The Optimal Penal Code vs. Infinite Nash Reversion in Trade Liberalization.

This paper derives Abreu's stick-and-carrot strategy optimal penal codes (1986) in a partial equilibrium model that has been widely used to examine trade liberalization. Unless the asymmetry between countries is significant, the optimal penal codes take a simple form. It is also shown that the difference between the most-cooperative pairs of tariffs supported by two schemes, the optimal penal code and infinite Nash reversion, depends crucially on the size of the surplus from exports that a deviating country foregoes when the other country places an embargo, rather than the (punitive) optimum tariff, on imports in the punishment. Copyright 1999 by Blackwell Publishing Ltd.