Problems and Applications Q4 Consider trade relations between the United States
ID: 1174412 • Letter: P
Question
Problems and Applications Q4
Consider trade relations between the United States and Mexico. Assume that the leaders of the two countries believe the payoffs to alternative trade policies are shown in the following payoff matrix:
The dominant strategy for the United States is to always choose tariffs. The dominant strategy for Mexico is to always choose tariffs.
True or False: The Nash equilibrium outcome for trade policy is for the United States to have high tariffs and Mexico to have low tarriffs.
True
False
In 1993, the U.S. Congress ratified the North American Free Trade Agreement, in which the United States and Mexico agreed to reduce trade barriers simultaneously.
True or False: Given the trade strategy decisions in the table, the United States is worse off and Mexico is better off with this new trade policy.
True
False
Based on your understanding of the gains from trade (discussed in Chapters 3 and 9), which of the following statements accurately characterize how well the payoffs indicated for the four possible outcomes actually reflect a nation’s welfare? Check all that apply.
The payoffs in the upper right and lower left corners of the matrix reflect a nation’s welfare because the nation with lower tariffs is better off, since that nation is more open to trade.
The payoffs in the upper right and lower left corners of the matrix do not reflect a nation’s welfare because tariffs hurt overall total surplus, so both countries’ welfare should decline regardless of who charges the high and low tariffs.
The payoffs in the upper left and lower right corners of the matrix reflect a nation’s welfare because they show that trade is beneficial and tariffs are a barrier to trade.
United States’ Decision Low Tariffs High Tariffs Mexico’s Decision Low Tariffs $25 billion, $25 billion $10 billion, $30 billion High Tariffs $30 billion, $10 billion $20 billion, $20 billionExplanation / Answer
Nash equilibrium outcome is one where neither player can maximize payoff by changing his/her strategy decisions. This means that given the strategy of one player, the other player is maximizing his/her payoff.
The statement says that “The Nash equilibrium outcome for trade policy is for the United States to have high tariffs and Mexico to have low tariffs.”
When US chooses High Tariff, Mexico chooses high tariff ($20 billion > $10 billion) which means that (High Tariff, Low tariff) for US and Mexico respectively cannot be a Nash equilibrium. Thus the given statement is false.
After reducing trade barriers, both countries will be following a low tariff rate. This means that the countries will go from a (High Tariff, High Tariff) strategy to a (Low Tariff, Low Tariff) strategy. As opposed to a high tariff rate, US is better off ($25 billion > $20 billion) and Mexico is also better off ($25 billion> $20 billion). Therefore the given statement is false.
No matter who charges tariff in what form, tariffs always create trade distortions and generate deadweight losses thereby reducing total surplus. With low tariffs from the payoff matrix, it is clear that the payoffs are higher and with high tariff, the payoffs are lower because of existence of barriers to trade. Therefore the correct options are:
‘The payoffs in the upper right and lower left corners of the matrix do not reflect a nation’s welfare because tariffs hurt overall total surplus, so both countries’ welfare should decline regardless of who charges the high and low tariffs.’
AND
‘The payoffs in the upper left and lower right corners of the matrix reflect a nation’s welfare because they show that trade is beneficial and tariffs are a barrier to trade.’
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