A Prisoner’s Dilemma Tariff Setting Game with an Escape Clause

This paper attempts to provide a game theoretic rationale for the inclusion of escape clause mechanisms in trade agreements, by examining the effects of uncertain outcomes on the sustainability of cooperation in an infinitely repeated Prisoner’s Dilemma tariff setting game. Since, in the presence of uncertainty affecting the outcome under cooperation, deviations and thus the breakdown of cooperation may occur, it is necessary to design an agreement such that cooperation can be sustained under all contingencies. The introduction of an escape clause that allows a shock-affected country to temporarily deviate, while sufficiently compensating its trading partner in order to alleviate the loss from being ex-posed to the deviation, offers such a possibility. It is shown that with such a mechanism cooperative behavior can always be sus-tained. Moreover, the expected per-period payoff increases as compared to the case when there is no escape clause. For a suf-ficiently high discount factor, the threshold level for temporary deviation through the escape clause will be at the efficient level. It is shown that, when the optimal compensation cost can be ap-plied, the optimal cooperative is strictly smaller than the optimal cooperative tariff in the absence of uncertainty. Furthermore it is shown that a decrease in the cooperative tariff unambiguously leads to an increase in the use of the escape clause. ∗Institute for International Economic Studies, Stockholm University, August 2003 †This paper is a draft of what will be the first essay of my dissertation. I am grateful to my advisors Harry Flam and Henrik Horn. I would also like to thank the participants of the Stockholm Trade Workshop in September 2002 for valuabl