Tariffs and the Prisoner's Dilemma

Tariffs are almost always a bad idea. Specifically, the tariffs Trump seeks with China and visa versa will be bad for the vast majority of people. The Chinese imposed tariffs will be bad for american farmers as well as Chinese consumers. The American farmers will sell less internationally and the Chinese consumers have to pay more for their goods. Likewise, tariffs on Chinese raw materials places a burden on American manufacturing and hurts Chinese materials production.

There are a few pluses to tariffs. A very small group of people are actually helped by tariffs. For example, coal miners or other natural resources sourced here in America will experience increased prices due to less supply. But this is a small group, and the widespread effects of price increases are much larger in impact. Additionally, tariffs can be used to protect some industries. This is commonly used as part of a national defense argument. For example, if the US was totally dependent on foreign food, the suppliers of food could have a lot of influence over the US. But this example is really quite far from reality as the US is a big exporter of food.

There is a possible exception to my tariffs-equal-bad argument that involves the idea of a Nash equilibrium. Simply, if China declares tariffs on the US, how should the US react? Well, it all depends on the weights of the different values …

You may be familiar with the prisoner's dilemma, a situation where two prisoners are faced with the option of either ratting out the other, or not. There are 4 outcomes in this situation. The two prisoners both don’t rat each other out, and they both get one year of jail time. On the opposite side of the spectrum, both rat each other out and get 2 years jail time. If one rats and other other doesn’t, the cooperative prisoner gets out free and other other gets 3 years. See the table below.

The bottom right square in this situation is the Nash equilibrium, it is the point where the game will go to give time. Why? Well look at the numbers. Both prisoners getting one year sentences is the best outcome for them overall, as 2 combined years is the shortest sentence. But for an individual player, getting zero years is better. So players will gravitate away from the top left square to the top right or bottom left. Well, anytime one player rats and other other doesn’t, the non-ratter will regret their decision as two years as a ratter is better than 3. Which then places the game in the bottom right box. At this point, neither player is incentivized to make a different decision since they cannot control the others actions. This point where there is no incentive to change decisions is called the Nash equilibrium.

Now, what does this all have to do with tariffs? Clearly, no tariffs is the ideal outcome on the top left. Its best for other parties overall. However, perhaps one party issuing tariffs is like one of the prisoners deciding to rat. Once one country makes a tariff, the other country is incentivized to respond with a tariff of its own, leading to a downward spiral. Both countries are worse off in this case. If trade is similar to the prisoners dilemma, maybe retaliatory tariffs are just part of the game.

We can look at strategies for playing the prisoner's dilemma and apply them to tariffs. The best strategy is called tit of tat, and its rules are quite simple. The player cooperates unless the other player didn’t cooperate in the last round, in which case the player will not cooperate. Here is an entire video discussing why this tactic is best.

So in short, if the tariff situation is like the prisoner's dilemma, a tariff in response to a tariff may be a fair strategy. However, there was a big assumption in this argument that tariffs are similar in weights to the prisoner's dilemma. It is possible that, in reality, the US is better off cooperating with China regardless as to what they do.

The next time you go to Walmart and see everything from China is slightly more expensive, you can think to yourself, is this all part of a big strategy? Or is this all just a game of chicken that ended in a collision? Just something to think about as you check out.