The prisoners dilemma and international trade Tariffs and

The prisoners’ dilemma and international trade: Tariffs and the potential for trade wars

price The effects of a tariff: Pre-tariff (free trade) situation for a country S pw D imports Qf Cf quantity

price Partial equilibrium analysis of the impact of a tariff; home country is small and has no influence on world prices: Price rises to Pw+t; A + C are S net welfare losses Tariffs mean net losses for Small countries Pw+t pw E A B C D imports Qf Qt Ct Cf quantity

Optimal tariffs; home country is large and world prices fall to Pwn with the tariff (domestic price does not fall). Leads to a gain represented by H. Net gains for the country S are H – (A + C) price Pw+t pw Large countries can gain from trade restrictions like tariffs – but not if there is retaliation implying a trade war E A B C H New Pwn Qf import s Qt D Ct Cf quantity

3 possible scenarios 2 large countries n 2 small countries n 1 large country and 1 small country n ¨ Countries unilaterally decide whether or not to impose a tariff ¨ If both countries impose a tariff this means there is a trade war (retaliation) n In which scenario is there more likely to be a trade war? ¨ Analyse using game theory

International trade 1: both countries relatively large i. e. can affect own terms of trade Rosatia Jesmania no tariff impose tariff no tariff 10, 10 -1, 15 impose tariff 15, -1 2, 2 • Payoffs represent the value of net gains in €billions • Interpret the payoffs • What is the equilibrium of this trading game?

International trade 1 Rosatia no tariff Jesmania no tariff 10, 10 impose tariff -1, 15 impose tariff 15, -1 2, 2 • The dominant strategy equilibrium is for both countries to impose the tariff even though they would both be better off if neither imposed a tariff: • the countries are playing a prisoners’ dilemma

International trade 2: both countries relatively small Little Rosatia Little Jesmania no tariff impose tariff 10, 10 -1, 8 8, -1 -2, -2 • Payoffs represent the value of net gains in €billions • Interpret the payoffs • What is the equilibrium of this trading game?

International trade 2: both countries relatively small Little Rosatia no tariff Little Jesmania impose tariff no tariff impose tariff 10, 10 -1, 8 8, -1 -2, -2 The Nash equilibrium of this trading game is for neither country to impose a tariff

International trade 3: one large country one small country Little Rosatia Greater Jesmania no tariff impose tariff no tariff 10, 10 -1, 8 impose tariff 15, -1 2, -2 • Payoffs represent the value of net gains in €billions • Interpret the payoffs • What is the equilibrium of this trading game? ?

International trade 3: one large country one small country Little Rosatia Greater Jesmania no tariff impose tariff no tariff 10, 10 -1, 8 impose tariff 15, -1 2, -2 The Nash equilibrium of this trading game is for Little Rosatia not to impose the tariff but for Greater Jesmania to impose the tariff

Implications n Trade wars are more likely between large countries and large trading blocks ¨ like n the EU and NAFTA Small countries are unlikely to get involved in trade wars – more likely to gain from trade ¨ They stand to lose more than they gain by imposing tariffs since they are at the mercy of world markets n But small countries will lose out when large countries or trading blocks impose tariffs

Test your understanding n In the context of the economic analysis of tariffs, use game theory to explain why trade wars between large countries are more likely than trade wars between small countries.