Game Theory and the US-China Trade War

Intro to Game Theory

Game theory is the analysis of decision-making assuming all participants are rational and logical. In game theory, the goal of each participant is to maximize their own profits and increase payoffs. It is a subject with a wide variety of applications, including computer science, philosophy, economics, and of course, politics.

One of the most fundamental cornerstones of this field was introduced by mathematician John Forbes Nash in the mid-1900s. Nash proposed that when no participants can benefit from changing their actions, then the participants have reached “Nash Equilibrium“. Nash Equilibrium assumes that each player is constant and logical in their actions. Therefore, the players likely know each other’s moves, yet cannot profit from changing their own strategy

What Game Theory says about the Trade War

The United States and China are arguably the most influential world powers of today. Considering their immense influence , the actions made during this trade war will have lasting ramifications on the world. Therefore, we can assume that each country will take the most logical course of action for the sake of the world.

If the United States chooses to cede ground in the trade war, it will result in a loss for them. This is because China reaps the benefits of their imposed tariffs. The same applies to China if they choose to loosen their involvement in the trade war. Because of this, the only option for the United States and China is to continue participating in the trade war. With each of these outcomes considered, the countries are now considered at Nash Equilibrium. Both world powers will likely continue the trade war with an unchanging strategy, until diplomacy can promote reaching a mutual agreement to end the conflict.

Context

As of the end of August, the total US tariffs applied to Chinese goods amount to $550 billion USD, and total Chinese tariffs applied to US goods amounting to $185 billion USD. How did the trade war get to this point?

This “Trade Game” of sorts laid its roots around the late 1900s, when the United States accused China of imposing unfair trade policies. They also blamed China for taking advantage of their cheaper currency on imported goods, which accelerated the United States’ trade merchandise deficit. In response, the US began imposing heavy tariffs on China starting in 2005 on the contingency that China appreciate their currency. For more information on the role of currency manipulation in the trade war, click here.

The Game Theory Behind the War

This can be separated into two cases for the United States. First, they can continue imposing tariffs and call for Chinese currency appreciation. Alternatively, they can accept the increasing trade merchandise deficit inflicted by China. If the United States chooses this strategy, China has two options. They can either choose to abide by the United States’ terms and appreciate their currency, or they can further instigate the trade war by imposing tariffs on the US’s exports. If the United States chooses the second case and does nothing, then the trade game ceases to happen. Alternatively, China can also take no action in response to the US imposing tariffs. This means the current situation remains the same and the trade war continues. This scenario can be represented by a simple decision tree:

If both powers continue to impose tariffs on each other with increasing stakes, then they will eventually reach a Nash Equilibrium.

Although game theory can only predict so much in real-life situations, it can generally envision larger macroeconomic trends. Jumping ahead from when the trade war first started in the early 2000s, we start noticing the trend of rising stakes in the trade war between the United States and China. Take August of 2019 for example. On August 23rd, the Customs Tariff Commission of China’s State Council announced $75 billion USD in tariffs on US goods. On the same day, the previously exempt tariffs on US automotive and auto parts reinstated. Later in the year, on September 1st, the US responded by pushing tariffs valued at more than $125 billion USD onto Chinese goods. China again retaliated by imposing additional tariffs to their original $75 billion USD in late-August.

The Future of the “Trade Game”

What separates game theory from reality is the fact that people, and nations, aren’t machines. They are able to end games by meeting a mutual consensus, agreed on by both parties, or take an alternative path.

The US and China both have their individual backgrounds and a history with each other that creates an interesting dynamic. Their unwillingness to cooperate in the trade war extends to more than just unfavorable trade deals, but also ideological differences. The US maintains itself as the face of capitalism while China operates as a prominent Communist power. Keeping this in mind, there are certainly struggles in creating agreements that align with each country’s agenda.

Game theory’s inability to completely account for behavioral economics, like that of the US and China’s history, is one of the main reasons why game theory in practice does not always work out like it does in theory.

However, it’s interesting to note that talks of amending growing trade war threats have occurred recently. Liu He, one of China’s top trade negotiators, said the increasing severity of the trade war was against the interest of China, the US, and the entire world.” President Trump responded by stating that talks to de-escalate tensions would proceed. Amazingly, at least thirteen rounds of trade talks have been made throughout the trade war’s history, yet the United States and China have been unable to break the Nash Equilibrium.

It is undeniable that progress is materializing, however slowly. Recently, tariffs on both sides have decelerated with several grants of tariff exemptions. Even more promising is a new trade deal both sides are optimistic about. Hopefully, this agreement will break the Nash Equilibrium predicted by game theory and end the trade war once and for all.