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

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

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

3. 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 net welfare losses price S Tariffs mean net losses for Small countries Pw+t pw E A B C D imports quantity Qf Qt Ct Cf

4. 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 are H – (A + C) price S Large countries can gain from trade restrictions like tariffs – but not if there is retaliation implying a trade war Pw+t pw E A B C H New Pwn D imports quantity Qf Qt Ct Cf

5. 3 possible scenarios • 2 large countries • 2 small countries • 1 large country and 1 small country • Countries unilaterally decide whether or not to impose a tariff • If both countries impose a tariff this means there is a trade war (retaliation) • In which scenario is there more likely to be a trade war? • Analyse using game theory

6. International trade 1: both countries relatively large i.e. can affect own terms of trade • Payoffs represent the value of net gains in €billions • Interpret the payoffs • What is the equilibrium of this trading game?

7. International trade 1 • 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

8. International trade 2: both countries relatively small • Payoffs represent the value of net gains in €billions • Interpret the payoffs • What is the equilibrium of this trading game?

9. International trade 2: both countries relatively small The Nash equilibrium of this trading game is for neither country to impose a tariff

10. International trade 3: one large country one small country • Payoffs represent the value of net gains in €billions • Interpret the payoffs • What is the equilibrium of this trading game??

11. International trade 3: one large country one small country The Nash equilibrium of this trading game is for Little Rosatia not to impose the tariff but for Greater Jesmania to impose the tariff

12. Implications • Trade wars are more likely between large countries and large trading blocks • like 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 • But small countries will lose out when large countries or trading blocks impose tariffs

13. Test your understanding • 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.