International Trade

Trade Policies using Game Theory

Introduction

Strategic trade policies aim to promote exports or discourage imports in particular sectors, to increase a nation's welfare. While some policy makers advocate the policy, many economists have raised questions on the justification and validity of the policy.

Among many strategic trade policies, this section analyses "industrial subsidy" using game theory.

Example - Airbus and Boeing
In this example, Boeing (American) and Airbus (European) are competing in a world market. They can choose to produce (P) or not (N).

  • If they both produce, competition will drive down the price and they will both lose. [1]
  • If neither produces, neither gains. [2]
  • If one produces and the other doesn't, the producing company takes all the market share and the other company gets nothing. [3]


    • This is similar to the previous example. Again, we find two Nash equilibria (P, N) and (N, P). [4]

    If we assume that Boeing is already in the market (in other words, has chosen P already) and Airbus is considering entering it, how is the game played out? By the same process of backward induction as before, we find that Boeing chooses P and Airbus chooses N. [5] In other words, it is not in Airbus's interests to enter the market.

    Government Subsidy

    Now suppose that the European government regards the aircraft industry as very important. To encourage Airbus to enter the market, the European government might subsidise production by, say, 25. This changes some payoffs, and changes the game's structure:

  • If Boeing chooses P, Airbus will choose P. [1]
  • If Boeing chooses N, Airbus will still choose P. [2]


    • Now Airbus has a dominant strategy P. Then, theoretically, Boeing calculates its payoff again and finds that N is its best strategy. [3]

    Although this looks attractive for Airbus, there are other factors to consider:

  • If Airbus is subsidised by the European government, the U.S. government can retaliate by subsidising Boeing. Then Boeing will keep producing (strategy P), which will incur losses to both producers. Both producers are then subsidised by their governments, and all the burden from the subsidy is borne by taxpayers.
  • If Boeing is stable in the U.S. domestic market, it might be able to absorb the competition from Airbus. In other words, its P payoff might be greater than anticipated by Airbus. If Boeing's payoff from P is positive, it will keep producing.
  • To finance the subsidy, the European government must use consumers' money. How can we justify the transfer of money from consumers to subsidise Airbus?


    • [Back] Games with Nash Equilibrium
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    [Topic] Application of Game Theory to International Trade


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