We provide a simple but novel model of trade agreements that highlights the role of transaction costs, renegotiation and dispute settlement. The model allows us to characterize the appropriate remedy for breach and whether the agreement should be structured as a system of “property rights”or “liability rules.”We then study how the optimal rules depend on the underlying economic and contracting environment. Our model also delivers predictions about the outcome of trade disputes, and in particular about the propensity of countries to settle early versus “…ghting it out.”

We characterize the optimal tariff bindings in a trade agreement among asymmetric countries that are subject to idiosyncratic political-economy shocks. We find that the optimal tariff binding is decreasing in the relative size of the importing country and its degree of comparative disadvantage. Moreover, under an optimal agreement a smaller country is more likely to apply a tariff that is substantially below its tariff binding. Using applied and bound tariff data from WTO member countries, we …nd strong empirical support for our predictions.