Theory Application

The trade war that the Trump administration started against the Chinese
government is not one that is based on ideological protectionism but rather,
a strategic conflict. Therefore, there is a multitude of possible results which
will have a significant effect on equity markets. This trade war can best be
analyzed through the scope of Game Theory.
In brief, "Game Theory" is the study of strategic interaction between two or
more rational decision-makers and it is employed where the decision-
makers are attempting to make optimal decisions across various sectors such
as economics, finance and diplomacy where each player or actor has a
number of options which he/she can choose from and the potential
outcomes, be them positive or negative, depend on the other actors or
players' choices.1
The Trump administration was, to some extent, confident about this strategy
because it worked with South Korea. Upon Trump's imposition of tariffs on
steel and aluminum, the South Koreans made concessions to avoid this
imposition; the South Korean government agreed to cut its steel exports to
the United States by roughly 30 percent in return for the rest being exempt
from steel tariffs. Nevertheless, the South Korean aluminum would still be
subject to a 10 percent tariff.2
The specific strategy that the United States and China are employing is
"equivalent retaliation" or "tit for tat," under the umbrella of game theory,

1
Matthew Haupt, "China v America Trade War: Who Has the Most to Lose, According to Game Theory?"
Financial Review, September 10, 2018, https://www.afr.com/personal-finance/china-v-america-trade-war-
who-has-the-most-to-lose-20180904-h14wov.
2
Lawder, David. "U.S., South Korea to Revise Trade Pact with Currency Side-deal,..." Reuters. March 28,
2018. https://www.reuters.com/article/us-usa-trade-southkorea/u-s-south-korea-to-revise-trade-pact-with-
currency-side-deal-autos-concessions-idUSKBN1H32SI.
this strategy means that the agent who first started using this strategy, in this
case, the Trump administration, will first cooperate, and in due course, will
imitate the opponent's previous action. Thus, if the opponent had been
cooperative, then the agent will be cooperative, if not, the agent will not be
either.3 The equivalent retaliation's problem is not irrationality but rather
miscalculation. Hence, if the two agents, the United States and China, keep
upping their game expecting that the other agent will eventually back down
and will stop retaliating, the outcome will be high tariff barriers and reduced
cross-border commerce that will end up for both sides being worse off than
their initial condition.4
The first agent, the United States, made the first move on the 15th of June,
2018 when President Donald Trump announced that his administration
would be soon charging duties on 50 billion-dollar worth of Chinese imports
because, he believes that the Chinese have been stealing American know-
how for decades and it was high time they paid back. In the same statement,
he contended that another goal was to reduce America’s 376 billion-dollar
trade deficit in goods with China. The Chinese Ministry of Commerce
retaliated with a statement assuring that the Chinese government will
counter the American endeavors with “equal scale, equal intensity” by
targeting soybeans, corn, wheat, rice, sorghum, beef, pork, poultry, fish,
dairy products, nuts and vegetables, and autos..etc. Again, in a statement on
June 18, 2018, Donald Trump asked his staff to create a list of 200 billion-
dollar worth of other Chinese imported goods that are eligible for the

3
Slantchev, Branislav L. "Game Theory: Repeated Games." March 7, 2004.
http://slantchev.ucsd.edu/courses/gt/07-repeated-games.pdf.
4
"America and China Are in a Proper Trade War." The Economist. September 20, 2018.
https://www.economist.com/finance-and-economics/2018/09/20/america-and-china-are-in-a-proper-trade-
war.
imposition of punitive tariffs. Afterwards, the Chinese did not relent and
threatened that they will respond as as equally harshly, namely, by imposing
tariffs of different rates on 60 billion-dollar worth of American goods if the
United States follows through with the threat and actually publish that list.
On September 17, 2018, Trump finally announced 10% tariffs on 200
billion-dollar worth of Chinese goods, saying China and in the same
statement he mentioned that he had to impose those tariffs because,
according to him, the Chinese were unwilling to change their practices. The
following day, the Chinese contended that President Trump left them with
no choice but to impose tariffs in order to guard their legitimate rights and
interests, hence, they imposed tariffs on 60 billion-dollar with of American
goods exported to China.5 6
According to a study conducted in Cornell University, both the United
States and China should have a free trade system. The following table (Table
1) represents the payoff Matrix of the United States and China.

TABLE 1: THE PAYOFF MATRIX OF THE UNITED STATES AND CHINA

US/CHINA Free Trade (F) Tariff (T)

Free Trade (F) 100, 100 70, 120

Tariff (T) 120, 70 75, 75

SOURCE: CORNELL UNIVERSITY

5
Coy, Peter, Andrew Mayeda, and Sofia Horta E. Costa. "Using Game Theory to Explain the U.S.-China
Spat." Bloomberg.com. June 24, 2018. https://www.bloomberg.com/news/articles/2018-06-21/game-theory-
explains-why-the-u-s-china-trade-spat-is-worsening.
6
Martin, Will, and Bob Bryan. "China Hits Back at Trump with Tariffs on $60 Billion of US Goods."
Business Insider. September 18, 2018. https://www.businessinsider.com/trade-war-china-to-retaliate-to-
fresh-trumps-200-billion-tariffs-2018-9.
According to the numbers in Table 1, the Nash Equilibrium is (F, F) where
both countries have free trade policies and it should be the optimal decision
for both sides. Furthermore, when Trump made his first move, he expected
that China would change their trade practices which he considered unfair
and also because China has an incentive to promote free trade since their
payoff is only 70 under the US tariff compared to 100 during in the case of
free trade. However, after the United States decided to impose a tariff on
200 billion-dollar worth of Chinese goods because the payoff is 75 if it fights
back than 70. In turn, the outcome moves to (T, T) where neither of the
countries is having the optimal retaliation.7

References:
"America and China Are in a Proper Trade War." The Economist.
September 20, 2018. https://www.economist.com/finance-and-
economics/2018/09/20/america-and-china-are-in-a-proper-trade-war.

Calamur, Krishnadev. "Networks." Powered by CU Blog Service.

https://blogs.cornell.edu/info2040/2018/09/18/trade-war-between-us-and-
china-game-theory/.

Coy, Peter, Andrew Mayeda, and Sofia Horta E. Costa. "Using Game
Theory to Explain the U.S.-China Spat." Bloomberg.com. June 24, 2018.
https://www.bloomberg.com/news/articles/2018-06-21/game-theory-
explains-why-the-u-s-china-trade-spat-is-worsening.

Haupt, Matthew. "China v America Trade War: Who Has the Most to
Lose, According to Game Theory?" Financial Review. September 10,
2018. https://www.afr.com/personal-finance/china-v-america-trade-war-
who-has-the-most-to-lose-20180904-h14wov.
7
"Trade War between US and China — Game Theory." Networks. Course blog for INFO 2040/CS
2850/Econ 2040/SOC 2090. Course blog for INFO 2040/CS 2850/Econ 2040/SOC 2090.
https://blogs.cornell.edu/info2040/2018/09/18/trade-war-between-us-and-china-game-theory/
Lawder, David. "U.S., South Korea to Revise Trade Pact with Currency
Side-deal,..." Reuters. March 28, 2018. https://www.reuters.com/article/us-
usa-trade-southkorea/u-s-south-korea-to-revise-trade-pact-with-currency-
side-deal-autos-concessions-idUSKBN1H32SI.

Martin, Will, and Bob Bryan. "China Hits Back at Trump with Tariffs on
$60 Billion of US Goods." Business Insider. September 18, 2018.
https://www.businessinsider.com/trade-war-china-to-retaliate-to-fresh-
trumps-200-billion-tariffs-2018-9.

Slantchev, Branislav L. "Game Theory: Repeated Games." March 7, 2004.

http://slantchev.ucsd.edu/courses/gt/07-repeated-games.pdf.

"Trade War between US and China — Game Theory." Networks. Course

blog for INFO 2040/CS 2850/Econ 2040/SOC 2090. Course blog for
INFO 2040/CS 2850/Econ 2040/SOC 2090
https://blogs.cornell.edu/info2040/2018/09/18/trade-war-between-us-and-
china-game-theory/