ESSA

ESSA

Why Free Trade?


David Hurley

By

October 1st, 2015


A Game theory analysis of the Trans-Pacific Partnership.

This article first appeared in Short Supply 2015 – check out the full magazine via the Short Supply tab at the top of this page!


“Every time one person freely trades with another, wealth increases”—that is, if you believe former Prime Minister Tony Abbott. [1] Somewhat surprisingly, Tony Abbott is correct—it is generally accepted that removing barriers to trade is beneficial. Given that free trade is hailed for its ability to improve living standards, decrease prices, and add variety to available goods, why haven’t barriers to trade been eradicated everywhere? The answer (somewhat tautologically) is that there haven’t been enough free-trade agreements. Perhaps a better question is why we need free-trade agreements at all. The agreements are necessary due to the ‘Prisoner’s dilemma’ of trade—more on this later. For now, let’s examine the most recent answer to the problem—the Trans-Pacific Partnership (TPP).

The TPP is the most ambitious and controversial multilateral free trade agreement of the 21st century. The proposal involves over 10 countries and 40% of global GDP. [2] Free trade agreements such as the TPP seek to remove barriers to trade between countries. The barriers can be thought of as ‘transaction costs’ of external trade, and range from tariffs to quotas to domestic subsidies. The TPP seeks to incorporate the US, Australia, Japan, Chile and other major trading partners into one big market. The agreement can be viewed as a new paradigm in Australian trade—it seeks to eliminate the barriers which have made exchange difficult for Australian exporters and importers. In many respects the TPP represents the future of trade in Australia.

The benefits of the comprehensive proposal can be shown using a simple model of strategic interaction known as ‘game theory.’ Game theory is a staple of economic analysis. It typically maps the strategies of two ‘players’ (firms, countries, consumers etc.), and expresses the relative outcomes (benefits) of pursuing certain strategies. To simplify matters, I will illustrate a basic model of outcome and strategy to show the possible outcomes from employing ‘high’ or ‘low’ barriers to trade. Assuming a country has a choice between high and low barriers to trade:

In order to understand the workings of the game, we must first establish the assumptions of the model. I have assumed that when the strategy is high/low (i.e. one country employs high barriers to trade and the other employs low barriers), one country will lose out (by paying out only 1) and the other will gain massively (by paying out 12). The rationale is straightforward; the high barriers in one country will allow their domestic producers to be insulated from external competition from country two. On the other hand, the exporters from the country with high barriers to entry will be able to compete with those from the country with low barriers to entry. Hence the domestic firms in the low barriers country are exposed to competition, and may be forced out of business. In this situation, the country which retains the high barriers to trade is a clear winner (in terms of overall production).

The payoff in the top right hand corner is (5,5)—each country benefits the same amount by employing ‘high barriers.’ The outcome of both playing ‘high barriers’ is lower on aggregate, compared to both playing ‘low barriers.’ The bottom right payoff is intended to model a situation where there are no barriers to trade. Both countries will receive better outcomes if they remove their barriers to trade, primarily due to the effects of ‘comparative advantage.’ By specialising in a good in which they have comparative advantage, a country is able to produce more efficiently and trade with other countries.

Overall, between the countries, production levels will increase and welfare will improve on aggregate. By reducing barriers to trade, each state will expose its import-competing firms to external competition. Consequently, domestic firms will be forced to improve productivity, or risk being undercut. Hence consumers in both countries benefit from this arrangement via lower prices and a wider range of goods available. In short, the ‘low barriers/low barriers’ situation is the most beneficial for each country overall (though some individuals/firms will be disadvantaged).

It seems as though the game is settled by each playing ‘low barriers,’ since this benefits everyone the most. But

the most likely equilibrium without intervention is the payoff in the top right corner (5,5). Herein lies the ‘dilemma’ of trade—all parties would benefit from the Pareto-optimal equilibrium, but the stable equilibrium involves both countries erecting high barriers. However unpopular or controversial, the fact remains that agreements like the TPP solve the dilemma of free trade.

The outcome of a game of this kind was first modelled by the late John Nash. Nash was a prominent American economist whose game theory thesis earned him a Nobel prize in 1994; he is regularly described as one of the greatest mathematical minds of the 20th century. [3] He described the equilibrium arrived at when both players play dominant strategy, which became known as the ‘Nash equilibrium.’ The dominant strategy is defined as choosing the option which will maximize the minimum payout. In this example, by exercising the ‘high barriers’ strategy, both countries will be guaranteed a payout of at least 5. If they were to choose ‘low barriers,’ each would risk being paid out only 1. If both countries initially agreed to play ‘low barriers,’ for instance, then the game would quickly revert to the Nash equilibrium. At ‘low barriers/low barriers’ one country can benefit by playing ‘high barriers’—they can gain a payout of 12 instead of 10. But since both countries know this, they will both try to play ‘high barriers’ and end up at the top right hand outcome, where neither can defect to gain a higher payout. Hence the inevitable result of the game is that each will choose to enact ‘high barriers’ to trade.

Here we come back to the Trans-Pacific Partnership. The purpose of the arrangement is to arrive at something like this bottom-right corner outcome. If there is a binding agreement for each player to set ‘low barriers’ to trade, then the outcome is set at (10, 10). As neither player has the choice to enact ‘high barriers,’ everyone in the game is assured that defection will not occur. Subsequently the Pareto-optimal (i.e. most efficient) outcome is reached. Hence, the purpose of the TPP is to remove the option for countries to ‘cheat.’ Thus, despite its controversial and polarising nature, the agreement is essential to achieving the most efficient outcome.

From the above we can see the paradox of trade—all countries benefit from free trade, but the rational strategy is to maintain high barriers to trade. Hence, former Prime Minister Abbott is accurate when he emphasises the benefits of trade. Here we can see why agreements like the TPP are crucial if Australia is to remain a prosperous country in the long term.

 

David is a third year Arts and Economics student who is particularly concerned with the political economy. He initially became interested economics due to the 2008 Global Financial Crisis.

 

[1] Abbott, T. (2015, January 23). This Year’s G20: Getting the Fundamentals Right. Address to the World Economic Forum. Davos, Switzerland.

[2] Kotschwar, B and Schott, J. (Spring 2013). The Next Big Thing? The Trans-American Partnership & Latin America. Americas Quarterly. Retrieved from: http://www.americasquarterly.org

[3] Goode, E. (May 24 2015). John F. Nash Jr., Math Genius Defined by ‘A Beautiful Mind,’ Dies at 86. The New York Times. Viewed 31 August 2015. Retrieved from: http://www.nytimes.com

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

Founding sponsors

 

 

Partner

Gold sponsors

 

 

Silver sponsors

 

 

 

 


Affiliates