Cap and Escape in Trade Agreements

Abstract

We characterize the optimal tariff bindings and the escape clause in a trade agreement among asymmetric countries that are subject to idiosyncratic political-economy shocks. We assume that shocks are private information, and that escape clauses allow the use of a costly monitoring technology to reveal the true value of the private information. We define a concept of convergence of tariff preferences, and show that bindings are higher for countries whose preferences are less convergent and for countries with a lower degree of market power. We also show how the introduction of contingent protection will substitute for tariff overhang, and establish that a sufficient condition for contingent protection to eliminate the use of tariff overhang is that tariff preferences be globally convergent.