Question

4. Consider trade relations between the United States and Mexico. Assume that the leaders of the two countries believe the payoffs to alternative trade policies are as follows:

United States' Decision Mexico's Decision
Low Tariffs U.S. gains $25 billion Mexico gains $25 billion
High Tariffs U.S. gains $20 billion Mexico gains $20 billion
US low tariff/Mexico high tariff U.S. gains $10 billion Mexico gains $30 billion
US high tariff/Mexico low tariff U.S. gains $30 billion Mexico gains $10 billion

a. What is the dominant strategy for the United States? For Mexico? Explain?
b. Define Nash equilibrium. What is the Nash equilibrium for trade policy?
c. In 1993, the U.S. Congress ratified the North American Free Trade Agreement, in which the United States and Mexico agreed to reduce trade barriers simultaneously. Do the perceived payoffs shown here justify this approach to trade policy? Explain.
d. Based on your understanding of the gains from trade (discussed in Chapters 3 and 9), do you think that these payoffs actually reflect a nation's welfare under the four possible outcomes?

Answer 1

First let us draw the normal form game to help us answer the problems.

a. What is the dominant strategy for the United States? For Mexico? Explain?

In this case, we compare payoffs. US compares the first column vertically and Mex compars the second column vertically

25 25 30 10

10 30 20 20

In this case, both US and Mex independently have a dominat strategy to choose low

b. Define Nash equilibrium. What is the Nash equilibrium for trade policy?

Nash equilibrium is the strategy set/ combination when both players choose their best position. In this case, the nash equilibrium is the box low,low . We know this because there are two highlighted outcomes

c. In 1993, the U.S. Congress ratified the North American Free Trade Agreement, in which the United States and Mexico agreed to reduce trade barriers simultaneously. Do the perceived payoffs shown here justify this approach to trade policy? Explain.

Yes, they do. In this case, we see that if both produce low, both countries will earn a higher outcome than both choosing high. If one trys to cheat, the other will also cheat and the result will always be low,low

d. Based on your understanding of the gains from trade (discussed in Chapters 3 and 9), do you think that these payoffs actually reflect a nation's welfare under the four possible outcomes?

This does, acurately portray gains from trade. If both collude and price high, they will earn 20, if one decides to cheat, they essentially steal the other firms profit, and if both price low, they will both recieve a higher paypout because of the higher demand of quantity.

Hope this helps