Bilateral Trade as a Coordination

GameNimarjit Singh

IntroductionO Interest in International TradeO Increased Globalization has made the world

more integrated. A lot of rhetoric in Politics, especially in this election on outsourcing.

O Global trade has grown during the last 60 years at an average rate of 6 percent per year.

O As a result, annual world merchandise trade has risen from $84 billion in 1953 to$15.7 trillion in 2008

Gains to TradeO Economically it makes sense to Trade.O Comparative Advantage and the Production

Possibility Frontier.O Some countries can make goods with a lower

opportunity cost. O If all the countries were to specialize and

trade, each country would enjoy the benefits of consuming beyond the PPF

O The US can focus on making more Iphones, while China can produce wheat, the resulting trade would make them both better off!

The US and ChinaO China is the second largest trade partner of the US,

after Canada as of December 2011 O China’s Strategy of Export led growth – undervalued

Currency, lower wages.O Many US manufacturers have set up shop in ChinaO Since China entered the World Trade Organization in

2001, the U.S. trade deficit with China eliminated or displaced more than 2.7 million U.S. jobs. Most of them from the Manufacturing sector

O The U.S. trade deficit with China has surged over the past two decades, as U.S. imports from China have grown much faster than U.S. exports to China.

The US and ChinaO Bone of contention – US policy makers say

China is not abiding by the rules. O Tensions have risen over a number of

Chinese economic and trade policies that many U.S. critics charge are protectionist, economically distortive, and damaging to U.S. economic interests.

O The U.S. trade deficit with China has surged over the past two decades, as U.S. imports from China have grown much faster than U.S. exports to China.

Prisoner’s Dilemma GameO The Nash Equilibrium

occurs at (Protection, Protection), and both of the players end up with (1,1) which is the lowest payoff.

O Suggests that even when both countries would clearly benefit from trade liberalization, political dynamics trap governments in a protectionist world

Repeated PlayO Concept of Discounting Future

Gains/lossesO If the value of future cooperation is

large, and exceeds what can be gained in the short term by defecting, then the long term individual interests of the players can automatically keep them from defecting.

General Model

• C : Cooperative Outcome; H: high payoff that goes to defector when other player cooperates; D – Outcome where neither player Cooperates

• From the first table we saw that H>C>D>0

“Tit for Tat” StrategyO In infinitely repeated games, players can adopt a "Tit

for Tat" trigger strategy,O Each player plays the strategy that the other player

played in the previous round of the game. O Therefore, trade liberalization by one player in one

round of play is met by trade liberalization from the other player in the next round.

O Should any player defect and play 'Protection' then it can be 'punished' in the next round by the other player and will end up with a lower payoff than before.

O Such iterative play coupled with 'tit-for-tat' strategies allows players to reward each other for cooperation and punish each other for cheating

DiscountingO Is it worthwhile to defect against a

rival playing a tit for tat strategy? O Depends upon the present value of

the losses and gains incurred over an infinite horizon.

O The "discount factor" is δ = 1/1+r, and is used to find the present value. Here, 'r' is a rate of return, and is a positive number.

Discounting Gains and Losses

O Therefore, the value of all future cooperative play gives a present value payoff of (C + δC + δ.δ.C+..) up to infinity.

O The sum of this infinite series is [C + δC/(1- δ)].

O Similarly, the present value of future losses from defection (including the immediate short term gain) is [H + (δD)/(1- δ)]

EquilibriumO This means that for cooperation

between the US and China to realize the Pareto superior Nash Equilibrium, the following equation must hold: [C + δC/(1- δ)] ≥ [H + (δD)/(1- δ)]

O Rewrite as: [(C-D)*δ/(1-δ) ≥ (H-C)] O In English: as long as the long term

costs of defecting are higher than short term gains, there will be cooperation

The WTOO In real life, the WTO ensures an

enforcement mechanism, as well as iteration.

O WTO member countries know that the governments with which they negotiate today will be the governments with which they negotiate in the future.

The WTOO The WTO collects and disseminates information

on its members' trade policies. O WTO rules provide clear standards against

which governments' trade policies can be evaluated.

O The high quality information and transparency provided by the WTO allows governments to monitor the behavior of other WTO members.

O Therefore, I assume that governments (players) have complete knowledge about their opponent's history of play

Dispute Settlement Mechanism

O The 'tit-for-tat' strategy can be used through the WTO's 'dispute settlement mechanism'.

O Following an alleged violation of a trade agreement, the WTO Dispute Settlement Body (hereafter referred to as DSB) creates a formal panel to investigate the incident.

O If it is found that some country did indeed impose protection in an unfair manner, the WTO allows the 'victim' country hurt by the tariff to retaliate by imposing protection on the 'aggressor' country

International RelationsO China and the US are both members of the UN

Security Council. O Strained economic relations between the two

countries have often translated to negotiation problems within the UN.

O Both countries have the power to veto resolutions, and the US has often had trouble convincing China to support resolutions imposing tougher sanctions on Iran to dismantle their efforts to build a nuclear weapon.

O President Obama has said that China is both an adversary, but also a potential partner in the international community if it's following the rules.

All this means that….O [(C-D)*δ/(1-δ) ≥ (H-C)] – Long term

punishment is larger than short term gains. O Costlier to defect – repercussions in

International Relations.O If China defects against the US, it will be

widely reported in the media, and if the WTO favors the US it could be particularly embarrassing for China.

O It could affect it’s relationship with neighboring countries and other partners.

O Thus, I propose a change in pay offs

Coordination GameO It is now costlier for governments

to cheat on trade agreements.

O It becomes a Coordination game with 2 Nash Equilibria.

O 'Free Trade, Free Trade' emerges as the pure strategy Pareto-superior Nash Equilibrium, where both players are better off with the payoff (5,5)

O Protection, Protection' emerges as the pure strategy Pareto inferior Nash Equilibrium, where the players are 'stuck' with the lower payoff (1,1) and have no incentive to change their choices.