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

S D price quantity p w Q f C f The effects of a tariff: Pre-tariff (free trade) situation for a country imports

S D price quantity P w +t p w Q f Q t C t C f AC E A B C Partial equilibrium analysis of the impact of a tariff; home country is small and has no influence on world prices: Price rises to P w +t; A + C are net welfare losses imports Tariffs mean net losses for Small countries

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

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

International trade 1: both countries relatively large i.e. can affect own terms of trade Rosatia Jesmania no tariffimpose tariff no tariff10, 10-1, 15 impose tariff15, -12, 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 Jesmania no tariffimpose tariff no tariff10, 10-1, 15 impose tariff 15, -12, 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 tariffimpose tariff no tariff10, 10-1, 8 impose tariff8, -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 Little Jesmania no tariffimpose tariff no tariff10, 10-1, 8 impose tariff8, -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 tariffimpose tariff no tariff10, 10-1, 8 impose tariff15, -12, -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 tariffimpose tariff no tariff10, 10-1, 8 impose tariff15, -12, -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 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

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.