1. Bilateral Trade as a Coordination Game Nimarjit Singh

2. Introduction O Interest in International Trade O Increased Globalization has made the world more integrated. A lot of rhetoric in Politics, especially in this election on outsourcing. O Global trade has grown during the last 60 years at an average rate of 6 percent per year. O As a result, annual world merchandise trade has risen from $84 billion in 1953 to$15.7 trillion in 2008

3. Gains to Trade O Economically it makes sense to Trade. O Comparative Advantage and the Production Possibility Frontier. O Some countries can make goods with a lower opportunity cost. O If all the countries were to specialize and trade, each country would enjoy the benefits of consuming beyond the PPF O The US can focus on making more Iphones, while China can produce wheat, the resulting trade would make them both better off!

4. The US and China O China is the second largest trade partner of the US, after Canada as of December 2011 O China’s Strategy of Export led growth – undervalued Currency, lower wages. O Many US manufacturers have set up shop in China O Since China entered the World Trade Organization in 2001, the U.S. trade deficit with China eliminated or displaced more than 2.7 million U.S. jobs. Most of them from the Manufacturing sector O The U.S. trade deficit with China has surged over the past two decades, as U.S. imports from China have grown much faster than U.S. exports to China.

5. The US and China O Bone of contention – US policy makers say China is not abiding by the rules. O Tensions have risen over a number of Chinese economic and trade policies that many U.S. critics charge are protectionist, economically distortive, and damaging to U.S. economic interests. O The U.S. trade deficit with China has surged over the past two decades, as U.S. imports from China have grown much faster than U.S. exports to China.

6. Prisoner’s Dilemma Game O The Nash Equilibrium occurs at (Protection, Protection), and both of the players end up with (1,1) which is the lowest payoff. O Suggests that even when both countries would clearly benefit from trade liberalization, political dynamics trap governments in a protectionist world

7. Repeated Play O Concept of Discounting Future Gains/losses O If the value of future cooperation is large, and exceeds what can be gained in the short term by defecting, then the long term individual interests of the players can automatically keep them from defecting.

8. General Model C : Cooperative Outcome; H: high payoff that goes to defector when other player cooperates; D – Outcome where neither player Cooperates From the first table we saw that H>C>D>0

9. “Tit for Tat” Strategy O In infinitely repeated games, players can adopt a "Tit for Tat" trigger strategy, O Each player plays the strategy that the other player played in the previous round of the game. O Therefore, trade liberalization by one player in one round of play is met by trade liberalization from the other player in the next round. O Should any player defect and play 'Protection' then it can be 'punished' in the next round by the other player and will end up with a lower payoff than before. O Such iterative play coupled with 'tit-for-tat' strategies allows players to reward each other for cooperation and punish each other for cheating

10. Discounting O Is it worthwhile to defect against a rival playing a tit for tat strategy? O Depends upon the present value of the losses and gains incurred over an infinite horizon. O The "discount factor" is δ = 1/1+r, and is used to find the present value. Here, 'r' is a rate of return, and is a positive number.

11. Discounting Gains and Losses O Therefore, the value of all future cooperative play gives a present value payoff of (C + δ C + δ. δ.C+..) up to infinity. O The sum of this infinite series is [C + δ C/(1- δ )]. O Similarly, the present value of future losses from defection (including the immediate short term gain) is [H + ( δ D)/(1- δ )]

12. Equilibrium O This means that for cooperation between the US and China to realize the Pareto superior Nash Equilibrium, the following equation must hold: [C + δ C/(1- δ )] ≥ [H + ( δ D)/(1- δ )] O Rewrite as: [(C-D)* δ /(1- δ ) ≥ (H-C)] O In English: as long as the long term costs of defecting are higher than short term gains, there will be cooperation

13. The WTO O In real life, the WTO ensures an enforcement mechanism, as well as iteration. O WTO member countries know that the governments with which they negotiate today will be the governments with which they negotiate in the future.

14. The WTO O The WTO collects and disseminates information on its members' trade policies. O WTO rules provide clear standards against which governments' trade policies can be evaluated. O The high quality information and transparency provided by the WTO allows governments to monitor the behavior of other WTO members. O Therefore, I assume that governments (players) have complete knowledge about their opponent's history of play

15. Dispute Settlement Mechanism O The 'tit-for-tat' strategy can be used through the WTO's 'dispute settlement mechanism'. O Following an alleged violation of a trade agreement, the WTO Dispute Settlement Body (hereafter referred to as DSB) creates a formal panel to investigate the incident. O If it is found that some country did indeed impose protection in an unfair manner, the WTO allows the 'victim' country hurt by the tariff to retaliate by imposing protection on the 'aggressor' country

16. International Relations O China and the US are both members of the UN Security Council. O Strained economic relations between the two countries have often translated to negotiation problems within the UN. O Both countries have the power to veto resolutions, and the US has often had trouble convincing China to support resolutions imposing tougher sanctions on Iran to dismantle their efforts to build a nuclear weapon. O President Obama has said that China is both an adversary, but also a potential partner in the international community if it's following the rules.

17. All this means that…. O [(C-D)* δ /(1- δ ) ≥ (H-C)] – Long term punishment is larger than short term gains. O Costlier to defect – repercussions in International Relations. O If China defects against the US, it will be widely reported in the media, and if the WTO favors the US it could be particularly embarrassing for China. O It could affect it’s relationship with neighboring countries and other partners. O Thus, I propose a change in pay offs

18. Coordination Game O It is now costlier for governments to cheat on trade agreements. O It becomes a Coordination game with 2 Nash Equilibria. O 'Free Trade, Free Trade' emerges as the pure strategy Pareto-superior Nash Equilibrium, where both players are better off with the payoff (5,5) O Protection, Protection' emerges as the pure strategy Pareto inferior Nash Equilibrium, where the players are 'stuck' with the lower payoff (1,1) and have no incentive to change their choices.