Question

b) he following matrix describes the payoffs of two countries (China and the US) whenthey decide for protectionism or free trade. In each cell of the matrix, the first numberdenotes the payofffor the US and the second number denotes the payofffor China.

b1) Based on the above matrix, explain why countries might end up in a trade war without trade agreements.(3 pts)
b2) Based on the above matrix, discuss the following statement:“International trade agreements can solve the Prisoner’s dilemma that governments face when it comes to the reduction of trade barriers.”

	Protectionsim	free trade
protectionsim	-1, -1	10, -5
free trade	-5,10	8, 8

Answer 1

b1.

Both the players (US and China) playing "protectionism" is the dominant strategy. To see that, suppose one of them played "free trade". Then the other would get a payoff of 8 from playing free trade as well but a payoff of 10 from playing protectionism. Next suppose one of them played "protectionism". Then the other gets a payoff of -5 from playing free trade and a payoff of -1 from playing protectionism. Notice how a nation gets a higher payoff from playing protectionism- no matter what the other nation has played. Hence, we say protectionism is a dominant strategy and both nations will end up playing this strategy (since players always play their dominant strategy if exists)

This can explain why at equilibrium we will see a situation where both US and China choose protectionism over free trade, which will lead to a trade war. In this equilibrium both get a payoff of -1.

b2.

Notice if both of them had decided to play free trade instead they would both get a payoff of 8 instead of -1. But if any one nation does end up playing free trade the other one will be tempted to switch their strategy and play protectionism instead (getting a payoff of 10). International agreements help prevent such temptations. International agreements will ensure that if the two nations agree to play free trade instead of protectionism then no one nation can cheat the other and play protectionism. Knowing they are both safe from the possibility of the other nation cheating, both will find it optimal to choose free trade and get a pay off of 8 each instead of -1 each like they otherwise did. Hence, here we observe that international trade makes both nations better off.