industrial policies are impacting trade and investment flows and quantifies the costs of a breakup of the global economy into separate geopolitical blocs (Aiyar et al., 2023; Alfaro and Chor, 2023; Fajgelbaum et al., 2024; Freund et al., 2024; Gopinath et al., 2024). We contribute to these branches of the economics literature by investigating the conditions under which there are continuing gains from trade cooperation in the presence of geopolitical rivalry, and by analyzing the design feature of a world trading system that could allow such cooperation to persist.

The rest of the paper proceeds as follows. In section 2 we lay out our two-country model Foreign trade would lead to relationships of dependence and influence between nations. Let us call this the influence effect of foreign trade... Every sovereign nation has some influence of this kind, since through the control of its frontiers and the power over its citizens it can at any time interrupt its own export and import trade, which is at the same time the import and export trade of some other countries. The stoppage of this trade obliges the other country to find alternative markets and sources of supply and, should this prove impossible, it forces upon them economic adjustment and lasting impoverishment.” (Hirschman, 1945, pages 15-16) 5
and derive our basic results on the possiblity of trade cooperation between geopolitical rivals. Section 3 then explores the implications of these findings for trade bargaining. In section 4 we lay out our three-country model, show that our two-country results extend without qualification to this setting, and explore new issues that arise in a multilateral world. Section 5 explores the implications of our results for the core institutional features of the world trading system governed by the GATT/WTO. Finally, section 6 concludes. An Appendix provides further exploration of the generality of our results.

# **2 Geopolitical Rivalry and Trade Cooperation**

In this section we consider a two-country two-good general equilibrium neoclassical trade model where governments utilize tariffs to achieve their objectives. In section 4 we will extend the analysis to more than two countries.

## **2.1 The model world economy**

We adopt the textbook two-good two-country neoclassical trade model that Bagwell and Staiger (1999) employed to consider the purpose and design of GATT. This model has two countries, home (no *) and foreign (*), and two goods, _x_ the natural import good of the home country and _y_ the natural import good of the foreign country. The two goods are normal in consumption and produced in perfectly competitive markets. We define _p ≡ px/py_ and _p_<sup>_∗_</sup> _≡ p_<sup>_∗_</sup> _x_<sup>_/p∗_</sup> _y_<sup>asthelocalrelativepriceinthehomeandforeignmarketand</sup><sup>_τ_and</sup><sup>_τ ∗_the</sup> home-country and the foreign-country import tariff (each expressed in ad valorem terms), respectively. It follows that _p_ = (1 + _τ_ ) _p_<sup>_w_</sup> _≡ p_ ( _τ, p_<sup>_w_</sup> ) and _p_<sup>_∗_</sup> = _p_<sup>_w_</sup> _/_ (1 + _τ_<sup>_∗_</sup> ) _≡ p_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, p_<sup>_w_</sup> ), where _p_<sup>_w_</sup> _≡ p_<sup>_∗_</sup> _x_<sup>_/py_isthe“world”(i.e.,untaxed)relativeprice.Theforeigntermsoftradeis</sup> then given by _p_<sup>_w_</sup> while the home terms of trade is given by (1 _/p_<sup>_w_</sup> ).

Production in a country occurs at the point on the production possibilities frontier, denoted by _Q_ for the home country and _Q_ * for the foreign country, where the marginal rate of transformation between _x_ and _y_ is equal to the local relative price, allowing home and foreign production functions to be represented as _Qi_ = _Qi_ ( _p_ ) and _Q_<sup>_∗_</sup> _i_<sup>=</sup><sup>_Q∗_</sup> _i_<sup>(</sup><sup>_p∗_)for</sup><sup>_i_=</sup> _{x, y}_ . Consumption depends on both the local relative price and on tariff revenue, which is distributed lump-sum back to consumers. We denote by _R_ the tariff revenue collected in the home country, and by _R_<sup>_∗_</sup> the tariff revenue collected in the foreign country. National consumption in the home and foreign country can then be written as _Di_ = _Di_ ( _p, R_ ) and _Di_<sup>_∗_=</sup><sup>_D_</sup> _i_<sup>_∗_(</sup><sup>_p∗, R∗_) for</sup><sup>_i_=</sup><sup>_{x, y}_, where tariff revenue is defined implicitly by</sup><sup>_R_= [</sup><sup>_Dx_(</sup><sup>_p, R_)</sup><sup>_−_</sup> _Qx_ ( _p_ )][ _p−p_<sup>_w_</sup> ] or _R_ = _R_ ( _p, p_<sup>_w_</sup> ) for the home country and by _R_<sup>_∗_</sup> = [ _Dy_<sup>_∗_(</sup><sup>_p∗, R∗_)</sup><sup>_−Q∗_</sup> _y_<sup>(</sup><sup>_p∗_)][1</sup><sup>_/p∗−_</sup> 1 _/p_<sup>_w_</sup> ] or _R_<sup>_∗_</sup> = _R_<sup>_∗_</sup> ( _p_<sup>_∗_</sup> _, p_<sup>_w_</sup> ) for the foreign country, and where each country’s tariff revenue is an increasing function of its terms of trade under the normal-goods assumption. This allows national consumption to be written as _Ci_ ( _p, p_<sup>_w_</sup> ) _≡ Di_ ( _p, R_ ( _p, p_<sup>_w_</sup> )) and _Ci_<sup>_∗_(</sup><sup>_p∗, pw_)</sup><sup>_≡_</sup> _Di_<sup>_∗_(</sup><sup>_p∗, R∗_(</sup><sup>_p∗, pw_))for</sup><sup>_i_=</sup><sup>_{x, y}_,with</sup><sup>_Ci_decreasingin</sup><sup>_pw_and</sup><sup>_C_</sup> _i_<sup>_∗_increasingin</sup><sup>_pw_.</sup> The equilibrium world price is determined by the market clearing conditions. We define the home-country imports of _x_ and exports of _y_ by _Mx_ ( _p, p_<sup>_w_</sup> ) _≡ Cx_ ( _p, p_<sup>_w_</sup> ) _− Qx_ ( _p_ ) and _Ey_ ( _p, p_<sup>_w_</sup> ) _≡ Qy_ ( _p_ ) _− Cy_ ( _p, p_<sup>_w_</sup> ), and the foreign-country imports of _y_ and exports of _x_ by _My_<sup>_∗_(</sup><sup>_p∗, pw_)</sup><sup>_≡Cy_(</sup><sup>_p∗, pw_)</sup><sup>_−Q∗_</sup> _y_<sup>(</sup><sup>_p∗_)and</sup><sup>_E_</sup> _x_<sup>_∗_(</sup><sup>_p∗, pw_)</sup><sup>_≡Q∗_</sup> _x_<sup>(</sup><sup>_p∗_)</sup><sup>_−C_</sup> _x_<sup>_∗_(</sup><sup>_p∗, pw_),respectively.For</sup> 6
any world price, we also have the following balanced trade conditions The equilibrium world price, _p_ �<sup>_w_</sup> ( _τ, τ_<sup>_∗_</sup> ), is thus determined by the requirement of marketclearing for good _y_ : with market clearing for good _x_ implied by (1), (2) and (3).

In this world economy, given any pair of tariffs, the equilibrium world price is determined by (3), and this price and the tariffs then determine the local prices and, in turn, the production, consumption, import, export and tariff revenue levels. In the rest of this paper, we focus on the standard case where the Lerner and Metzler paradoxes are ruled out, so that

# **2.2 Geopolitics**

As discussed in the Introduction, we follow the international relations literature and model geopolitical rivalry as a quest for dominance over one’s rival as gauged by the relative success in achieving one’s underlying objectives. To formalize the quest for dominance, we adopt the following specification of government objective functions: where _ρ ≥_ 0 and _ρ_<sup>_∗_</sup> _≥_ 0 and where both _ρ_ and _ρ_<sup>_∗_</sup> are finite.<sup>4</sup> We interpret the presence of geopolitical rivalry as corresponding to the case where government objectives are characterized by (5) with _ρ >_ 0 and _ρ_<sup>_∗_</sup> _>_ 0.<sup>5</sup> We interpret the absence of geopolitical rivalry as corresponding to the case where government objectives are characterized by (5) with _ρ_ = 0 = _ρ_<sup>_∗_</sup> , so that the home government objective function would be _W_ ( _τ, τ_<sup>_∗_</sup> ) and the foreign government objective function would be _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ ).

In the Appendix, we consider a more general structure for government objectives and show that our results are not driven by the particular functional form that we have adopted in (5) to capture geopolitical rivalry. Instead, the key feature of (5) that underlies our results is

> 4Later in this section we will also consider the limiting case where _ρ →∞_ and _ρ∗ →∞_ . And in a later section we will comment on how the issue of dependence can also be captured by our modeling framework.

> 5To minimize taxonomy, we are ignoring the case where only one of these inequalities holds strictly. But as will become clear below, that case yields results that are qualitatively identical to the case where both inequalities are strict, so we feel justified in ignoring it in our exposition.

7
that the rivalry between the two governments can be couched in terms of the _relative_ success in achieving their underlying goals as those goals are captured by _W_ ( _τ, τ_<sup>_∗_</sup> ) and _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ ).<sup>6</sup> We introduce some minimal structure on _W_ ( _τ, τ_<sup>_∗_</sup> ) and _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ ). In particular, we assume that _W_ is strictly decreasing and convex in _τ_<sup>_∗_</sup> when evaluated in the relevant range of _τ_ and that _W_<sup>_∗_</sup> is strictly decreasing and convex in _τ_ when evaluated in the relevant range of _τ_<sup>_∗_</sup> as long as there is strictly positive trade between the two countries, owing to the adverse termsof trade implications that would be experienced by a country under the standard conditions in (4) when its trading partner raises its tariff.<sup>7</sup> We also assume that _W_ is concave in _τ_ and that _W_<sup>_∗_</sup> is concave in _τ_<sup>_∗_</sup> , with each function reaching a maximum level at an interior value of its own tariff. In the absence of geopolitical rivalry when _G_ = _W_ and _G_<sup>_∗_</sup> = _W_<sup>_∗_</sup> , this latter assumption ensures that each government’s best-response tariff schedule is uniquely defined; we will confirm that this property is also inherited by _G_ and _G_<sup>_∗_</sup> in the presence of geopolitical rivalry when both of these assumptions are satisfied.

To keep things simple, our default interpretation will be that _W_ is real national income in the home country and _W_<sup>_∗_</sup> is real national income in the foreign country, but the minimal stucture we impose on _W_ ( _τ, τ_<sup>_∗_</sup> ) and _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ ) allows for a broad range of possible interpretations. For example, this structure is consistent with the specification of government objectives proposed by Bagwell and Staiger (1999), where _W_ ( _τ, τ_<sup>_∗_</sup> ) _≡ W_ ( _p_ ( _τ,_ � _p_<sup>_w_</sup> ( _τ, τ_<sup>_∗_</sup> )) _,_ � _p_<sup>_w_</sup> ( _τ, τ_<sup>_∗_</sup> )) with _Wpw <_ 0 but where _Wp_ is unrestricted and _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ ) _≡ W_<sup>_∗_</sup> ( _p_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _,_ � _p_<sup>_w_</sup> ( _τ, τ_<sup>_∗_</sup> )) _,_ � _p_<sup>_w_</sup> ( _τ, τ_<sup>_∗_</sup> )) with _W_<sup>_∗>_0butwhere</sup><sup>_W ∗_unrestricted.Becausegovernmentobjectivefunctionsof</sup> _p_<sup>_w_</sup> _p_<sup>_∗_is</sup> this form do not place restrictions on how each government feels about changes in its local relative price, these objective functions are consistent with a wide range of industrial policy goals, where governments intervene to favor a certain sector. And as Bagwell and Staiger note, these objective functions are also consistent with governments that have general distributional goals as well as political preferences that include all of the major models of political economy of trade policy.

The minimal structure we place on _W_ ( _τ, τ_<sup>_∗_</sup> ) and _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ ) can be viewed as a selling point of our model, because this allows the specification of geopolitical rivalry in (5) to then capture the possibility that the two governments might each be wielding trade policy, not just in an attempt to dominate each other in terms of GNP (though as we have noted that possibility is also included), but possibly in an attempt to dominate the world steel industry or ship building or chip production, or in an attempt to achieve an edge in terms of domestic political support so as to be in a better position to ask for the national sacrifice that would

> 6Even this feature may be less restrictive than it might seem. If we were to adopt a partial equilibrium perspective on the purpose and design of trade agreements as in Bagwell and Staiger (2001b), then the government objectives in (5) could be interpreted as applying to an industry over which rivalry was relevant (e.g., advanced microchips). All industries where rivalry was not present (e.g., basic consumer goods) could then be included in a second and additively separable term representing the nonrivalrous objectives of each government (e.g., the real value of consumer goods that could be afforded by its citizens) which each government cared about only in absolute terms. With this partial equilibrium setting generating tariff choice problems that are separable across industries, it is straightforward to show that the general equilibrium results we report below carry over to a partial equilibrium setting of this kind.

> 7See Bagwell and Staiger (2005) on why these restrictions are relatively benign.

8
be needed in the event of war.<sup>8</sup> Thus for example, prior to the rise of geopolitical rivalry, the two governments might each be using tariffs to protect their ship-building industry, something that is easily captured by the home- and foreign-government objective functions _W_ ( _τ, τ_<sup>_∗_</sup> ) and _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ ). The rise of geopolitical rivalry according to (5) would then lead the home government to seek not only the expansion of its own ship-building industry (raising _W_ ( _τ, τ_<sup>_∗_</sup> )), but also the demise of the ship-building industry of its foreign rival (reducing _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ )), with an analogous incentive arising for the foreign government. In this sense, our modeling of geopolitical rivalry is very general.

But this feature also carries with it a potential caveat: whatever the underlying goals governments are using their tariffs to achieve, according to our specification those same goals define the essence of their rivalry. Whether that is sensible in a given situation will depend on the nature of geopolitical rivalry itself, and in particular on whether these goals can be seen as contributing to the strengthening of relative power in the international arena. Our formal analysis is premised on the assumption that this is the case.<sup>9</sup>

# **2.3 Nash**

We first consider the impact of geopolitical rivalry in a world without trade cooperation. To this end, we solve for Nash tariffs as a function of _ρ_ and _ρ_<sup>_∗_</sup> . These tariffs, which we denote by _τ_<sup>_N_</sup> and _τ_<sup>_∗N_</sup> , are defined by the two first-order conditions where subscripts denote partial derivatives. The top first-order condition in (6) defines the home-government tariff reaction curve _τ_<sup>_R_</sup> ( _τ_<sup>_∗_</sup> ) while the bottom first-order condition defines the foreign-government tariff reaction curve _τ_<sup>_∗R_</sup> ( _τ_ ), with the joint solution defining the Nash tariffs _τ_<sup>_N_</sup> and _τ_<sup>_∗N_</sup> . It is easy to confirm that these reaction curves are uniquely defined given the structure we have placed on _W_ ( _τ, τ_<sup>_∗_</sup> ) and _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ ). The reaction curves may be either upward sloping or downward sloping (see Dixit, 1987), and we place no restrictions on their slopes other than standard restrictions that ensure that reaction curve “stability” conditions are met.

The first-order conditions in (6) can be rewritten in the equivalent form

> 8For example, in his October 1 _The Morning_ Newsletter for the New York Times on the geopolitical tensions between Iran and Israel, David Leonhardt includes the following quote from Alissa Rubin, a senior Middle East correspondent for The Times: “You cannot win a war in the long run without popular support from your own people.” (New York Times, 2024)

> 9In this regard, Lynch III and Hoffman (2020) (Table 2.2) list five categories of issues over which greatpower rivalry is typically thought to occur: political and diplomatic, ideological, informational, military and economic. Of these, they cite rivalry over economic issues as the category most frequently emphasized in the major academic works on great-power competition. Arguably, our modeling of government objectives can be interpreted as capturing aspects of many, though not all, of these categories.

9
which, using _Wτ_<sup>_∗<_0and</sup><sup>_Wτ ∗<_0,implythat</sup><sup>_τ R_(</sup><sup>_τ ∗_)isincreasingin</sup><sup>_ρ_while</sup><sup>_τ ∗R_(</sup><sup>_τ_)is</sup> increasing in _ρ_<sup>_∗_</sup> . Intuitively, this reflects the fact that, beginning from the noncooperative Nash tariffs in the absence of rivalry, where each country’s tariff is set so that a small further increase in its tariff would leave its own welfare unchanged, rivalry makes a small increase in the tariff attractive for each country because it _hurts the rival_ .

Under our imposed reaction-curve stability conditions, this then means that _τ_<sup>_N_</sup> is increasing in _ρ_ while _τ_<sup>_∗N_</sup> is increasing in _ρ_<sup>_∗_</sup> , and if tariff reaction curves are upward sloping it then follows that both Nash tariffs are increasing in both _ρ_ and _ρ_<sup>_∗_</sup> . However, if tariff reaction curves are downward sloping, then _τ_<sup>_N_</sup> will be decreasing in _ρ_<sup>_∗_</sup> while _τ_<sup>_∗N_</sup> will be decreasing in _ρ_ , and it is then possible that a rise in both _ρ_ and _ρ_<sup>_∗_</sup> could increase the Nash tariff of one country while reducing the Nash tariff of the other.

With the rise of geopolitics captured by an increase in _ρ_ and _ρ_<sup>_∗_</sup> above the levels _ρ_ = 0 = _ρ_<sup>_∗_</sup> , we may therefore state:

**Proposition 1** _The rise of geopolitical rivalry raises the Nash tariff of at least one of the rivals. If tariff reaction curves are upward sloping, the rise of geopolitical rivalry raises the Nash tariffs of both rivals; but if tariff reaction curves are downward sloping, the rise of geopolitical rivalry may raise the Nash tariff of one country while lowering the Nash tariff of its rival._

# **2.4 International Efficiency Frontier**

Next we characterize the internationally efficient combinations of tariffs, where efficiency is judged in light of the objectives of the governments as defined by (5).

**The Absence of Geopolitical Rivalry** To serve as a benchmark with which to compare the impacts of rivalry, we begin by reviewing the case of _no rivalry_ , which is captured with (5) under the assumption that _ρ_ = 0 and _ρ_<sup>_∗_</sup> = 0 implying

For this case, a pair of internationally efficiency tariffs _τ_<sup>_E_</sup> and _τ_<sup>_∗E_</sup> must solve the following program: where _W_<sup>_∗E_</sup> is a fixed and feasible level of _W_<sup>_∗_</sup> . The international efficiency frontier is characterized by the locus of tariff pairs that solve (9) for all feasible levels of _W_<sup>_∗E_</sup> . The portion of that locus describing internationally efficient tariff pairs that would deliver at least the Nash level of welfare to each government can then be characterized by solving (9) for all values of _W_<sup>_∗E_</sup> between the Nash level _W_<sup>_∗_</sup> ( _τ_<sup>_∗N_</sup> _, τ_<sup>_N_</sup> ) and the level of of _W_<sup>_∗E_</sup> that would yield _τ_<sup>_E_</sup> and _τ_<sup>_∗E_</sup> satisfying _W_ ( _τ_<sup>_E_</sup> _, τ_<sup>_∗E_</sup> ) = _W_ ( _τ_<sup>_N_</sup> _, τ_<sup>_∗N_</sup> ).

10
The Lagrangian associated with (9) is given by where _λ_ is the Lagrange multiplier. The first-order necessary conditions for the solution to (9) are given by Equating the two expressions for _λ_ implied by the two first-order conditions yields the characterization of internationally efficient tariffs The left-hand side of (10) is the slope of a home-government indifference curve in a graph with _τ_ on the vertical axis and _τ_<sup>_∗_</sup> on the horizontal axis, while the right-hand side of (10) is the slope of a foreign-government indifference curve in the same graph. The condition in (10) states the familiar requirement that, when evaluated at any pair of internationally efficient tariffs, these slopes must be the same so that the home-government and foreign-government indifference curves passing through this point are tangent.

Interpreting _W_ and _W_<sup>_∗_</sup> as real national income for the home and foreign country, respectively, we can be more explicit about the conditions that internationally efficient tariffs must satisfy, by appealing to the results of Mayer (1981). Mayer showed that in this case the locus of internationally efficient tariffs is defined as and thereby consists of tariff combinations that equate the home-country relative price _p_ with the foreign-country relative price _p_<sup>_∗_</sup> .<sup>10</sup> Figure 1 depicts the locus of internationally efficient tariffs in the absence of rivalry under the interpretation that _W_ and _W_<sup>_∗_</sup> are the real national income levels for the home and foreign country, respectively. This locus is labeled _EM −EM_ , because it reflects the particular position of the efficiency locus that, as Mayer (1981) showed, arises when both countries are national-income maximizers. As noted, with _τ_ on the vertical axis and _τ_<sup>_∗_</sup> on the horizontal axis, the efficient tariffs correspond to the locus of tangencies between a home-government and a foreign-government indifference curve (the indifference curves in Figure 1 have the curvature properties depicted as a result of the minimal structure we have placed on _W_ and _W_<sup>_∗_</sup> ). And as the Mayer locus in (11) implies, the efficiency locus passes through the reciprocal free trade point ( _τ_ = 0 _, τ_<sup>_∗_</sup> = 0) but also includes combinations of an import tariff in one country ( _τ >_ 0 or _τ_<sup>_∗_</sup> _>_ 0) combined with an import subsidy in the other country

> 10That the tariff combinations in (11) equate _p_ and _p∗_ can be seen by observing that by the arbitrage conditions _p_ = (1 + _τ_ ) _p_<sup>_w_</sup> and _p_<sup>_∗_</sup> = _p_<sup>_w_</sup> _/_ (1 + _τ_<sup>_∗_</sup> ) we must have _pp_<sup>_∗_= (1 +</sup><sup>_τ_)</sup><sup>_×_(1 +</sup><sup>_τ ∗_)</sup><sup>_._</sup>

11
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how each government feels about changes in its local relative price, such objective functions are consistent with a wide range of industrial policy goals and general distributional goals as well as political preferences. With these government objective functions, the efficiency locus depicted in Figure 1 need not pass through the reciprocal free trade point ( _τ_ = 0 _, τ_<sup>_∗_</sup> = 0) as the Mayer locus does when governments are assumed to maximize real national income with their tariff choices. But beyond that difference, Figure 1 would look qualitatively identical under these more general interpretations of the government objective functions _W_ and _W_<sup>_∗_</sup> .

**Geopolitical Rivalry** We now allow for the presence of geopolitical rivalry, where _ρ >_ 0 and _ρ_<sup>_∗_</sup> _>_ 0 and government objectives are given by (5), which for convenience we reproduce here:

For this case, a pair of internationally efficiency tariffs _τ_<sup>_E_</sup> and _τ_<sup>_∗E_</sup> must solve the following program: where _G_<sup>_∗E_</sup> is a fixed and feasible level of _G_<sup>_∗_</sup> . Similar to the case with no geopolitical rivarly, here the portion of the international efficiency frontier that would deliver at least the Nash level of welfare to each government can then be characterized by solving (12) for all values of _G_<sup>_∗E_</sup> between the Nash level _G_<sup>_∗_</sup> ( _τ_<sup>_∗N_</sup> _, τ_<sup>_N_</sup> ) and the level of _G_<sup>_∗E_</sup> that would yield _τ_<sup>_E_</sup> and _τ_<sup>_∗E_</sup> satisfying _G_ ( _τ_<sup>_E_</sup> _, τ_<sup>_∗E_</sup> ) = _G_ ( _τ_<sup>_N_</sup> _, τ_<sup>_∗N_</sup> ).

The Lagrangian associated with (12) is given by where _λ_ is again the Lagrange multiplier. The first-order necessary conditions for the solution to (12) are given by Equating the two expressions for _λ_ implied by these two first-order conditions yields which simplifies to the exact same characterization of internationally efficient tariffs as in (10).

Again interpreting an increase in _ρ_ and _ρ_<sup>_∗_</sup> above the levels _ρ_ = 0 = _ρ_<sup>_∗_</sup> as a rise in geopolitical rivalry, we may therefore state: 13
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# **2.5 A Role for Trade Policy Cooperation**

With our characterizations of Nash and efficient tariffs in hand, we can now ask a basic question: Is there any role for cooperation over trade policy between geopolitical rivals? The answer is yes if and only if, when _ρ >_ 0 and _ρ_<sup>_∗_</sup> _>_ 0, the noncooperative Nash tariff choices characterized by (7) do not rest on the efficiency frontier characterized by (10). Plugging the Nash expressions for _Wτ_ and _Wτ_<sup>_∗∗_givenby(7)intotheconditionsforefficienttariffsgiven</sup> by (10) implies that Nash tariffs are efficient if and only if We may conclude from (13) that Nash tariffs are inefficient as judged by the governments’ objectives, and therefore that a role for cooperation over trade policy continues to exist for geopolitical rivals, except in the limiting case where _ρ →∞_ and _ρ_<sup>_∗_</sup> _→∞_ .

To interpret this limiting case, note that we can represent the government objectives in (5) in the limit as _ρ →∞_ and _ρ_<sup>_∗_</sup> _→∞_ by the functions where Γ is a monotonic transformation of _G_ with Γ _≡_<sup>_<u>G</u>_</sup> _ρ_<sup>and Γ</sup><sup>_∗_is a monotonic transformation</sup> of _G_<sup>_∗_</sup> with Γ<sup>_∗_</sup> _≡_<sup>_<u>G∗</u>_Accordingto(14),inthislimitingcaseeachgovernmentcaresonly</sup> _ρ_<sup>_∗_.</sup> about dominating its rival, and cares nothing about achieving its underlying objectives for their own sake. And with each rival’s objective then diametrically opposed to the other, _any_ pair of tariffs will be efficient, including the Nash tariffs.<sup>11</sup> We may therefore state:

**Proposition 3** _A role for trade policy cooperation persists in the presence of geopolitical rivalry unless domination becomes the sole objective of each rival._

According to Proposition 3, it is indeed the case that the rise of geopolitics could preclude the possibility of trade cooperation between the rivals. But what is most notable about this case is the extreme assumption about the nature of geopolitical rivalry that is required to generate it. And unless one is willing to take this extreme position, Proposition 3 implies that the rise of geopolitical rivalry leaves the case for cooperation over trade policy intact. Intuitively, as long as the rival governments’ objective functions exhibit “enlightened – self-interest” i.e. as long as governments care more about promoting their own national – objectives, however defined, than they do about frustrating the objectives of their rival there is a continuing case for trade cooperation under geopolitical rivalry, as governments continue to value the gains that such cooperation delivers.

> 11This can also be seen in terms of Figure 2, where in the limiting case the slopes of the iso- _G_ and iso- _G∗_ lines converge to 1 and these lines would lie on top of each other.

15
# **3 Implications for Trade Cooperation and Negotiations**

Having established in Proposition 3 that trade policy cooperation is possible in all but the most extreme situations of geopolitical rivalry, we now turn to a second question: Can tariff negotiations as traditionally conceived succeed in allowing countries to maintain cooperative trade relations when geopolitical rivalry erupts or intensifies _after countries have already bargained to the international efficiency frontier_ ? We argue here that the answer is likely to be no, because the rise of geopolitical rivalry will require that governments find a way to make tariff adjustments that can move them _along_ the efficiency frontier, not from a position off the efficiency frontier _toward_ the frontier; and as we will argue, traditional negotiations driven by reciprocal tariff concessions that generate mutual benefits for the negotiating parties are not well-suited to facilitate such tariff adjustments in an efficient manner.

We develop this argument below maintaining our focus on great-power rivalry as defined by a quest for dominance, as emphasized by the realist school of the international relations literature. We then pause to consider the robustness of our basic conclusions along an important dimension, namely, to a broader understanding of geopolitics that includes government concerns about dependence in addition to concerns over dominance.

## **3.1 Dominance**

To see that the rise of geopolitical rivalry will require that governments move along the — international efficiency frontier and hence, beginning from the status quo cooperative tariffs that prevailed before the rivalry erupted, require tariff adjustments that are not pareto — preferred it is helpful to consider what Propositions 1 and 2 imply about how the rise of geopolitics would impact the outcome of efficient tariff bargaining as characterized by the Nash Bargaining Solution.

By Proposition 1 we know that Nash tariffs will be altered by geopolitical rivalry, and by Proposition 2 we know that the original status quo cooperative tariff pair will continue to be efficient after the rivalry has erupted, as will every other tariff pair on the original efficiency frontier defined by (12). This latter property allows us to recast the Nash Bargaining Problem in terms of choices over _W_ and _W_<sup>_∗_</sup> , regardless of the values of _ρ_ and _ρ_<sup>_∗_</sup> .

To this end, we define _G_<sup>ˆ</sup> ( _W, W_<sup>_∗_</sup> ) _≡ W_ + _ρ×_ [ _W −W_<sup>_∗_</sup> ] and _G_<sup>ˆ</sup><sup>_∗_</sup> ( _W_<sup>_∗_</sup> _, W_ ) _≡ W_<sup>_∗_</sup> + _ρ_<sup>_∗_</sup> _×_ [ _W_<sup>_∗_</sup> _−W_ ], and we define _W_<sup>_N_</sup> _≡ W_ ( _τ_<sup>_N_</sup> _, τ_<sup>_∗N_</sup> ) and _W_<sup>_∗N_</sup> _≡ W_<sup>_∗_</sup> ( _τ_<sup>_∗N_</sup> _, τ_<sup>_N_</sup> ). We can then express the Nash Bargaining problem as where _W_<sup>_E_</sup> ( _W_<sup>_∗_</sup> ) is the mapping from _W_<sup>_∗_</sup> to _W_ described by the efficiency frontier characterized by the solution to (12), and where the mapping from the efficient levels of _W_ and _W_<sup>_∗_</sup> to the efficient tariffs that implement them is given by (10). Plugging the constraint from (15) into the Nash Bargaining product and manipulating the first order necessary condition for maximization of that product yields the following characterization of the Nash Bargaining 16
Solution in the presence of geopolitical rivalry: where The characterization of the Nash Bargaining Solution in (16) is easy to interpret. Suppose first that _ρ_ = 0 = _ρ_<sup>_∗_</sup> so that there is no rivalry. In that case, Θ = 0 = Θ<sup>_∗_</sup> and (16) collapses to the condition that the (negative of the) ratio of the home- to foreign- bargaining surplus _−_ (( _W_<sup>_W∗−_</sup> _−_<sup>_W_</sup> _W_<sup>_N∗N_</sup> <u>))</u> must be equal to the slope of the efficiency frontier (<sup>_<u>∂W</u>_</sup> _∂W_<sup>_E∗_).Inthe</sup> � � case of transferable utility the slope of the efficiency frontier would be equal to _−_ 1, implying the familiar result that the Nash Bargaining solution splits the bargaining surplus evenly between the two parties; more generally, when the efficiency frontier is concave as we have depicted it in our figures, the Nash Bargaining solution would deviate from an even split of the surplus depending on the slope and curvature properties of the efficiency frontier. Now consider how the Nash Bargaining Solution responds to the rise of geopolitical rivalry. One possibility of interest is the case of symmetric rivalry where _ρ_ = _ρ_<sup>_∗_</sup> _>_ 0. In this case, we have Θ = Θ<sup>_∗_</sup> _>_ 0, and it therefore follows that (16) will continue to be satisfied by setting _−_ (( _W_<sup>_W∗−_</sup> _−_<sup>_W_</sup> _W_<sup>_N∗N_</sup> <u>))</u> equal to<sup>_<u>∂W</u>_</sup> _∂W_<sup>_E∗_ifandonlyifutilityistransferablesothat</sup><sup>_<u>∂W</u>_</sup> _∂W_<sup>_E∗_=</sup><sup>_−_1.</sup> � � If utility is transferable and if in addition the two countries are more broadly symmetric in the specific sense that _W_<sup>_N_</sup> and _W_<sup>_∗N_</sup> change proportionately with the eruption of their (symmetric) rivalry, then the Nash Bargaining Solution is left completely unaffected by this rivalry and the cooperative tariffs are unchanged. But unless these additional conditions are met, then even when the strength of the geopolitical rivalry is symmetric across the two countries and _ρ_ = _ρ_<sup>_∗_</sup> _>_ 0, the Nash Bargaining Solution will identify a new point on the efficiency frontier when the rivalry erupts, and a movement along the efficiency frontier from the original status quo cooperative point to the new cooperative point will be required.

The other possibility to consider is where the rivalry is asymmetric, as when _ρ_<sup>_∗_</sup> _> ρ >_ 0 so that the foreign government gives greater weight to the rivalry between the two governments than does the domestic government. In this case, it follows that Θ<sup>_∗_</sup> _>_ Θ _>_ 0, and (16) implies that this gives a boost to the share of the bargaining surplus that the foreign government will receive in the Nash Bargaining Solution relative to its share when the rivalry is symmetric. Again in this case, the Nash Bargaining Solution will identify a new point on the efficiency frontier when the rivalry erupts, though relative to the symmetric rivalry case this new point will tend to favor the foreign government (or more generally, the government that puts more weight on the rivalry).

As these possibilities illustrate, it is only in knife-edge cases that one would _not_ expect the rise of geopolitical rivalry to require that governments find a way to move along the efficiency frontier in order to maintain trade cooperation. Figure 3 depicts how the change 17
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_the international efficiency frontier and implement tariff changes that are not pareto preferred relative to the status quo._ At a broad level, Figure 3 suggests two alternative paths that might be taken from the existing efficient bargaining outcome to the new efficient geopolitical bargaining outcome.<sup>13</sup> As we detail further below, in a first path of “(trade) war and redemption,” geopolitics initially leads to an unraveling of liberal trade policies and reversion to the new Nash equilibrium (from _B_ 1 to _N_ 2) where welfare is lower for both economies. But starting from the new Nash equilibrium under geopolitical rivalry, governments may then conduct classical trade negotiations involving reciprocal tariff concessions that deliver mutual benefits until the new efficient bargaining outcome ( _B_ 2) is reached. Alternatively, countries could avoid the policy disruption and loss of welfare implied by this first path, and instead directly negotiate a transition to the new bargaining outcome on the efficiency locus (from _B_ 1 to _B_ 2).

Clearly, the second path would be preferred to the first path by both governments if they can find a way to implement it.<sup>14</sup> Since this second path would move countries along the international efficiency frontier, it involves efficient transfers of surplus from (in this case) the home country to the foreign country; and if explicit transfers are not feasible, implicit transfers could be implemented via changes in tariffs, with the surplus-granting country lowering its tariffs and the surplus receiving country raising its tariffs. But at a fundamental level, such tariff changes would go against the essence of the “reciprocal and mutually advantageous”tariff reductions that GATT’s Preamble describes, both because the required tariff changes are not reciprocal (one country is cutting its tariffs while the other country is raising its tariffs) and because the outcome of these tariff changes is not mutually advantageous (one country gains relative to the status quo while the other loses).<sup>15</sup>

> 13In section 5 we will be more specific about how tariff renegotiations traditionally occur in the GATT/WTO.

14In making this comparison, we are leveraging the complete information assumption of our formal analysis. But our findings suggest that rivals would have an incentive to overstate the weight placed on rivalry if these weights were not common knowledge, in order to adopt a “tough” stance in the Nash bargain with their rival. In this light, a difference between the first and the second path that our formal analysis does not capture is that, in the first path where reciprocity (and nondiscrimination) are maintained, these kinds of strategic considerations would in principle not arise (see Bagwell and Staiger, 2018).

> 15For simplicity, we have maintained our focus on the implications of geopolitical rivalry for the outcomes of efficient “power-based” tariff bargaining as characterized by the Nash Bargaining Solution. Bagwell and Staiger (2016) have argued that the design features of the GATT/WTO may lead governments toward a “rules-based” bargaining outcome that Bagwell and Staiger refer to as the “political optimum.” As they note, while corresponding to a point on the efficiency frontier, the political optimum itself is not influenced by threats and the possibility of disagreement. And they argue that GATT’s reciprocity rule creates a “reciprocity-constrained” bargaining frontier that corresponds to the efficiency frontier at the political optimum but lies inside the efficiency frontier everywhere else. Bargaining on this frontier then has the effect of penalizing governments who attempt to move the bargaining outcome away from the political optimum, and in this way it delivers a rules-based outcome that is closer to the political optimum than would be a power-based Nash bargain. We will show (Proposition 9) that the rise of geopolitical rivalry would leave the position of the political optimum unchanged and that the political optimum would continue to reside on the (unchanged) efficiency frontier. And it is easy to show that the rise of geopolitical rivalry would cause an inward shift of the reciprocity-constrained bargaining frontier at all points other than the political optimum. This implies that, as with the power-based bargains that we have analyzed, moving to the new rules-based bargaining outcome in the presence of geopolitical rivalry would require non-pareto-improving tariff adjustments relative to the status quo.

19
Below we will argue that the changes in tariffs required to navigate this second path would create significant challenges for the world trading system in its present form. But before doing so, we first pause to consider how our basic conclusions would be impacted by the issue of national-security-related dependence concerns, and we then consider the possibility of bilateral rivalry in a multilateral world.

# **3.2 Dependence**

As discussed in the Introduction, according to the international relations literature (e.g., Mearsheimer, 2003) a hallmark of great-power rivalry is the quest for dominance, where relative power considerations are paramount. To capture this, we have modeled the rise of great-power rivalry as reflecting a change in government preferences, whereby governments have new concerns about the _relative_ success with which they achieve their underlying objectives, not just their absolute success.

But geopolitics is multifaceted. An issue often associated with geopolitical concerns, in addition to dominance, relates to national-security-related dependence concerns. Are our basic conclusions robust to the presence of these additional concerns? We now argue that they are.

To establish this, we first note that when it comes to geopolitics and dependence, some subtle issues are introduced. For one thing, the rise of geopolitics does not itself _introduce_ dependence concerns where otherwise none would exist. Even governments that are not involved in great-power rivalry typically have concerns about over-dependence on trading partners (hostile or otherwise) regarding certain critical sectors that, in the event of supply cutoff, could hobble a country’s ability to defend or feed or immunize itself.<sup>16</sup> It is therefore relevant to recall that, because our modeling of the underlying objectives of governments does not place restrictions on how each government feels about changes in its own local relative price, these objective functions are consistent with a wide range of industrial policy goals where governments intervene to favor a certain sector, and this would include the goal of reducing dependence on one’s trading partners by stimulating local production in strategic sectors. So our model already allows for dependence concerns of this kind.

Still, the rise of geopolitics might also _alter existing concerns about dependence_ along either of two dimensions. A first dimension is along the extensive margin: the rise of geopolitics may extend a country’s dependence concerns to include not only its existing concerns about over-dependence on its trading partners but now also a new desire to _induce a rival to be more dependent on it_ . While not our focus, in at least one important case this, too, is captured by our modeling of geopolitics. Suppose, for example, that the foreign government is concerned about over-dependence on the home country because of the greater leverage that the home-country government would have on the foreign country in case of future conflict. This concern would be captured in our model by the underlying objectives of the foreign government as represented by _W_<sup>_∗_</sup> , and in particular by the foreign government’s implied preferences over its own local relative price _p_<sup>_∗_</sup> . And suppose further that the rise of geopolitics leads the home government to now desire to induce the foreign country to be

> 16Dependence on a rival is obviously risky for a country, but even dependence on allies could be risky in times of natural disaster or global pandemics, or if the country’s adversaries could attack shipping lanes and blow up pipe lines between the country and its allies.

20
more dependent on it for precisely this reason. Our modeling of geopolitical rivalry in (5) would capture this situation, as reflected in the diametrically opposed home-country and foreign-country concerns over the foreign local relative price _p_<sup>_∗_</sup> that would be implied by the relative power term in the home-country geopolitical objective _G_ .<sup>17</sup> Nevertheless, there is also a second possible dimension along which the rise of great power rivalry could alter national-security-related dependence concerns, and this dimension runs along the intensive margin: in particular, concerns about limiting own-dependence could themselves be _heightened_ by the rise of great-power rivalry, giving rise to a _shift in the underlying objectives of each government_ with respect to its preferred own local relative price. Our analysis thus far has ruled out this possibility. We now consider how this second dimension would impact our findings above.

To this end, we suppose that the rise of geopolitical rivalry now introduces _two_ shocks to the preferences of the home and foreign governments. First, and different from our analysis above, we assume that rivalry creates a desire in each government to be less dependent on imports from its rival, as measured by the ratio of the country’s import volume relative to its production of the import-competing good. In our model, this new desire would translate into a shift in the underlying objectives of the home government toward a preference for a higher home tariff _τ_ and higher local relative price _p_ in the home country, and a shift in the underlying objectives of the foreign government toward a preference for a higher foreign tariff _τ_<sup>_∗_</sup> and a lower local relative price _p_<sup>_∗_</sup> in the foreign country. And second, we assume that the rise of geopolitical rivalry also translates into a quest for dominance over one’s rival as gauged by the relative success in achieving one’s underlying objectives, just as we have modeled great-power rivalry above.

We assume for purposes of illustration that the pre-rivalry objectives of the two governments are defined as their real national income, so that the pre-rivalry set of internationally efficient tariffs is given by the Mayer locus as illustrated in Figure 1. And we assume further that, prior to the onset of their rivalry, the two governments had previously negotiated to a point on the Mayer locus, which for illustrative purposes we take to be the point of reciprocal free trade. Denoting by _WD_ ( _τ, τ_<sup>_∗_</sup> ) and _WD_<sup>_∗∗_(</sup><sup>_τ ∗, τ_)thenewunderlyinghome-andforeign-</sup> government objectives respectively that reflect their heightened concern for dependence once rivalry erupts, Figure 4 labels the status quo reciprocal free trade point as _B_ 1 and depicts the upward shift of the efficiency locus in tariff space – from the Mayer locus labeled _EM − EM_ to the new efficiency locus labeled _ED − ED_ – implied by the points of tangency of the indifference curves associated with these new underlying objectives. As Figure 4 illustrates, the status quo tariffs at _B_ 1 are no long efficient when judged by the underlying objectives of the two governments once their rivalry erupts and these underlying objectives reflect the heightened concern that each government has about dependence on its rival. But given these new underlying objectives, we know from Proposition 2 that the quest for dominance that the rivalry also engenders does not itself alter the set of efficient tariffs from those depicted by _ED − ED_ .

This underpins the features illustrated in Figure 5, which translates the information from

> 17That said, our modeling of geopolitical rivalry cannot account for all circumstances in which this first dimension could be important. For example, our modeling approach cannot capture the possibility that one country wished to induce its rival to be more dependent on it while its rival was simply not concerned with its dependence on the first country.

21
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<!-- Start of picture text --> Wp<br><!-- End of picture text --> <!-- Start of picture text --> 1f<br>1i<br>I1<br>T'<br>1!<br>11<br>1T<br>11<br>Bi@---\--------<br>/<br>N 2<br><!-- End of picture text --> WwW D*
countries *1 and *2 and exports good _y_ to each of these foreign countries. We assume that the two foreign countries do not trade with each other, and as before we focus on nonprohibitive tariffs.<sup>19</sup> Our three-country setting is therefore analogous to that considered by Bagwell and Staiger (2005), and we will build on their analysis in what follows.

The main novelty of the three-country setting relative to the two-country model of section 2 arises if the home country sets discriminatory tariffs against the imports from its two foreign trading partners, _τ_<sup>1</sup> against imports from foreign country *1 and _τ_<sup>2</sup> against imports from foreign country *2 with _τ_<sup>1</sup> = _τ_<sup>2</sup> . In this case, there will be two world relative prices rather than just one, a world relative price for the trade between the home country and foreign country *1, _p_<sup>_w_1</sup> _≡ p_<sup>_∗_</sup> _x_<sup>1</sup><sup>_/py_,and a world relative price for the trade between the home country</sup> and foreign country *2, _p_<sup>_w_2</sup> _≡ p_<sup>_∗_</sup> _x_<sup>2</sup><sup>_/py_;andasbefore,wecanrepresenteachcountry’slocal</sup> relative price in terms of its tariff and the world price it faces: _p_ = (1 + _τ_<sup>_i_</sup> ) _p_<sup>_wi_</sup> _≡ p_ ( _τ_<sup>_i_</sup> _, p_<sup>_wi_</sup> ) and _p_<sup>_∗i_</sup> = _p_<sup>_wi_</sup> _/_ (1 + _τ_<sup>_∗i_</sup> ) _≡ p_<sup>_∗i_</sup> ( _τ_<sup>_∗i_</sup> _, p_<sup>_wi_</sup> ) for _i_ = 1 _,_ 2. These world prices are linked across bilateral trading relationships through the home country’s local price expression according to implying that under nondiscriminatory (MFN) tariffs for the home country _τ_<sup>1</sup> = _τ_<sup>2</sup> _≡ τ_ we have a single world price _p_<sup>_w_1</sup> = _p_<sup>_w_2</sup> _≡ p_<sup>_w_</sup> .

Imposing standard international market clearing conditions, we can determine the equilibrium world prices for any set of tariffs in this three-country setting. As noted, in the case of discriminatory home-country tariffs there are two world prices, _p_ �<sup>_w_1</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) and _p_ �<sup>_w_2</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ), that are determined by a market clearing condition together with the linkage condition in (17). And while in this case the terms of trade for foreign country * _i_ for _i_ = 1 _,_ 2 is given by the world price _p_ �<sup>_wi_</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) that applies to its trade with the home country, the (multilateral) terms of trade of the home country is a trade-weighted average of these world prices. In the case of nondiscriminatory MFN tariffs, the market clearing condition determines the single equilibrium world price _p_ �<sup>_w_</sup> ( _τ, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ), which is then the terms of trade for all countries.

As we did in section 2, we place minimal structure on the underlying objectives of each country, this time relying explicitly on the structure imposed by Bagwell and Staiger (2005). In particular, letting these objectives be represented by _W_<sup> ̃</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ), _W_<sup> ̃</sup><sup>_∗_1</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) and _W_<sup> ̃</sup><sup>_∗_2</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) when the home government can choose discriminatory tariffs, we follow Bagwell and Staiger and assume that, when evaluated at any set of efficient tariffs, the following conditions hold for _i, j_ = 1 _,_ 2 and _i_ = _j_ : These restrictions follow directly from the government objective expressed as general functions of a country’s local price and its terms of trade, provided that government welfare is

> 19If the home country imposes a non-discriminatory tariff, the two foreign countries have no basis to trade with each other in this two-good general equilibrium setting. If the home country imposes discriminatory tariffs against the two foreign countries, then a basis for trade between these two countries could arise to take advantage of arbitrage opportunities created by the home-country discriminatory tariffs, but not if transport costs between them are sufficiently high.

24
sufficiently sensitive to terms-of-trade changes. And alternatively, letting these objectives be represented by _W_<sup> ̄</sup> ( _τ, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ), _W_<sup> ̄</sup><sup>_∗_1</sup> ( _τ, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) and _W_<sup> ̄</sup><sup>_∗_2</sup> ( _τ, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) when the home government is restricted to MFN tariff choices, we again follow Bagwell and Staiger and assume that, when evaluated at any set of efficient tariffs, the following conditions hold for _i, j_ = 1 _,_ 2 and _i_ = _j_ : Again, these restrictions follow directly from the government objective expressed as general functions of a country’s local price and its terms of trade, as long as the tariffs under consideration are consistent with the nature of GATT bindings.

Following Bagwell and Staiger (1999) and (2002), we also record the derivative properties of the government objectives when evaluated at reaction-curve tariffs, where the signs of these derivatives are determined by the sign of the terms-of-trade movement induced by the tariff change and the following conditions hold for _i, j_ = 1 _,_ 2 and _i_ = _j_ : Beyond these restrictions, we continue to assume curvature properties on these functions that ensure unique tariff reaction curves.

Finally, we assume that the home country and foreign country *1 are the geopolitical rivals, so that _ρ ≥_ 0 and _ρ_<sup>_∗_1</sup> _≥_ 0, with foreign country *2 assumed to be the neutral country—i.e. not to be involved in such rivalry so that _ρ_<sup>_∗_2</sup> _≡_ 0. This is then reflected in our specification of government objectives, which are the analogs of the government objectives given in (5) for the two-country setting. When the home country can choose discriminatory tariffs, these objectives are given by And when the home country is restricted to MFN tariffs, these objectives are given by

# **4.1 Nash**

We first consider the impact of bilateral geopolitical rivalry in a three-country world without trade cooperation, solving for Nash tariffs as a function of _ρ_ and _ρ_<sup>_∗_1</sup> . In such a world, we assume that the home country is unconstrained in its ability to choose discriminatory tariffs (extending the Nash results to comply with MFN is straightforward and leads to results that are analogous to what we report below). The noncooperative tariffs, which we denote by _τ_<sup>1</sup><sup>_N_</sup> , _τ_<sup>2</sup><sup>_N_</sup> , _τ_<sup>_∗_1</sup><sup>_N_</sup> and _τ_<sup>_∗_2</sup><sup>_N_</sup> , are defined by the four first-order conditions associated with the 25
government objective functions in (21). These first-order conditions can be manipulated to yield which, using the conditions in (20), imply that _τ_<sup>1</sup><sup>_R_</sup> ( _τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) is increasing in _ρ_ , _τ_<sup>2</sup><sup>_R_</sup> ( _τ_<sup>1</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) is decreasing in _ρ_ and _τ_<sup>_∗_1</sup><sup>_R_</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_2</sup> ) is increasing in _ρ_<sup>_∗_1</sup> , while _τ_<sup>_∗_2</sup><sup>_R_</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> ) is independent of _ρ_ and _ρ_<sup>_∗_1</sup> . Under our assumed reaction-curve stability conditions, this then means that _τ_<sup>1</sup><sup>_N_</sup> is increasing in _ρ_ and _τ_<sup>2</sup><sup>_N_</sup> is decreasing in _ρ_ while _τ_<sup>_∗_1</sup><sup>_N_</sup> is increasing in _ρ_<sup>_∗_1</sup> , and if tariff reaction curves are upward sloping it then follows that the Nash tariffs that the two rivals impose on each other are increasing in both _ρ_ and _ρ_<sup>_∗_1</sup> while the Nash tariffs between the home- and third-country may be increasing in _ρ_<sup>_∗_1</sup> but decreasing in _ρ_ . However, if tariff reaction curves are downward sloping, then _τ_<sup>1</sup><sup>_N_</sup> and _τ_<sup>2</sup><sup>_N_</sup> will be decreasing in _ρ_<sup>_∗_1</sup> while _τ_<sup>_∗_1</sup><sup>_N_</sup> will be decreasing in _ρ_ , and it is then possible that a rise in both _ρ_ and _ρ_<sup>_∗_1</sup> could increase the Nash tariff of one of the rivals while reducing the Nash tariff of the other rival and the third country.

With the rise of geopolitics captured by an increase in _ρ_ and _ρ_<sup>_∗_1</sup> above the levels _ρ_ = 0 = _ρ_<sup>_∗_1</sup> , we may therefore state:

**Proposition 5** _In a three-country world with two potential rivals, the rise of bilateral geopolitical rivalry raises the Nash tariff of at least one of the rivals. If tariff reaction curves are upward sloping, the rise of bilateral geopolitical rivalry raises the Nash tariffs that the two rivals impose on each other and may lower the Nash tariffs that the home- and the neutralcountry impose on each other; while if tariff reaction curves are downward sloping the rise of bilateral geopolitical rivalry may raise the Nash tariff that one country applies to trade with its rival while lowering all other Nash tariffs._

# **4.2 International Efficiency Frontier**

Next we consider the internationally efficient combinations of tariffs. We divide this characterization into efficient discriminatory tariffs and efficient tariffs when the home country tariffs cannot be discriminatory.

Efficient tariffs when discriminatory tariffs are allowed solve the following program: 26
where _G_<sup> ̃</sup><sup>_∗_1</sup><sup>_E_</sup> and _G_<sup> ̃</sup><sup>_∗_2</sup><sup>_E_</sup> are fixed and feasible levels of _G_<sup> ̃</sup><sup>_∗_1</sup> and _G_<sup> ̃</sup><sup>_∗_1</sup> respectively. As before, the portion of the international efficiency frontier that would deliver at least the Nash level of welfare _G_ ̃<sup>_∗_2</sup><sup>_E_</sup> tobetween the Nash levelseach government can then _G_ ̃<sup>_∗_1</sup> ( _τ_ be<sup>1</sup><sup>_N_</sup> characterized _, τ_<sup>2</sup><sup>_N_</sup> _, τ_<sup>_∗_1</sup><sup>_N_</sup> _, τ_<sup>_∗_2</sup> by<sup>_N_</sup> ) andsolving _G_ ̃<sup>_∗_2</sup> ((24 _τ_<sup>1</sup> )<sup>_N_</sup> for _, τ_<sup>2</sup> all<sup>_N_</sup> _, τ_ values<sup>_∗_1</sup><sup>_N_</sup> _, τ_<sup>_∗_</sup> of<sup>2</sup><sup>_N_</sup> _G_ ) and the<sup> ̃</sup><sup>_∗_1</sup><sup>_E_</sup> and levels of _G_ ̃( _τ_<sup>1</sup><sup>_N_</sup> _, τG_<sup>2 ̃</sup><sup>_N∗_1</sup> _, τ_<sup>_E∗_</sup> and<sup>1</sup><sup>_N_</sup> _, τG_<sup> ̃</sup><sup>_∗∗_22</sup><sup>_NE_</sup> ).that would yield _τ_<sup>1</sup><sup>_E_</sup> , _τ_<sup>2</sup><sup>_E_</sup> , _τ_<sup>_∗_1</sup><sup>_E_</sup> and _τ_<sup>_∗_2</sup><sup>_E_</sup> satisfying _G_<sup> ̃</sup> ( _τ_<sup>1</sup><sup>_E_</sup> _, τ_<sup>2</sup><sup>_E_</sup> _, τ_<sup>_∗_1</sup><sup>_E_</sup> _, τ_<sup>_∗_2</sup><sup>_E_</sup> ) = Similarly, efficient tariffs when home-country tariffs must conform to MFN solve the following program: where _G_<sup> ̄</sup><sup>_∗_1</sup><sup>_E_</sup> and _G_<sup> ̄</sup><sup>_∗_2</sup><sup>_E_</sup> are fixed and feasible levels of _G_<sup> ̄</sup><sup>_∗_1</sup> and _G_<sup> ̄</sup><sup>_∗_1</sup> respectively. And as before, the portion of the international efficiency frontier that would deliver at least the Nash level of _G_ ̄<sup>_∗_1</sup> welfare<sup>_E_</sup> and _G_ ̄to<sup>_∗_2</sup><sup>_E_</sup> eachbetween the Nash levelsgovernment can then _G_ ̄be<sup>_∗_1</sup> ( _τ_ characterized<sup>_N_</sup> _, τ_<sup>_∗_1</sup><sup>_N_</sup> _, τ_<sup>_∗_2</sup><sup>_N_</sup> ) andby solving _G_ ̄<sup>_∗_2</sup> ( _τ_<sup>_N_</sup> (25 _, τ_ )<sup>_∗_1</sup><sup>_N_</sup> for _, τ_<sup>_∗_</sup> all<sup>2</sup><sup>_N_</sup> ) and thevalues of levels _G_ ̄( _τ_<sup>_N_</sup> _, τ_ of<sup>_∗_1</sup> _G_<sup>_N_ ̄</sup><sup>_∗_</sup> _, τ_<sup>1</sup><sup>_E∗_2</sup> and<sup>_N_</sup> ). _G_<sup> ̄</sup><sup>_∗_2</sup><sup>_E_</sup> that would yield _τ_<sup>_E_</sup> , _τ_<sup>_∗_1</sup><sup>_E_</sup> and _τ_<sup>_∗_2</sup><sup>_E_</sup> satisfying _G_<sup> ̄</sup> ( _τ_<sup>_E_</sup> _, τ_<sup>_∗_1</sup><sup>_E_</sup> _, τ_<sup>_∗_2</sup><sup>_E_</sup> ) = The efficient tariffs that solve (24) and (25) in the absence of geopolitical rivalry, that is, for _ρ_ = 0 and _ρ_<sup>_∗_1</sup> = 0, are characterized by Bagwell and Staiger (2005, Propositions 4 and 7, respectively). We now argue that, just as in our Proposition 2 for the two-country model, the same set of tariffs that is efficient in the absence of geopolitical rivalry when _ρ_ = 0 and _ρ_<sup>_∗_1</sup> = 0 is also the set of tariffs that is efficient in the presence of bilateral geopolitical rivalry, that is, when _ρ >_ 0 and _ρ_<sup>_∗_1</sup> _>_ 0.

To see this, consider first the efficient tariffs that solve (24) in the absence of geopolitical rivalry. With _W_<sup> ̃</sup> on the vertical axis and _W_<sup> ̃</sup><sup>_∗_1</sup> on the horizontal axis and with _W_<sup> ̃</sup><sup>_∗_2</sup> held fixed at an arbitrary feasible level, Figure 6 plots the combination of _W_<sup> ̃</sup> and _W_<sup> ̃</sup><sup>_∗_1</sup> that are implied by the efficient sets of tariffs that solve (24) for _ρ_ = 0 and _ρ_<sup>_∗_1</sup> = 0. As we did for Figure 2, we plot these combinations as tracing out a concave frontier, and this frontier gives the outer boundary of the feasible combinations of _W_<sup> ̃</sup> and _W_<sup> ̃</sup><sup>_∗_1</sup> given the fixed _W_<sup> ̃</sup><sup>_∗_2</sup> . Also depicted in Figure 6 is a family of iso- _G_<sup> ̃</sup> lines, each with slope 1+ _<u>ρ</u> ρ_<sup>and with</sup><sup>_G_ ̃1</sup><sup>_<G_ ̃2</sup><sup>_<G_ ̃3, and a family</sup> of iso- _G_<sup> ̃</sup><sup>_∗_1</sup> lines, each with slope<sup>1+</sup> _ρ_<sup>_∗ρ_1</sup><sup>_∗_1</sup> and with _G_<sup> ̃</sup><sup>_∗_</sup> 1<sup>1</sup><sup>_<G_ ̃</sup><sup>_∗_</sup> 2<sup>1</sup><sup>_<G_ ̃</sup><sup>_∗_</sup> 3<sup>1.Clearlytheiso- ̃</sup><sup>_G_linesin</sup> Figure 6 must be flatter than the iso- _G_<sup> ̃</sup><sup>_∗_1</sup> lines. But it is then immediate from Figure 6 that, for any level of _G_<sup> ̃</sup><sup>_∗_1</sup> (and the fixed level of _G_<sup> ̃</sup><sup>_∗_2</sup> = _W_<sup> ̃</sup><sup>_∗_2</sup> ), the maximum attainable level of _G_<sup> ̃</sup> – (corresponding to the highest attainable iso- _G_<sup> ̃</sup> line) and hence the level of _G_<sup> ̃</sup> that solves – ( ̃24) for _ρ >_ 0 and _ρ_<sup>_∗_1</sup> _>_ 0 but finite will correspond to a point on the frontier of _W_<sup> ̃</sup> and _W_<sup>_∗_1</sup> combinations that are implied by the efficient sets of tariffs that solve (24) for _ρ_ = 0 and _ρ_<sup>_∗_1</sup> = 0. A completely analogous argument holds for the efficient tariffs that solve (25). We may therefore state: 27
<!-- Start of picture text --> . Gtx, x<br>Ww , Gt G," G;<br>(1+p"*)/ p"? S<br>G,<br>—EE p/(1+p)<br><!-- End of picture text --> <!-- Start of picture text --> w"t<br><!-- End of picture text --> W’? held fixed at an arbitrary feasible level
rivalry, the only possibility for tariff negotiations to yield strict welfare improvements for the negotiating governments comes if the two rivals are not both present at the negotiating table and the negotiations are instead _bilateral_ , between the government of foreign country *2 and _either_ the home-country government _or_ the government of foreign country *1.

If we restrict attention to tariff negotiations that have the potential to yield strict welfare improvements for the negotiating governments, we may then state:

**Proposition 7** _A role for multilateral trade policy cooperation persists in the presence of bilateral geopolitical rivalry unless domination becomes the sole objective of each rival._

# **4.3 Implications for Trade Cooperation and Negotiation**

Along with reciprocity, non-discrimination is a second pillar of the world trading system. Will the rise of geopolitics create tension with the non-discrimination principle as well? The two-country model of section 2 is of course silent on this issue, but our results from the three-country model suggest that the answer to this question may be yes.

In particular, by Proposition 5 we know that the rise of geopolitical rivalry between the home government and the government of foreign country *1 in our three-country model will impact the noncooperative Nash tariffs and payoffs; but by Proposition 6 we also know that this rivalry will leave unchanged the set of tariff combinations that are internationally efficient, both when tariffs are constrained to conform to MFN and when they are allowed to be discriminatory. These two findings in turn suggest that the pre-rivalry cooperative tariffs can no longer be sustained as the outcome of efficient tariff bargaining once geopolitical rivalry has erupted, and to maintain trade cooperation the three governments must find a way to navigate along the international efficiency frontier, just as in our two-country model.

In our two-country analysis we used the Nash Bargaining solution to characterize the outcome of efficient tariff bargaining and formalize this point, but that approach does not extend naturally to a many-country setting.<sup>21</sup> For the discussion of our three-country model we therefore follow Bagwell and Staiger (2005) and do not take a stand on the particular bargaining solution under which the three countries would achieve a point on the frontier. Instead, we focus on the nature of the tariff adjustments that could enable governments to move along the efficiency frontier, and we highlight a basic point: restricting countries to non-discriminatory tariff adjustments could make such movements more cumbersome, by preventing the rivals from adjusting their tariffs in a way that could effect the needed transfer of surplus between them while neutralizing the impacts on the third country.

To see the point, it is useful to first recall the findings of Bagwell and Staiger (2005), who adopting the formalization of reciprocity proposed by Bagwell and Staiger (1999) showed that when the home country and foreign country *1 engage in bilateral tariff negotiations that lead to _reciprocal_ tariff changes, it is _only_ when the home country’s tariff is constrained to be non-discriminatory that the impact on foreign country *2 of the home country’s bilateral tariff negotiation with foreign country *1 will be neutralized. As Bagwell and Staiger observe, this is because non-discrimination ensures that there will be a single relative world price _p_ �<sup>_w_</sup> ( _τ, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) at which both foreign countries trade with the home

> 21See, for example, the discussion in Bagwell et al. (2020) and (2021) and the application of Horn and Wolinsky (1988) “Nash-in-Nash” solution concept to multi-country tariff bargaining.

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country, and because reciprocal changes in _τ_ and _τ_<sup>_∗_1</sup> leave the world price unchanged.<sup>22</sup> And with _τ_<sup>_∗_2</sup> unchanged, these tariff changes therefore also leave unchanged foreign country _W_ ̄<sup>_∗_2</sup> _∗_ ( _p_ 2’s<sup>_∗_2</sup> (local _τ_<sup>_∗_2</sup> _,_ � _p_<sup>_w_</sup> price( _τ, τ_<sup>_∗_</sup> _p_<sup>1</sup> _, τ_<sup>_∗_2</sup> (<sup>_∗_</sup> _τ_<sup>2</sup><sup>_∗_</sup> ))<sup>2</sup> _,,_ � � _pp_<sup>_ww_</sup> )( _τ, τ_ and<sup>_∗_1</sup> _, τ_ hence<sup>_∗_2</sup> )). itsAs Bagwell and Staiger note, the “third-countrygovernment welfare level _W_<sup> ̄</sup><sup>_∗_2</sup> ( _τ, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) _≡_ neutrality” property exhibited by bilateral tariff negotiations that conform to reciprocity and non-discrimination can help governments decentralize the tariff bargaining problem that they face in moving from noncooperative Nash tariffs to cooperative tariffs on the international efficiency frontier in a multilateral world.

But as we have observed, the rise of geopolitical rivalry between the home country and foreign country *1 will require that governments find a way to navigate along the international efficiency frontier. This in turn will require _non_ -reciprocal tariff changes for the home country and foreign country *1, the purpose of which is to efficiently shift surplus between them with movements in relative world prices. And with non-discrimination ensuring that there is a single relative world price, any transfer of surplus between the home country and foreign country *1 that comes from a movement in _p_ �<sup>_w_</sup> ( _τ, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) _must_ spill over to the welfare of foreign country *2.<sup>23</sup> In fact, in this situation it is only when the home country government is allowed to make _discriminatory_ tariff changes in negotiations with the government of foreign country *1 that it would even be _possible_ for the two rivals to alter the three tariffs under their control in a way that shifts surplus between them while holding the welfare of foreign country _∗_ 2 fixed. This is because with discriminatory tariffs there are now two relative � – world prices _p_<sup>_w_1</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) for trade between the home country and foreign country � – *1 and _p_<sup>_w_2</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) for trade between the home country and foreign country *2 and the two rivals can then alter the three tariffs under their control in a way that moves _p_ �<sup>_w_1</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) to shift surplus between them while holding � _p_<sup>_w_2</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ), and hence foreign country *2’s welfare _W_<sup> ̃</sup><sup>_∗_2</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> ) _≡ W_<sup> ̃</sup><sup>_∗_2</sup> ( _p_<sup>_∗_2</sup> ( _τ_<sup>_∗_2</sup> _,_ � _p_<sup>_w_2</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> )) _,_ � _p_<sup>_w_2</sup> ( _τ_<sup>1</sup> _, τ_<sup>2</sup> _, τ_<sup>_∗_1</sup> _, τ_<sup>_∗_2</sup> )) – fixed.

We record these observations with

**Proposition 8** _It is not possible for two rival countries to make non-discriminatory tariff adjustments that transfer surplus between them without altering the surplus of the neutral third country, but this would be possible if the rival countries could make use of discriminatory tariff adjustments._

> 22As formalized by Bagwell and Staiger (1999), tariff changes implemented by the home country and foreign country *1 conform to (multilateral) reciprocity when each of these countries experiences a change in its import volume that is equal to the change in its export volume with all changes valued at the original relative world price. Applying the balanced (multilateral) trade condition for each country that must hold at the original relative world price and at the new relative world price, it follows directly that under this formalization of reciprocity the relative world price will be unchanged by the reciprocal tariff changes of the home and foreign *1 countries.

> 23With more than two goods, it might become possible to make non-discriminatory tariff adjustments in a way that moved some world prices that were particularly important for a target country while leaving unchanged other world prices that had larger impacts on third countries. But even with many goods, a country’s non-discriminatory tariff changes will still imply that any movement in the world price of a good will impact all exporters of the good to that country, and only in knife-edge cases where the trade patterns lined up in just the right way might it be possible to shift surplus with non-discriminatory tariff adjustments between two countries without impacting the surplus of any third countries.

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With Proposition 8 in hand and in light of the results from Propositions 5 and 6, it is clear that the nondiscrimination principle may create difficulties for countries as they attempt to navigate their way along the international efficiency frontier when geopolitical rivalries erupt. In the next section we explore this point in more depth.

# **5 Implications of Geopolitics for Trade Rules**

What do our findings above mean for the design of the world trading system? In this section we consider this question. We first show that rivalry itself does not change the purpose of a trade agreement, that is, the “problem” that a trade agreement must “solve” in order to eliminate international policy inefficiencies and deliver mutual benefits for its members. With this established, we can then appeal to the results of Bagwell and Staiger (1999) and conclude that, if the design of GATT was effective in helping countries navigate from noncooperative Nash tariffs to the international efficiency frontier in the absence of rivalry as Bagwell and Staiger argue, that same design should also be effective in bringing countries from Nash to the efficiency frontier in the presence of rivalry. But our findings above indicate that the rise of geopolitics will confront the world trading system with a different problem: moving from one point on the international efficiency frontier to another. And as we detail below, it is this imperative that is in tension with GATT’s core reciprocity and MFN principles.

## **5.1 Geopolitics and the Purpose of Trade Agreements**

We begin by demonstrating that the purpose of a trade agreement is not changed by the presence of geopolitical rivalry as we have modeled that rivalry above. We establish this formally in the two-country model of section 2, and then observe how our arguments extend to the three-country model setting of section 4.

Specifying the home government objective function as _W_ ( _τ, τ_<sup>_∗_</sup> ) _≡ W_ ( _p_ ( _τ,_ � _p_<sup>_w_</sup> ( _τ, τ_<sup>_∗_</sup> )) _,_ � _p_<sup>_w_</sup> ( _τ, τ_<sup>_∗_</sup> )) with _Wpw <_ 0 but where _Wp_ is unrestricted and the foreign government objective function as _W_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _, τ_ ) _≡ W_<sup>_∗_</sup> ( _p_<sup>_∗_</sup> ( _τ_<sup>_∗_</sup> _,_ � _p_<sup>_w_</sup> ( _τ, τ_<sup>_∗_</sup> )) _,_ � _p_<sup>_w_</sup> ( _τ, τ_<sup>_∗_</sup> )) with _Wp_<sup>_∗w>_0butwhere</sup><sup>_W ∗_</sup> _p_<sup>_∗_isunrestricted,</sup> Bagwell and Staiger (1999) and (2002) define _politically optimal tariffs_ as the tariffs _τ_<sup>_PO_</sup> and _τ_<sup>_∗PO_</sup> that solve the two equations They then observe that (i) the home government would choose _τ_<sup>_PO_</sup> and the foreign government would choose _τ_<sup>_∗PO_</sup> if the two governments made their tariff choices unilaterally and simultaneously but neither valued the terms-of-trade (world-price) implications of its tariff choice for its welfare (i.e., if the home government acted “as if” _Wpw ≡_ 0 and the foreign government acted “as if” _Wp_<sup>_∗w≡_0),andthat(ii)thepoliticallyoptimaltariffpair</sup> ( _τ_<sup>_PO_</sup> _, τ_<sup>_∗PO_</sup> ) is internationally efficient, in the sense that it achieves a point on the international efficiency frontier defined according to the actual government objective functions _W_ and _W_<sup>_∗_</sup> . Since this “politically optimal thought experiment” would bring governments from their inefficient Nash tariff choices to a point on the international efficiency frontier, Bagwell and Staiger conclude that, as long as government objectives take this form, the purpose of a 31
trade agreement is to eliminate terms-of-trade manipulation from the unilateral tariff choices of the governments.

We now extend Bagwell and Staiger’s (1999, 2002) definition of politically optimal tariffs to our setting in section 2 where geopolitical rivalry is present, and we show that politically optimal tariffs are still efficient, and hence the purpose of a trade agreement is unchanged by the presence of geopolitical rivalry. In particular, with and we define the politically optimal tariff choices ( _τ_<sup>_PO_</sup> _, τ_<sup>_∗PO_</sup> ) as the tariffs that would result if the two governments made their tariff choices unilaterally and simultaneously but neither valued the terms-of-trade (world-price) implications of its tariff choice for its welfare (i.e., if the home government acted “as if” _Gpw_ = _Wpw_ + _ρ_ [ _Wpw − Wp_<sup>_∗w_]</sup><sup>_≡_0andtheforeign</sup> government acted “as if” _G_<sup>_∗_</sup> _p_<sup>_w_=</sup><sup>_W ∗_</sup> _p_<sup>_w_+</sup><sup>_ρ∗_[</sup><sup>_W ∗_</sup> _p_<sup>_w−Wpw_]</sup><sup>_≡_0).</sup> As defined, in the presence of geopolitical rivalry politically optimal tariffs ( _τ_<sup>_PO_</sup> _, τ_<sup>_∗PO_</sup> ) must then satisfy the following two first-order conditions: which simplify to Hence, the politically optimal tariffs are not altered by the presence of geopolitical rivalry (i.e., by _ρ >_ 0 and _ρ_<sup>_∗_</sup> _>_ 0). But we know from Bagwell and Staiger (1999) and (2002) that these tariffs are efficient in the absence of geopolitical rivalry, and we know from Proposition 2 that these tariffs are therefore also efficient in the presence of geopolitical rivalry. We may therefore conclude that, as long as government objectives in the presence of geopolitical rivalry take this form, the purpose of a trade agreement is unchanged by this rivalry, and it continues to be to eliminate terms-of-trade manipulation from the unilateral tariff choices of the governments.

Finally, while our argument here has been couched in the two-country model of section 2, analogous arguments deliver the same conclusion in the three-country model of section 4 when tariffs are nondiscriminatory (i.e., conform to MFN). Intuitively, as Bagwell and Staiger (1999) and (2002) observe, politically optimal tariffs are efficient if the externalities countries impose on each other with their tariffs travel only through world prices. In a multicountry world where MFN is respected, the trade policy externalities indeed travel in this way when countries adopt their politically optimal tariffs. Tariff discrimination complicates 32
the transmission of externalities by allowing _bilateral_ trade volumes, and hence _local_ prices, to transmit externalities across trading partners as well.

We summarize this discussion with:<sup>24</sup>

**Proposition 9** _The presence of geopolitical rivalry does not change the purpose of a trade agreement, which remains to eliminate inefficient terms-of-trade manipulation motives from the unilateral tariff choices of governments, just as Bagwell and Staiger (1999) demonstrate is the purpose of a trade agreement in the absence of geopolitical rivalry._

From Proposition 9, it then follows that the existence of geopolitical rivalry per se does not undercut the attractiveness of GATT’s design for helping governments navigate from noncooperative Nash tariffs to a point on the international efficiency frontier, as was the task over much of the GATT era.

# **5.2 Reciprocity**

The GATT/WTO system is designed to allow adjustments to a variety of shocks. As Pauwelyn (2008) observes, GATT market access commitments are structured as _liability rules_ , in the sense that a government may legally escape for any reason from the market access implied by its tariff commitments, as long as it is willing to pay the “price” implied by the reciprocal actions that its impacted trading partners are then legally allowed to take, namely, the withdrawal of equivalent market access concessions of their own. The purpose of this design was to allow some flexibility in GATT market access commitments while at the same time, in the words of a drafter of the GATT Articles quoted by Jackson (1969, pp 170-71), providing governments with the assurance that in their GATT market access negotiations, “a balance of interests once established, shall be maintained.” In this way, GATT is set up to accommodate occasional, _reciprocal_ , adjustments to the bargain, either temporarily (through the GATT Article XIX safeguards clause) or permanently (through the GATT Article XXVIII renegotiation provision), where by design these adjustments allow a country to reduce import volumes while preserving the balance established in prior GATT negotiations between its rights to market access in other countries and its obligations to provide market access to other countries. It was expected that such adjustments might be needed when a country faced any of a variety of circumstances that might develop subsequent to the time of its original tariff negotiations, such as substantial injury to import-competing workers or political pressure from the lobbies that represent them, and the flexibilities afforded by this design have been used by governments from time to time throughout GATT’s history.<sup>25</sup> The GATT/WTO design, however, is less-well suited to facilitate the kinds of _non_ - reciprocal adjustments that Proposition 4 describes. After all, the movement of the cooperative arrangement from point _B_ 1 to point _B_ 2 depicted in Figure 3 would imply that the home government must respond to an increase in the foreign government’s tariff by _reducing_

> 24See also Maggi (2014) (p 336), who derives a result from which the result we report in Proposition 9 would be an immediate implication in a partial equilibrium two-country tariffs-only setting.

> 25On the history of GATT negotiations under Article XXVIII bis and renegotiations under Article XXVIII, see Hoda (2001). See Bown and Ruta (2008) for evidence that GATT/WTO members do indeed abide by reciprocity in their retaliatory actions.

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its own tariff to shift surplus from itself to the foreign government, a combination of tariff changes that is fundamentally at odds with the essence of the “reciprocal and mutually advantageous”tariff reductions that GATT’s Preamble describes. The problem is not that such movements _couldn’t_ in principle be accommodated while honoring the reciprocity norms within the GATT/WTO system. The problem is rather that in practice accomplishing the required adjustments in a way that is consistent with GATT/WTO reciprocity norms would carry obvious risks.

More specifically, and referring again to Figure 3, in principle the “war-and-redemption” path described above could be achieved by employing Article XXVIII and GATT Article XXVIII bis (under which tariff liberalizing negotiations occur), allowing countries to navigate from _B_ 1 to _B_ 2 while hewing to the reciprocal flexibilities provided in GATT Articles. In the first phase the foreign country would escape from its tariff binding under Article XXVIII renegotiation. It could move all the way back to its original Nash tariff, with the home country then allowed under Article XXVIII to withdraw equivalent concessions and revert to its original Nash tariff, positioning the two countries at the point _N_ 1. However, with both countries then freed from their original tariff bindings and free to set tariffs in an unconstrained way, their best-response tariffs would not stop at _N_ 1, but would further adjust (now in a non-reciprocal way) to implement the new Nash point labeled _N_ 2 in Figure 3, which reflects the impact of geopolitical rivalry on their noncooperative tariffs and as depicted is more favorable to the foreign country than the original (pre-rivalry) Nash point _N_ 1. This would complete the (trade) war phase. At this point, and recalling from Proposition 9 that the purpose of a trade agreement is not changed by the presence of geopolitical rivalry, the negotiating problem facing the two countries would then conform with the standard negotiating problem that GATT-member governments have successfully addressed repeatedly in the GATT era under Article XXVIII bis negotiations, and the redemption phase could begin, with each country agreeing to reciprocal and mutually beneficial reductions in tariffs that move them from the Nash point to the efficiency frontier (and specifically to the point labeled _B_ 2 in Figure 3 if the bargain delivers the Nash Bargaining solution).

With the logic of the war-and-redemption path fully described, the risks associated with this two-phase approach are now transparent. In reality it took GATT-member governments 50 years to traverse from the non-cooperative (Nash) tariffs of the 1940’s to the cooperative tariffs that were implemented at the 1995 culmination of the Uruguay Round, and there is no guarantee that in escaping from their existing market access commitments and attempting to replicate this process countries would not again spend substantial time far away from the cooperative tariffs that their “redemption” phase is meant to deliver. The direct path from the cooperative status quo to the new cooperative outcome in the presence of geopolitical rivalry can avoid this risk, but as we have noted that path requires tariff changes that are fundamentally at odds with GATT/WTO’s reciprocity norm.

Hence, according to the results reported in Proposition 4, the rise of geopolitics poses an important and unfamiliar challenge to the traditional GATT/WTO negotiating process, and confronts the world trading system with a difficult choice. Summarizing this discussion, we may state the following Corollary to Proposition 4:

**Corollary** _The rise of geopolitical rivalry will confront the world trading system with a choice between two uncomfortable alternatives: adjustment to the new cooperative outcome_

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_in the presence of geopolitics requires either a temporary unraveling of existing liberal trade policies, or a departure from the principle of reciprocity in negotiated tariff changes._ A real-world example can offer suggestive insights into the forces at play and the mechanisms captured by the model. The “Economic and Trade Agreement between the Government of the United States and the Government of the People’s Republic of China” (henceforth “Phase 1 Agreement”) was concluded outside the WTO in January 2020, a year and a half after the US-China trade war began and the countries significantly increased import tariffs on bilateral trade. The Phase 1 Agreement was different from existing Regional Trade Agreements (RTAs) because the focus was not on creating general mutual obligations but on specific actions by China to grant additional market access to US exporters to achieve explicit import targets. China was required over the years 2020 and 2021 to import from the United States specific manufactured goods, agricultural goods, energy products, and services exceeding the corresponding 2017 baseline amount by no less than 200 billion dollars.

Staiger (2022) provides the following description of the initial tariff actions of the Trump Administration in 2018 and the tariff responses of China and other US trading partners that led to the Phase 1 Agreement:<sup>26</sup> A broad caricature of these trade actions is as follows. The Trump administration took unilateral actions to raise tariffs. Its injured trading partners responded with countermeasures that amounted to reciprocal tariff hikes of their own. In some cases, the Trump administration responded to these countermeasures with further punitive unilateral tariffs, which led to further countermeasures from its trading partners, some of which were reciprocal and some of which were less than reciprocal. In the end, several bilateral deals were struck, some involving the reciprocal removal of tariffs and others the avoidance of threatened further tariff increases by the Trump administration but with most of the already-imposed tariffs remaining in place pending possible further deals. p 113 Broadly speaking, these tariff actions and responses might be understood through the lens of our model as reflecting the consequences of the onset of heightened geopolitical rivalry between the United States and China.

More specifically, under this interpretation, in the new geopolitical environment the United States was not satisfied with the existing bargaining outcome reflected in the terms of China’s accession to the WTO in 2001. Frustrated with its inability to adjust the bargain along the efficiency frontier due to the deviation from reciprocity that this adjustment path would entail, the United States unilaterally imposed a first round of “bargaining tariffs” against China, initiating the path toward a new threat point which would reflect the new geopolitical realities. China retaliated, at first moderating its tariff response below its best-response tariffs according to the principle of reciprocity but later finding that even its best-response tariffs fell short of reciprocating the further unilateral tariff increases of the United States, in

> 26Chad Bown provides the definitive timeline of the US-China trade war up through April 2023 at https://www.piie.com/research/piie-charts/2019/us-china-trade-war-tariffs-date-chart.

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what may have been a step in the countries’ descent to a new non-cooperative equilibrium.<sup>27</sup> The Phase I Agreement could then be seen as an attempt by the two countries to arrest that descent and achieve a new bargaining outcome. China’s import commitments under the agreement were a form of import subsidy for US exporters, and in combination with the more significant US tariffs against China that remained in place as stipulated under the agreement, amounted to a transfer of surplus from China to the United States relative to the original terms of China’s accession to the WTO in 2001.<sup>28</sup>

# **5.3 MFN**

We saw from Proposition 8 that restricting countries to non-discriminatory tariff adjustments could make any geopolitical rivalry-driven movements along the efficiency frontier cumbersome. MFN would prevent the rivals from adjusting their tariffs in a way that could effect the needed transfer of surplus between them while neutralizing the impacts of their tariff adjustments on the third country.

The problem is not that such movements could not be accomplished while honoring the MFN rule. As with our discussion of the two-country model, in principle countries could make use of Article XXVIII renegotiations over their MFN tariffs to escape from their current market access commitments, and at their new noncooperative MFN tariffs begin again from scratch with the process of liberalizing their tariffs with reciprocal tariff negotiations under Article XXVIII bis. The problem is rather that in practice navigating this circuitous path from the status quo to the new bargaining equilibrium would carry obvious risks.

Of course, simply freeing countries from their MFN obligations would not do the job either. Without _some_ constraints on the tariff adjustments that the home-country government and the government of foreign country *1 are allowed to make, there would be nothing to prevent them from adjusting their tariffs in a way that benefited them at the expense of foreign country *2. Such a maneuver, as we observed above, _would_ have been prevented under MFN when combined with reciprocal tariff changes. Multilateral disciplines of some form would therefore still be needed to ensure an “orderly” departure from MFN, so that the MFN exemption in these circumstances is not used for opportunistic purposes.<sup>29</sup> And identifying an effective form that these disciplines might take is not an easy task.

> 27If it is posited that the United States began to feel threatened by the rise of China and that this drove the new geopolitical rivalry between the two countries, then in the language of our model _ρ_<sup>_US_</sup> would have increased from zero, and according to the tariff reaction curves characterized in (7) and Proposition 1 this would move the threat point for tariff negotiations between the United States and China in a direction that favored the United States. Notice, too, that while in principle the United States might have invoked GATT Article XXVIII to achieve its initial tariff increase and in this way maintained consistency with GATT/WTO rules, in fact the United States took this tariff action unilaterally; it was United States’ trading partners who hewed to reciprocity in their responses to the US unilateral tariff actions.

> 28To be sure, there were also other motives for US trade policy actions toward China during this period, and US trade policy actions extended to US trading partners beyond China. We choose to emphasize the US-China tariff actions here because they arguably fit most closely our emphasis on the rise of geopolitical tensions as a cause of such actions.

29And while our discussion has focused on the possibility of opportunistic discriminatory tariff adjustments made by the two rivals to hurt third parties, it is also clear that in the presence of rivalry there would be new incentives for each rival to negotiate discriminatory tariff arrangements with third countries in order to hurt its rival with trade diversion (see Ruta, 2023).

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To illustrate the issues at hand, consider again the US-China Phase I agreement. As we described above, China’s import commitments under the agreement were a form of import – subsidy for US exporters and in fact they were _discriminatory_ import subsidies for US – exporters and in combination with the more significant US tariffs against China that remained in place as stipulated under the agreement, which were also discriminatory, a transfer from China to the United States was achieved. Here the findings of Freund et al. (2020) are illuminating. Using a quantitative trade model to simulate the relevant counterfactuals, they report that the United States and China were both better off under their Phase I Agreement than they would have been if the trade war between them had instead escalated further to its noncooperative equilibrium outcome. However, compared with the policy status quo at the time the Phase I Agreement was signed, the agreement only benefited the United States (and its input-supplying neighbor, Mexico): China and everyone else was made worse off. Specifically, Freund et al. find that, relative to the status quo, real income in the United States would rise by 0 _._ 9 percent as a result of the agreement while China’s real income would fall by 0 _._ 38 percent due to the trade diversion that the agreement caused, with real incomes in the rest of the world also declining by 0 _._ 16 percent.

Thus, according to the findings of Freund et al. (2020) this bilateral discriminatory deal, negotiated outside of the WTO and hence unconstrained by WTO rules, achieved a bilateral income transfer from China to the United States, but at a cost to third countries. By keeping such adjustments _within_ the WTO system and subject to effective disciplines, the MFN exemption we describe above would be subject to conditions that prevent departures from the multilateral efficiency locus and ensure third countries are not made worse off.

Like our earlier Corollary to Proposition 4 regarding the tension with GATT’s reciprocity norm created by the rise of geopolitical rivalry, Proposition 8 also allows us to summarize our discussion regarding the MFN principle with:

**Corollary** _The rise of geopolitical rivalry in a multilateral world will confront the world trading system with an additional choice between two uncomfortable alternatives: adjustment to the new cooperative outcome in the presence of geopolitics requires either a temporary unraveling of existing liberal trade policies, or an orderly departure from the MFN principle in negotiated tariff changes._

The Corollary to Proposition 8 suggests the potential attractiveness of a conditional MFN exemption for geopolitical rivalry. The design of such an exemption could in some respects be inspired by the GATT Article XXIV exemption from MFN for the purpose of forming free trade agreements and custom unions. Whereas the Article XXIV exemption was meant to accommodate greater mutual affinity between a subset of GATT/WTO members, the purpose of a geopolitical exemption from MFN would be to accommodate greater rivalry between a subset of the members. The Article XXIV exemption notably carries a stipulation that the parties not raise their tariffs against third countries.<sup>30</sup> A geopolitical exemption to

> 30Article XXIV also requires that parties eliminate the tariffs that they apply to each other on “substantially all” of their trade, the latter stipulation included in an attempt to reduce the frequency with which such exemptions might be invoked by putting some “sand in the gears.” It was thought that together these two stipulations would effectively discipline the use of the Article XXIV exemption from MFN and prevent it from being used for opportunistic tariff actions against third countries, though in practice the effectiveness of these disciplines is questionable.

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the GATT/WTO’s MFN rule could in principle go further and require that any new bargain negotiated under this exemption leave third countries completely unaffected. Our discussion here suggests that this might be accomplished in practice with a precise and, in principle, observable condition: that any new bargain negotiated under a geopolitical exemption to MFN must leave world prices between the rivals and third countries unchanged.<sup>31</sup> Finally, it bears emphasis that for both the Corollary to Proposition 4 regarding reciprocity and the Corollary to Proposition 8 regarding MFN, the problem is not the presence of geopolitical rivalry per se. After all, as Proposition 9 confirms, geopolitical rivalry itself does not change the purpose of a trade agreement. Hence, regardless of whether or not such rivalry is present, in principle GATT/WTO’s pillars of MFN and reciprocity remain useful in helping countries navigate from noncooperative tariff choices to tariff choices that achieve the international efficiency frontier. The tension with these rules and norms is created only when geopolitical rivalry erupts or intensifies _after countries have already bargained to the efficiency frontier_ . Unfortunately for the existing world trading system, that may be a reasonable approximation of the situation the world now confronts.

# **6 Conclusion**

While a growing area of interest, analysis of the interplay between geopolitics and economics is still in its infancy. This paper seeks to contribute to our understanding of this issue by focusing on the implications of geopolitical rivalry for trade cooperation. To this end, we combine insights from the international relations literature on the nature of geopolitical rivalry with a standard framework used in economics to study trade cooperation.

Our findings indicate that the rise of geopolitics does not obviate the need for international cooperation over trade policy. But our findings also suggest that the WTO’s relevance may be severely compromised if it adheres too rigidly to its existing rules and norms when applying those rules and norms to geopolitical rivals. This is because, while the GATT/WTO principles of reciprocity and non-discrimination work well to facilitate a movement from noncooperative trade policies that lie off the international efficiency frontier to internationally – efficient policies that lie on the frontier the central task of GATT over the last half of – the twentieth century our findings indicate that with the rise of geopolitics this is not the problem that countries now face. Rather, we show that the problem is now to find a way to move along the international efficiency frontier to accommodate the change in efficient bargaining outcomes brought about by the rise of geopolitics, and this is a problem that GATT/WTO principles are not well-designed to handle. In this light, it may only be through measured adaptation to the geopolitical imperative that the WTO can continue to thrive as a forum for multilateral trade cooperation in the age of geopolitics.

Of course, in its 75 year history the rules-based multilateral trading system has weathered many shocks to the status quo. But our findings suggest that the contemporary rise of geopolitics poses an especially thorny problem for the world trading system, for two reasons. First, shocks that occurred earlier in the decades-long process of GATT-sponsored tariff negotiations when the world was still far away from the international efficiency frontier

> 31This condition is in the spirit of a “Kemp-Wan” rule (Kemp and Wan, 1976) applied in the context of geopolitical exceptions to MFN.

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would have allowed more room for countries to adjust their path to the efficiency frontier while still ensuring that mutual benefits could be enjoyed along that path; by contrast, contemporary geopolitical tensions between the United States and China have arisen after countries have already arrived at or are at least near the international efficiency frontier, and such path adjustments are now not an option. And second, even beginning from a point on the international efficiency frontier, most shocks (such as changes in government objectives that might arise with shifts in political economy forces or, as we have shown, heightened national security concerns) could be expected to alter the internationally efficient sets of tariffs, thereby making the status quo tariffs inefficient and creating room for mutually beneficial tariff adjustments from the status quo as countries move toward the new efficiency frontier. But as we have demonstrated, the rise of great-power rivalry when interpreted as a quest for dominance does not itself alter the internationally efficient sets of tariffs, and so it does not share this feature.

Our analysis can be extended in at least three directions concerning the nature of policy instruments, the nature of trade and trade agreements, and the nature of geopolitical rivalry. First, we have assumed that with regard to policy instruments governments have only tariffs at their disposal. To the extent that governments have alternative means to make bilateral transfers as part of real-world trade negotiations, the use of such transfers might help them avoid the “uncomfortable choices” that we have highlighted here. Similarly, our analysis could be extended to consider the implications of geopolitics in a richer setting where governments have at their disposal both trade and domestic policy instruments (as in Bagwell and Staiger, 2001a, and Staiger and Sykes, 2011 and 2021) that they might use to pursue industrial policy goals more generally. Along these lines, extending the model to allow for the analysis of export restrictions would also be important given the recent prominence of these instruments as tools of geopolitical rivalry.<sup>32</sup> Second, while we have built on a standard framework used in economics to study trade cooperation and trade agreements, Antr`as and Staiger (2012a) and (2012b) have shown that important qualifications to the framework can arise in the presence of offshoring, if offshoring alters the nature of international price determination between buyers and sellers. Such qualifications could be particularly relevant in the China-US context that we have used to motivate our results. And there are other approaches to understanding the role of trade agreements that could also be adopted, and that might lead to different conclusions. For example, the commitment theory of trade agreements (Staiger and Tabellini, 1987; Maggi and Rodriguez-Clare, 1998 and 2007; Brou and Ruta, 2013), which holds that trade agreements can be useful to governments as a way to tie their hands against domestic actors, could yield distinct conclusions about the implications of geopolitical rivalry for trade cooperation. Finally, as we demonstrate in the Appendix, the analysis in this paper is valid for a

> 32For example, as reported in an October 7 2022 _New York Times_ article, “The Biden administration on Friday announced sweeping new limits on the sale of semiconductor technology to China, a step aimed at crippling Beijing’s access to critical technologies that are needed for everything from supercomputing to guiding weapons.”(New York Times, 2022). Our general equilibrium model does not allow a distinction between an import tariff and an export tax due to Lerner symmetry, but in a partial equilibrium extension of the model with many sectors (see also note 6) such export restrictions could be interpreted through the lens of the model as naturally arising in the context of geopolitical rivalry and the quest for dominance (in this case, over high-end microchips).

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wide range of objective functions beyond the explicit form considered in the main body of the paper. However, as shown in other recent studies on geopolitics and international economic relations (especially, Clayton et al., 2023; Becko and O’Connor, 2024; Clayton et al., 2024), there are alternative approaches to capturing the nature of geopolitics that model the specific channel of dependency and how governments can leverage this as a tool to increase their relative power. As we discussed in the Introduction, our objective functions are flexible enough to address the essence of these forms of interdependencies in a reduced-form way. But a more explicit formalization may reveal insights beyond those captured by our relatively general approach. Extending our analysis of trade cooperation in the presence of geopolitics in each of these directions would appear to be a fruitful area for future research.

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