Analysis of the current administration’s trade policy choices has typically interpreted them in terms of a zero-sum game, i.e., rather than generating mutual benefits in a positive-sum game, international trade is a game where economically, one country is a winner while the other must be a loser (Chow and Sheldon, 2019). However, there is an alternative explanation for these actions: the administration has chosen to move from rules-based to power-based bargaining over tariffs as a means of dealing with latecomers to the World Trade Organization (WTO) (Mattoo and Staiger, 2019). The concern here is that by switching from rules-based to power-based bargaining, the United States is putting the future of the post-war trading system at risk, as well as inflicting economic costs on both itself and its trading partners.
Key to the functioning of the WTO and its predecessor, the General Agreement on Tariffs and Trade (GATT) have been the most favored nation (MFN) principle and reciprocity, both acting as a constraint on exercise of bargaining power by a powerful country such as the United States. Specifically, MFN dilutes bargaining power by ensuring that tariff commitments to either one country or a sub-set of countries in the WTO are then offered to all other countries in the WTO, and at the same time reciprocity establishes the idea that there will be a balance of tariff concessions in any negotiating round of WTO. By committing to such a set of rules, the United States has helped induce other weaker/smaller countries to successively lower their tariffs under the WTO.
In 2017, the average U.S. MFN tariff was 3.4 percent, which compared to China’s average MFN tariff of 9.6 percent (Bown, 2019). Given this asymmetry in average bound tariffs, the current administration perceived that it had little left to offer a latecomer to the WTO such as China in terms of reciprocity, and instead it resorted to unilaterally raising its tariffs as a means to inducing China to cut their tariffs. However, in switching to unilateralism, the United States is following a “myopic logic”, i.e., by using bargaining tariffs, the United States seems to have ignored the real possibility that a large country such as China would likely resort to the same strategy, thereby undermining the multilateral trading system.
The administration’s strategy ignores the basic principles of game theory, and the economic argument for why the WTO has, until now, been largely successful in its promotion and governance of international trade. The underlying logic of the WTO has been explained by trade economists in terms of the resolution to a prisoner’s dilemma (Bagwell and Staiger, 1999). Imagine a non-cooperative world where the strategic choice of one country is to maximize its own objective function through tariff policy, given the tariff policy of the other country(ies). To understand their strategic choices, it is important to think through the economic effects of a tariff and why a country such as the United States would rationally choose to apply one (Amiti et al., 2019)
Assuming exporters do not adjust their price, an import tariff has the following effects: it raises the domestic price of the good being imported, but it also generates tariff revenue on that good. Once the transfer of revenue to the domestic treasury has been accounted for, the net effect of the tariff generates a “deadweight loss”, i.e., there is a reduction in domestic consumers’ real income, with redistribution to both import-competing firms and the government. In other words, the incidence of the tariff is borne entirely by consumers of the imported good, thereby reducing domestic economic welfare. The rationale for a country to follow a strategy that fails to maximize national income can only be political, i.e., governments adopt protectionist policies for electoral reasons. For example, protectionist policies can be chosen either to satisfy sector-specific lobby groups who provide campaign contributions to political parties or specific voter groups who are close to being indifferent between candidates (Grossman and Helpman, 1994; 2005).
However, if exporting firms do reduce their prices in response to the tariff, there will be a terms-of-trade benefit to the importing country, captured in the form of additional tariff revenue. In this case, the incidence of the tariff is partially borne by exporting firms, and it is quite possible for the terms-of-trade gain to outweigh the deadweight loss of the tariff, domestic economic welfare increasing. The optimal import tariff, and hence the extent of the terms-of-trade gain, will depend on the price elasticity of supply (Broda et al., 2008).
Essentially, the tariff game has the structure of a prisoner’s dilemma: in the absence of cooperation, both countries, in choosing to maximize their payoffs, have a unilateral incentive to utilize a tariff, whatever the strategic choice of the other country. Each country seeks to improve its terms-of-trade, knowing that the other country will rationally adopt that same strategy, the outcome being a Nash equilibrium (Zissimos, 2007). The net result is that each country loses market access to the other country’s market because of tariffs, the reduction in the volume of international trade being economically inefficient.
The latter result suggests that it would be beneficial for countries to agree to reduce their tariffs, and in the absence of a binding bilateral agreement between countries, the WTO has essentially neutralized the terms-of-trade incentive for countries to raise tariffs (Bagwell and Staiger, 1999). In other words, if terms-of-trade effects have been removed from any country’s objective function, it will set tariffs to satisfy domestic political objectives alone. These would be either zero if a country seeks to maximize its national income through free trade, or they would be positive in order to satisfy domestic political constraints, but importantly, they are lower than those in a non-cooperative game. Therefore, if countries enter into a trade agreement, they will seek mutual reductions in tariffs generating an increase in national and global economic welfare.
The lower tariff equilibrium under WTO has been supported by a credible enforcement mechanism embodied in the WTO dispute settlement process. Standard game theory would suggest that countries would have an incentive to deviate from a low-tariff equilibrium. However, in a repeated game, the punishment for not adhering to a trade agreement is reversion to the Nash equilibrium, i.e., a trigger strategy (Zissimos, 2007). In practice, the rules of the WTO seek to maintain the balance of tariff concessions and avoid the use of punitive, and therefore economically destructive actions (Staiger, 1995).
Essentially, if one country were to raise its tariff, this would imply a loss of previously negotiated market access for the foreign country. Assuming that this action is not “abusive”, under WTO rules, the other country can withdraw an equivalent amount of market access, a punishment path that is subgame perfect (Zissimos, 2007). However, if a country deviates in an “abusive” manner, there is reversion to the trigger strategy, i.e., there is an indefinite suspension of WTO obligations, both countries setting higher tariffs. In other words, the objective of WTO rules is to ensure that retaliation by one country against the unilateral action of another is proportionate, thereby minimizing the chance of a trade war.
By unilaterally raising tariffs to such an extent in 2018, an action that was clearly “abusive”, the United States simply provoked a trigger strategy reaction on the part of China. Instead of cutting its tariffs in response to the United States raising tariffs, China (and other countries) retaliated in kind by raising tariffs against the United States, their average tariff reaching 18.3 percent by 2018, and while the two countries did halt escalation of the trade war in early-2020 through the Phase 1 U.S.-China Trade Agreement, neither side has actually reduced tariffs to their pre-2018 level (Bown, 2020). Essentially, power-based bargaining by the United States has failed in the sense that the bilateral relationship with China has been pushed closer towards the higher, non-cooperative tariff equilibrium, thereby putting the multilateral trading system at risk.
See my next blogpost for a discussion of the economic and political costs of power-based bargaining over trade by the United States.
This blogpost draws on a recently completed paper co-authored with Professor Daniel Chow (Ohio State University Moritz College of Law): “Understanding the Economic and Politcial Effects of Trump’s China Tariffs”.