Game theory analysis

Prisoner’s Dilemma

For theory analysis we have applied Prisoner’s dilemma situation. The prisoner’s dilemma is
probably the most widely used game in game theory. Its use has transcended Economics,
being used in fields such as business management, psychology or biology, to name a few.
Nicknamed in 1950 by Albert W. Tucker, who developed it from earlier works, it describes a
situation where two prisoners, suspected of burglary, are taken into custody. However,
policemen do not have enough evidence to convict them of that crime, only to convict them
on the charge of possession of stolen goods.
If none of them confesses (they cooperate with each other), they will both be charged the
lesser sentence, a year of prison each. The police will question them on separate
interrogation rooms, which means that the two prisoners cannot communicate
(hence imperfect information). The police will try to convince each prisoner to confess the
crime by offering them a “get out of jail free card”, while the other prisoner will be
sentenced to a ten years term. If both prisoners confess (and therefore they defect), each
prisoner will be sentenced to eight years. Both prisoners are offered the same deal and
know the consequences of each action (complete information) and are completely aware
that the other prisoner has been offered the exact same deal (therefore, it’s common
knowledge).
Since prisoners cannot communicate and will (supposedly) make their decision at the same
time, this is considered to be a simultaneous game, and can be analysed using the strategic
form, as in the adjacent game matrix. As described before, if both prisoners confess the
crime they will be charged an eight years sentence each. If neither confesses, they will be
charged one year each. If only one confesses, that prisoner will go free, while the other will
be charged a ten years sentence. These can be seen as the respective payoffs for each set of
strategies.

Using the above theory, we have calculated the best payoffs for Chine and USA.
The matrix below shows the standard way of thinking about the tariffs, it represents the
prisoner’s dilemma situation. The set-up is as followed the two players are USA and China
Each of them has two strategies either to impose tariffs (T)or maintain free trade(F).
Their preferences are shown below. The best response for each country is to impose tariffs,
which results in the Nash Equilibrium of TT , from which neither country has motives to
deviate.
Although, this is the NE and it is their optimal response, both countries could have received
higher payoffs if they had continued coordinated. In reality, this ‘coordination’ is both
encouraged and policed by the World Trade Organization. If the USA and China maintained
free trade, then both countries would have benefitted from higher levels of trade, and
received higher payoffs. The research has shown that increasing free trade results in
increased per capita income and lowered living costs and these results in higher standards
of living. The matrix suggests that if USA imposes new tariffs and china does not retaliate
then Americas exports will not change but the price of imported goods will increase and
demand for them will decrease. This will lead to increase in demands of the goods of
domestic producers which in turn will increase the domestic output and hence the GDP.
Alternatively, if China is subject to American tariffs and choose not to retaliate, they will see
a decrease in their export levels, while their imports will not get affected. If we take that
that the Chinese economy is so strong on export-led growth, this is a dangerous possibility.
Viewing this in a strategic simultaneous format, however, implies that this interaction is
simultaneous and that there are no opportunities for either country to respond to the
actions of the other. This lacks real-life validity. A sequential game is a more realistic model.
It should be noted that this model assumes that the USA and China are immune to penalties
imposed on them for applying tariffs and breaking WTO and other trade agreements.
Payoffs represents the impact of the chosen strategy on exports and imports. As it stands,
the payoffs are symmetrical and so the rationale above can be applied when the strategies
are reversed. If both countries opt for free trade, then a prosperous free trade environment
remains, and, as aforementioned, if both impose tariffs, the result is a dramatic decline in
world trade and a subsequent fall in GDP and welfare.
Here for our payoffs we have taken references from different sources and then applied our
collective efforts to reach this payoff results.
Some of the main sources of our information regarding payoffs are from
1) https://www.tcd.ie/Economics/assets/pdf/SER/2017/9trump.pdf
2) https://www.researchgate.net/publication/23529970_The_US-
China_Trade_Conflict_A_Game_Theoretical_Analysis

Conclusion based on the model:

This model has sought to provide a deeper understanding of the complexity and uncertainty
inherent in the trade decisions facing today’s leaders and policymakers. In the strategic
interaction between the USA and China, information asymmetries allow the Chinese
government to choose to act either aggressively or tactically. The payoffs that the USA
receives vary greatly depending on China’s type. This analysis highlights the negative effects
of protectionism, and, in doing so, the dangers associated with populist politics, in which
logical reasoning and empirical analysis no longer provide a basis for policy agendas. It can
affect the outside world with the positive and negative effects.