The Prisoner's Dilemma in Modern Trade Wars: Analyzing the US-China Tariff Escalations

Tariffs are highly controversial in economics, with most economists supporting the merits of free trade.  

In game theory, two or more competitors must analyze others’ actions when making a decision.  This is seen in oligopoly markets, where a relatively small number of firms compete.  Each firm controls enough market share to impact the revenue and/or profits of its rivals, so every firm in the market must consider its rivals' likely actions.  It is simplest to analyze game theory with two rivals, known as a duopoly.  

Why Impose Tariffs?

In a simple game theory matrix with the United States and China, with each nation having a simple choice of imposing tariffs or not imposing tariffs, things become complex very quickly.  Most economists believe that both nations would make more export revenue by not imposing tariffs.  However, one might impose tariffs for a number of reasons, some political and some economic.  This would lead the other to respond in kind and also impose tariffs.  Historically, this was seen in the early 1930s after the infamous Smoot-Hawley Tariff Act.

A nation’s government might choose to impose tariffs, even if it knows the other nation will respond in kind, if there is political benefit to doing so.  There can be political benefits to protectionism, or limiting free trade to protect a domestic industry.  Tariffs may protect a domestic industry and preserve, or even increase, jobs in that field.  However, prices for consumers will rise.

Whether the political benefits of protectionism outweighs the political costs of higher prices for consumers is influenced by several factors, some economic and some political.  Economically, higher prices will be more tolerated by consumers if they have relatively inelastic demand for the products.  Inelasticity means a change in the independent variable, such as price, results in a proportionally smaller change in the dependent variable, such as quantity demanded.  For example, a 20% increase in price results in only a 10% decrease in quantity demanded.  Total revenue increases as most consumers continue to buy.

If demand is relatively inelastic, economic metrics will continue to look okay, and the government can proclaim that raising tariffs and protecting domestic industries did not hurt the economy.  

Politically, raising tariffs can be advantageous if voters are open to seeing protectionism as a patriotic move.  It can also be justified as an attempt to solve a problem, which is where a game theory analysis may support it.

If voters perceive an economy to be in poor shape, they may view virtually any realistic attempt at reform, including raising tariffs, as positive.  The government or political candidate can declare that tariffs will save the economy by protecting domestic industries, reducing reliance on imports, and raising tax revenue.  If this turns out to be untrue, the government or candidate (perhaps now an incumbent) can always try to shift blame, deflect, or even outright deny.  In sum, there may be short term political gains to pursuing tariffs: it can make one look tough in the moment on foreign competition, appear as a savior to struggling domestic industries, and buy time to figure things out if tariffs are unsuccessful.

Another factor supporting the imposition of tariffs in a game theory scenario is the greater emotional impact of unemployment versus inflation.  Both conditions can be harmful to an economy, but unemployment has a greater individual impact.  Inflation is very unpleasant, but is spread across the population.  In terms of political impact, it is easier for politicians to advertise that they reduced unemployment by protecting domestic industries, even at the cost of tariff-induced inflation, than to advertise that they lowered costs through free trade.  

In terms of negative campaigning, it is likely easier to counter a politician’s declaration that prices have fallen than that jobs have been created.  A rival politician can cherry pick specific prices that have not fallen and publicize them, casting doubt that inflation has actually decreased.  If a domestic company adds fifty jobs, that can be harder to dispute.  The negative campaigner may have to publicize job losses in other areas, which may not have as much impact on voters.

Unilaterally Imposing Tariffs Can Signal Strength

In game theory, and among oligopolies in general, a competitor always wants to know what its rivals are most likely to do.  In the event that this is unknowable, the firm may have to consider worst-case scenarios.  For a politician, this would likely be a trade rival imposing tariffs first.  If tariffs are imposed and not met with immediate retaliation, this could make the non-retaliator look weak.  Therefore, there is an incentive to impose tariffs unilaterally when there is deep uncertainty about a rival’s likely action on tariffs.

Similar to the prisoner’s dilemma - a game theory duopoly - there is an incentive to act first.  The tariff imposer looks strong and confident, which may provide some political protection against the inevitable increases in prices that follow.  Although tariffs may be economically harmful, especially in the long run, being subject to a rival’s tariffs may be a political death knell.  Even if a government responds immediately with retaliatory tariffs, there will be a brief period of weakness where country A imposed tariffs first.  

Long-Term Implications of Game Theory Favoring Tariffs

Tariffs raise prices and harm consumers, but may be politically desirable in the short term due to the potent imagery of protectionism.  Choosing to raise tariffs can also give a politician the opportunity to accuse his or her non-tariff-raising rival of doing nothing to help struggling consumers and firms (at least as long as the non-tariff-raising rival is not actively and publicly pursuing a trade agreement).  These political benefits of tariffs will likely lead to the continued popularity of tariffs as a political tool over the long term.  Despite economists’ warnings about tariffs, conservative politicians are often swayed by the relative simplicity and potency of raising them.

In most aspects of life, there is the tendency to choose the quick-and-easy option whenever faced with a dilemma.  In economics, tariffs are often one of these quick-and-easy options for bolstering ailing domestic industries.  They can be implemented almost immediately, raise measurable revenue, and be explained simply to voters.  Other government options, such as tax credits or subsidies, will likely take longer to implement and be more difficult to explain to voters.  In the real world, we saw these competing economic options in the 2024 United States presidential election.

Republican nominee Donald Trump argued that raising tariffs would protect domestic industries and reduce America’s reliance on imports.  Democratic nominee Kamala Harris, the incumbent vice president, supported the Biden administration’s use of tax credits and subsidies under the Inflation Reduction Act and CHIPS and Science Act to help the growth of domestic tech and green energy companies.  Despite record-low unemployment, and even saving many industrial jobs, the Biden administration and Kamala Harris struggled to win voters’ favor on the economic front.  

The loss of the Biden-Harris administration and its analytical use of tax credits, subsidies, and guaranteed loans will likely encourage future political candidates to pursue more radical proposals, such as hiking tariffs, to boost economic metrics.  Voters tend to want simplicity, immediacy, and confidence, which tariffs as a policy provide more easily than tailored fiscal spending.  Fiscal policy options like the Inflation Reduction Act and CHIPS and Science Act can also face political allegations of bias - who gets the money?

Tariffs, in the United States and other pro-capitalist countries, may be seen as more advantageous than fiscal policy because they are not “socialist” and do not award credits or subsidies to specific firms or groups.  Fiscal policy may be vulnerable to political attacks and accused of taboos like “socialism” and “communism”, while tariffs are less painfully criticized as economically ignorant.  Most politicians would rather be considered an economic dunce than a socialist.