Consider trade relations between the U.S. and Mexico. Assume that the leaders of
ID: 1250852 • Letter: C
Question
Consider trade relations between the U.S. and Mexico. Assume that the leaders of the two countries believe the payoffs to alternative trade policies are as follows:U.S. Decision U.S. Decision
Low Tariffs High Tariffs
Mexico's Decision Low Tariffs (25,25) (10,30)
Mexico's Decision High Tariffs (30,10) (20,20)
a. What is the dominant strategy for the U.S.? For Mexico?
b. Define Nash equilibrium. What is the Nash equilibrium for trade policy?
c. In 1993 the U.S. Congress ratified the North American Trade Agreement, in which the U.S. and Mexico agreed to reduce trade barriers simultaneously. Do the perceived payoffs shown here justify this approach to trade policy?
d. Based on your understanding of the gains from trade, do you think that these payoffs actually reflect a nation's welfare under the four possible outcomes?
Explanation / Answer
a) Both countries dominant strategy is high tariffs because it gives them a higher payoff no matter what the other party does. b) A Nash equilibrium is a situation where every party is playing his optimum strategy given what the other party is doing. The Nash equilibrium is high tariffs for both parties. c) Yes, because if both parties have low tariffs they are mutually better off (25 payoff for each party) than if they have high tariffs (20 payoff for each party). d) No, free trade benefits a country even if the other countries have high tariffs. The overall benefit to a country outweighs the gain (because of higher prices) to producers.