ECON1001 Study Guide - Final Guide: Nash Equilibrium, Strategic Dominance, Opportunity Cost

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Published on 14 Jun 2020
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1. The United States and China are deciding on whether to impose higher tariffs on
imports from the other country. President Trump and President Xi believe the
payoffs to alternative trade policies are as follows:
United States
Low tariffs
High tariffs
China
Low tariffs
US gains $220 billion
China gains $200 billion
US gains $230 billion
China gains $100 billion
High tariffs
US gains $100 billion
China gains $220 billion
US gains $150 billion
China gains $150 billion
(a) What is the United States’ dominant strategy? What is China’s dominant strategy?
Explain
Define dominant strategy: play regardless of opponent’s move
US dominant strategy is high tariffs b/c 230 > 220 and 150 > 100
China dominant strategy is high tariffs because 220 > 200 and 150 > 100
(b) What is the Nash equilibrium for trade policy in this instance?
Define Nash Equilibrium: stable equilibrium (no incentive to switch strategy).
High-High in this case.
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(c) Worrying about a trade war with China, Trump tweets:
China and the United States are working well together on trade, but past negotiations
have been so one sided in favor of China, for so many years, that it is hard for them to
make a deal that benefits both countries. But be cool, it will all work out!” (14 May
2018)
What is the expected gain from such an agreement that would have both countries
lower tariffs? What is the opportunity cost of failing to successfully conclude
negotiations?
In the aggregate, low-low results in 420 while high-high only results in 300. So the expected
gain is 120
The highest value among forgone options is 120, so the opportunity cost of failing to
conclude negotiations is 120.
(d) Based on your understanding of the gains from trade from basic economic theory,
do you think these payoffs actually reflect a nation’s welfare under the 4 possible
outcomes?
No, the low-high payoff makes no sense. Liberalization is welfare enhancing in both
import and export sectors. It increases productivity and competition across the
economy. The country thinks it is better for them to keep a high tariff and the other
lowers them but they are missing out on all the benefits of competition. Politicans
prefer this strategy because they are focused on concentrated losses instead of
diverse benefits.
No. The low-high payoffs are disingenuous. Unilateral trade liberalisation is welfare-
enhancing in both exporting and importing sectors, increases competition and associated
productivity improvements, and improves consumption possibilities. Politicians fail to
understand this because they fixate on identifiable losers from trade rather than considering
the more diffuse benefits. They think it would be ideal to maintain high tariff barriers while
others lower there’s, but then they would miss out on all the benefits of competition and
imports.
2. Draw a diagram or table to give an example of the prisoners’ dilemma. What
choices do the players make? Explain why they make these choices.
The PD is a game where each player has a dominant strategy which results in a
sub-optimal outcome.
Correct diagram [4 points]
The players chose the non-cooperative equilibrium where they each have a lower payoff
than in the cooperative equilibrium. [2 points but just for picking the right
combination don’t need to state this]
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