Question

Trade agreements encourage countries to reduce tariffs so that goods may flow across international boundaries with fewer restrictions. Using the following payoff matrix, determine the best policies for China and the United States in this example.

Part 1

The dominant strategy for the United States is to institute low tariffs high tariffs 

China's dominant strategy is to institute 

Part 2

What is the outcome? 

Choose one: 

A. The United States institutes high tariffs; China institutes low tariffs. 

B. Both countries institute high tariffs. 

C. Both countries institute low tariffs. 

D. The United States institutes low tariffs; China institutes high tariffs.

Suppose the United States and China enter into a trade agreement in which both countries agree to reduce tariffs. What other possible Nash equilibrium could they sustain? Choose one: 

A. Both countries institute high tariffs. 

B. The United States institutes high tariffs; China institutes low tariffs. 

C. The United States institutes low tariffs; China institutes high tariffs. 

D. Both countries institute low tariffs. 

E. There is no other sustainable equilibrium.

Answer 1

1) The following table summarizes the above game:

US / CHINA	LOW TARIFFS	HIGH TARIFFS
LOW TARIFFS	50, 50	10 , 100
HIGH TARIFFS	100, 10	25, 25

If China institutes low tariffs, then US will choose high tariffs as it gives him a higher pay-off of 100 as compared to 50.

If China institutes high tariffs, then US will choose high tariffs as it gives him a higher pay-off of 25 as compared to 10.

So, no matter what China chooses, US is always choosing high tariff. So, dominant strategy for US is high tariff.

If US institutes low tariffs, then China will choose high tariffs as it gives him a higher pay-off of 100 as compared to 50.

If US institutes high tariffs, then China will choose high tariffs as it gives him a higher pay-off of 25 as compared to 10.

So, no matter what US chooses, China is always choosing high tariff. So, dominant strategy for China is high tariff.

2) From the above explanation it is clear that the nash equilibrium is determined where the pay-off for both the firms is 25, 25 that is where both the countries choose high tariffs. So, the outcome is where both the countries institute high tariffs.

3) There is no other sustainable equilibrium if they both lower the tariffs as either of the two countries will have an incentive to deviate from their decided strategy and move to other strategy. For example, US will have an incentive to move from low tariff to high tariff as it gives him a higher pay-off. Similarly, China will have an incentive to move from low tariff to high tariff to get a higher pay-off.