Strategic Behavior in Trade Wars

With Donald Trump starting a Trade war, The EU is under pressure. While some favour abstaining from countermeasure, others are willing to engage in that war. We take a look at the insights of game theory to formulate a rational strategy for the European perspective.

After the White House announced punitive tariffs on European steel and aluminum, the European Union (EU) declared its willingness to prepare counteractions.  While the EU initiates tariffs on US products like Bourbon whiskey or Harley-Davidson motorbikes, Donald Trump is threatening to further broaden the tariffs on cars and auto-parts made in Europe. We observe the beginning of a trade war, even though both administrations assure that this is not their intention.

Since it is difficult to identify the long-term strategy of the current US government, the question arises how the EU should react in this situation. Is it better to seek ways to cooperate with the strongest ally, or to demonstrate strength in order to make the US reconsider their actions? For that matter we take a theoretic approach and have a look at the theory of cooperation and conflict, known as “The Prisoner’s Dilemma” in game theory.

A theory of conflict

The game theory approach allocates strategies and responding payoffs to the participating players. With players acting rationally, an optimal strategy can be computed. In a simplified theory of conflict both players – the US and the EU – can either choose to liberalize trade or to impose tariffs. The state’s welfare is the payoff in the game, which is the highest, if both decide for liberalization. Should one player unilaterally choose protectionism, some short-term benefits will be outweighed by overall losses (see earlier blog), while the other player suffers from the tariff.

The best response of the other player is to equally impose tariffs, which leaves both players with a lower payoff. We can identify two equilibrium stages: Both players choosing free trade, or both players choosing protectionism with lower welfare for both (see Harrison and Rutström 1991:420). Note, that so far there is no dilemma, as everybody can benefit by mutually choosing liberalization, as it is depicted in the matrix.

According to this theory, the free trade scenario should be stable scenario and it would be irrational for both players to choose protectionism. Yet, the US decided to help the domestic steel and aluminum industry and accept the overall negative effects.  A possible explanation could be that these industries belong to Trump’s electoral clientele. Irrespective of the motivation, what should a strategic response look like? Clearly, the best choice would be to answer Trump’s move with an equal dimension of protectionism. Both players are stuck in the trade war, which knows no winner.

The trade game is played repeatedly

However, this approach so far only considers a singular event, while the trade relation between nations is an ongoing process. This process can be interpreted, as if the decision of liberalization or protectionism has to be made over and over again. These games are called repetitive games and are more suitable for this issue… In such a case the literature denominates a tit-for-tat strategy to be optimal: choose free trade as long as the other players does and punish with tariffs if the other player has (see Myerson 2013:308).

Building up trust is crucial

Applying this insight from the European perspective suggests a two-sided strategy: On the one hand the EU must answer the punitive tariffs with countermeasures, on the other hand it needs to reach out for a cooperative solution. This strategy appears to be contradicting and challenging to implement. A possible answer to this contradiction is a step-by-step implementation of tariffs. The EU should be able to gradually respond to the US government, which allows steps to both escalate and deescalate.  In that sense, it was on appropriate measure to start with tariffs on rather symbolic US products. Yet, it is key feature of this strategy to credibly announce further steps. Only a credible player can prevent the other party from taking further protective action.

European answer is needed

Another crucial element of that strategy is coordination on a European level. The presented arguments of cooperation and conflict only apply, if the two players actually play in the same league. A single European country deciding to implement a tariff would hardly impress the US side, as the impact of such an action would be too small. Yet, the size of the European market surpasses the US market and ensures a sufficient market power.

Coordination marks greatest challenge

In the last argument lies both the greatest chance for the European Union and the greatest challenge. Engaging in a trade war means not only a reduction of total welfare, but also that those sectors of the economy that are now facing tariffs inevitably become the losers. Since the European countries need to find a consensus about their strategy, these losses need to be balanced. This becomes particularly difficult, as some countries are more exposed and vulnerable to trade wars than others due to the high importance of their exporting sectors.

Conclusion

The theory of conflict and cooperation teaches us that counteractions are a necessary element to answer the start of a trade war, while at the same time the perspective to return to a liberalized market must be held alive. To strengthen its bargaining position, it is essential that the EU actually act as a union and demonstrates its willingness to take action.

Literature

Harrison, Glenn W., and E. Elisabet Rutström. “Trade wars, trade negotiations and applied game theory.” The Economic Journal101.406 (1991): 420-435.

Myerson, Roger B. Game theory. Harvard university press, 2013