International trade is not a prisoners’ dilemma – cheating is how you lose.

The final sentence of this article poses a question: “Why, when America is acting outside the rule book, should others stick to it?”

This is a dangerous thing for The Economist – formerly a champion of free trade and State inaction – to say.

Firstly, China itself is definitely not innocent of playing outside the rule book – think counterfeited US luxury goods, bootlegged Hollywood films, fake Apple stores, trade secrets pilfered from cutting edge US tech companies, forcing US firms to hand over their technology if they wanted to operate in China. But as I’ve made clear before, the solution was never to trigger a trade war, but to create a coalition of trading partners that would put pressure on China to behave better – something like the TPP that Trump abandoned. This would have been far more likely to generate cooperation rather than escalation.

Now to the question of why we should all keep playing by the rules if one or two players have already started cheating. This is the common misconception about world trade, and exactly how to trigger escalation and cause everything to get worse.

Game theory has a scenario called the ‘prisoners’ dilemma’, where two arrested criminals have the choice to ‘rat out’ one another, or remain silent. Here are the possible outcomes:

·         Both stay silent, and only get 1 year in prison for a lesser crime;

·         Only one criminal ‘rats’, resulting in the ‘rat’ going free and the one who remained silent getting 5 years in prison; or

·         Both criminals ‘rat’, resulting in both going to prison for 3 years (less than the 5 years because they cooperated).

So even though the best outcome for both of the criminals combined is to stay silent, the incentive for each criminal, no matter what the other one does, is to ‘rat’:

·         If you assume your partner will stay silent, you will go free by ‘ratting’;

·         If you assume your partner will ‘rat’, you also ‘ratting’ will give you a lesser prison term than staying silent.

		Criminal 2
		Stay Silent	Rat
Criminal 1	Stay Silent	1,1	5,0
	Rat	0,5	3,3

Applying this logic to international trade, we could say that the optimal outcome is for everyone to cooperate (free trade), but that everyone has an incentive to cheat, always, especially if someone has already broken the rules.

But this is wrong.

During a trade war, retaliation (cheating in response to someone else cheating) causes a worse outcome for everyone, including the ‘justified’ retaliator, as follows (the numbers are arbitrary, but think of them as percentage changes in your country’s GDP):

		Country 2
		Cooperate	Cheat
Country 1	Cooperate	10,10	7,12
	Cheat	12,7	5,5

·         Both countries gain 10% in GDP by trading freely;

·         If one country imposes tariffs, they gain 12% while the other still gains, but only 7%;

·         If both country’s cheat, they both only gain 5%.

So in international trade, even when your partners cheat, it is still in your best interests to be able to import freely. Escalating a trade war is never rational, even if it means swallowing a little pride.

Furthermore, the above example assumes that a country like the US can benefit from being the only one who imposes tariffs because of their size and market power. But as the steel and aluminium tariffs demonstrated, even in a country with the US’s market power, such poorly targeted tariffs damaged US companies that use steel and aluminium as inputs (e.g. the auto industry) far more than it helped steel and aluminium producers (by an estimated factor of 16:1!). So the incentive to cheat is even more questionable, even if you can get away with it.

So this is not the traditional ‘prisoners’ dilemma’ – yes, we are better off cooperating, and if we have any market power, we do have an incentive to cheat, just like the traditional game. BUT, the costs of the escalation of a trade war rapidly increase as more players cheat, meaning that it was better to just deal with one cheater than many.

In other words:

·         Both sides combined are better off cooperating (like the prisoners’ dilemma);

·         If you assume your trade partner will cooperate, you may have an incentive to cheat (like the prisoners’ dilemma);

·         But if you assume your trade partner will cheat, you are better off not escalating and instead, cooperating (unlike the prisoners’ dilemma).

As I wrote before about retaliating to Trump’s tariffs, we should have left it.