What can parties to a trade agreement achieve by institutionalizing a rules-based dispute settlement procedure? What role can third-party arbitration play in dispute settlement? I study these questions within a mechanism design framework. The model generates predictions regarding the pattern of pre-trial and post-trial settlement negotiations, non-compliance with the arbitrator's ruling, and retaliations under an optimal trade agreement. It is shown that an Arbitrated-Liability Regime, under which a defecting party is liable for damages only to the extent that an arbitrator specifies, could implement the optimal direct mechanism. Moreover, property rule is not an optimal "escape" provision as it induces too much retaliations.
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